Musings from the Oil Patch – May 11, 2010

• Deepwater Horizon: Black Swan The Oil Industry Never Saw
• Henry Groppi’s Radical Gas Price Thought: Much Higher!
• Growing Gas Storage Fails To Slow Drilling
• High Gas Prices and Weak Economy Impact Miles Driven
• Car Industry: New Business Models Alter Transportation?
• Cape Wind Wins; Legal Fight Ahead; Wind Energy’s Future?
• Oil Companies Dominate World’s Leading Companies List

Musings From the Oil Patch
May 11, 2010

Allen Brooks
Managing Director

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

Exhibit 1.  Unforeseen Black Swan Produces Challenges

Source:  Transanima.blogspot.com

On April 20th, when an explosion and fire erupted on Transocean’s (RIG-NYSE) Deepwater Horizon semisubmersible rig drilling an exploratory well for BP plc (BP-NYSE) some 45 miles off the tip of Louisiana in 5,000 feet of water, the initial concern was for the 11 missing workers.  As the fire raged unchecked for hours, the prospect of safely finding the missing workers faded.  When the Deepwater Horizon sank two days later despite repeated assurances it would not, the focus shifted from the fate of the missing workers to concerns about the oil leaking from the well.  It was believed initially that the well had been totally shut-in as emergency procedures activated on the rig at the time of the explosion suggested the task had been accomplished.  The oil feeding the surface fire was assumed to be some of the 700,000 gallons of fuel onboard the sunken rig. 

It soon became evident that oil was leaking from the well.  A remotely operated vehicle (ROV) was deployed to activate the ram valve in the blowout preventer (BOP) stack to cut off the pipe in the well and stem the oil flow.  As time progressed, however, it became apparent the ram valve had not completely severed the pipe and that oil was still leaking from the well.  After ROV inspections and further attempts to stem the oil flow proved unsuccessful, environmental concerns about the leaking oil grew. 

Exhibit 2.  Deepwater Horizon’s Spectacular Fire

Source:  U.S. Coast Guard

At the time of the accident and sinking of the rig, we were attending the National Ocean Industries Association (NOIA) annual meeting in Washington, D.C.  At one session we were briefed by Coast Guard Admiral Thad Allen who was preparing to lead a late afternoon briefing that day for President Obama and other White House aides and government officials.  The news then was that the well had been secured and the fire was burning oil spilled by either the sunken rig or the leak in the well before its closure.  The audience and government officials were all breathing a sigh of relief and talking about how lucky the industry was. 

However, relief quickly turned to concern.  By Friday it became apparent that the well was continuing to leak oil, but the flow was estimated at only 1,000 barrels per day.  Many of us were frustrated hearing the media shift their reporting from barrels of oil to the much larger gallons of oil figure.  We were also frustrated hearing about Gulf of Mexico oil spill data, much of which comes from ships transporting petroleum to the United States.  The excellent safety record of the U.S. Gulf of Mexico offshore industry was dismissed by a torrent of news stories comparing the Deepwater Horizon accident to the Exxon Valdez tanker spill in Alaska’s Prince William Sound. 

Before long, the well’s leak increased from one distinct area to now three, but particularly disappointing was the failure of all the attempts to secure the wellbore by activating the BOP.  BP and its partner Anadarko Petroleum (APC-NYSE), along with other oil company deepwater drilling experts, began exploring alternative ways to shut off the well and minimize its environmental damage.  One idea was to fabricate a domed structure to be placed over the principle leak in an attempt to trap the oil and then pump it to the surface where it could be placed in a ship.  Unfortunately, the plan needed time, something in short supply.  BP secured two semisubmersible drilling rigs and mobilized them to drill relief wells even though they may take upwards of 60-90 days to reach the target.  There also are no assurances the initial relief wells will hit the target.  In fact, this technique was employed following a recent blowout in the Timor Sea off Australia, but it took four relief well attempts before being successful.

As the oil spill at the surface of the Gulf of Mexico has grown in size to upwards of 2,000 square miles – size of Delaware – the potential environmental and economic damage from it reaching the shores of Louisiana’s wet lands or the beaches of Mississippi, Alabama and the Florida Panhandle could be immense.  Miles of containment booms have been deployed and planes have spread chemical dispersants.  A controlled burn of some of the crude oil on the surface was tried, but a shift in winds ended that attempt.  Rain, wind and rough seas have hindered many of the efforts, but a recent wind shift helped hold the spill offshore.  Recent reports suggest oil did land on some of the offshore islands off Louisiana, but better weather has helped accelerate the clean-up effort.

