Musings from the Oil Patch – September 13, 2011

• Trying To Solve Mystery Of Missing Marcellus Resource
• Whither The Direction Of Natural Gas Markets
• In Job Search Obama Keeps Targeting Green Job Potentia
• World Wind Energy Market Continues To Grow
• Can A Government’s Business Policy Screw Up A Market?

Musings From the Oil Patch
September 13, 2011

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

A tenant of America’s gas shale revolution is that shale is ubiquitous and uniformly spread under our oil and gas producing basins.  That belief has translated into growing estimates of the resource’s potential and how it has radically changed the long-term outlook for America’s, and potentially the world’s energy future.  Is it possible this tenant has been knocked into a cocked hat by the latest estimate of the resource potential of one of our largest gas shale basins – the Marcellus Shale? 

The recent assessment by the U.S. Geological Survey (USGS) that the Marcellus Shale contains 84 trillion cubic feet (Tcf) of undiscovered natural gas and 3.4 billion barrels of undiscovered natural gas liquids was greeted with both joy and consternation.  The joy came from the recognition that the USGS estimate was a huge increase from its prior assessment made in 2002 that said there was only about 2 Tcf of gas reserves in the shale formation that stretches from Alabama to New York.  The consternation stems from the assessment being about 80% less than an estimate promoted earlier this year by the Energy Information Administration (EIA) that there was 410 Tcf of gas in the basin.  Talk about a gap wide enough to drive a truck through, how about a whole fleet of pickups?

First, it is important to understand that the USGS estimate is the mean of various estimates the agency prepared.  Each estimate was assigned a confidence level based on how sure the agency was that the estimated volume actually is present.  The estimates ranged from a very highly confident (95%) estimate of 43 Tcf to the estimate with the lowest confidence (5%) of 144 Tcf.  The 50% confidence scenario estimated total gas reserves of 78.7 Tcf, or somewhat below the mean estimate the agency decided to publish.  Second, it is important to understand that these estimates reflect a view that the resources are technically recoverable, which, to quote from the agency’s press release, means “are those quantities of oil and gas producible using currently available technology and industry practices, regardless of economic or accessibility considerations.”  The USGS went on to say, “…these estimates include resources beneath both onshore and offshore areas (such as Lake Erie) and beneath areas where accessibility may be limited by policy and regulations imposed by land managers and regulatory agencies.” 

Importantly, the USGS attributed the increase in its undiscovered resource estimate to the “new geologic information and engineering data, as technological developments in producing unconventional resources have been significant in the last decade.”  Clearly, the USGS was referring to the improvements in horizontal drilling and hydraulic fracturing, which the petroleum industry has embraced wholeheartedly in driving the gas shale revolution. 

In doing periodic Google searches of news articles discussing the new USGS estimate, we found that they overwhelmingly focused on the new estimate being 42 times greater than the 2002 estimate.  In fairness, the successful marriage of horizontal drilling and hydraulic fracturing that has driven the success of the gas shale revolution had barely begun when the previous assessment was prepared, so it is not surprising the new estimate jumped.  For people counting on the Marcellus Shale to rewrite the nation’s plan for powering the Northeast region, there was concern about how low the USGS estimate is compared to the recent estimates made by academics and consultants, one of which was officially embraced by the EIA. 

In Exhibit 1, we show a table taken from the Scope and Results section of the report, “Review of Emerging Resources: U.S. Shale Gas and Shale Oil Plays” published in July by the EIA and based on a report it had commissioned.  The agency contracted with the consulting firm INTEK, Inc., “to develop an assessment of onshore Lower 48 States technically recoverable shale gas and shale oil resources.”  As can be seen from the table, the Marcellus Shale is assigned an estimated 410 Tcf of “undeveloped technically recoverable shale gas and shale oil resources remaining in discovered shale plays as of January 1, 2009.”  Both the description of what the 410 Tcf represents and the date of the estimate are important and we will come back to them in a minute.

The Marcellus Shale Coalition, fearing the USGS estimate might be misinterpreted, undertook a “myth dispelling” effort in a press release.  The Coalition’s release was titled, “Myth vs. Fact: USGS/EIA Marcellus Data.”  The thrust of the release was to counter those news reports that focused not just on the huge increase in the USGS resource estimate, but how it clashed with the EIA’s assessed resource estimate.  The relevant section of the press release is quoted below.

Exhibit 1.  EIA Estimate of Gas Shale Resources

Source:  EIA

“Over the course of the past week, while several flawed media reports surfaced regarding the new USGS data, straightforward facts ultimately prevailed. Below are several of these claims and corresponding facts. Most importantly, the latest production estimates remind us that, more than ever before, the dialogue about the Marcellus Shale continues to be rightfully focused on the region’s leading role in providing clean-burning, job-creating American energy for our nation. (Coalition emphasis). 

