Musings from the Oil Patch – January 17, 2012

• Will Natural Gas Price Bears Be Disappointed This Year?
• Rep. Markey Questions Race To Export US LNG
• Outlook For EVs In 2012 Depends On Subsidies
• Rare Earth Metals Put Clean Energy Technologies At Risk
• Promoting Clean Energy Often Requires Gymnastic Skills
• The Challenge Facing Energy Demand In 2012
• 2012 Brings End To Ethanol Subsidy But Not Mandate

Musings From the Oil Patch
January 17, 2012

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

An article in the business section of the Ft Worth Star-Telegram over the New Year’s weekend discussed the outlook for the region’s natural gas play – the Barnett Shale – in light of gas prices closing out 2011 at under $3 per thousand cubic feet (Mcf).  The expectation is that this low gas price will continue in 2012 and act as a damper on activity in the basin.  A senior energy analyst with the investment firm Global Hunter said that the impact of weak gas prices can be expected to cause drilling to “tail off in the Barnett….It’s going to be hard for them to keep the rigs running.”  Global Hunter has reduced its projection for 2012 average gas prices to $4/Mcf from its prior $5/Mcf estimate.  In light of currently weak gas prices, the firm expects to further reduce its price projection.

Earlier in December, the Energy Information Administration (EIA) lowered its estimate for average natural gas prices this year to $3.70, down from its prior projection of $4.13.  The agency attributes the fall in prices to the sustained production growth from gas shale basins that has pushed total U.S. natural gas production steadily higher.  The EIA estimates that 2011 production averaged 65.9 billion cubic feet per day (Bcf/d), a 6.6% gain over the average for 2010.  Since gas production grew throughout the year, coupled with few signs of any slowing in gas drilling activity, which absent a dramatic demand increase will contributes to further production growth, there will continue to be a gas surplus depressing prices. 

One of the impacts of the fall-off in drilling in the Barnett has been a decline in the financial terms for new leases.  An executive of a company involved in negotiating leases in the basin pointed out that in 2008, at the height of the Barnett boom, landowners could lease their property for $25,000-$30,000 per acre and 25%-27.5% royalties.  Today, typical lease terms would be $2,500-$3,000 per acre (some deals can get as high as $5,000-$7,000 an acre) with 20%-25% royalties.  The days of super-wealth from land ownership may be over.  As one landman once described things at the height of the boom, he laughed as he drove past a gas station and saw a farmer in his overalls filling up a Maserati. 

The extent of the decline in drilling in the Barnett can be seen from the chart (Exhibit 1) showing rig activity of major producers operating in the basin since 2008.  At year-end, Barnett active rig count jumped up to 64, but it is still only about a third of its 2008 peak.

Exhibit 1.  Barnett Producer Rig Count Down Sharply

Source:  Smith Bits, HPDI

The drilling decline can be directly tied to the fall in natural gas prices over this period.  At the height of 2008, natural gas futures were priced in excess of $13/Mcf.  Today, at just under $3/Mcf, natural gas prices are less than a quarter of their peak in 2008.  During this same period, while leasing terms declined, most oilfield service costs increased making it highly unlikely producers were making money from drilling purely dry gas wells.  To the extent that gas prices remain where they are currently trading, it is hard to see how there will be any incentive for producers to boost their drilling activity.  But in the end, this is the natural course of events that will take us to higher commodity prices as the cessation of drilling activity results in a decline in gas production, reducing the supply overhang that is depressing gas prices.

One can already see the impact of the reduction in drilling since 2008 in the chart in Exhibit 3 showing Barnett Shale horizontal well production since 2003.  Gas production from horizontal wells increased steadily from 2003 until reaching a peak at mid-year 2009.  Production then declined for about six months before resuming a steadily increasing trend until recently.  As the data shows, the

Exhibit 2.  Gas Is Now A Quarter Of 2008 Price

Source:  EIA, CME, PPHB

number of producing horizontal wells increased 230% between January 2008 and the fall of 2011, but gas production during that period only increased 62%.  This looks like a clear case of declining well productivity from newly drilled wells.  New production is struggling to offset the depletion from existing producing wells. 

Exhibit 3.  Wells Growing Faster Than Production

Source:  HPDI

What we are seeing in the Barnett data is the “treadmill effect” of gas shale developments.  That means that if drilling doesn’t remain high, a basin’s total output will eventually stop growing, flatten out and then start to decline.  The timing of this sequence will be determined by the relationship of the productivity of new wells compared to older producing wells since the normal pattern in exploitation of a basin’s resources has the more productive wells being drilled initially with subsequent wells being less productive.  As a result of this pattern, the number of new wells drilled needs to increase faster to offset the declining output from earlier, more productive wells. 