Oceanographers have been studying the drifting spill along with the currents of the Gulf Stream.  Some of them have sounded warnings about the potential for the spill to travel to the Florida Keys and then around the tip of the state and up its east coast dramatically increasing the environmental and economic damage.  Talk about a possible public relations challenge for the oil industry.

Whether the spill lands on Florida’s east coast or not, the Deepwater Horizon accident is the black swan the petroleum industry was not contemplating.  It will change the future course of the offshore oil and gas industry just as the black swans of the Santa Barbara oil spill and the Exxon Valdez tanker spill did.  One might even toss in the black swan of the 1973 Arab oil embargo.  Each black swan changed the future course of the oil and gas industry in ways never contemplated.  What might be the outcome of this black swan?

On January 28, 1969, a blowout occurred on Union Oil’s “Platform A” in the Santa Barbara Channel.  Over the next 10 days, roughly 80,000-100,000 barrels of oil spilled out fouling the coasts of Southern California and the four channel islands.  The gooey oil claimed the lives of upwards of 10,000 birds.  The result of this blowout and another the following year in the Gulf of Mexico was a mandate that all offshore wells install a subsurface safety valve.  But the Santa Barbara black swan, coupled with the burning of pollutants in the Cuyahoga River in Cleveland, combined to produce the first Earth Day and the passage of President Nixon’s National Environmental Policy Act that created the EPA.  Other results included the moratorium prohibiting offshore drilling on the Atlantic and Pacific Coasts, new, tighter air quality rules and the Clean Water Act.  One would be hard pressed to ignore the impacts of the 1969 black swan on today’s energy industry, especially in light of the EPA’s recent endangerment ruling on CO2 and the move to regulate carbon emissions.

Twenty years later, the Exxon Valdez oil tanker ran aground in Alaska’s Prince William Sound spilling 11 million gallons of crude oil all along the coast of that inlet.  That black swan scuttled the plans of the first President Bush administration to open the Arctic National Wildlife Refuge for drilling.  It also brought changes in determining liability for environmental oil spill cleanups and was the first step in banning the use of single-hull oil tankers in U.S. waters, and now worldwide.  The spill also ended one CEO’s career and sparked another.  Criticism over the delayed response to the clean-up needs by Exxon was the first blow that eventually ended Larry Rawl’s tenure as Exxon’s CEO while propelling Lee Raymond into the chairman’s seat due to his successful efforts in getting the clean up accomplished and fighting the resulting litigation. 

Between these two black swans, we would toss in the black swan associated with the 1973-1974 Arab Oil Embargo.  When Arab oil producing countries shut off flows to those western countries including the United States that resupplied Israel following the Yom Kippur War, fear of economic distress grabbed the attention of the federal government.  Gasoline rationing, lowered highway speed limits, turning down thermostats, adding insulation to homes and mandating improved fuel efficiency for autos were only some of the policy actions.  The powers of the federal government over the energy industry were greatly expanded.  As an oil and oil service investment analyst at that time, we found ourselves spending more time in Washington than with our companies since that was where industry decisions were being made.  Companies could only respond to the pronouncements on new energy policies and directions; the oil companies had little impact on shaping the policy responses. 

Thinking about the impact of this black swan event, one is left with the belief that the natural bias of the current federal bureaucracy is to get involved in the energy business and dictate actions.  We were amused by a Wall Street oil analyst’s recent article based on a trip he made to Capitol Hill to talk to Republican and Democratic congressional staffers about the fallout from the oil spill.  His first claim was that there would be no drilling moratorium.  The ink was barely dry on the report when Interior Secretary Ken Salazar announced a suspension in granting new offshore drilling permits, at least until a report on the Deepwater Horizon accident is presented to the President on May 28th.  But what happens after that date?  How many offshore rigs will be forced to cease operations because of this permit freeze is unknown, but we venture a guess that there will be some.  That means drilling and supply vessel crews and oil service hands will likely be laid off until drilling permits begin to be awarded again.  So much about the concern for creating jobs.

Not long before the Deepwater Horizon accident, President Obama had backed the possible opening up of more U.S. waters to offshore drilling.  That move was designed to sway some wavering senators to vote for the senate energy and climate bill.  Media reports suggest there is little hope of getting this bill through Congress now, although the sponsors plan to introduce the legislation this week.  Emissions and climate change policies attacking the energy business will now rest in the hands of bureaucrats and that isn’t good for the industry. 