“CLAIMS: Citing Philip Budzik, an Energy Information Administration (EIA) bureaucrat who touts the work of anti-shale gas groups like the Natural Resources Defense Council (NRDC), Bloomberg News claims new USGS data will cause “U.S. to Slash Marcellus Shale Gas Estimate 80%.” (Coalition emphasis). 

“The U.S. will slash its estimate of undiscovered Marcellus Shale natural gas by as much as 80 percent after an updated assessment by government geologists. The formation, which stretches from New York to Tennessee, contains about 84 trillion cubic feet of gas, the U.S. Geological Survey said today in its first update in nine years. That supersedes an Energy Department projection of 410 trillion cubic feet, said Philip Budzik, an operations research analyst with the Energy Information Administration. (Bloomberg News, 8/23/11) 

“The New York Times’ Ian Urbina, in his story entitled “Geologists Sharply Cut Estimate of Shale Gas,” writes that the new USGS data “is drastically lower than the 410 trillion cubic feet that was published earlier this year by the federal Energy Information Administration,” and also cites Mr. Budzik. (New York Times, 8/24/11) (Coalition emphasis). 

“FACTS: USGS notes that “it’s important to do an apples-to-apples comparison here” – something Bloomberg News and the New York Times fundamentally failed to do. “Hold off on those shale gas obituaries,” accurately reports the Washington Post’s Brad Plumer. (Coalition emphasis). 

“As it turns out, many of those stories may have been premature — and appear to be based on a slight misunderstanding of the USGS survey. … As Brenda Pierce, program coordinator for the USGS energy resources program told me, it’s important to do an apples-to-apples comparison here. The USGS and EIA aren’t measuring the same thing, exactly: The USGS offered an estimate of undiscovered resources that can be recovered with current technology, whereas the EIA report looked at both “active” and “undeveloped” reserves together. “Ours is additive to what’s already in production,” explains Pierce. … So the revision could end up being much less stark than early media reports implied. (Washington Post, 8/26/11) 

“As [Kenneth Medlock, an energy fellow at Rice University’s Baker Institute] explains, the USGS figures refer only to “undiscovered” resources — which implies that gas that producers have already discovered cannot be included in the USGS assessment. The terminology favored by the EIA, meanwhile, implies that it can include resources that producers have already discovered. The variation can be significant. … The USGS estimate would theoretically exclude such reserves because they have already been discovered, while the EIA estimate could include them. … Medlock said that anybody who points to the latest USGS assessment as an indication that the Marcellus is less prolific than initially thought should take note of the magnitude of the increase. “They went from 2 Tcf to 84 Tcf. That’s a pretty big signal,” Medlock said. He also noted that shale has gone from accounting for just 1% of domestic gas production to 25% in less than ten years. “That doesn’t happen if it’s a Ponzi scheme,” Medlock said. (Energy Intelligence, 8/28/11)” 

So what do we know about these two estimates?  According to the USGS spokesperson, their estimate is purely of “undiscovered resources” so it should be added to what reserves are already known, although we’re not sure whether that means actually proven reserves or merely those reserves “guessed at.”  Secondly, we know, according to Dr. Medlock of Rice University, the Marcellus is not a “Ponzi scheme,” dredging up a pejorative phrase that originated with The New York Times gas shale articles in June and that would be best left out of discussions.  But Dr. Medlock does appear to credit the Marcellus with single-handedly accounting for the dramatic rise in U.S. gas shale production by pointing out how much shale gas now accounts of our gas production.  That may be a loose reading of his statement, but it highlights why people discussing topics such as this need to be more accurate in their statements because of how they may be interpreted. 

A chart presented by the Coalition in its press release, and taken from the EIA’s web site, was headlined “Pennsylvania drives Northeast natural gas production growth.”  In the explanation accompanying the chart, the EIA quotes Bentek Energy LLC, an energy consulting firm, saying that Pennsylvania and West Virginia production now accounts for nearly 4 Bcf per day of gas production, and that represents more than five times the average daily production of 2004-2008.  Together, Pennsylvania and West Virginia account for 85% of total Northeast production, according to Bentek.  It is interesting that the EIA doesn’t have its own data to demonstrate this point, as the last year for individual state production data that includes Pennsylvania is 2009. 

Exhibit 2.  Gas Production For Northeast States

Source:  Bentek; EIA

One of the questions is what does the Bentek estimate represent?  According to EIA data, we know Pennsylvania and West Virginia were producing natural gas before the Marcellus Shale emerged as a hot spot, so how much of the estimate Bentek reports is from conventional gas and how much from shale?  The EIA has shale gas production by state for 2007-2009 and shows that Pennsylvania shale produced 1 Bcf in 2007, 2 Bcf in 2008 and 76 Bcf in 2009.  Since the EIA doesn’t have more recent data, we are forced to turn to the Pennsylvania Department of Environmental Protection’s web site that shows the amount of gas production from the Marcellus.  The problem with the state data is that it is only reported for blocks of time, now six month intervals, but before it was 12 months.  This makes it impossible to know on a real-time basis actual production.

