Musings From The Oil Patch, February 4, 2014

• A Dutch Gas Bubble Could Create Global Indigestion
• Auto Sales, Fuel Demand And Our Vehicle Future
• Was Obama’s Climate Change Effort Sabotaged By The NSA?
• Europe Facing The Reality Of Climate Change/Energy Policy
• Energy Markets Confront Another Polar Vortex

Musings From the Oil Patch
February 4, 2014

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 recent article discussing production-related challenges for the giant Groningen natural gas field located in the northern region of the Netherlands referred to the field as a “bubble” holding an estimated 2,800 billion cubic meters (Bcm) of gas.  The field’s initial discovery well was drilled in 1952 and the field was defined by 1959.  It is the largest gas field in Europe and the tenth largest in the world.  The significance of Groningen was not merely its size but that its development provided knowledge to oil and gas companies about how to develop such large fields.  Additionally, the geologic knowledge from developing the field enabled the industry to open up the entire Northwest region of Europe to the hydrocarbon industry that eventually led to the development of the North Sea.  Despite its age, still today, more than 50% of all the natural gas reserves produced in Europe come from Dutch territory.  Groningen has been a major source of income for the government while supplying the Netherlands and other European countries with clean energy.  Estimates suggest the field has about 720 Bcm of natural gas remaining after producing roughly 2,000 Bcm over its 50-year life. 

Just over a week ago, the Dutch government announced it would reduce output from the field by about 25% in order to appease local residents concerned about the impact of earthquakes associated with the field’s production.  Beginning in 1986 near the town of Assen, tremors were felt.  Since then, there have been about 1,000 earthquakes recorded in the area according to the Dutch Meteorological Institute, with the largest reaching 3.6 on the Richter scale in August 2012 near the village of Huizinge.  The oil and gas industry has warned of the possibility of earthquakes, ranging upwards of 4.5 to 6.0 on the Richter scale, associated with production from the Groningen field.  Essentially, the earthquakes result from shifts in the subsurface of the field as gas volumes are extracted.  In essence, this is a case of localized subsidence, which when it occurs can create underground tremors as the subsurface compresses. 

Exhibit 1.  Location Of Groningen Gas Supply

Source:  energy-pedia.com

Last November, the local cultural heritage service said that the earthquakes had damaged 69 out of 100 listed buildings in the northern part of the province.  A survey by current affairs program EenVandaag showed that 60% of the local residents want gas production from the field to be cut while 23% want it stopped all together.  Mining regulator Staatstoezicht op de Mijnen has advised government ministers that Groningen’s output should be reduced by 40% to help mitigate the recurring earthquakes.  A reduction of that magnitude would have significant financial repercussions on the Dutch government that is still struggling from the aftermath of the financial crisis and a stagnant economy over the past five years. 

At his weekly press conference a few weeks ago, Netherlands Prime Minister Mark Rutte said in response to the issue of the earthquakes associated with the Groningen gas field, "The studies showed that there are risks and consequences, including earthquakes."  He went on to say, "They not only cause material damage but also serious emotional damage.  The cabinet understands that people are worried."  The emotional distress can be explained by the fact that in 1991 there were only four tremors compared to 125 last year.  The prime minister’s comments were followed the next day with the announcement that gas output would be cut to 42.5 Bcm for 2014

Exhibit 2.  Frequency Of Earthquakes In Groningen

Source:  State Supervision of Mines

and 2015 and further reduced to 40 Bcm for 2016.  The prime minister said that it was technically feasible to reduce output from the field to 30 Bcm a year and still meet the nation’s gas supply needs.  In 2013, Groningen produced 53.8 Bcm due to a long and cold winter.  Production for 2014 had been targeted to be about 49 Bcm before the reduction edict.  (The production forecast shown in Exhibit 3 below reflects a 2007 plan.  The first blue bar would have been about 10 Bcm higher for 2013.  Given the production cuts, the next three blue bars will be below those pictured in the chart.)

Exhibit 3.  Groningen Gas Output And Forecast

Source:  www.nlog.nl

The difference between 2013’s gas output from Groningen and the technically-feasible level needed to satisfy domestic supply is only one highlight of potential shifts that may occur within the European natural gas market with knock-on effects throughout Europe, Russia and the United States.  The operator of the field, Nederlandse Aardolie Maatschappij BV, otherwise known as NAM, a 50/50 joint venture between Royal Dutch Shell (RDS.A-NYSE) and Exxon Mobil Corp. (XOM-NYSE), produces 75% of all the gas extracted on Dutch territory and about 50% of all the crude oil produced.  The gas from Groningen goes to GasTerra, a Groningen-based international company that trades in natural gas, with most of the output being sold to utilities and large industries in the Netherlands, although some gas is shipped to Germany, Italy, France and the UK. 