A media and congressional assault has just been launched on the Minerals Management Service (MMS) for being too cozy with the oil and gas industry and abdicating regulatory oversight to the companies, suggesting it will become a high profile target of reform.  Overhauling government bureaucracies and installing new people in charge is always disruptive.  So the oil and gas industry should probably anticipate longer waits for approvals, more nitpicking over operational details, and a push for greater redundancy in offshore equipment and services; all leading to increased costs for operating offshore.  This will come at the same time the federal government, in this new age of austerity, looks for additional sources of tax revenues.  The BIG oil companies are already targets for higher taxes, but the entire industry will pay a price.

The Deepwater Horizon spill has given rise to bureaucrats talking about “keeping the boot on the throat of BP” to pay for the clean-up effort and the environmental and economic costs.  We notice that there has been a recent recognition in the media of BP and Transocean being foreign corporations.  We haven’t seen anyone talk about Transocean having done a corporate inversion to exit the U.S.  Weren’t companies labeled “traitors” during that debate?  What about a traitor who is a party to creating what may be the greatest environmental disaster in U.S. history?  With an administration headed by a man who follows Saul Alinsky’s radical policy of making conflict with one’s political enemies personal, we could be on the cusp of an age of bitter criticism and vilification of the energy business.  Of course that would also be used to help boost the administration’s flagging “green energy” initiatives. 

With the recent approval of the wind farm off Cape Cod, the need to rush this project into construction will grow in light of the oil spill.  More offshore wind farms are in the hopper and we suspect they will be pushed by the government regardless of their economic cost. 

The effort to allow a higher percentage of ethanol in motor fuel is about to be finalized, even though tests show a large proportion of vehicle engines today could be damaged by the move. 

We remain convinced that the energy business still has many good days ahead, but we worry that the number of bad days may also grow.  We are on record as saying this decade may be more like the 1980s when the energy business suffered and energy stocks were shunned by investors following their outstanding performance during the 1970s.  We have just finished an outstanding decade for energy and energy investments.  If history does repeat, energy faces nine and two-thirds more years of tough sledding.  Fortunately, the energy business is populated with resilient people.  The industry will survive and thrive once again, but its near-term outlook suggests more turbulent days and periods of adverse publicity ahead.

We were inundated by copies of articles from the Canadian press about an interview with Henry Groppi, the 80-year old head of Texas petroleum reservoir firm Groppi Long & Littell, in which he argued that natural gas prices will more than double from current levels within the next 120 days.  Long known as an accurate seer of the petroleum industry, with a track record to support that claim, the initial reaction of many industry participants was: What is this man thinking?

His thesis is perfectly logical – the only question is does the timing make sense?  In Mr. Groppi’s view, swelling gas inventories are about to reverse at the same time new supplies – those gas shale plays everyone is so gaga over – are overstated.  In his view, the market, as reflected by $4 per Mcf spot prices, is totally wrong and we will see prices north of $8 per Mcf before the end of summer. 

Mr. Groppi points out that the average depletion rate in conventional gas wells is about 25% each year, while for gas shale wells it is 45% or more.  (Mr. Groppi may be generous in his estimate of gas shale well depletion rates as many wells are showing 80+% first year declines.)  In his view, the rapid pace of gas shale drilling is doing little more than draining those reserves much faster than they would otherwise.  He noted that gas shale production accounts for just 6% of U.S. natural gas production.  The other 94% – conventional gas – has experienced a 70% decline in drilling since immediately before the financial crisis dawned in September 2008.  He went on to say, “With that extraordinary drop in drilling, the decline rate from all these [conventional] sources is accelerating – and will much more than offset whatever increases you get in shale.” 

To get to Mr. Groppi’s $8 per Mcf target, supply will have to fall short of demand.  That is the threshold price at which he sees “demand destruction” beginning for natural gas, something he believes will need to occur to keep the supply-demand picture in balance. 

Eventually he expects gas prices to creep up toward $10 per Mcf as gas production slowly depletes.  Obviously Mr. Groppi doesn’t believe we need Boone Pickens’s compressed natural gas vehicle program as a part of our national energy program.  As for the revolutionary impact of gas shales changing the trajectory of North American natural gas supplies, he thinks the facts don’t support that view.  “When you take apart all the pieces from the bottom, there’s absolutely no way for that to take place.  We don’t think any of them have done a detailed dissection of what’s going on.” 

