- Oil Companies Become More Bullish
- ExxonMobil’s Tillerson – Gas Pipeline Bad Cop?
- Is India the World’s Overlooked Energy Dynamo?
- Oil Company Cash Flow Allocation Strategies
- Wind Power Is Good; Just Not In Front of Anyone
- Environmental Columnist Attacks Offshore Virginia Drilling
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
Oil Companies Become More Bullish
The mid-year Lehman Brothers worldwide exploration and production capital expenditure survey for 2007 suggests that oil and gas companies are becoming more bullish about the outlook for their business. The survey reports that global expenditures of the companies surveyed will climb by 13% this year, up from the December 2006 estimate of a rise of only 9%. The major driver for the increased bullishness is a more than 50% increase in the growth in international expenditures to 20% from the earlier forecasted gain of 12.7%. This step-up in international expenditures supports the discussion among oilfield service industry executives about better overseas business opportunities. The service companies have been capitalizing on these improved market opportunities by shifting assets and staff abroad. Witness the growth in the international drilling rig count over the past 12 years, which is further reflected in this month’s rig count jump the largest monthly gain since 2002.
Exhibit 1. Oil Industry 2007 E&P Spending Ramping Up
Source: Company data, Lehman Brothers, PPHB
The Lehman spending survey also showed that spending plans in
In the
Exhibit 2. International Rig Count Reflects Higher Spending
Source: Bear Stearns, Baker
What may be the most important consideration for oilfield service executives and investors are the survey’s indications for preliminary spending plans in 2008. According to the survey, only about 8% of respondents indicate that they plan to reduce their spending in 2008. That response may be deceiving as it may reflect a handful of companies transitioning exploration and development programs, i.e., a spending reduction due to timing issues. Importantly, some 45% of respondents indicate that they plan to spend 10% or more in 2008 than this year. Clearly, that margin of enthusiasm for increased drilling might be tamed if the global economy softens and energy prices weaken, or oilfield inflation accelerates. Indications are that the latter issue may be less of a problem as the weakening in North American drilling activity in late 2006 and early 2007, coupled with growing equipment capacity additions has taken the wind out of the sails of oilfield price increases.
Last Monday when the Lehman Brothers’ oilfield service analyst team issued its report on the capex survey and held a teleconference call with investors to discuss the results, the Philadelphia Oil Service Index (OSX) soared by 2.6% over its close on Friday. To Monday’s intraday high, the OSX rose 2.8%. In contrast, the Dow Jones Industrial Index climbed only 0.1% with an intraday high rise of 0.4%, while the Standard & Poor’s 500 Index was up 0.2% with an intraday peak gain of 0.3%. Investors apparently were wowed by the higher growth forecast for exploration and development expenditures. The fact that the broad stock market indices barely climbed highlights the impact of this survey on the investor love-affair with energy and oilfield service stocks.
ExxonMobil’s Tillerson – Gas Pipeline Bad Cop?
In a meeting with reporters following the company’s annual shareholders meeting in
Earlier this year, ExxonMobil’s 69.6% owned subsidiary, Imperial Oil Company (IMO-TSX), the lead on the Mackenzie Valley pipeline project, announced that the projected cost to construct the 1,200-kilometer natural gas pipeline had grown to $16.2 billion from the
Exhibit 3. Significant Arctic Gas Reserves Are At Risk of Loss
Source: CAPP
prior estimate of $7.5 billion. The project is currently under review by
Exhibit 4. Lost
Source: EIA
Exhibit 5.
Source: CAPP
Mr. Tillerson further commented to the reporters that although his company has not done any recent cost studies for the Alaskan natural gas pipeline, he believes these costs have risen dramatically, also. One major explanation for the rising costs has been the jump in the price of steel, which is the primary component in the pipelines. In addition, as we have seen in the escalating costs to develop new oil sands projects, labor costs are rising sharply due to its lack of availability. Since new and expanded oil sands projects are scheduled for construction for a number of years into the future, the labor supply to support the new Arctic pipeline projects is shrinking. The remaining labor supply will cost much more than previously projected.
What is most interesting in reading Mr. Tillerson’s comments, and those of an Imperial Oil spokesman, is speculating on whether the former was playing the bad cop while the latter was the good cop. For example, according to press reports, Mr. Tillerson characterized the viability of the
On the other hand, Imperial Oil spokesman, Pius Rolheiser, stated that his company doesn’t believe the project is “dead”, but he acknowledged that, “We’re looking for a fiscal framework that recognizes the unique and now very high-cost nature of this development.” He went on to point out that, “Historically, projects that have opened a new basin have been subject to similar challenges.” Imperial Oil has asked the Canadian federal government to pay for related infrastructure such as roads, for accelerated depreciation (to shelter earnings and maximize cash flow) and for a guarantee that third parties will ship gas on the line.