What we know from the state web site is that for the 12-month period of July 2009 through June 2010, average monthly production was 16.2 Bcf.  For the six-month period of July 2010 through December 2010, it averaged 45.3 Bcf per month and increased to 60.8 Bcf for the first half of 2011.  Clearly this is exemplary performance in growing Marcellus shale gas production.  But that doesn’t answer the key question about the resource’s potential. 

If we start with the EIA assessment of 410 Tcf of gas shale resources, we need to keep in mind that the estimate was based on data as of January 1, 2009.  Then, according to the EIA, the Marcellus Shale had proven reserves of 102 Bcf.  During 2009 proven reserves increased by 4.4 Tcf.  Unfortunately, 2010 data won’t be available until the end of 2011.  The EIA’s proven reserve estimate comes from its Form EIA-23, “Annual Survey of Domestic Oil and Gas Reserves,” which surveys 1,200 domestic operators, both public and private companies.  This survey is more comprehensive than the data collected from companies reporting reserves to the Securities and Exchange Commission (SEC), because those are only companies with a minimum of $10 million in assets and whose securities are held by more than 500 owners.  There is also a difference in that the SEC asks only about reserves owned by a company, and not those operated.  As a result, the EIA captures more of the total reserves, especially those held by individuals and very small companies who are not operators.

Exhibit 3.  Gas Shale Production And Reserves

Source:  EIA

To better understand how INTEK prepared its estimate, we turned to the section following its table of shale resource estimates by basin entitled “Methodology.”  We copied the relevant section of their methodology with emphasis added.

“The resource estimates shown in Table 1 were developed by

INTEK from publicly available company data and commercial databases for wells and acreage currently in production. The estimates of technically recoverable resources shown in Table 1 are based on the area, well spacing, and average expected ultimate recovery (EUR) for each shale play or subportion of the play. An effective recovery factor has been applied which reflects: (a) a probability factor that takes into account the results from current shale gas activity as an indicator of how much is known or unknown about the shale play; (b) a recovery factor that takes into account prior experience in how production occurs, on average, given a range of factors (including mineralogy and geologic complexity) that affect the response of the geologic play to the application of best-practice shale gas recovery technology; and (c) resources in the play that have already been produced or added into proved reserves.

“Estimates of technically recoverable shale gas resources are certain to change over time as new wells go into production and new technologies are developed. For example, the gas resource estimates in the INTEK shale report are predicated on the assumption that natural gas production rates for current wells covering only a limited portion of a play are representative of an entire play or play sub-area; however, across a single play or play sub-area there can be significant variations in depth, thickness, porosity, carbon content, pore pressure, clay content, thermal maturity, and water content. As a result, individual well production rates and recovery rates can vary by as much as a factor of 10. (Emphasis added.)

“There is considerable uncertainty regarding the ultimate size of technically recoverable shale gas and shale oil resources, including but are not limited to the following:

“• Because most shale gas and shale oil wells are only a few years old, their long-term productivity is untested. Consequently, the long-term production profiles of shale wells and their estimated ultimate recovery of oil and natural gas are uncertain. (Emphasis added.)

“• In emerging shale plays, production has been confined largely to those areas known as “sweet spots” that have the highest known production rates for the play. If the production rates for the sweet spots are used to infer the productive potential of entire plays, their productive potential probably will be overstated. The INTEK shale report mitigates this problem by differentiating the productivity of a play’s sweet spot from the productivity for rest of that play.” (Emphasis added.)

Based on the first highlighted text, it appears INTEK relied on estimates of the production and ultimate recovery from wells and applied that information to larger shale areas.  They did correctly warn of the risk of this method, especially in the second highlighted text.  The last paragraph (highlighted) is the more troubling one considering that the report was based on data as of 2008.  We aren’t sure the idea of “sweet spots” was clearly delineated at that time.  Then the industry was embracing the blanket formation and factory development approach to shales, both of which are questionable assumptions today.  What we do know is that the USGS worked with various state geological associations and had more recent data to work with.  Now that still doesn’t mean their estimate is gospel, but we need to see what additional information they publish later.

Exhibit 4.  Proven Reserve Changes For 2009

Source:  EIA

If we look at the estimates and apply what we have found out, here’s what we know.  The EIA says there are 410 Tcf of shale gas in the Marcellus Shale.  If we subtract from that estimate what the USGS says is undiscovered (84 Tcf), we have 326 Tcf of reserves that supposedly are known or should be known by now.  Of course, it is possible that the 84 Tcf of USGS reserves should be added to the EIA estimate, bringing it to nearly 500 Tcf. 