We were reminded of a time in the past when gas supplies were overwhelming demand and driving gas prices down to the $1 per Mcf level.  The Gulf of Mexico was declared to be the “Dead Sea” as low gas prices killed offshore drilling.  We dug out of our files a report presented by David Herasimchuk of Global Marine, a leading offshore drilling contractor, at the fall meeting of the National Association of Petroleum Investment Analysts (NAPIA) entitled “Has Technology Made the Gas Bubble Permanent?”  It seems the title of this report, presented nearly 15 years ago, may be appropriate today in regards to gas shales and their impact on the energy industry. 

Natural gas production continues to grow while demand remains stagnant.  As a result, the amount of natural gas flowing into storage continues to grow and generally at a faster pace than most commodity experts and petroleum analysts have been expecting.  The latest weekly storage injection of 83 billion cubic feet (Bcf) exceeded analyst estimates by 3 Bcf.  For the week ending April 30th, total gas in storage was 1.995 trillion cubic feet (Tcf), which was 5.1% ahead of the volume in storage at this time last year and 18.8% above the five-year average. 

As shown by the chart below, after falling back into the middle of the five-year average range of storage volumes beginning in January, storage volumes are now at or above the top end of the five-year range.  April is the start of the shoulder season for natural gas demand.  That means demand is low because winter is over and the air conditioning load from hot summer weather has yet to arrive.  Industrial and commercial gas demand remains weak as the economic recovery is advancing at a slower than desired pace.  But the bigger problem is the continued high level of gas-related drilling, especially in the gas shale basins. 

There are many pressures on oil and gas companies to drill their gas shale leases even in the face of weak natural gas prices.  The need to hold the leases for which many of the companies have spent large sums of money is one pressure.  Another is to use the money raised on Wall Street or through joint ventures and/or creative financing ventures.  Lastly, the companies have pledged to investors that they will grow their production volumes at above-industry growth rates.  As a result, when we examine the pattern of changes in rigs drilling

Exhibit 3.  Storage Volumes Swelling Faster Than Anticipated

Source:  EIA

for natural gas and rigs drilling horizontal wells compared to the trend in natural gas futures prices, we see why the industry seems reluctant to slow down its drilling.

Exhibit 4.  Gas Drilling Little Deterred By Low Gas Prices

Source:  Baker Hughes, EIA, PPHB

So far in 2010, there has been only one week in which the number of rigs drilling for natural gas fell.  The drop was 17 rigs, but the following week two of those rigs went back to work.  Admittedly there have been several weeks when the additions to gas-oriented drilling were only one or two rigs, but on balance there has been little slowdown in gas drilling despite low gas prices.  In fact, over the first four months of this year, there have been 199 additional gas-focused drilling rigs put to work, or a 26% increase in activity.

The science for successful gas shale development marries the technologies of horizontal drilling with multiple fracturing intervals in each well, all designed to maximize the amount of the formation exposed and crushed to release its trapped gas.  If we look at the change in horizontal rigs working we get a partial picture of what is happening in the gas shales, but the advent of increased horizontal drilling for crude oil has muddied the comparison.  As the chart below shows, there have been two weeks in 2010 with declines in the number of horizontal rigs working – one week with a five-rig decline and another with a one-rig drop.  Between the start of 2010 and the end of April, the horizontal rig count increased 194, or a 34% increase.

Exhibit 5.  Oil Price Hides Gas Price Horizontal Drilling Impact

Source:  Baker Hughes, EIA, PPHB

As long as natural gas producers believe their finding and development costs for gas shale reserves are below $4 per Mcf, the current futures price, they will continue to drill.  One begins to question whether E&P executives are addicted to drilling and will need an “intervention” by their shareholders in order to break their habit.

A recent opinion article in The New York Times Sunday Business section highlighted the pattern in miles driven by Americans over the past fifty years and considered recent changes in the pattern.  The data was presented in a chart, which is reproduced below.  The point of the article was to demonstrate how over this long time span Americans consistently drove more each year except for recessionary periods.  The question is whether the changes in miles driven per capita during the latest recession are signs of permanent adjustments in driving habits.  According to the writer, the high unemployment due to the economic turmoil has meant fewer people are driving and that the slump in consumer spending has reduced the amount of freight needed to be moved around the country. 

The decline in miles driven actually began in 2005 as gasoline prices soared, crossing the magical $2.50 per gallon threshold, and the decline continued beyond 2008 even though gasoline pump prices fell.  The most recent monthly data on total vehicle miles driven shows upticks but, when measured on a per capital basis, the improvement has been muted.  The important question now is whether the decline in per capita miles driven reflects permanent changes in American driving habits.

