Musings From the Oil Patch – October 2, 2006

• Chavez’s Devil May Have the Upper Hand
• Energy – The Popular Girl at the Dance
• El Nino, Winter Weather and Global Warming
• Putting Numbers into Perspective
• Good News from U.S. Drilling Effort
• The Dreaded Gas Shut-in
• The United States as a Third World Country
• Highlighting O&G Industry Challenges and Successes
• Mr. Putin, We Need Your Help
• Northeast LNG Remains Under Attack

Note: Musings from the Oil Patch reflects an eclectic collection of stories and analyses dealing with issues and developments within the energy industry that I feel have potentially significant implications for executives operating oilfield service companies.  The newsletter currently anticipates a semi-monthly publishing schedule, but periodically the event and news flow may dictate a more frequent schedule. As always, I welcome your comments and observations. Allen Brooks

Chavez’s Devil May Have the Upper Hand

 

Two weeks ago during the opening of the United Nations annual session, a number of foreign leaders stepped to the podium to discuss world issues.  One of those speakers was Venezuelan President Hugo Chavez who followed the presidents of the United States and Iran by a day.  Mr. Chavez’s speech was a classic anti-U.S. tirade presented by a passionate speaker and in front of a supportive audience.  Mr. Chavez’s speech rivaled past speeches at the UN by world leaders such as Cuba’s Fidel Castro and the Soviet Union’s Nikita Khrushchev. 

 

Mr. Chavez, who has been campaigning among third world and non-aligned countries for support in his effort to secure a two-year term on the UN’s Security Council, called U.S. President George W. Bush “the devil” and chided his listeners that they needed to exorcize him.  While flush with cash from $70 per barrel oil and buoyed by his economic power over western energy and mining companies operating in his country, Mr. Chavez is auditioning to become the world leader for the socialist movement.  Strong cash flow from its oil output has enabled Venezuela to build a currency reserve account pushing $35 billion.  However, Venezuelan social spending has tripled over the past three years as Mr. Chavez is spending money as if the good times will go on forever.  This increased social spending is designed to build and sustain his political power in Venezuela and to support similar-mined leaders in their efforts in other South American countries to promote socialist agendas.  The problem is that under Mr. Chavez’s leadership, the Venezuelan economy is being rotted out from the inside.  Falling oil prices, coupled with diminishing production could be this leader’s undoing. 

 

Mr. Chavez’s UN presentation has become a stimulus for Americans to seek how to diminish his role.  On September 27, just a few days after Mr. Chavez’s speech, convenience store operator 7-Eleven Inc. announced it was not renewing a 20-year gasoline supply contract with Venezuelan-owned refiner/retailer CITGO.   Consumers at 7-Eleven’s 2,100 U.S. locations that sell CITGO gasoline will probably not notice much change, other than the removal of CITGO signs.  CITGO, on the other hand, may be forced to sell some of its output into the spot gasoline market here until it is able to dispose of its refineries and exit the U.S. petroleum market altogether, which appears to be Mr. Chavez’s strategy.  Spot gasoline sales may not be as lucrative for CITGO as its long-term contract with 7-Eleven.

 

CITGO indicated that the contract cancellation was negotiated two months ago at the time of the sale of its interest in a joint-venture refinery in Houston.  It had offered to supply gasoline to 7-Eleven’s stores in Texas and Florida but not in other states.  This would better match CITGO’s output.  CITGO claimed the contract cancellation announcement was being used for political purposes, and one has to think that is true, but most would call it marketing.  If the public is enraged about Mr. Chavez’s derogatory rhetoric, some might switch their purchases to 7-Eleven stores because of the perception the chain was making a pro-American statement. 

 

North of the 48th parallel border of the U.S. lies a huge deposit of oil sands that Canadian energy companies are rushing to develop.  From a miniscule amount of production merely a few years ago, Canada’s oil sands production has climbed to a million barrels per day (b/d).  With the industry planning to invest C$36 billion over the next ten years, production should easily double.  Plans suggest a possible quadrupling of production to four million b/d by 2020 if all new mines are constructed.  For that target to be reached, the Canadian oil industry will need to build both gas pipelines to bring fuel to fire processing plants and oil export pipelines.