Exhibit 5.  Individual State Shale Gas Reserves

Source:  EIA

If we look at the total gas discoveries (Exhibit 4) for the nation in 2009, 47.6 Tcf, and attribute 100% of them to the Marcellus, that only represents 15% of our mystery reserves.  Unfortunately that isn’t the case as we see when we look at the chart in Exhibit 5, which shows that Arkansas and Louisiana added more shale gas reserves in 2009 than Pennsylvania. 

While our article in the last Musings discussing the USGS estimate and its discrepancy from the EIA number may have been among those the Marcellus Shale Coalition was targeting as spreading myths, an examination of the data suggests there is a mystery that needs to be solved.  As we said at one point in that article, “It [the USGS assessment] will force everyone to question what the USGS sees, or doesn’t see, that everyone else assumes as gospel.”  Unfortunately, solving this mystery will not be as “Elementary” as Sherlock Holmes would have suggested to us, assuming we are merely another Dr. Watson.  Our hope is that the gas industry and the nation finds out sooner rather than later the answer to the missing reserves as they account for approximately half the EIA’s total shale gas resource estimate for the country.  Shale gas is an important energy resource and a necessary one.  Billions of dollars are being wagered on shale gas being America’s energy salvation.  If there is a problem with this assumption, we need to figure it out soon in order to make a mid-course correction if needed. 

Natural gas prices continue, as they have for the past three months, to fluctuate around $4 per thousand cubic feet (Mcf).  Futures prices show more hope with a February 2012 price of $4.35 and October 2012 (a year from now) of $4.48.  The market expects further improvement with October 2013 and 2014 prices of $4.92 and $5.25, respectively.  This outlook is in contrast to the latest Short-term Outlook published by the EIA that says gas prices will average $4.20 per Mcf in 2011, down $0.18 from 2010’s average.  The EIA forecasts the Henry Hub average price for 2012 of only $4.30, which is certainly conservative compared to the commodity markets’ view.

Exhibit 6.  Latest 12 Month Nat Gas Prices

Source:  Rigzone

The divergence in the outlook for gas prices probably reflects different views of economic activity.  The EIA says it is now using GDP growth expectations for 2011 and 2012 of 1.5% and 1.9%, respectively, compared to the previous estimates of 2.4% and 2.6%.  The new GDP assumptions suggest industrial demand for natural gas may be weaker than what others expect.  Since gas demand in the electricity sector should continue to grow as almost all new power generating capacity built has been based on gas.  Electricity demand, however, remains both seasonal and dynamic.  Greater energy conservation continues to slow electricity’s growth along with a slowing economy. 

One reason the EIA maintains its somber view of natural gas prices through the balance of this year and in 2012 is because it expects gas storage to grow and approach last year’s highest end-of-injection season volume.  A high storage volume, absent a very cold winter, will keep gas prices from rising materially in response to greater natural gas demand.  At the end of the day, while industrial demand remains a key to future gas prices, the issue of gas supply may be the more important dynamic at the moment.

Exhibit 7.  Land Gas Production Continues To Grow

Source:  EIA, PPHB

The latest gas production data suggests that the surge in supply coming from the high level of drilling in gas shale formations and the hooking up of previously drilled-but-uncompleted wells continues, especially for onshore gas.  The slight dip in production early in 2011 reflects the impact of the freeze-offs that occurred during the extremely cold weather in February.  However, based on the EIA’s Form 914 survey of operators’ monthly gas production, we are troubled by the recent trend in revisions compared to initial estimates.  If we look at Lower 48 land production, the chart in Exhibit 8 shows the initial and revised monthly estimates.  During much of 2009-2010, revisions were below initial estimates, but starting last fall the pattern reversed.  This trend suggests caution should be used about interpreting initial estimates in future months. 

Exhibit 8.  Lately Gas Production Revisions Are Positive

Source:  EIA, PPHB

The greatest challenge for the natural gas industry is to know how much gas is being added by drilling.  In 2011, there has been a significant shift in the focus of drilling due to strong crude oil and weak natural gas prices.  At the end of 2010, according to Baker Hughes’ (BHI-NYSE) rig count, 54.3% of the rigs were targeting gas, or 919 rigs.  At the start of September, natural gas was only being targeted by 45.5% of working rigs, or 895, some 24 fewer than nine months before.  For crude oil, the industry has added 299 rigs.  Overall, the industry has added a net 274 rigs drilling for oil and gas this year.  What is often missed by many analysts is that there are still significant volumes of natural gas produced from fields considered primarily oily or having high liquids content.  Thus, the shift in drilling does not shut down natural gas additions completely.