We may be about to experience Barnett production trends nationally.  The EIA gas production data obtained from the Form 914 survey for October showed that onshore output grew at half the rate of September.  Between October and September, Lower 48 Onshore gas production increased 0.54 Bcf/d.  This was in contrast to the September/August increase of 1.37 Bcf/d.  This much smaller October increase came despite the Baker Hughes (BHI-NYSE) gas rig count increasing by 26 rigs, which was twice the increase experienced in September.  The rig count data for November and December showed gas rig declines of 53 and 49, respectively, leading us to think we may see a further flattening in gas supply growth. 

The interesting thing about the individual state production data is how trends are beginning to show that gas production may be slowing.  In October, the Lower 48 producing states other than Louisiana, New Mexico, Oklahoma, Texas and Wyoming accounted for two-thirds of the nation’s production increase.  Those same “Other States” were responsible for only 15% of the total increase in September.  Additionally, Louisiana and New Mexico production was down in October after being up in September.  The other large producing states were also showing significant slowing of production growth.  Oklahoma was only up 0.01 Bcf/d in October versus 0.07 in September.  Texas experienced half the rate of increase in October from September while Wyoming had about a third of its September increase.  For those with optimistic gas price outlooks for 2012, the latest data provides a challenge for the market given the current oversupply situation.

Much like death and taxes, well depletion will eventually overwhelm a field’s productivity if drilling activity does not remain high.  Low natural gas prices will, at some point, make the economics of drilling additional gas shale wells unattractive.  Then we will see the onset of production declines that will lead to higher future gas prices.  We may be starting to see that trend reversal emerging.  The challenge for producers is to absorb the current agony of low prices while awaiting the future ecstasy of higher prices. 

Rep. Ed Markey (D-Mass) warned Energy Secretary Steven Chu about the government’s move to license liquefied natural gas (LNG) export terminals.  The ranking Democrat on the House Natural Resources Committee warned about the potential for exporting domestic natural gas in order to capture higher market prices abroad that could lead to higher home heating costs and industrial fuel bills.  "I am worried that exporting America’s natural gas would raise energy costs for American consumers, reduce the global competitiveness of U.S. businesses, make us more dependent on foreign sources of energy, and slow our transition away from fossil fuels," Markey wrote. 

We were intrigued by that last part of Rep. Markey’s statement: exporting natural gas will “slow our transition away from fossil fuels?”  One would think that if we sent all our gas abroad, then we would have to fill the fuel gap here with something else or pay substantially higher prices for new natural gas resources, which should help boost the outlook for alternative fuels.  Of course, what he is worried about is that high natural gas prices will enable cheaper coal to gain a greater share of the energy market.  But the EPA will see that that doesn’t happen. 

Is it possible that Rep. Markey doesn’t consider natural gas a fossil fuel?  Is he still back with the environmental movement when it used to love natural gas because it was the expensive but cleaner alternative to dirty oil?  When the price collapsed, cheap natural gas undercut expensive alternative energy sources depressing their chances of competing in the fuel market without massive government subsidies.  At current gas prices, the environmental movement has been forced to make every possible problem with natural gas development a scary risk to humans because cheap gas and the government’s financial crisis are clean energy’s main foes. 

In May of last year, the Energy Department approved plans for the construction of a LNG export facility by a subsidiary of Cheniere Energy Inc. (LNG-NYSE) to be located at Sabine Pass on the border of Texas and Louisiana.  The Energy Department is now considering seven additional export terminal applications.  According to Rep. Markey’s letter, which cited statistics from the Energy Department, if all eight terminals were constructed, the industry would be exporting the equivalent of 18% of America’s current natural gas consumption. 

When he approved the Sabine Pass terminal, Sec. Chu said this project “would put Americans to work producing the energy the world needs.”  At the same time he said the department would be cautious in approving additional terminals to make sure that the efforts didn’t adversely impact natural gas prices.  This was the point that Rep. Markey is concerned about.  As he wrote in his letter, "If exporting means accelerated development, then we will more rapidly deplete natural gas resources that could help sustain future generations of Americans, leading to higher prices as resources diminish."  

According to Greenwire, in a December 21, 2010, telephone briefing by Sec. Chu for the media, he commented about the possible impact on gas prices by a greater number of export terminals.  "It may be by the time you’re at five.  Or 10 might see an impact.  But we can be watching this on a continuous basis."  The problem is that approving the terminals may not have any impact on gas prices.  It will be when these terminals begin buying spot gas or contract for long-term gas supplies that a price impact may begin to be noticed.  In Cheniere’s application, its consultants stated that the impact of the Sabine Pass terminal would be at most a 20-cent boost to Henry Hub spot gas prices.  Based on current spot gas prices, that would amount to about a 7% increase from $3.00/Mcf to $3.20/Mcf.  But what might the price impact be when 18% of U.S. gas needs are being shipped abroad?  We suspect the price impact will be more than 20-cents.  The offset to an explosion in gas prices is that the higher prices will cause the gas industry to drill more wells that are currently uneconomic, and thus the nation’s supply of gas would expand to accommodate the additional demand. 