Exhibit 6.  Driving Habits Altered By Gas Prices and Jobs

Source:  The New York Times

If one examines the miles driven per capita chart, it becomes clear that both times in history − the late 1970s and early 1980s and again in the years following 2005 − when gasoline prices went above $2.50 per gallon, there was a reaction as Americans drove fewer miles.  In the early 1980s as the recession was beginning to moderate and gasoline prices fell, the number of miles Americans drove rose.  In the latest recession, the number of miles driven started falling several years before the official onset of the recession, suggesting that gasoline prices played a greater role in the decline than economic issues. 

How much of the fall in miles driven during the past several years is due to the recession and the loss of jobs?  What we know is that the unemployment rate didn’t begin to rise to its current very high levels until sometime during 2008.  That would suggest that the fall in miles driven per capita in 2005-2007 was due to gasoline prices and possibly other factors unrelated to the recession.  We suspect that high gasoline prices convinced more people to use mass transit, work at home through telecommunicating and shift to owning and using smaller, more fuel-efficient vehicles.  These factors, coupled with significantly slower growth among the teenager and early 20s driver category, may help to explain the decline in miles driven per capita as much as do higher gasoline prices.  Clearly, as unemployment rates rose and fewer people were driving to work, there was also an impact.  However, it seems to us that the recession may have had less to do with the drop in the per capita mileage trend than many suppose.

Exhibit 7.  Unemployment Soared In 2008 With Recession

Source:  Shadow Statistics

The author quotes a transportation economist at the University of California, Irvine who opines about the recessionary impact on driving habits.  Kenneth A. Small said, “People were surprised by the very rapid rise in gas prices, and they changed their driving behavior.  But my suspicion is that it is temporary.  As soon as unemployment gets back to pre-recession levels, we will see Americans doing a lot more driving again.”  This seems to be a statement of a forecaster expecting two important things to happen in the future – first that unemployment will be cut in half in order to get back to pre-recession levels and second that gasoline prices are going to fall back below $2.50 per gallon.  While either or both of these scenarios could occur the probability of their occurrence seems low based on the latest predictions of economists and petroleum industry specialists.  As we well know, what experts predict often fails to materialize, and in fact, the reality often turns out to be the exact opposite of what was predicted.

To assess the likelihood of unemployment falling and/or gasoline prices falling, we need to understand the current and future economic landscape and the outlook for oil supplies and gasoline demand.  On this last point, most U.S. refiners are resigned to little or no growth in gasoline consumption and are reconfiguring their facilities to produce more middle distillates where they see greater growth and profit potential and less gasoline.  The prospect for lower gasoline consumption is based on expectations about the impact of the government’s recently increased Corporate Average Fuel Efficiency (CAFE) standards for the American vehicle fleet on fuel consumption.  The mandated increase in the use of ethanol in gasoline is also having an impact on the volumes of gasoline produced.  In addition, there is an Obama administration’s push to put a million new electric and plug-in electric cars on the road in 2015. 

The average fuel efficiency standard for cars has been raised from the current 27.5 miles per gallon (mpg) to 37.8 to be met by 2016.  The requirement for light trucks is being raised from the 2010 standard of 23.5 mpg to 28.8 mpg in 2016.  The overall fleet average for cars and trucks will be 34.1 mpg in 2016.  In order to achieve these higher standards, the automobile industry will need to produce more small cars with significantly higher mpg ratings along with all-electric and hybrid vehicles that have even higher mpg performance ratings in order to offset the number of light trucks and other vehicles that have performance measures below the fleet average.

The auto industry is in a race to see who can produce the first profitable all-electric vehicle.  That will require cars that sell somewhere in the $20,000-$40,000 range and that actually can deliver meaningful distances between battery charges and that can be easily and quickly re-charged either at home, work or a public facility.  Nissan (NSANY.PK) has begun to take orders for its Leaf electric car that the company expects to begin producing this September.  Nissan has priced the Leaf at $32,780 that after the $7,500 federal tax credit for electric vehicles reduces the buyer’s cost to $25,280, which would seem to be an attractive price point.  Can Nissan make money with the Leaf?

A recent analysis we saw suggested that Nissan’s Leaf will be profitable at its target price.  The analysis is based on the following metrics and assumptions.  The car has a 24 kilowatt-hour (kWh) battery.  Based on the cost of conventional batteries, this battery would have a $21,000 price tag.  If the battery of an electric car represents about a third of the total vehicle cost, then the Leaf would sport a $60,000 price.  According to the CEO of EnerDel who makes batteries for Think, the cost of their battery is about $700 per kWh, which would make the Leaf a $50,000 car.  If Nissan is able to get the battery price to $500 per kWh, then the Leaf would be a $36,000 car.  With five months to go and time to shave costs further, it would appear that Nissan is going to price the Leaf at a point at which it would be profitable.  It remains to be seen whether this analysis is close or whether Nissan is willing to forego profitability to be the first into the marketplace. 