So what is to be gained by this good cop/bad cop routine? For the companies that own the natural gas reserves on the North Slope of Alaska and in the
As ExxonMobil, Royal Dutch Shell (RDS.B-NYSE), BP (BP-NYSE) and ConocoPhillips (COP-NYSE), the primary North American arctic gas reserve owners, look to their future corporate growth opportunities, developing the arctic reserves is rising in importance. We suspect this realization may be behind Mr. Tillerson’s comments. Attempting to convince the Canadian, Alaskan and
Exhibit 6. The Pipelines Are Challenging Construction Jobs
Source: CAPP
Is India the World’s Overlooked Energy Dynamo?
Whenever global energy demand drivers are discussed, besides questions about the supply side of the equation, the most talked about subject is the growth of developing countries –
Another reason China’s entry onto the global energy stage was so dramatic was due to the fact that the world’s primary energy forecaster, the International Energy Agency (IEA), had a poor model, due somewhat to the lack of timely and accurate energy consumption figures for the country. As the IEA improved its forecasting model, it faced the question of how best to revise its historic data and unveil a new, sharply higher energy demand forecast. When the IEA decided to announce its revisions in one fell swoop, energy markets were shocked. However, the IEA’s new forecast has proved quite accurate. But what is interesting is that while the focus on the impact of
The IEA in its Monthly Oil Market Report discusses the economic activity and its impact on energy demand in both China and India each month, but it usually only identifies China’s oil demand, while lumping India’s in with the rest of Asia. Recently, there have been a couple of reports on
Exhibit 7.
Source: McKinsey & Company, PPHB
The impact of this growth will be that almost 300 million Indians will emerge from poverty. It will produce about 1,000% expansion in India’s middle class – from about 50 million people, or five percent of the population, in 2005 to 583 million in 2025, almost twice the current population of the United States. The MGI report, entitled “The ‘Bird of Gold’: The Rise of India’s Consumer Market” has a number of other interesting predictions. The report predicts that
The MGI report examined the population growth of
When the study examines population spending patterns into the future, it finds that more of the consumer’s income will be spent on discretionary items and less on necessities. Of particular interest to energy markets is the prediction that transportation, a key discretionary budget item, should expand from its 7% share of consumer spending in 1985 to 20% of a significantly larger income stream by 2025. What does that mean for
As we look at the historic growth in consumption of highly developed economies and the low per capita use of oil by countries such as
Exhibit 8.
Source: Energy & Capital
more closely mirror those of
Exhibit 9.
Source: BP, EIA, UN, PPHB
We also looked at the impact on consumption if
As we look to
When we project
So which oil consumption pattern will
Oil Company Cash Flow Allocation Strategies
We’ve written several articles lately discussing the issue of how best for managements to return surplus corporate cash to shareholders. The issue is whether dividend payments or stock buybacks are the most effective way to achieve this objective. After our latest missive, our good friend Art Smith, the head of oil industry research firm, John S. Herold, Inc., sent along a recent report he and his staff prepared entitled “Cash Flow Management – XOM Style”, subtitled: “Strategies for Reinvestment of Cash Flows By the International Integrated Oils” (IOCs).
The report pointed out how the funds returned to the shareholders of the IOCs reached $98 billion ($35 billion of dividends and $63 billion in share repurchases) in 2006, and that this largess is claiming a greater proportion of the companies’ cash flows. These increased returns to shareholders have been supported by strong cash flow growth, evidenced by a doubling of the combined cash flows since 2002 for the six leading IOCs. As Mr. Smith points out, based on his knowledge since the 1970s (he’s been at this almost as long as I have), in all prior energy bull markets the oil industry’s mantra has been to invest every dollar of cash flow, and them some, in drilling new holes in the ground searching for more oil and gas. It was this strategy, and the poor shareholder returns it produced that has been responsible for the greater attention to dividends and share repurchases in recent years. For once, it appears the old expression ‘This time is different!’ may be right.
The Herold research paper examines the amount of cash flow the IOCs have had and are likely to have in the future, how they have spent and may spend it, and the potential impact of their decisions. The analysis begins with the recognition that dividends and share repurchases have increased as a share of the growing cash flows of the companies. Herold pointed out that the six IOCs devoted 53% of their 2006 cash flow to dividend payments and share repurchases. They averaged spending 45% of their cash flows on dividends and shares during 2002-2006. Last year, the amount of money spent on dividends and share repurchases was equal to 90% of the total amount the companies spent on new capital expenditures to grow their companies.
Given the vast amount of money devoted to share repurchases by these IOCs, the study’s conclusion of the financial impact was most interesting and, as the authors concluded, counterintuitive. They found that the “relative or absolute dollars channeled into share repurchases do not directly translate into superior total shareholder returns.” The conclusion was supported by their examination of the allocation of cash flows by the individual IOCs during 2002-2006 between dividends and share repurchases and the resulting share price performance.
Herold was quite intrigued that ExxonMobil (XOM-NYSE), who led the pack in terms of dollars committed for share repurchases (buying back 16% of its 2002 share base) and dividends paid, finished in the middle of the pack in stock performance with an average annual total return of 16%. In contrast, ConocoPhillips (COP-NYSE) invested the least amount of money in dividends and share repurchases, but topped the group in return performance with a 21% average annual total. The conclusion is that investors were applauding the aggressive merger and acquisition program of ConocoPhillips and that its use of financial leverage was truly working for shareholders during the current bull market for commodities.