But if the latter scenario doesn’t happen, or the additional gas supplies aren’t found, at what price, or price increase, would the Energy Department feel compelled to step in and shut down LNG exports?  One of the early buyers of U.S. LNG has told us that they fully expect gas exports to be limited to about the volumes from two of the proposed eight terminals.  A reporter for Platts stated that based on conversations with Asian LNG buyers, they are avoiding U.S. LNG because they see it as a guaranteed future force majeure event, something that would create future supply problems for them. 

While many people are excited about the miracle of gas shales and their ability to radically alter the domestic gas industry, we believe Rep. Markey is asking the appropriate question of Sec. Chu and the Energy Department’s handling of LNG export terminal applications.  It is one thing to approve terminals, but another to have to intervene in the export market.  Having watched the natural gas industry for 40 years, government regulatory policy is the greatest cause of disruption for the business.  Regulatory changes have created periods of severe financial stress for the industry and its investors as government policies react to perceived shortages and surpluses.  Bureaucrats have never proven as capable of operating energy markets as free markets have.

We read a financial newsletter focused on clean energy investments at year-end in which the writer was patting himself on the back for the auto industry exceeding his estimate of the number of electric vehicles (EVs) that would be sold in the U.S. in 2011.  Obviously this writer had been less optimistic about the emerging EV market because he expected the industry to sell 10,000 units.  That figure alone was the target General Motors (GM-NYSE) set for its Chevy Volt, but it only sold about 7,000 of them.  Many of these Volts were purchased by government units and GE (GE-NYSE) who made a point of declaring its intent to support this new technology, probably because its chairman is the head of a government panel and a supporter of President Obama.  EVs are a large part of the President’s green agenda.  Nissan (NSANY-PK), the other leading manufacturer of EVs sold about 20,000 units globally, including an estimated 8,200 in the United States.  Combined, these two EV manufacturers sold roughly 15,000 units, which exceeded our financial writer’s estimate by 50%, making him ecstatic. 

One of the reasons why EVs did not sell as well as the manufacturers had anticipated was the supply chain interruption due to the Japanese earthquake and resulting tsunami.  That was not the case for the Volt, however.  Its problem was its cost, even after the $7,500 federal tax credit, and then the battery fires that hurt its public image.  EV costs and inconvenience, along with the limited number of models available were also suggested as reasons for poor sales.  EV interest was also restricted due to a lack of battery charging infrastructure.  This limited sales to people interested in the novelty of being an auto technology first mover rather than buyers attracted to the vehicle’s qualities.  The first mover influence on initial sales is supported by data showing that the average family income of Volt buyers was $170,000, not your typical car buyer. 

EV cost is a major stumbling block for these cars gaining meaningful market share.  EVs are being subsidized heavily by governments around the world, but they remain expensive even after the subsidies.  Both Britain and France have EV subsidy programs.  In Britain, buyers are provided a plug-in car grant of up to £5,000 ($7,748), and in France they get a clean-car bonus of €5,000 ($6,390).  Still, with these subsidies there were barely 1,000 EVs registered in the UK through October.  France had fewer than 2,000 EVs registered. 

Early reviewers of EVs raved about their performance, but complained about their price, especially given their limited driving range.  Nissan’s Leaf sells for more than £25,000 ($38,745) after Britain’s subsidy.  The Citroen C-Zero electric city car costs €30,000 ($38,338) even after France’s subsidy.  Autocar magazine pointed out the problem of the high price for a car “that cannot travel more than 100 miles before it needs to be stationary for hours.”  Likewise, Calum MacRae, the head of PWC Autofacts, says that these prices are extremely high even after subsidies for cars that are limited in their convenience.  PWC Autofacts estimates that pure EVs will make up 1% of the global car market in 2017. 

High vehicle cost and limited market appeal has led Morgan Stanley (MS-NYSE) auto analyst Adam Jonas to cut his global market penetration estimate for 2025 to 4.5% from his previous estimate of 8.6%.  A major reason for this lowered expectation is the competition coming from cheaper internal combustion models and the potential for significant improvement in their fuel-efficiency and reduced greenhouse emissions. 

Besides the direct tax subsidies provided to EV buyers in the United States, the federal government has provided substantial loans and grants to auto manufacturers and battery providers.  An analysis conducted by James Hohman, assistant director of fiscal policy at the Mackinac Center for Public Policy, demonstrated that each Chevy Volt sold in the U.S. in 2011 had about $250,000 in state and federal incentives behind it.  When you add up all the Volts sold, this

Exhibit 4.  High EV Costs Fail To Dent Forecasts

Source:  Financial Times

amounts to about a $3 billion subsidy for EVs.  This research group previously demonstrated there were substantially fewer green jobs generated from the grants provided to battery companies than the Obama administration claimed there would be when they proposed the funding.  While a GM spokesman, in an email response to the study and article reporting on it, characterized the analysis as “simple and selective” he offered no numbers or other information to back up that statement.  Our experience has been that when critics of a numerically-based analysis offer qualitative statements questioning the results, it is because they can’t refute the numbers.