 

Exhibit 1.  A Direct Route to Texas Saves Time and Money

Source: Altex Energy

 

 

Altex Energy, a new Calgary pipeline firm, is seeking support to build a pipeline direct from Alberta to Texas, bypassing current transportation bottlenecks in Oklahoma and the Midwest.  Altex suggests that the direct route could cut transportation time by between one-third and one-half, allowing producers to sell their crude more quickly.  The direct route will get Alberta oil sands production to Gulf Coast refineries that are configured to process heavy crude oils, including supplies from Venezuela.  Altex is also developing a new dilutent that it plans to use to move the bitumen to market and potentially slashing transportation costs further. 

 

Besides Altex’s new pipeline, other pipeline projects are being planned or implemented.  These include TransCanada’s (TRP-NYSE) new Keystone pipeline project and a reversal of the flow of an Enbridge (ENB-NYSE) oil line running between Oklahoma and Chicago.  As the North American oil pipeline infrastructure is expanded and revamped, the ability to move increased oil sands output to U.S. refineries will grow.  Growing Canadian heavy oil supplies will enable U.S. refiners to forego Venezuelan oil.  So while Mr. Chavez is calling President Bush the devil, U.S. oil professionals, who consider the president one of them, are working hard to undermine Venezuela’s future North American oil market opportunities.  What we know is that Venezuela’s alternative oil market opportunities will not be as profitable as its current U.S. market.  The devil may yet get his revenge.

 

Exhibit 2.  Keystone Represents Another Pipeline Expansion

Source: TransCanada

 

 

 

 

Energy – The Popular Girl at the Dance

 

Do you want to know why energy stocks and commodities have done so well over the past few years, and so terribly these past few months?  The following data points were made by Chris Mayer of The Daily Reckoning in an email.

 

“Exhibit A: There are now 68 commodity-oriented hedge funds. There were only 29 three years ago.

 

“Exhibit B: There are now 48 mutual funds specializing in commodities – and they hold $56 billion in assets. This compares with only 34 funds and $10 billion in assets only three years ago.

 

“And none of this includes money invested in commodities by funds not specializing in commodities.”

 

El Niño, Winter Weather and Global Warming

 

The early prognoses for this winter’s weather have been announced and they suggest the Northeast and Midwest will start with mild temperatures but experience increasingly colder weather as the season progresses.  Overall, the West is expecting a warmer than normal winter.  The Southeast should be about normal with wetter than normal precipitation.  The primary driver behind these forecasts is the formation of El Niño in the Pacific Ocean late this summer, which also altered this year’s hurricane season, making it significantly less active and destructive from initial forecasts.

 

Exhibit 3.  Warm Waters Signal El Niño

Source: NASA

 

El Niño means little boy in Spanish and refers to the birth of Jesus.  The name reflects the fact that the effects of the weather pattern usually reach a peak around Christmas.  The cyclical warming in the Pacific Ocean rearranges the atmospheric circulation pattern.  There is an increase in winds that shear off the tops of thunderstorms before they have a chance to spin up and become a tropical storm.  As a result, when El Niño forms in the Pacific, places such as Malaysia, Indonesia and the Philippines experience drier conditions.

 

 

Exhibit 4.  How El Niño Differs From Normal

                 Normal Non-El Niño Conditions

                        El Niño Conditions

Source: NASA

 

The formation of El Niño shifts the jet stream’s path over the Northern Hemisphere and affects the temperature and weather patterns over the United States.  This shift, which began late this summer, partially explains the impact El Niño had on limiting the formation of hurricanes in the Atlantic basin during the summer.  This weather pattern shift should also lead to a more active southern jet stream this winter.  As a result, the northern United States, much of the West, the Great Lakes and parts of New England should experience warmer than normal temperatures as winter begins, but these temperatures should drop as the season progresses. 