An unanswered question is whether ExxonMobil’s beginning valuation was much higher than its competitors such that the other companies were actually closing a gap that enhanced their short-term performance. ExxonMobil has outperformed its competitors in most return and profitability measures for a long time. As a result, we suspect its shares were more highly valued by investors than the competitors. As the energy bull market developed, investors focused on the lower valued companies attempting to capitalize on both rising company earnings and expanding share valuations.
After weighing the pros and cons of dividends and share repurchases, Herold favors the latter. Their reasoning is that share repurchases help support the share price by offsetting the creeping dilution from option exercises and grants. They also believe that
At the end of the day, Herold would like to see more funds devoted to enhancing organic growth within the IOCs, but it recognizes the challenges management has in attaining this objective in a cost-efficient manner. Management must always be trying to balance the cost and potential returns from organic growth investments (drilling new wells) versus reserve acquisitions through either share repurchases or purchases of other companies. Depending upon stock market conditions and company valuations along with potential exploration projects, managers must constantly balance the return opportunities. In the interim, share repurchases are a cost-effective strategy for boosting volumetric/operational metrics on a per share basis, which seems to be the only concern of Wall Street analysts and investors. But if share repurchases haven’t helped ExxonMobil shareholders as much as other strategies, one has to question this conclusion.
Wind Power Is Good; Just Not In Front of Anyone
Last week, an op-ed article in The Providence Journal, authored by David Tuerck, the executive director of the Beacon Hill Institute and the co-author of several studies attacking the Cape Wind wind-farm project in Nantucket Sound, discussed why this is a poor project. He cited many economic and political reasons to oppose
Additionally according to Mr. Tuerck, “concerns abound that the project would pose threats to navigation, fishing and birds.” However, virtually every review of the
Wind power is recognized as possibly the most environmentally-friendly energy source available, although its consistency is always a question mark. But those wind turbines are not the most visually-pleasing sight. So wind farm developers are trying to come up with alternatives that are more consistent, thus being more economic, while remaining out of sight. How do you do that? One idea is to stick it up in the air, about six miles up. This would put it in the middle of the jet-stream where the winds are stronger and blow more consistently than ground-level winds and can generate up to a hundred times more energy.
Sky WindPower, a company based in
Exhibit 10. Sky WindPower Arial Wind Turbine
Source: Sky WindPower, Economist
Ken Caldeira, a climate scientist with the Carnegie Institute, who has worked with Sky WindPower, estimates that harvesting just one percent of the jet stream’s energy would produce enough power for everyone on the planet. This would represent the holy grail of energy markets. Even at lower altitudes, the winds are stronger than they are at the surface, and that is attracting the attention of other investors.
A Canadian company, Magenn Power, has developed a proposal for a wind generator filled with helium that revolves around a horizontal axis, like a water mill, and could fly at an altitude of up to one kilometer. A Dutch venture, with backing from Royal Dutch Shell (RDS.B-NYSE) and Nederlandse Gasunie, a Dutch natural gas company, is developing a dual kite system in which each kite turns a generator as it rises to an altitude of several hundred meters. At its peak altitude, the kite shape is altered so it catches less wind and it is then reeled back in using a very small amount of electricity. By having one kite reeling out at the same time the other is being reeled in enables the system to create a steady source of electricity.
We wonder how many people are going to want to see cables and wires rising into the sky in front of their homes. Or maybe all these wind farms can be located in remote areas of the country. Of course, we would then need to erect more transmission towers and power lines in order to move the electricity to the population centers. For those of us who fly, will we now be treated to announcements from the cockpit suggesting we look out our window to see the new power plants in the sky? I wonder if they can be used as signposts for the pilots to know where to turn left or right. Talk about more visual pollution!
Environmental Columnist Attacks Offshore Virginia Drilling
Spending time at our summer house in
The recently proposed five-year plan for offshore oil and gas lease sales by the Interior Department contained a sale of three million acres located in the central Atlantic Ocean off
Mr. Flattau attacks the drilling plan because he fears the damage that might be done to the beauty of the chain of barrier islands off a 50-mile stretch of the
According to Mr. Flattau, “Oil from the notorious 1989 Exxon Valdez spill in
There are two very critical points Mr. Flattau gets wrong in dragging out the Exxon Valdez for his argument against offshore drilling. First, this was a tanker accident, not a drilling-related spill. In fact, almost all offshore oil spills in
Exhibit 11. Location of
Source: State of
The second consideration is that the Exxon Valdez accident occurred within 50 miles, not 200 miles, of the coast. Maybe Mr. Flattau confused the fact that oil from the spill covered heavily or moderately about 200 miles of
Exhibit 12. The Extent of Exxon Valdez Oil Spill
Source: EPA
As far as offshore oil drilling accidents, the most famous
The most spectacular offshore drilling accident was the Ixtoc well blowout in June 1979. That offshore drilling accident happened in the
The
The case against drilling offshore
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