According to Neville Jackson of engineering consultant Ricardo, gasoline and diesel vehicles use less than 20% of the energy stored in their fuel to drive their wheels, leaving substantial room for fuel-efficiency improvement.  In the United States, where the auto industry is only now being pushed to substantially increase vehicle miles per gallon of fuel performance, while Europe has been more aggressive for years.  As a result, U.S. vehicles use about the same amount of fuel as they did a decade ago.  In Britain, the average new car sold does 52.5 miles per gallon (mpg), up from 40.6 mpg ten years ago.  The engine improvements and new technologies being developed are offering car buyers similar performance with smaller, more fuel thrifty engines.  In Europe, Ford (F-NYSE) will offer a new Focus compact car that uses a one-liter, three-cylinder engine that performs as well as the 1.6 liter, four-cylinder engine it replaces, yet it uses about 20% less fuel.  Likewise, buyers of Ford’s F-150 pickups are switching to the new V6 engine that performs as well as its V8 model but is more fuel-efficient. 

Despite all this, we found that clean energy research firm Pike’s Research remains quite optimistic about what will happen to the EV market in 2012.  They put forth a list of ten observations about the future development of this market.  Those observations are:

Exhibit 5.  Room For Improving Engines

Source:  The Economist

• Increased availability and sales of EVs will answer the question of “are they for real?”
• Car sharing services will expand the EV market.
• Battery production will be ahead of EV production.
• Road tax legislation that charges for miles driven and not gallons of fuel purchased will fail.
• The Asia/Pacific region will be the early leader in developing vehicle-to-grid applications.
• PEV prices will continue to disappoint consumers.
• Third-party charging companies will dominate the public EV charging market.
• Germany, South Korea and Japan make the most progress toward commercialization of fuel cell vehicles and hydrogen fuel infrastructure.
• Employers will begin to purchase EV chargers in large numbers as a fringe benefit and to attract employees.
• EVs begin to function as home appliances adding to household power consumption.

Pike’s Research recently prepared a market study and conducted a market survey of EVs.  The consumer survey was conducted on the Internet and tapped 1,051 U.S. consumers.  The respondents were nationally representative and demographically balanced.  The study concluded that based on American’s driving and commuting patterns, plug-in vehicles (PEVs) would be a strong fit for a large number of consumers.  Forty percent of respondents indicated that they were “extremely” or “very” interested in purchasing such a vehicle, assuming the price was right.  Price sensitivity remains the overriding challenge for this industry.  The survey showed participants’ willingness to pay is much lower than EV prices currently planned by the auto manufacturers.  

Based on its outlook for the EV market and the consumer survey, Pike’s Research prepared a market study.  The firm concluded that cumulative PEV sales (including Plug-in Hybrid EVs and Battery EVs) will reach 5.2 million units worldwide by 2017.  That is up from just under an estimated 114,000 units sold in 2011.  Cumulative Hybrid EVs add 8.7 million units for a combined total of EVs of 13.9 million.  Pike’s Research believes that PEVs and HEVs combined will represent about 3% of total light-duty vehicle sales in 2017.  Unless petroleum prices escalate substantially and/or EVs get cheaper, it is hard to see these vehicles taking more than a 3% market share, and maybe even less.  That assumes governments don’t institute more mandates to drive EV sales higher.  For all the effort of governments in an era of limited spending ability to drive a green agenda based on EVs, these vehicles will only capture a minor share of the global vehicle market over the next decade.

The U.S. Department of Energy’s 2011 Critical Materials Strategy report recently issued highlights the challenges several clean energy technologies may face due to potential shortages of several rare earth metals.  The first two highlights in the Executive Summary of the report put the clean energy industries on notice of their future challenges although the report also points out that many of these businesses are already working on ways to reduce their dependency on these metals.  The two conclusions were:

“Several clean energy technologies – including wind turbines, EVs (electric vehicles), PV (photovoltaic) thin films and fluorescent lighting – use materials at risk of supply disruptions in the short term.  Those risks will generally decrease in the medium and long terms.

“Supply challenges for five rare earth metals (dysprosium, neodymium, terbium, europium and yttrium) may affect clean energy technology deployment in the years ahead.”

The report assessed 16 elements for their criticality in wind turbines, EVs, PV cells and fluorescent lighting using methodology developed by the National Academy of Sciences.  The criticality assessment measured the importance of these metals to clean energy and their supply risk.  Five rare earth elements (REEs) – dysprosium, terbium, europium, neodymium and yttrium – were found to be critical in the short term (present-2015).  These five REEs are used in magnets for wind turbines and EVs or phosphors in energy-efficient lighting.  Other elements – cerium, indium, lanthanum and tellurium – were found to be near-critical.  According to the DOE, between the short-term and the medium-term (2015-2025) the importance to clean energy and supply risk shifts for some of the elements.