Exhibit 9.  Rigs Drive Gas Production Higher

Source:  EIA, Baker Hughes, PPHB

The primary culprit in the growth of natural gas production has been the relentless rise in the use of rigs drilling horizontal wells targeting gas that are associated with high initial production from shale formation wells.  In preparing the chart in Exhibit 9, we used the percentage of total rigs drilling for natural gas and applied that to the number of active horizontal drilling rigs.  This is a crude measure of drilling, but it helps eliminate some of the horizontal rigs drilling for crude oil.  Based on that measure, from 2005 through nearly the end of 2008, there was a steady parallel rise in the horizontal rig count and gas production.  That pattern ended with the financial crisis in late 2008 and resulting 2009 recession.  Gas production began rising shortly after the horizontal rig count upturn.  So far this year, the horizontal rig count is climbing faster than in 2010.  Since the reported gas production data is lagged by two months, we can figure out what the horizontal rig count might suggest for future monthly production.  The monthly gas-oriented horizontal rig count has continued climbing even in the face of a declining percentage targeting gas, suggesting gas production will also rise in the near future.  But the horizontal gas rig count is now declining, on our measure, telegraphing that gas production should stop rising soon.  It also suggests the natural gas market may see an improved supply/demand balance by next summer.  That improvement could be delayed because the gas industry is focused on drilling shale formation sweet spots with greater output, plus accelerated completion of previously drilled-but-uncompleted wells, about 3,000.  The surge in finishing uncompleted wells will ebb as hydraulic fracturing capacity expands to match the drilling industry’s need. 

As we look to the future, baring another economic recession, we think natural gas dynamics are beginning to shape up for better gas prices next year.  As a result, we are slightly more optimistic about natural gas prices averaging higher than the EIA’s forecast.  Many might say we are walking on a tightrope over a chasm with this forecast.  But like all good stunt performers, we believe there are plenty of mattresses under us for when we fall.

Even though Vice President Joe Biden didn’t know how many letters make up the word “jobs” that hasn’t deterred President Barack Obama from continuing to hype the potential of “green jobs.”  He did it in his Labor Day speech in Detroit.  His focus continues despite the high-profile failure of solar power company Solyndra that the administration backed with a loan of $535 million in 2009.  This is not the first high-profile renewable energy company that has failed to deliver its promised green jobs despite being showered with government cash, but it may be the most significant given recent developments. 

Despite having these high-profile examples of a failed strategy, think tanks continue to churn out reports showing how successful this stimulus strategy has been or could be.  The most recent report was issued by the Metropolitan Policy Program of The Brookings Institute in conjunction with the Battelle Technology Partnership Practice titled, “Sizing the Clean Economy – A National and Regional Green Jobs Assessment.”  There were a number of conclusions from the report, which we list below. 

• “The clean economy, which employs some 2.7 million workers, encompasses a significant number of jobs in establishments spread across a diverse group of industries.

• “The clean economy grew more slowly in aggregate than the national economy between 2003 and 2010, but newer “cleantech” segments produced explosive job gains and the clean economy outperformed the nation during the recession.

• “The clean economy is manufacturing and export intensive.

• “The clean economy offers more opportunities and better pay for low- and middle-skilled workers than the national economy as a whole.

• “Among regions, the South has the largest number of clean economy jobs though the West has the largest share relative to its population.

• “Most of the country’s clean economy jobs and recent growth concentrate within the largest metropolitan areas.

• “The clean economy permeates all of the nation’s metropolitan areas, but it manifests itself in varied configurations.

• “Strong industry clusters boost metros’ growth performance in the clean economy.”

The critical point for green job proponents is that there are 2.7 million jobs, but we find a number of problems with how these jobs were counted.  The proponents point to there being more green jobs than oil industry jobs.  Even with creative counting, though, the report’s authors had to admit that the clean economy created jobs more slowly than the national economy, but it did outperform during the recession.  The record shows that earlier when the economy was roaring ahead, the government wasn’t boosting green jobs, but during the recession when private sector jobs were slashed, government-supported jobs were maintained or even added until the recession forced state and local governments to cut employees.  The fact that most of these clean economy jobs the authors found were in large metropolitan areas probably also says more about job classifications and municipal spending than anything else. 

Last week, California-based solar panel manufacturer Solyndra was forced to file Chapter 11 bankruptcy due to its inability to slash product costs as fast as its competitors, especially those in China and Europe.  Having been founded in 2005, Solyndra developed unique solar panels made from non-conventional materials that probably further hurt its global competitiveness.  These unique characteristics were considered key to the projected success of the company.  The Treasury’s Federal Financing Bank loan was made in 2009 to help the company build a manufacturing plant to enable it to ramp up output and lower costs.  During the global recession, Chinese solar panel manufacturers moved to grab market share by building new plants and ramping up production.  Their product costs fell by more than 50%.  Their plants were financed by money from Chinese government-owned banks, which lead many producers in the U.S. and Europe to claim that China is violating World Trade Organization agreements over government support of an industry. 