 

Greater amounts of precipitation should fall throughout the Southeast and this precipitation will gradually work its way up the East Coast.  What is unknown at the present time is whether the precipitation in the East will materialize as rain or snow.  The rain or snow issue will be determined by the timing of the arrival of cold air from Canada.  While forecasters are uncertain about the rain or snow issue, they are fairly confident that the Northeast will experience several Nor’easters, or the winter’s equivalent of hurricanes.  Nor’easters can be almost as devastating as hurricanes.

 

A large high pressure area should dominate the West this winter, which will make the region warmer and less wet, except for the West Coast that will be more susceptible to coastal storms.  Thus, the West likely will have less snow than normal hurting the seasonal ski industry, but its greater impact will be on the amount of hydroelectric power that will be generated due to lower water levels and the reduction in water supplies that could hurt farming and ranching and residential development.  Overall, these early weather forecasts suggest that winter temperatures generally will be about normal, moderating the stress on energy markets, other than for brief periods of time. 

 

On top of forecasts for a close-to-normal winter, energy markets are being roiled by the ongoing global warming battle that continues to escalate.  The latest global warming research was published in the Proceedings of the National Academy of Sciences by lead author Dr. James Hansen, head of the National Aeronautics and Space Administration’s Goddard Institute for Space Studies, along with colleagues from the Columbia University Earth Institute in New York and the University of California at Santa Barbara. 

 

The paper focuses on the rising trend in the Earth’s temperature.  According to the study, the world has warmed at a faster rate per decade since 1975 than in previous decades.  The global mean temperature is now within one degree Celsius (1.8 degrees Fahrenheit) of the maximum mean temperature of the past million years.  At the recent rate of increase of about 0.2 degrees Celsius (0.36 degrees Fahrenheit) per decade, that historic peak temperature could be reached in 50 years.

 

The rhetoric of this global warming debate continues to escalate.  According to the authors of the paper, the warming of one degree Celsius could create much higher sea levels and make extinct some species and these changes could become difficult to manage.  As measured as this conclusion is, the quote from Dr. Hansen in The Wall Street Journal article discussing the study is not.  He told the WSJ, “If further global warming reaches two or three degrees Celsius, we will likely see changes that make Earth a very different planet from the one we know.  The last time it was that warm was in the middle Pliocene, about three million years ago, when sea levels were estimated to have been 25 meters (80 feet) higher than today.” 

 

Dr. Hansen’s statement makes for good scare tactics in the ideological war over global warming, but he ignores the natural pattern of cyclical weather and temperature adjustments at work.  Recently, we saw two stories about the issue of ocean currents and their possible relationship to a new global ice age (believe it or not).  An upcoming paper being published in Science by researchers from the Marine Biological Laboratory in Woods Hole, Massachusetts calculates that the timing for the switch from global warming to global cooling may occur sooner than originally thought. 

 

The theory for an earlier than expected switch focuses on the flow of cold, salty water in the North Atlantic and Arctic Oceans and the impact of lake-effect snow.  Warm waters from the Gulf Stream go past Norway and into the Arctic Ocean and melt the ice there.  However, this does not raise sea levels since the floating ice is already part of the ocean.  As the ice melts, it cools the water and the cold water sinks, where it is picked up by a massive deep-ocean current that flows south and then east.  To replace all the sinking water, more warm surface water from the tropics is drawn up.  That flow further warms the Arctic Ocean melting more ice.  But as more ice melts it dilutes the ocean water and makes it less salty.  As the water’s salinity drops, it reaches a point where the cold water stops sinking.  At that point the thermal conveyor belt stops. 

 

At some point, as the Arctic ice fields retreat due to the increase in warm surface water, the large open ocean area creates the Mother of All Lake Snow Effects, similar to the winter storms that hit upstate New York as very cold Canadian air mixes with moist air over the Great Lakes.  This lake snow effect dumps heavy snow over Greenland, Iceland, Lapland and the Arctic shores of Russia, Alaska and Canada.  Eventually the snow piles up so deep that even the following summer doesn’t melt it all.  Piled-up snow compacts under its own weight and forms glaciers. 