Regardless of whether the Nissan Leaf price is profitable or not, the big question will be consumer demand.  The company had a number of pre-orders when it started taking reservations, but that doesn’t begin to address the issue of infrastructure for servicing electric vehicles.  There will always be a small cadre of individuals who want to be first with the latest technology.  For them, unique is more important than practical.  For electric vehicles to impact the auto market, practical must become a more important demand driver.

If Dr. Small is right, for miles driven per capita to increase, America needs a significantly improved economy.  Despite all the federal government’s pump-priming efforts, there has been little impact on the overall unemployment rate in the past year.  Much of the recent improvement has been due to the hiring of temporary workers, especially for the federal census.  Many of those jobs will disappear at the end of the summer.  With the prospect that the housing sector is likely to experience an extended period of high foreclosure rates and depressed house prices, coupled with a highly stressed commercial real estate market, one of the usual prime drivers for lower unemployment coming out of a recession – construction – is not likely to rebound anytime soon. 

Exhibit 8.  Commercial Mortgage Delinquencies Climbing

Source:  Agora Financial

The state of the housing market is shown in the following two charts.  One details the rising number of homes where the owner is 90 days or more delinquent on mortgage payments or in foreclosure.  The second chart shows the debt service of unemployed people that confirms why we are seeing mortgage delinquency and home foreclosure rates rising.  Gradually this debt service amount will decline, but more from home loan modifications and concessions rather than payoffs, at least until the unemployment situation improves dramatically.

Recently much has been made about the strength and resilience of the American consumer as retail spending has increased in each of the last four months.  What has not been focused on is the lack of consumer income growth to fund the increased spending.  Without income growth, consumers are either increasing their borrowings or drawing down on their savings.  In the latest consumer spending and

Exhibit 9.  Foreclosures And Mortgage Delinquencies Growing

Source:  Agora Financial

Exhibit 10.  Unemployed People Carry Substantial Debt Loads

Source:  Agora Financial

income figures, the savings rate fell by 0.3% from 3.0% to 2.7%, while spending increased 0.6%.  At some point that will change unless employed people go on a spending spree.  The growth in household credit shows no signs of that spending spree yet. 

Another possibility is that as the number of housing foreclosures rise consumers are generating financial windfalls as they cease paying high monthly mortgage payments.  At some point, and probably fairly soon, the weak housing market and lack of consumer income growth will hit retail sales.  It is important, however, that one not pay too much attention to the year-over-year changes as we are still comparing against a very weak 2009 economy.  The key is to look at where we are compared to the pre-recession economy, as that was what held unemployment down.  In our view, we believe it unlikely that unemployment will drop meaningfully in the near term.  So while Dr. Small may ultimately be right, the issue is how long before he is?

Exhibit 11.  Increased Debt Use Can’t Drive Economic Cycle

Source:  Agora Financial

Two leading European car manufactures are experimenting with new business models that potentially could change their industry and impact global energy demand.  Daimler (DAI-NYSE), of Mercedes-Benz fame, and PSA Peugeot Citroën (PEV.F), the French carmaker, have each started programs that make the experience of driving and owning a car more like that of using a cell phone.  Daimler has its program, car2go, underway in Ulm, Germany and Austin, Texas.  Peugeot operates “Mu by Peugeot” in four French cities and plans to take it to Berlin and London this year.  Will these schemes prove successful in meeting the needs and desires of younger people who see cars as merely one form of transportation in a world where different forms of transportation may be more desirable at various times?

In the Peugeot program of partial car ownership, customers can choose their mode of transportation and prepay for transport “units” much like they prepay for airtime on mobile phones.  The customer has a card and an online account allowing him to purchase “mobility units” at €10 ($13) per 50 units.  They use these units to rent a family car, a sports car, a scooter or even a bicycle depending upon their needs.  According to Pascal Feillard, head of foresight and marketing intelligence at Peugeot, after conducting focus groups worldwide, “People want to see if they can broaden this, not necessarily by cars: they want to be able in large urban areas to shift from one mode to the other – train, metro, bicycle – quite seamlessly.”