The failure of the company caused the plant to close and 1,100 workers to lose their jobs.  The ignominy of the situation was the FBI raid of the company headquarters last week seeking documents related to the Energy Department loan and subsequent private financing.  (Nobody in Washington bothered to keep a copy?)  Despite this failure, the Energy Department continues heaping funds on other renewable energy companies – the two recent recipients include solar energy companies 1366 Technologies and SolarCity, who received $425 million collectively.  The interesting thing about these latest loan guarantees is one is to help a company whose product cost is too low, while the other is to a company selling rooftop solar panels for use on buildings on government military bases.  In one case, we are subsidizing the cost of a product being bought by another government department, while in the other one has to wonder why private investors aren’t interested in financing a cheap alternative.  Something doesn’t seem right with these loans.

The Brookings report began by emphasizing that the biggest problem with estimating the impact of green jobs on the economy is that there is no accepted definition for classifying and counting the jobs.  The authors developed their own definition.  Shown in Exhibit 10 is their list of green jobs and how many were counted by them.  We know the table is hard to read in its shrunken form, but the greatest number of green jobs is Waste Management and Treatment – your basic sewage plant operator.  That group is closely followed by Public Mass Transit.  We bet you never thought of your bus driver or train conductor as a green employee.  The third largest group is involved in Conservation, or your park ranger.  We’re sure most of you never considered your garbage collector as a green employee, but 129,252 of them are Recycling and Refuse employees.  We sure hope they drive trash trucks powered by CNG or electricity!

Exhibit 10.  Green Jobs As Counted by Brookings

Source:  The Brookings Institute

The authors of the study also wanted to show how robust the green economy was so they produced a graph that showed clean economy jobs created versus total jobs.  As the chart in Exhibit 11 shows, the clean economy didn’t do a real good job of competing with overall job creation until the recession hit in 2008/09.  You may notice if you read the caption of the chart that the clean economy jobs numbers exclude companies that closed – either green companies or competitive firms (lost jobs due to green jobs).  The best the authors could do was to try to capture the total number of jobs lost over the entire 2003-2010 period and subtract them from the starting point.  That makes growth appear stronger than if the lost jobs were correctly subtracted from the jobs created in specific years. 

Exhibit 11.  Green Economy Jobs Vs. National Jobs

Source:  The Brookings Institute

Amidst all this discussion about green jobs and the lack of success in generating them, we were captivated by two recent articles.  One was an editorial in The Wall Street Journal (WSJ) about a study measuring the 2009 economic stimulus legislation’s impact and a report on the UK failure of green jobs written by George Hughes, formerly with the World Bank and at the University of Edinburgh. 

In the WSJ editorial, it referenced a study by George Mason economists Garett Jones and Daniel Rothschild who did field research on who actually received stimulus money and how they spent it.  The relevant paragraph stated: “In one redolent example, a federal contractor said he was told to use smaller, nonstandard tiles that are harder and more expensive to install in order to increase the cost of the project.  That way, the government could claim the money was moving out the door faster.  The famous Milton Friedman line about government ordering people to dig with spoons to employ more people comes to mind.”

The situation described by the WSJ was akin to George Hughes, writing in his report, “Myth of Green Jobs,” asking whether job creation is a good basis for assessing a nation’s economic policies. 

“I will start with a simple parable.  Suppose we are considering the adoption of two varieties of wheat.  The varieties are identical in all respects – yield per hectare, fertilizer and machinery requirements, environmental impact, nutritional value, ease of use, etc – except that Variety A requires an input of 50 hours of labor per hectare of land over the course of a crop year, whereas Variety B requires an input of 100 hours of labor.  Thus, planting 100,000 hectares of land to Variety A would “create” half the number of jobs as planting Variety B.  Does this mean that economic policy should encourage the adoption of Variety B in preference to Variety A?  Of course, the question answers itself: it would be an absurd distortion of economic criteria to argue that Variety B should be preferred on the grounds that it has a higher labor requirement.  Anyone inclined to dispute this statement should first replace all references to labor by references to energy or capital and explain why it would be more desirable to adopt a technology that requires more energy or capital without any reduction in other costs.” (English spelling corrected).

As any competent economist would agree, George Hughes concluded that “Using more labor – or capital – than necessary to produce wheat or electricity serves no purpose and simply reduces net incomes and the benefits of economic activity.  It cannot be a sensible goal of policy to achieve that outcome.”  This was essentially the conclusion of the WSJ editorial based on the two professors’ study.  This is the outcome of social policy masquerading as economics.