Exhibit 6.  REE Criticality (Present-2015)

Source:  DOE report

Exhibit 7.  REE Criticality (2015-2025)

Source:  DOE report

In recent years, the report pointed out, demand for almost all of the materials examined has grown more rapidly than demand for commodity metals such as steel.  The demand has been driven by growth of clean energy technologies as well as consumer products such as cell phones, computers and flat panel televisions.  At the same time, global material supply has been slow to respond to the rise in demand due to a lack of available capital, long lead times to open new mines, trade policies and other factors.  Some of these other factors include complexities of coproduction and byproduction.  In other cases, the lack of market transparency and small size can affect its ability to function efficiently, further failing to provide proper market signals to producers.

With respect to the clean energy technologies, permanent magnets containing neodymium and dysprosium are used in wind turbine generators and EV motors.  These REEs are highly valued because of their magnetic and thermal properties.  Manufacturers in both industries are making decisions on future system design, trading off the performance benefits of the metals against the vulnerability to potential supply shortages.  For example, wind turbine manufacturers are deciding among gear-driven, hybrid and direct-drive systems, with varying levels of rare earth content.  Some EV manufacturers are pursuing rare earth free induction motors or are switching to reluctance motors as alternatives to permanent magnet motors.

Exhibit 8.  Materials In Clean Energy And Components

Source:  DOE report

The CFL business may be at particular risk.  The projected increase in demand for CFLs and linear fluorescent lamps as a result of the regulatory changes mandated around the globe will put upward price pressure on rare earth phosphors in the 2012-2014 timeframe when europium, terbium and yttrium will be in short supply.  Longer term, growth in the use of light-emitting diode (LED) lights to meet energy-efficiency requirements will ease the price pressure on rare earth supplies, but these bulbs are extremely expensive and not popular with consumers. 

The DOE’s strategy for dealing with these market challenges is a three-prong attack.  Manufacturers must develop strategies based on diversifying supply, developing substitutes and improving recycling.  These strategies may become challenged when, and if, governments enact new or changed clean energy technology mandates or standards.  This disruptive force – government policy – is sure to play a role in the clean energy market of the future.  Since we don’t know when or how it will impact the market, expect volatility in the REE business. 

A friend and neighbor of ours had a letter to the editor published in The Houston Chronicle shortly after Christmas.  He was formerly in the lighting business, and his letter was congratulating Nobel Prize winning economist, professor at Princeton University and New York Times columnist Paul Krugman for finally getting his desired policy of restricting toxic emissions, in particular mercury, from coal-burning power plants as mandated by the Environmental Protection Agency (EPA).  Our friend contrasted that policy with the EPA’s push to restrict the sale of incandescent light bulbs in favor of compact fluorescent light (CFL) bulbs that contain mercury but release fewer greenhouse gas emissions when used.  His argument implied that the EPA had engaged in some difficult mental gymnastics in order to justify banning the release of mercury from one energy source while at the same time promoting the increased use of it in a basic household product required to produce light. 

Exhibit 9.  Infamous Spiral CFL Bulb

Source:  Sylvania

CFL bulbs are made of glass tubes filled with gas and a small amount of mercury.  CFLs produce light when the mercury molecules are excited by electricity running between two electrodes in the base of the bulb.  The mercury emits ultraviolet light, which in turn excites the tube’s phosphor coating, leading it to emit visible light.  Conventional incandescent light bulbs produce light by heating up the metal filament inside the bulb.  When electricity passes through the filament, its temperature rises to 2,300 degrees Celsius, with the heat causing the filament to glow white-hot and emit light.  Only about 5% to 10% of the electricity is transformed into visible light with the balance generating heat. 

We are all generally familiar with the issues with CFLs and incandescent bulbs.  The former uses less energy to produce the same amount of light of the latter and as a result tend to have significantly longer useful lives.  On the other hand, CFL bulbs are initially more expensive to purchase, and until recently, were less useful – they couldn’t be used with dimmer switches, in light sockets attached to timers and in recessed light fixtures.  Until recently, the CFLs that we used at home never seemed to live up to their estimated life adding to the cost of owning them.  Lately, the performance of CFLs has improved and there are more CFLs that will work with dimmer switches, although we continue to have to hunt to find those that due work with timers.  We’ve solved the recessed light fixture issue by going to smaller sized bulbs, which means that our rooms are somewhat darker.  But we haven’t dispelled our fear of breaking one of these bulbs forcing us to undertake a “hazmat” clean-up effort. 

Because mercury is toxic to humans if consumed in large doses, the EPA has a recommended procedure for cleaning up whenever a CFL breaks.  Listed below are the recommended steps in the clean-up as presented on the EPA web site (http://www.epa.gov/cfl/cflcleanup.html). 

“Before Cleanup

Have people and pets leave the room.
Air out the room for 5-10 minutes by opening a window or door to the outdoor environment.
Shut off the central forced air heating/air-conditioning system, if you have one.
Collect materials needed to clean up broken bulb:

• stiff paper or cardboard;
• sticky tape;
• damp paper towels or disposable wet wipes (for hard surfaces); and
• a glass jar with a metal lid or a sealable plastic bag.