The Dutch government earns about €12 ($16.3) billion annually from the sale of Groningen production.  The decision to cut output means state income will fall by €600 ($813.2) million in 2014, €700 ($948.7) million in 2015 and €1 ($1.4) billion in 2016, given the projected production and gas prices.  The lost income will be in addition to the €1.2 ($1.6) billion to be spent over the next five years to strengthen buildings, houses and infrastructure in the region.  These investments hope to reverse the decline in house prices due to the actual and potential earthquake damage. 

Making up for the potential €3.5 ($4.8) billion drain on the Dutch treasury over the next 3-5 years is the first order of business for the government.  Expectations are that some of the lost income will be recouped by increased imports and exports that will find their way through the Dutch energy hub.  The expectation that Groningen’s gas volumes would be cut has already boosted local gas prices, which should not be a surprise, but also a pain for citizens and businesses.  The biggest beneficiary of the Dutch cut will be Gazprom (GAZ.BE), which sees being able to sell an additional 175 Bcf of gas to Europe, thus earning an additional $1-2 billion in revenues, and further strengthening Europe’s dependency on Russian gas.  Oil-price-linked gas imports will keep energy prices in Europe high providing an environment in which slightly cheaper Russian pipeline gas can capture a greater market share. 

Another unique aspect of Groningen that may alter the European market is its gas quality.  The Groningen field produces low-calorific gas, used extensively in central heating boilers and for domestic cooking.  Europe has limits in processing capacity to convert high-calorific gas into low-calorific gas through the addition of nitrogen.  This raises the issue of how easily the lost Groningen gas output can be replaced with high-calorific imports.  This increases the possibility of a two-tiered gas market for low- and high-calorific natural gas, at least for a while, until conversion capacity is installed, further complicating the European gas market.

The Netherlands faces another challenge from the Groningen production reduction, which is the potential impact on pricing of seasonal flexibility.  The field is used in conjunction with two smaller fields – Norq and Grijpskerk – for storage of gas for winter demand.  In a report on the impact of Groningen production on seismic activity following the August 2012 earthquake, the State Supervision of Mines made the following observation: “higher magnitude earthquakes seem to occur with a delay of six to nine months following a winter peak production period.”  If this observation holds up under further examination, it raises the possibility of a greater impact from restrictions on peak production.  This means Groningen’s flexibility to supply seasonal supply could be reduced.  The industry will not know how, or if, production restrictions might impact supply for some time. 

Ultimately, however, the greatest risk for the European gas market is the commodity’s high price and how that impacts current and future supply arrangements and demand.  Because so much of European gas volumes are indexed to high-priced crude oil, cheaper coal has been gaining market share in the power generation market.  With European Union environmental policies dictating that member governments institute mandatory purchase requirements for costly renewable fuels to enable the EU to meet its carbon emission goals, electricity costs have risen to levels that are hurting economic activity.  As a result, there is a growing concern over how much of an energy-demand failure the continent may experience.  In addition to that concern is the absence of any localized gas-on-gas price competition that could put downward pressure on overall gas prices.  Absent some change in the gas market, it appears that Russia will gain greater market share and have more influence over the European natural gas market in the future, something many governments fear.  Maybe that fear will translate into aggressive strategies to tap cheap LNG from the United States.  It could also make European governments question whether it is prudent to support exploration of their domestic shale resources. 

From a decision to cut Groningen gas output, we could see a series of events that lead to an even greater restructuring of the global natural gas market than presently contemplated.  While we have outlined some of the potential changes, we are sure there will be a multitude of associated market changes and unintended consequences that will further impact the market.  We are only now beginning to appreciate the potential scope of a global natural gas market.

American auto sales hit 15.6 million units last year, up 7.6% from 2012 and above the 15 million threshold for the first time since 2007.  Every auto manufacturer was profitable and results put the dismal fortunes of 2009 when General Motors (GM-NYSE) and Chrysler were forced into bankruptcy and a government bailout behind the industry.  Results were driven by a series of economic factors including: pent-up demand from buyers who had delayed purchases in recent years and were stuck driving older cars; an improved stock market, which lifted not only household wealth but also consumer confidence; lower unemployment, which means more Americans can afford to purchase a car; increased access to credit, as lenders offered attractive rates on both car loans and leases along with sub-prime lending returning with a vengeance; and the rebound in the housing market, which allowed homeowners to refinance and free up money for a car payment.  Expectations are that these forces will remain in place in 2014, but their impact on auto sales will moderate.  Industry experts anticipate an increase in 2014 sales to about 16 million units.