Exhibit 12.  Renewable Energy Subsidies

Source:  Cleantech Energy

One reason we are being hit over the head with study after study about the benefits of green jobs and clean energy is because the economy has failed to add new jobs despite massive amounts of government pump-priming spending, social give-aways and poorly conceived economic programs.  But the real reason is shown in Exhibit 12 – the pending end to green energy incentives.  With the Congress and populous more focused on government spending cuts, these green energy incentives are at risk of being terminated with devastating impact on those depending upon them for their business’s success.  As we have often said, businesses that depend upon government largess for their existence are only one legislative vote away from extinction.  That is not a blueprint for success.

The World Wind Energy Association (WWEA) released its report on the performance of the industry for the first half of 2011.  The WWEA called the first half a “sound revival” and declared that the industry had regained its momentum following a “weak” year in 2010.  Total wind energy installed capacity increased 18.4 gigawatts (GW) in the first half and the industry expects to add 43.9 GW for all of 2011.  The global industry added 37.6 GW in 2010. 

Exhibit 13.  Global Wind Capacity Additions

Source:  World Wind Energy Association

Five countries account for 74% of the installed global wind energy capacity led by China.  China added 8 GW of new turbines in the first half, the greatest half-year amount ever, which accounted for 43% of the global capacity added.  The United States, the second largest wind energy market, added 2.3 GW of power, or 90% more than added in the first half of 2010.  The other large wind power countries are Germany, Spain and India.  There are three new countries with installed wind power bringing the world total to 86.  The new wind users include Venezuela, Honduras and Ethiopia. 

Exhibit 14.  Top 10 Wind Energy Countries 2011

Source:  World Wind Energy Association

We would point out, however, that when the performance of various individual countries is examined, Spain (484 megawatts added) (MW) and Portugal (260 MW) showed very little additions as their governments have been forced to cut back the subsidies that had driven the rapid growth of prior years.  We also noticed that Italy (460 MW) and France (400 MW) also showed small wind power additions, and the UK only added 504 MW.  WWEA pointed out that only France showed a year over year decline in installed capacity.  Interestingly, Denmark dropped from tenth place to be replaced by Portugal.  This is an interesting development since Denmark is the poster child for how wind can reshape a country’s energy mix, but electricity costs have soared in recent years as a result. 

Assuming the world adds the expected new wind generating capacity in 2011’s second half, the industry will have 240.5 GW of installed capacity at year-end.  WWEA said the installed capacity would be able to cover almost 3% of electric demand all over the world.  What WWEA fails to note, however, is that the average wind turbine only produces about 30% of its rated output per year.  What that means is the installed wind capacity will only produce about 72 GW of power on a sustained basis, which represents about 1% of actual electric power generated. 

Another problem is the capital cost of wind energy compared to its primary energy rival – natural gas.  A recent report on green energy efforts in the UK showed that both onshore and offshore wind are considerably more expensive on an overnight capital cost basis than either combined cycle or single cycle natural gas-powered generators.  Offshore wind is also more expensive than nuclear power and a number of other renewable fuels.  Onshore wind compares better than offshore wind compared to other electricity generating sources.  Further to the challenge for wind power is the operating life of offshore wind facilities, which with solar, has the shortest useful operating life.  That is a factor totally ignored by proponents of wind energy when they attempt to compare the economics of wind versus conventional power plants powered by coal, gas or nuclear with operating lives of 40-60 years.

Exhibit 15.  Economic Comparison Of UK Power Sources

Source:  Gordon Hughes

Renewable energy remains the favorite of both environmentalists and our current government as the way to power the nation in the future and contribute to our economic recovery.  Despite facts about their costs and inability to create “green jobs,” renewable energy sources continue to receive funding and government support, primarily because they can be sold to the public on “feel-good” terms.  Inverting a nation’s electricity cost pyramid does not seem to us to be the best way to stimulate rigorous economic growth.

The answer to this question is important given that governments around the world desire to exercise greater control in directing how their nation’s resources are allocated with the expectation it can produce a more vibrant economy.  Underlying this economic intervention strategy is the belief that by directing or mandating investment in certain industries and businesses, faster growth can be stimulated with the result that more workers will be employed and new industries will be created.  Unfortunately, strategic government involvement has a poor record of success, yet it is repeated often by governments trapped in recessions and desperately seeking policy actions to help boost economic activity.  It reflects the mantra of politicians: Don’t just sit there, do something!

An example of an industrial policy action possibly run amuck is Brazil’s move to reduce the volume of ethanol blended in its gasoline fuel.  Beginning in the 1970s during the oil shortage era and the sharp rise in crude oil prices, Brazil, which then was a large importer of petroleum, faced significant economic issues.  The government turned to its agricultural industry to produce alcohol fuel in the form of ethanol from sugar cane and mandated the use of ethanol in gasoline to ease the economic cost of high oil prices.  The bust in energy markets in the 1980s caused considerable stress on the government’s policy, but it stayed the course while at the same time stepping up new offshore oil and gas exploration and development. 