“During Cleanup

DO NOT VACUUM. Vacuuming is not recommended unless broken glass remains after all other cleanup steps have been taken. Vacuuming could spread mercury-containing powder or mercury vapor.
Be thorough in collecting broken glass and visible powder.
Place cleanup materials in a sealable container.

“After Cleanup

Promptly place all bulb debris and cleanup materials outdoors in a trash container or protected area until materials can be disposed of properly. Avoid leaving any bulb fragments or cleanup materials indoors.
If practical, continue to air out the room where the bulb was broken and leave the heating/air conditioning system shut off for several hours.”

Later on the web page, the EPA tries to dispel citizen concerns about the impact of a mercury spill on their health.  It tells them that these are only recommended best practices.  It points out that the amount of mercury in the CFL bulb is only about 1/100 of the amount of mercury released from a broken thermometer.  But at the end, the EPA counsels readers that if they are concerned about their health they should consult their family doctor.  That is good advice, but if one reads an article posted on NaturalNews.com they might become quite concerned about the health impact of a broken CFL.

The article, after discussing mercury in CFL bulbs, focused on a study conducted in 2008 in which researchers broke 65 CFLs.  They then tested the air quality and clean-up methods.  They concluded that in many cases immediately after the bulb was broken (and sometimes even after clean-up) the levels of mercury were as much as 100 times higher than federal guidelines for chronic exposure.  Since mercury is a naturally occurring metal that can accumulate in the body, one needs to worry about too much mercury being accumulated.  If that happens, serious damage can be done to the central nervous system. 

The study also concluded that if a CFL bulb breaks, children and pets should immediately be removed from the room and it should be completely ventilated, which is an EPA recommendation.  They also agreed that nothing should be vacuumed up.  Instead, the clean-up should be done using stiff paper or tape to lift the small pieces.  It sounds like the EPA has adopted some of this study’s recommendations.

So what is the risk of mercury in CFL bulbs?  Each CFL bulb contains about 5 milligrams (mg) of mercury, which has been described as “just enough to cover a ballpoint pen tip” according to Russ Leslie, associate director of the Lighting Research Center at Rensselaer Polytechnic Institute.  The danger from mercury poisoning is tied to this small volume in every CFL bulb sold, but when put in context to the amount of mercury released from generating electricity from coal to power light bulbs it is not as great a risk as perceived. 

CFL bulbs require about 25% of the electricity needed by incandescent bulbs to produce the equivalent light.  Since about 50% of the electricity produced in the United States is generated by coal-fired power plants, reducing the amount of coal needed to be burned by lowering power demands by the light bulb switch should be a good thing.  When coal burns, mercury contained naturally in the coal releases into the air.  In 2006, coal-fired power plants produced 1,971 billion kilowatt hours of electricity, releasing 50.7 tons of mercury into the air.  This is the equivalent of the amount of mercury in more than nine billion CFLs.

According to calculations from Popular Mechanics magazine, “Approximately 0.0234 mg of mercury – plus carbon dioxide, sulfur dioxide and nitrogen oxide – releases into the air per 1 kwh (kilowatt-hour) of electricity that a coal-fired power plant generates.  Over the 7,500-hour average range of one CFL, then, a plant will emit 13.16 mg of mercury to sustain a 75-watt incandescent bulb but only 3.51 mg of mercury to sustain a 20-watt CFL (the lighting equivalent of a 75-watt traditional bulb.)”  The magazine also made the point that if the mercury contained in a CFL were released directly into the air, there would still be 4.65 more mg of mercury released into the environment over the life of an incandescent light bulb.  As a result, the EPA’s actions to cut mercury toxins released from coal-fired power plants would help clean up the air faster when coupled with the mandated switch to CFL bulbs over time. 

Lester Brown of the Earth Policy Institute estimates that there are 4.7 billion light sockets in the U.S. and that close to one billion have CFL bulbs.  Other estimates have put the count at about five billion light bulbs in use in America with 2.2 billion light bulbs being replaced each year.  Clearly not all these light bulbs replacements are targets for CFL bulbs, but the annual bulb market appears to offer a large market opportunity for CFL manufacturers.

Mr. Brown is very hopeful that if the world switches to CFL bulbs in homes, the most advanced linear fluorescents in office buildings, commercial outlets and factories, and to LED (light-emitting diode) bulbs in traffic lights, the world’s share of electricity used for lighting can be reduced to 7% from its current 19% share.  A move of that magnitude could cut power demand sufficiently to allow the closure of about 28% of the world’s current coal-fired power plants.  This is an admirable goal, but given the opposition to CFLs because of their light quality and cost, we suspect it will be a long time before we see that many coal-fired power plants closed due to declines in electricity demand. 