 

White snow reflects sunlight back into space.  Eventually the solar energy reflected by the increasing snow cover becomes greater than the energy gain from solar heating of atmospheric carbon dioxide and methane.  When that crossover occurs, the next ice age begins.

 

According to the researchers at Woods Hole, the rising precipitation and melting ice are flushing enough fresh water into the Arctic Ocean that the switch between global warming and global cooling may be flipped by 2100, well ahead of earlier thoughts about the likely timeframe.  It is this type of cyclical adjustment that Mother Nature makes that can reduce or eliminate Dr. Hansen’s fears. 

 

While climatologists and politicians believe that we must make significant lifestyle changes to avoid the potential problems of global warming, the critics believe that the natural weather cycle will correct the problem and that to engage in the lifestyle changes needed to modify the weather will be too costly both economically and socially.  At the end of the day, the issue should probably be viewed in the context of insurance.  What risk are we trying to insure?  How great is that risk?  What are the potential consequences of the risk?  And what is the cost of trying to insure against this risk? 

 

Putting Numbers into Perspective

 

The Texas Alliance of Energy Producers held its Houston Legends Luncheon last week where it honored two giants of the E&P industry – Roy Huffington and George Mitchell.  In our career we had the opportunity to follow the fortunes of these two visionaries and to have interacted with each.  In his comments at the lunch, Roy Huffington talked about several seminal events from his storied career.  The story that really caught our attention was his discussion of working at the Humble Oil & Refining Company, the forerunner of the Exxon Mobil Corporation (XOM-NYSE). 

 

Mr. Huffington went to work for Humble in 1946 as a geologist following a distinguished and decorated three-year war service.  He stayed with Humble until 1956, when he left to start finding oil for himself.  As he related the story, the cost of wells was rising and he worried about whether he would be able to find multi-well prospects for a quarter of a million dollars or less that would interest other oil companies or independent operators to invest in.  At that time, he said, a $400,000 well required the approval by the board of directors of Humble, so $250,000 multi-well prospects was his only hope of building an independent oil company.

 

Mr. Huffington also related that as he was preparing to go out on his own, he saved up about $19,000.  He figured with that money he and his family could live for about three years while he tried to find some oil and gas.  He contrasted his resources with the compensation of Morgan Davis, the chairman of Humble, who then was earning $82,000 per year for running the world’s largest oil company. 

 

When you consider these numbers against those of today’s industry, and the compensation of ExxonMobil’s chiefs, plus reflect on the challenges and successes Mr. Huffington, and other wildcatters such as George Mitchell, had, you develop a greater appreciation for what it took to create today’s oil and gas industry.  Our hats go off to those petroleum industry visionaries who have gone before us and helped create this monumental global business that is often derided and ridiculed by its primary beneficiaries – consumers.

 

Good News from U.S. Drilling Effort

 

The Energy Information Administration (EIA) published its Advanced Summary: U.S. Crude Oil, Natural Gas, and Natural Gas Liquids Reserves 2005 Annual Report last week.  The news was positive as the increased drilling effort in 2005 resulted in increases in all three categories of reserves: crude oil, natural gas and natural gas liquids.  The disappointment aspect of the positive news could be that the reserve increases were not greater.

 

According to the EIA, natural gas reserve additions of 11.9 Trillion cubic feet (Tcf) replaced 164 % of 2005 dry gas production.  The natural gas reserve increase marked the seventh year in a row and the largest annual increase in proved reserves since 1970, some 35 years earlier.  Boosting the performance of reserve additions versus production was the 3.7% drop in 2005’s natural gas production.  Had 2005’s gas production held steady with 2004, the reserve additions would have only replaced 158% of production.

 

Total natural gas reserve additions attributed to new well drilling were 23,200 Billion cubic feet (Bcf), of which just over 90% came from extensions to existing gas fields.  The volume of gas reserves attributed to new field discoveries was up 24% from 2004, but was 46% less than the prior 10-year average of new field discovery additions.  The net result is that the industry is working harder within existing fields to maximize gas reserves, but it is lagging in finding completely new gas fields.