The Daimler model is based more on the car sharing scheme such as that developed by Zipcar.  These car sharing business models enable people to rent cars for very short durations.  This business model helps meet the needs of younger people who are only interested in the utilitarian aspect of car ownership – getting from point A to point B.  Frost & Sullivan, the market research firm, expects membership in car-sharing schemes in Europe to increase tenfold from about 500,000 people today to about 5.5 million by 2016.  The relative success of these programs will certainly have implications for the volume of new vehicle sales and the amount of gasoline and diesel fuel needed.  These programs are certainly worthy of watching.

On April 28th, Interior Secretary Ken Salazar was in Boston to announce he was approving the awarding of a lease to allow for the construction of the 130-turbine wind project in Nantucket Sound proposed by Cape Wind Associates.  Secretary Salazar hailed the significance of the decision when he said the United States was leading "a clean energy revolution that is reshaping our future…  Cape Wind is the opening of a new chapter in that future and we are all a part of that history." 

Exhibit 12.  Location Of Cape Wind Project

Source:  Cape Wind

While Interior Sec. Salazar and Massachusetts Governor Deval Patrick were celebrating, opponents of the wind project, including the Alliance to Protect Nantucket Sound and the Wampanoag tribes, were preparing to go to court to block the decision.  This was just days ahead of a state court case ruling that threw out complaints about the legality of the project.  The state case, however, is only one of numerous cases that have been filed over the approval process and the legality of the wind project.  New England legal experts believe that after nine years of review, there is little the opponents can do beyond slowing the pace of the project as there is probably no fatal flaw in the project and its approval process.  The idea that the Interior Secretary’s decision clears the way for construction on the wind project to begin soon appears to us to be extremely optimistic. 

Sec. Salazar used the Cape Wind announcement to push forward on the Obama administration’s efforts to develop a green energy future.  At the press conference announcing the Cape Wind decision, Sec. Salazar said "This will be the first of many projects up and down the Atlantic coast."  The New York Times had run a story at the beginning of that week highlighting the number of wind farm proposals currently seeking approval off the East Coast.  The Cape Wind decision has to be good news for these developers, although there still remain many steps and several years of time before we will see wind turbines spinning in the ocean breezes.

Exhibit 13.  East Coast Wind Farms Ready For Approvals

Source:  The New York Times

In reading the decision record of the Interior Department in choosing to allow the wind farm destined for the Horseshoe Shoals location in Nantucket Sound, we were struck by a couple of points.  The record went through the advantages and disadvantages of the current project compared to a number of alternative locations.  Besides offering the least environmental damage and the prospect for the greatest amount of power, the cost of the project also was considered.  The Horseshoe Shoal location is estimated by the Interior Department to have an estimated cost for producing electricity of 12.8 cents per kilowatt hour (kWh).  This compares favorably with the estimated costs for two alternative sites in Nantucket Sound: Monomoy Shoals at 14.8 cents per kWh and The South of Tuckernuck Island at 20.9 cents per kWh.  One other economic assessment was done, which was to cut the Cape Wind project in half, but besides displacing the lost power generation to another location, this concept would boost the cost of producing

electricity to 15.9 cents per kWh.  We wonder how these cost figures will play into the electricity contract negotiations that must be concluded between Cape Wind and National Grid (NGG-NYSE), the state’s principal utility, before financing and final state approvals can be secured.

The major mitigating conditions being pushed onto Cape Wind are for additional archaeological surveys in the planned location and specifically at the location of each of the wind turbines.  There were also lighting dictates established in order to minimize the visual impact of the turbines.  Additionally, there is a requirement that the wind turbines be painted off-white (5% gray), again to minimize the visual impact.  There are some construction time restrictions and air pollution offset credits that need to be purchased during the construction phase.  The decision record has many pages of operational requirements for the project’s construction and operation, but most appear to be more traditional advice than radical mandates.

At the end of the day, the key consideration is the department’s rationale for the decision.  It basically hinged on the Obama administration’s priority for diversifying the nation’s energy portfolio in an effort to gain energy independence, battle climate change and create jobs.  For the region, natural gas supplies 40% of the fuel used to generate electricity and demand is expected to increase 31.6% by 2024, exposing the region to substantial fuel price fluctuations and adding to air pollution.  The Cape Wind project would help to diversify power supplies, contribute to more stable electricity prices and improve the region’s air quality.  Little was made of the fact that the 485 megawatts of wind turbine capacity will only average 39% output.  The project is estimated to cost somewhere between $1 and $2 billion, yet the impact on the cost of electricity for the Massachusetts consumers seemed not to be an issue.