If one has been watching global stock markets for the past six months or so, the overwhelming message has been: The world’s coming to an end!  No it’s not!  This bipolar view of our future has led to the Risk On/Risk Off trades in financial markets generating a high level of price volatility in the stock market with little positive or negative movement overall.  What has been keeping global financial markets in turmoil has been concern over the pace of the economic recovery in developed economies, the uncertainty about the true health of the Chinese economy, and, most importantly, the lack of confidence that Western Europe can solve its sovereign debt problems.  All of these are important determinants for economic activity in 2012, but the European challenge posses a significant dilemma because its resolution will determine the fate of one of the world’s major currencies – the euro. 

The resolution of these issues depends on how governments are going to deal with their massive debts and unfunded liabilities.  These unfunded liabilities are becoming a powder keg in societies, as they often represent the only financial support available for aging populations, a phenomenon that is beginning to overwhelm the fabric of society in many countries.  In many European countries, these social payments have encouraged citizens to leave the workforce early.  Shrinking workforces have been offset through increased immigration that has added new dynamics to the economic challenges – ethnic and cultural clashes.  As minorities with radically different cultures have grown to become meaningful percentages of various country populations, their lack of employment skills that limit many to only menial jobs has contributed to a growing disenfranchised segment of the population.  Over the past few years, we have witnessed violence fostered by these cultural and social problems and the belief by these disenfranchised people that they are entitled to economic rewards, which they take when riots lead to ransacking of shops.

To maintain the peace, governments have been forced to spend billions in social welfare aid to these disenfranchised minorities while still supporting their basic geriatric welfare systems.  This has contributed to the growth in government debt and unfunded liabilities.  The map in Exhibit 10 shows the world with circles representing the amount of government debt outstanding for major countries.  The size of the circles suggests the world has been on a borrowing binge financed by a handful of countries with better financial positions.  The structural problems for many of the wealthy western economies are dictating that overall debt balances need to be reduced in the coming years in order for them to begin growing.  Not until they start growing will governments be able to create well-paying jobs that will employ their growing ranks of unemployed who, at the moment, are adding to the government’s financial burden. 

Exhibit 10.  Debt Remains Big Overhang

Source:  Financial Times

The slow economic growth in the western economies is a reflection of the problems caused by this heavy debt load.  Government debt contributes to reduced consumer spending, higher inflation, lower capital investment and general anxiety.  These reactions also contribute to un- and underemployment, which in turn adversely impacts government finances causing economic pain to be constantly recycled. 

We were intrigued in reading a column from an Irish economist who discussed a recent paper by Richard Koo, a Japanese economist, who has studied the causes of the recession in Ireland.  Like almost all the countries that experienced a recession in 2008-2009, the initial cause was the collapse in the country’s housing market and the resulting fallout.  The recession came because of fear on the part of the country’s citizens after they saw their wealth evaporate with the collapse in housing prices and the explosion in debt used to finance home purchases.  As a result, citizens began to recognize that tens of thousands of their neighbors, and possibly even themselves, were broke and would likely never get out of debt.  This made them extremely nervous about spending and incurring debt. 

Exhibit 11.  Saving Is Recession Reaction

Data: Eurostat, Central Statistics Office, Ireland
Source:  www.DavidMcWilliams.com

The chart in Exhibit 11 shows how spending (or saving) by Ireland’s households, its corporate sector excluding its financial institutions and its government has trended since 2002.  The household sector was clearly on a spending/borrowing binge that reached a negative 10% of Ireland’s gross domestic product (GDP) in 2006.  On the other hand, the industrial corporate sector experienced cyclical periods when it generated funds and when it reinvested them during the first few years of the period, but as we neared the latter part of the decade, corporate investment ramped up.  During this entire period the government was generating positive savings because it was the beneficiary of tax inflows from the healthy economy.  When the housing bubble burst and people landed out of work and families went broke, the anxiety about debt and spending caused families to become reluctant to spend and they avoided debt at all costs while ramping up savings.  This anxiety-driven change in spending and savings habits became ingrained, much like the spending and saving patterns of those who lived through the Depression who remained thrifty throughout their lives. 

As the chart (Exhibit 11) shows, the combined savings of households (14.26%) and the corporate sector (7.29%) reached a combined 21.55% of GDP in 2009 compared to about a negative 4% in 2006.  Government has tried to offset this economic contraction by stepping up its spending, which accounted for 16.78% of GDP.  The net spread is nearly 5%, which is a drag on the Irish economy.  The problem is that this spending shift can only last for a short while, as the government finds its ability to finance the necessary economic support limited by its worsening financial picture.  In the end, Ireland, along with a number of other western economies needs to deleverage its balance sheet.  It is this phenomenon that is restricting economic activity, and in turn energy demand.