 

Reserve additions of crude oil replaced 122% of 2005 oil production.  Total discoveries of crude oil were 34% more than found in 2004, but 7% less than the prior 10-year average.  New field discoveries were 19.5% of total discoveries with almost all of that coming from discoveries in the federal waters of the Gulf of Mexico.  Crude oil reserve additions attributed to drilling in the Gulf of Mexico were six times greater than new field discoveries in 2004, but only 49% of the prior 10-year average.  Producers found an additional 805 million barrels of reserves through extensions of fields, 30% more than in 2004 and 53% more than the prior 10-year average.

 

At the end of 2004, the Baker Hughes drilling rig count stood at 1,243.  By the end of 2005, it had increased by 228 rigs, an 18.3% increase.  It appears from the 2005 reserve addition figures compared to 2004 that the stepped up drilling effort in the U.S. is beginning to pay off.  Experiencing greater reserve additions is not surprising given the high level of oil and gas prices.  The troubling aspect of the reserve additions report, however, is the lagging performance compared to the prior 10-year trend.  This may be signaling that producers are prospect limited.  Hopefully it is only a timing issue that will be solved by the recently stepped up seismic data gathering efforts undertaken by the industry.  It will take us at least two years to know whether that is the answer to the question.

 

The Dreaded Gas Shut-in

 

Chesapeake Energy Corp. (CHK-NYSE) announced last week that due to low gas prices it has decided to shut in some 100 million cubic feet per day (Mmcf/d) of net natural gas production (125-150 Mmcf/d of gross).  The gas to be shut in is being produced in various areas throughout the southwestern United States and represents gas that is un-hedged by Chesapeake.  The shut-in gas represents about 6% of the company’s net oil and natural gas production.  Chesapeake has been quite aggressive in hedging production in 2006 and has substantial production volumes hedged for 2007 (80% at $9.92 per mmbtu) and 2008 (60% at $9.44 per mmbtu) at attractive prices. 

 

Aubrey McClendon, Chesapeake’s CEO commented, “…we believe today’s low natural gas prices have more to do with temporarily high natural gas storage inventories largely caused by last winter’s abnormally warm weather and less to do with any return to a structural oversupply of natural gas…”  In a Musings item late last spring, we had hypothesized that the industry would see some gas volumes shut in unless there was a disruption to offshore production caused by a hurricane.  Since the weather this summer has been benign – both on the storm front and temperatures in the populous Northeast and Midwest regions – gas storage volumes have soared to levels well above recent highs.  As a result, natural gas futures prices that were over $11 per Mcf at the end of 2005 dipped as low as $4.20 for the October contract last week as it reached its expiration date.  The November contract ended the week at $5.68. 

 

Chesapeake is the only company that has formally announced it is shutting in production.  Most of the larger independent producers hedged substantial amounts of their gas production so they are not concerned about the current low prices.  Some of them have acknowledged that if prices remain weak, they may have to re-examine that strategy.  Everyone is convinced that come Nov. 1, natural gas prices will strengthen due to the seasonal demand pickup. 

 

Since producers are focused on stronger natural gas demand in 2007 and continued declines in well productivity, the rig count so far has not suffered materially due to the decline in gas prices.  The U.S. rig count had climbed steadily from 1,464 at the start of the year to its recent peak of 1,762 in mid August.  Last week the rig count stood at 1,744, some 18 rigs below the peak of seven weeks ago.  That drop represents just over a one percent retrenchment.  The year-over-year gain for the rig count is 17.6%.

 

Based on the comments from participants at the International Association of Contract Drillers (IADC) conference in San Antonio two weeks ago, drilling activity shortly will begin to resume the upward trend established throughout the pre-summer period.  Contractors continue to look toward a higher rig count in 2007. 