Exhibit 16.  The Many Ethanol Fuel Mixes

Source:  Wikipedia

By 1993, the government settled on 22% as the amount of ethanol to be blended into gasoline.  At the same time, the government provided the Executive with leeway to adjust the mandate.  In July 2007, the mandate was set at 25%.  In 2003, the auto industry introduced flex-fuel vehicles – or ones that can run on any combination of gasoline and ethanol – to gain fueling flexibility. 

These vehicles became a huge success such that by 2009, 92.3% of all cars and light vehicles sold in Brazil were flex-fuel.  In December 2009, flex-fuel vehicles accounted for 39% of all vehicles in the country’s fleet.  That ratio is now estimated to be 45% and a study by UNICA, the Brazilian sugar cane association, suggests that by 2020 the proportion should reach 86%. 

Exhibit 17.  Flex-fuel Vehicles Dominate Market

Source:  Brazil Business

While the Brazilian auto industry has been growing rapidly in step with the economy, the sugar cane industry has been lagging and bad weather and harvests have created periods of ethanol shortages that have boosted prices.  As a result of anhydrous ethanol shortages in 2009/10, the government mandated a 90-day gasoline blending reduction to 20% (E20) from the standard of 25% (E25).  In association with the 2010/11 harvest, more shortages developed and the ethanol industry needed to import supplies from the United States.  The ethanol industry’s problem is that its supply is falling short of demand, driving up prices and impacting gasoline prices and supply.  At the same time, due to refinery capacity being tight, Petrobras (PZE-NYSE), the national oil company, has been importing gasoline blending components and regular gasoline to help meet demand.  During the first half of 2011, Brazil’s gasoline consumption rose by 17%. 

There is also an E100 fuel market, or hydrous ethanol used by flex-fuel vehicles.  Due to the shortage of this ethanol (E100), its price soared and created dislocations in the gasoline market as flex-fuel vehicles turned to gasoline.  Since June 3rd, ethanol prices have climbed 27% from Real 1.13 ($0.71) per liter to a peak during the week of August 26th of Real 1.43 ($0.90) per liter.  At that point the government announced it planned to cut the mandatory blend of ethanol to E20 on October 1st.  The impact will be to cut demand for anhydrous ethanol supplies and encouraging more hydrous ethanol for the E100 market, reducing its price and boosting use.  The week following the announcement of the blending change, ethanol prices fell by 2.5% to Real 1.40 ($0.86). 

For a government struggling to deal with rapidly rising inflation, reducing gasoline and E100 prices would certainly help.  As the chart in Exhibit 18 shows inflation has been on the rise since 2010.  Since May, Brazil’s inflation has exceeded the government’s 6.5% upper target range.  Year over year, inflation has climbed steadily from 5.99% in January to July’s increase of 6.87%.  For the first half of 2011, inflation has risen at the fastest pace since 2008.

Exhibit 18.  Inflation On The Rise

Source:  Business Insider

A recently proposed solution for the ethanol problem is to expand the sugar cane industry.  Since sugar cane has only increased by 2% per year for the past three years while ethanol demand is up 9% annually, there is a growing supply problem.  The harvest this year is expected to actually shrink by 5.6% due to bad weather.  The sugar cane supply tightness is amplified during the rainy season when the mills shut down and supply shortages often develop.  To address the sugar cane tightness, the state-run development bank, BNDES, will provide Real 30 billion to Real 35 billion ($19-20 billion) to finance expansion in the sector through 2014.  The funds would support a potential increase in crop yield equal to two-thirds of the nation’s current output.  From 2000-2008, ethanol output increased by about 10% per year, but since then it has expanded by only 3.3%. 

At a seminar where this expansion plan was presented, discussion focused on what it would take for the Brazilian ethanol industry to expand.  The industry stated it wanted clearer guidance from the government on the required ethanol blend in the future.  The growers also suggested they be allowed to enter into long-term contracts with distributors.  And lastly, they believe they must be allowed to create ethanol stocks in order to reduce price volatility.  Many of these requests sound similar to America’s businesses demands of our government to stimulate investment and hiring.

Exhibit 19.  Ethanol Supply Growth

Source:  UNICA

The lesson from Brazil’s decision to reduce ethanol blending is that government intervention in specific markets to achieve social policy objectives often creates unintended problems.  After a period when the government provided stability in policy – a stable blending rate of E25 – it now finds itself forced to intervene to try to manipulate ethanol prices.  The inability of the ethanol market to function properly has put pressure on Petrobras to import gasoline and blending supplies, eroding its profits.  The government’s actions are the antithesis of what businesses desire.  Even with money being thrown at the sugar cane industry, will it respond as the government wants, especially after taking an action to reduce the product’s price?  This is not a good way to run a country, but then again if the population can be satisfied by a government’s actions, politicians will be happy.  We need more bread and circuses, please.

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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.