Martin Wolf, economic columnist for the Financial Times, has written a column about the fragility of the 2012 economic recovery in western economies.  One chart accompanying his article showed how the 2012 economic growth forecasts for western economies were reduced steadily throughout 2011 with the lone exception of a December increase for the United States.  (See top chart in Exhibit 12.)  The most recent forecasts now call for Italy, which was initially projected to have 1% GDP growth this year to now be looking at a negative 1%.  Spain, with an early estimate of greater than 1% growth is now expected to shrink by a few tenths of one percent.  That forecast is before the latest government estimates of Spain’s budget deficit, now projected at 8.2% of GDP, up from the prior estimate of 6%.  With new government spending cuts and increased taxes, Spain’s GDP growth will probably be lower than the December estimate. 

Germany that was once looking at 2% growth is now projected to grow by only an estimated 0.5%.  That will be better than France, which is now projected to barely have any growth in 2012.  The net result is that the eurozone is now projected to experience negative growth in 2012 in contrast to the earlier estimate of about 1.6% growth.  This gloomy outlook will continue to pressure countries in the eurozone to embrace austerity measures to attack their high debt levels, but at the same time further crippling their economies and their growth potential. 

Mr. Wolf examines the various government strategies that have been tested in recent years to deal with the economic fallout of the recession and financial crisis.  He draws on the theories of Hymen Minsky who laid out a hypothesis for financial instability of economies.  What Mr. Wolf fails to address is the prevailing view of European governments that treaty agreements, rules and regulations can solve the problem of a lack of cash.  This may be the greatest shortcoming in the European solution to its sovereign debt

Exhibit 12.  A Gloomy Outlook For Economies

Source:  Financial Times

crisis.  Mr. Wolf closes his column with the following observation about the eurozone.

“In the eurozone, however, this shift to fiscal austerity is running alongside a still bigger experiment: the construction of a currency union around a structurally mercantilist core among countries with negligible fiscal solidarity, fragile banking systems, inflexible economies and divergent competitiveness.  Good luck for 2012.  Everybody will need it.”  If you are in the energy business, you should not be counting on the eurozone to boost global energy demand this year.  Rather, you should be hoping that the eurozone doesn’t experience a Lehman-like financial crisis causing the euro currency to implode.  The eurozone remains the key risk to the global economy and energy prices in 2012.

As we ushered in the New Year, Congress in its infinite wisdom allowed the subsidy for producing ethanol, a 33-year venture, to expire.  The problem is that the Congress failed to end the mandate that ethanol account for at least 10% of our gasoline supply, which is now being pushed up to 15%.  The government used to subsidize the conversion of corn into ethanol, the original fuel used by Henry Ford when he built his first cars, but now no longer.  That subsidy was $0.45 per gallon and in recent years amounted to about $6 billion a year paid to farmers and ethanol refiners.  With the ending of that subsidy but not the mandate, consumers will have to pay more at the gasoline pump to account for the higher ethanol price needed to offset the lost subsidy.  Could that explain why gasoline pump prices jumped by 6-cents per gallon last week?

Because the mandate, coupled with the subsidy, contributed to a rapid growth in ethanol production, output today exceeds demand as gasoline consumption has been falling recently.  To deal with this ethanol oversupply, the government moved to mandate that ethanol account for 15% of our gasoline supply.  Since the U.S. has been less successful than Brazil, in convincing consumers to purchase flex-fuel vehicles that can use either the 10%/15% ethanol-blended gasoline or a fuel mix with 85% ethanol, demand for the product has failed to keep up with mandated supply growth.  This is due to ethanol consumption being tied to conventional gasoline consumption.  In the latest weekly data on gasoline purchases from MasterCard, volumes are down about 7% from a year-ago reflecting the fall in miles driven by the average vehicle. 

The ethanol situation is so bizarre that the U.S. is exporting corn-based ethanol to Brazil while California refiners are importing sugar-based ethanol because the price is cheaper given the removal of the export tariff.  So far, over the 33-year life of the ethanol subsidy, the cost to the American taxpayer has been about $45 billion.  The problem with the ethanol program is that it has failed to produce the

Exhibit 13.  Ethanol Mandate Drives Output Higher

Source:  International Business Daily

gains anticipated when it was established – to save our environment and set us on a path to energy independence.  Today, we are more dependent on foreign oil for our transportation needs and the environment has been hurt by the increased conversion of land to farming and greater use of water.  It takes 1,700 gallons of water to produce one gallon of ethanol.  In addition, it takes 130 pounds of nitrogen fertilizer and 50 pounds of phosphorus for each acre of farmland growing corn adding to our environmental issues.  Lastly, the mandate has driven the price of corn up, which has also raised food prices.

According to the Hoover Institution’s Henry Miller and professor Colin Carter of the University of California, Davis, "ethanol yields about 30% less energy per gallon of gasoline, so miles per gallon in internal combustion engines drop significantly."  Other than all these problems with ethanol, the program was a success.  The major problem is that Congress was only able to do half the job in killing the ethanol subsidy.  By failing to kill the mandate, it has insured the environmentalists a continuing cause to promote and it has condemned the American consumer to higher gasoline prices.  Nice job, Congress!

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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.