 

Exhibit 5.  Canadian Rig Count Suffers From Low Gas Prices

Source: BHI, PPHB

 

The $64-dollar question is what happens to drilling activity later this year and early in 2007 if natural gas markets remain depressed, oil prices weaken further and operator cash flows become constrained.  Looking at Canada may provide some perspective.  The Canadian rig count is almost 35% below where it was at the same time last year, as it has plummeted in the past couple of weeks.  Since August, this year’s Canadian rig count has lagged 2005’s count as certain operators this summer elected to cut back their exploration and development budgets due to weak natural gas prices.  As operators prepare their spending plans for 2007, we are hearing of potential further budget cuts from this year’s spending rate.  An interesting development is that seismic contractors are telling us that they are having a more difficult time securing commitments for new seismic programs for this winter and that seismic data library sales are slower than anticipated.  These trends often are precursors of an industry spending pause that will produce an activity slowdown.  For those contractors convinced about a strong 2007, we caution them about looking at the horizon and stepping in a pothole. 

 

The United States as a Third World Country

 

As the U.S. Congress tries to wrap up its business prior to taking a pre-election campaign break, the effort of getting a successful oil and gas drilling bill passed is being torpedoed by a desire to extort past royalties from oil companies who purchased Gulf of Mexico leases in 1998 and 1999 that failed to contain appropriate royalty relief clauses in the contracts.  The issue caused considerable consternation on Capitol Hill when it was revealed that the absence of the royalty clause is costing the federal government $1.3 billion.

 

When oil prices were low in the 1998-1999 time period the federal government offered relief for federal royalties on crude oil and natural gas production from Gulf of Mexico leases contracted by oil companies.  The royalty relief clause had been a part of Gulf of Mexico leases since the passage of the Deep Water Royalty Relief Act of 1995, which was designed to encourage oil companies to continue to explore and develop oil and gas resources despite low prices.  The royalty relief was available for specified volumes of production produced in certain water depths.  The relief was available for oil production priced below a certain price threshold.  For leases offered at area-wide lease sales during the two years in question, someone in the Interior Department failed to include the royalty relief clause in the lease contracts.  A recently concluded Congressional investigation of the source of the contract lapse proved inconclusive when it was discovered that the most knowledgeable source of the omission had died.

 

Two weeks ago, Minerals Management Service Director Johnnie Burton announced that the department opted to forgo trying to collect on these back royalty payments in favor of negotiating new agreements with the lease holders for collecting royalties on all future production.  Two Republicans, Rep. Tom Davis, R-Va., and Rep. Darrell Issa, R-Calif., wrote a blistering letter to Interior Secretary Dirk Kempthorne following Director Burton’s announcement.  The representatives wrote, “That money belongs to the federal government and must be collected just as any other benefit unduly conferred upon a private citizen.”  Unfortunately, these congressional leaders seem to miss the concept of a contract and its sanctity.  If our government follows the congressmen’s logic, the U.S. will join a small, but growing list of countries that show little regard for honoring contract terms. 

 

There have been proposals that the oil company holders of these royalty free leases not be allowed to bid on future Gulf of Mexico leases unless they agree to repay the missing royalties.  This is a form of blackmail.  It seems that the efforts of the government and the oil companies to negotiate reasonable settlements of this issue should be allowed to move forward.  However, based on our reading of U.S. history, government blackmail of corporations to make up for past failed government policies has been done before. 

 

I will give you two examples of what I consider forms of government blackmail.  During World War II, the federal government mandated the use of asbestos in ships because it was the best fire retardant available.  Expansion of the use of asbestos in commercial construction was also encouraged by the government, again for the safety aspect.  However, when the health dangers of asbestos were discovered, no company responding to government regulations and mandates was offered protection against the prior use of asbestos. 

 

The second example was in the 1950s when several companies manufacturing postage meters used faulty lock designs that broke, allowing unlimited postage to be obtained, and effectively stealing from the U.S. government.  Pitney-Bowes (PBI-NYSE), the leading postage meter manufacturer was asked by the U.S. Post Office to buy the manufacturers with the failed postage meter designs and remove them from the market.  In the early 1960s, when Singer, the only remaining postage meter manufacturer, exited the business, the federal government then turned around and sued Pitney-Bowes for antitrust behavior.  Rather than go to court, Pitney-Bowes paid a fine and agreed to make postage meter designs available to new competitors.