In light of the Cape Wind approval, the recent report of the American Wind Energy Association (AWEA) for the first quarter of 2010 showed that new wind construction of 539 MW had fallen to the lowest level in three years after having posted a record year in 2009 when the industry installed 10,000 MW of new wind power.  The more disconcerting aspect of the wind power market report is the number of new projects that have been cancelled or reduced.  The wind energy subsidiary of FPL Group (FPL-NYSE) will reduce its planned construction of wind power from 15% to 40% below its previously announced target.  It now plans to add somewhere between 600 MW and 850 MW in 2010, down from 1,000 MW added last year.

Projects canceled included Indianapolis Power and Light Company’s (IPWLG.PK) 201-MW wind farm in southwestern Minnesota that had been approved by Indiana regulators in January.  Also, Noble Environmental Power abandoned plans for two wind farms: a 19-MW one in northern New York and a 100.5-MW one in western New York.  All of these projects were canceled due to low power prices.  If natural gas prices remain low and act to keep electricity prices down, then wind power will have to depend solely on government subsidies or state power mandates to grow.

The latest issue of Forbes magazine has an article on the world’s leading companies.  The article focused on the top companies and their movement within the list of the Forbes Global 2000 top companies.  These companies are described by the magazine as the biggest and most powerful companies on the planet.  The ranking is complied by looking at each company’s sales, profits, assets and market value.  Of the 2000 companies ranked this year, the banking industry represented 308 companies while the oil and gas industry accounted for the next largest segment with 115 companies.

What was interesting was examining the role of the oil and gas and oilfield service companies among the top 150 companies.  There were a total of 16 oil and gas companies in the list.  Schlumberger (SLB-NYSE) was the lone oilfield service company in the total ranking 148.  That means the combined oil and gas and oilfield service industry accounted for slightly over 11% of the top 150 companies.

The oil and gas industry accounted for eight of the top 20 companies on the leading companies list.  Interestingly, only two of the companies were American – Exxon Mobil (XOM-NYSE) and Chevron (CVX-NYSE).  The six other oil and gas companies were from outside the United States, and even from outside North America.  Those six companies included: Royal Dutch Shell (RDS.A-NYSE); BP; Petro China (PTR-NYSE); Gazprom (GAZ.F); Petrobras (PZE-NYSE); and Total (TOT-NYSE). 

When the 50 companies were ranked only by sales, three of the top five were oil and gas companies: Royal Dutch Shell; ExxonMobil; and BP.  On the basis of absolute profits, five of the top six companies were oil and gas companies.  These included Gazprom, the most profitable, along with ExxonMobil in second place.  Petro China, Petrobras and BP made up the balance of the top profit earners.  The top two companies in market value were both oil and gas companies – Petro China and ExxonMobil.  Most significantly, there were no oil and gas companies in the list of the top 50 companies ranked by asset value.  What this says is that high oil and gas prices drive oil and gas company revenues and profitability.  Even with modest stock market valuations, the sheer size of oil and gas company profits guarantees that the companies will be at the top of the stock market valuation list.

Since the Global 2000 companies’ rankings were based on 2009 results, it was not surprising to see that ExxonMobil and Chevron were two of the top six companies in terms of largest profit declines.  On the other hand, ConocoPhillips (COP-NYSE), due to the absence of billion-dollar impairment charges in 2009, demonstrated the largest profit turnaround.

When we look through lists ranking company financial performance for a single year or their change relative to the prior year, we are always wondering about how these companies performed over time.  The Forbes article had a section detailing changes in the rankings of companies engaged in a number of industrial sectors between 2005 and 2010.  Their table presented an interesting perspective on the shifting forces at work within the international oil and gas industry.  Of the top five companies, the top three were the same companies with the same standing, although their overall rankings within the 2005 list have changed slightly.  The final two companies were different.  In 2005, the fourth and fifth companies were Total and Chevron, respectively.  By 2010, these two companies were replaced by Petro China and Gazprom, respectively. 

For those of us who are a part of the global oil and gas sector, we were not surprised by the rankings of the companies and the changes from the 2009 ranking.  The oil and gas industry is, by its very nature, a huge industry made up of many very large companies.  Therefore, it is not surprising that the oil and gas companies would rank high in virtually all categories.  On the other hand, it is very interesting to see the continuing rise in stature and financial performance of national oil companies.  This is a trend that will likely continue especially given the political trends in North America. 

Contact PPHB:
1900 St. James Place, Suite 125
Houston, Texas 77056
Main Tel:    (713) 621-8100
Main Fax:   (713) 621-8166
www.pphb.com

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.