 

While the oil industry is right to demand execution of their contracts with the government, they will eventually have to yield.  They need to recognize that they are being blackmailed, but public sentiment is not behind them given the level of crude oil and gasoline prices and industry profits.  We hope the federal government and the oil companies can negotiate a reasonable compromise while Congress is out of Washington.  If not, the oil industry should look out when Congress returns after the election. 

 

Highlighting O&G Industry Challenges and Successes

 

The John S. Herold energy research firm and the upstream corporate advisor Harrison Lovegrove & Co. issued their collaborative analysis of the 2005 financial and physical performance of a universe of 209 global oil & gas firms.  The study confirmed what most expected that 2005 was a good year for the industry.  However, buried in the numbers and the analysis are signs of a struggling and challenged industry that could quickly translate into a reversal of fortunes should oil and gas prices fall substantially.

 

The study showed that upstream investment of global energy companies climbed to $277 billion in 2005, a 31% increase from 2004.  Net income for this universe of companies crossed the $200 billion threshold, reflecting a 44% year-over-year increase.  Art Smith, the CEO of John S. Herold summed up the struggle of the industry when he stated, “Despite a 32% rise in wellhead petroleum prices, margins inched up only slightly to 29% and the industry continued to labor to grow production and reserves.”  The challenge for the industry was highlighted by Harrison Lovegrove Chief Executive Martin Lovegrove who noted, “Facing the challenge [of] diminished material investment opportunities and abundant cash flows, oil executives found a relief valve by accelerating the level of funds returned to shareholders.”

 

The inability to significantly boost reserves and increase production despite huge capital investment programs, and facing steeply rising oilfield costs, has put pressure on operators.  The recent retreat in oil and gas prices has operators looking squarely at shrinking margins.  This scenario was alluded to by Art Smith when he opined, “the potential for stormy seas looms.” 

 

The health of the oil and gas industry remains, by any historic standard, extremely robust.  The problem is that the slopes of the income and cost lines are changing with the result that profit margins are being squeezed.  A modest contraction will be tolerated as long as petroleum company executives believe it will be modest and last for only a brief period.  Should either, or both, of these beliefs change for the worse, we would expect to see quick activity adjustments.  A management skill that petroleum executives have honed over the past several decades is the art of retrenching.  Understanding how and where within corporations to cut and scale back has not been forgotten, despite the last several years of boom-time conditions. 

 

Exhibit 6.  Development Consumes More of Capital Investment

Source: Herold-Lovegrove, PPHB

 

Some of the key points of the Herold/Lovegrove study were that the 37% increase in worldwide revenues to $699 billion implied an average realization of $37.10 per barrel of oil equivalent (boe) production, up 32% from 2004.  For the fifth consecutive year, industry capital investment fell below cash flow.  In 2005, despite a 31% increase in capital investment, cash flow grew 32% and provided a cushion over investment of $45 billion.

 

Exhibit 7.  F&D Costs Jumped Last Year

Source: Herold-Lovegrove, PPHB

 

The reserve replacement rate continues to decline, falling to 143% from 177% in 2000, as the reserve replacement cost climbed to $10.27/boe, up 73%.  Finding and development cost increased 26% to $11.26/boe, while pure finding cost jumped 51% to $4.08/boe.  Lifting cost climbed to $10.69/boe for a 35% gain, and host governments took 53% more of the upstream dollar in the form of income taxes.  Despite the higher costs, the industry’s net income rose by 40% to $11.15/boe, which compares against a three-year average of $8.54/boe.

 

As Martin Lovegrove pointed out in his discussion of the challenges facing the petroleum industry, finding attractive investment opportunities has been a problem.  Given the geopolitical tensions around the world and the newfound machismo of the petro-country leaders, attractive investment opportunities are diminishing rapidly.  Mr. Lovegrove pointed out that in the study they found that the industry distributed to shareholders $63 billion in the form of dividends and another $65 billion through share buybacks.  In contrast, last year the industry only spent $60 billion to seek new reserves through leasehold and exploration activities.  Which of these categories will suffer if cash flow and margins shrink?  Do you think the short-term returns to shareholders, or the long-term investments in building the company will suffer the most?  The answer you select may influence your personal and professional investment strategy.

 

 

Exhibit 8.  Development Costs Jumped the Most in 2005

Source: Herold-Lovegrove, PPHB

 

Mr. Putin, We Need Your Help

 

A new study published in Nature, claims to explain the mystery of the ending in the early 1990s of the long-term rise in the atmospheric concentration of methane.  Scientists and environmental groups were surprised and uncertain as to why, after a tripling of the amount of methane in the atmosphere over the prior 200 years, the increase ceased.  They thought it was due to successful efforts to stem the emissions of methane including sealing pipeline leaks and capturing methane from landfills. 

 

According to this new study, the leveling off in the rise of methane concentrations was probably due to a downturn in emissions from industry and most likely attributable to the collapse of the Soviet Union and its economy.  After 1999, methane concentrations appear to have started rising again, especially in China, but overall there has been a shift in the sources.  Manmade sources of methane have increased, but much of those gains have been offset by a reduction in methane from sources in nature.  Tropical droughts reduced methane released by bacteria in muddy wetlands. 

 

Methane is considered the second-most-important heat-trapping gas emitted by human activities after carbon dioxide.  Methane exists in the atmosphere as a trace of less than two parts per million, but has more than 20 times the heat-holding capacity of carbon dioxide. 

 

The authors of the study are concerned that if methane concentrations resume their pre-1990 growth rate, the impact on global warming could become significant.  The study was prepared by using a combination of measurements of regional variations in methane levels and computer simulations to determine that changes in specific sources were the most likely cause of the overall shift in concentrations.  This is where we get nervous.  Computer simulations are often only as good as the assumptions upon which they are constructed.  Those assumptions may be open to bias if the authors are trying to reach a specific solution.  Regardless, the issue of increasing methane concentrations needs to be examined.

 

Northeast LNG Remains Under Attack

 

It is acknowledged that the Northeast, from New York to Maine, will soon be short of energy if ways to secure more fuel supplies are not found soon.  From Eastern Canada down to the Long Island Sound, numerous new LNG import facilities have been proposed to supplement the existing Everett, Massachusetts LNG terminal.  So far, every proposed new LNG facility has been found wanting by the locals.  They all want the LNG terminals to be located somewhere else, and always as far away as possible. 

 

The battle over the new Weaver’s Cove LNG terminal in Fall River, Massachusetts recently took an interesting twist.  With the terminal moving forward into the permitting phase, Fall River City Council President William F. Whitty filed a resolution asking the council’s support for a measure that would call on local, state and federal officials to begin the process of taking the Weaver’s Cove site by eminent domain.  Mr. Whitty said that the owners of the Weaver’s Cove terminal have been successful in the regulatory phase making adjustments to the plan to meet objections and it is now time to act. 

 

Mr. Whitty believes Massachusetts and Rhode Island should be preparing line items in their budgets to help pay for the property.  “Take the land.  Stop the project.  End the fear,” said Mr. Whitty.  Fall River’s mayor, Edward Lambert, thinks this is the wrong strategy as he believes the city still has successful challenges to make.  Eminent domain attorneys have said that the courts will not look favorably upon a move made by the city after the owners of the land have already begun developing the property for the terminal.

 

Almost due south of Weaver’s Cove, Broadwater Energy’s proposed LNG terminal to be located in the middle of Long Island Sound received a critical review from the United States Coast Guard.  While the Coast Guard did not explicitly offer support or non-support for the terminal, it said the facility would create a significant need for more resources to ensure public safety. 

 

It has been fun to watch the battles over these LNG facilities.  We couldn’t imagine the lengths and depths of some of the challenges to their sittings.  But what may be more significant is the growing view by the objectors to these new LNG terminals that their states and region need to “get off the dime” and formulate an effective energy conservation and development plan that includes alternative energy sources.  Our sense is that we are reaching a tipping point on energy policy, a topic we will deal with in the next issue of Musings From the Oil Patch.

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Parks Paton Hoepfl & Brown is an independent investment banking firm providing financial advisory services, including merger and acquisition and capital raising assistance, exclusively to clients in the energy service industry.