Exhibit 4.  History Of Vehicle Miles Traveled

Source:  St. Louis Federal Reserve Bank

There are several forces at work in the transportation market that will impact automobile sales and fuel consumption.  If we look at a chart (Exhibit 4) of vehicle miles traveled based on a 12-month moving average, we notice that following the 2007 peak there was a subsequent decline, but since 2009 the average has gone sideways, albeit in a wavy pattern.  This stability has not completely helped gasoline consumption as shown in Exhibit 5 on page 7, because we have had a reconfiguration of the American vehicle fleet with more fuel-efficient vehicles replacing older, less-efficient ones.  The demographic trends that are eroding the growth in vehicle miles traveled – an aging population that drives fewer miles; younger people who are delaying obtaining their driving licenses or are avoiding using cars altogether; and social trends including growing Internet shopping, more people working from home, increased urbanization reducing the need for cars, and higher unemployment eliminating commuting mileage – do not appear to be ready to change.  Still, the forecasters at the Energy Information Administration (EIA) continue to project that as we move further away from the 2008 financial crisis and resulting recession, American car ownership and vehicle miles traveled will return to their historical growth trend established from the 1950s through 2006. 

The upturn in gasoline sales, as shown within the oval in Exhibit 5, is touted as confirming that the forecast for auto travel trends and gasoline volume growth is happening.  The recent Detroit auto show and auto shows around the country that show off the 2014 models and new concept cars have attracted media attention to emerging consumer auto trends.  According to the media, consumers still want larger, more comfortable and more powerful vehicles, especially now that gasoline prices appear to be stabilizing in the low $3 a gallon range.  The media point to the vehicle sales data for 2013 to support their case. 

Exhibit 5.  Is Uptick In Gas Sales A Change In Trend?

Source:  EIA, PPHB

When we examine 2013 vehicle sales data by class of vehicle, we find that the industry sold 7.8 million new cars, up 4.9% over 2012, but it also sold 7.8 million light-duty trucks that include Sport Utility Vehicles, a gain of 10.5%.  The sales data by class of vehicle for December and the full year of 2013 is in Exhibit 6.  Regarding pickups, their sales volume increased by 12.1% for 2013, while SUVs gained 9.1% and cross-over vehicles increased by 13.1%.  The only light-duty vehicle category that experienced a sales decline was minivans, which fell by 0.4%.  The gain in light-duty vehicle sales, and especially SUVs and cross-overs, was pointed to as support for why gasoline volumes are rising and will continue to rise.  By implication, these vehicles are relatively less fuel-efficient than cars.

Exhibit 6  2013 Auto Sales By Vehicle Class

Source:  WSJ, PPHB

We analyzed this argument by examining the top 20 vehicle models in 2013 ranked by sales volume according to The Wall Street Journal’s Markets Data Center.  We then looked at each model’s average fuel-efficiency rating derived from the Model Year 2013 Fuel Efficiency Guide published by the Department of Energy and updated as of January 22, 2014.  In the case of certain vehicle models, there are a multitude of models based on engine size, passenger capacity and drive mechanism (two-wheel, four-wheel, all-wheel, etc.), so we looked at the central tendency within the rankings of fuel-efficiencies.  We excluded from our calculation those models that use diesel or were hybrids or plug-in electric vehicles, with the exception of the Toyota (TM-NYSE) Prius, which is a hybrid. 

Exhibit 7.  Top 20 Models By Sales And MPG Rating

Source:  WSJ, PPHB, DOE

There were four pickups included in the top 20 models with the top three selling vehicles all being pickups.  As can be seen from Exhibit 7, the pickups all had substantially lower mile-per-gallon ratings than the passenger car and cross-over vehicles.  When we focus exclusively on vehicles that are SUVs, their fuel-efficiency ratings are below those of the cars on the list.  This would appear to confirm the thesis as to why gasoline volumes are rising.  However, if we examine the market share of these less fuel-efficient vehicles, the results weaken the argument.  Pickups accounted for 14.0% of total vehicle sales in 2013 while SUVs represented 9.1%.  Combined, these two model classes accounted for less than a quarter of all the cars and light-duty vehicles sold last year, and since they would have been sold over the course of the year, it is hard to point to these sales as the explanation for the increase in gasoline sales during the latter part of 2013.  Another consideration is that these new vehicle sales most likely replaced older even less fuel-efficient vehicles in the fleet.  The question is how many of those used

vehicles remained in the fleet, which would have helped boost total fleet fuel consumption.  We know from contacts in the automobile industry that used car sales were strong last year, but largely due to the shortage of quality vehicles.  We understand that auto scrapping in 2013 was up, also.  If we assume that the price for crushed auto bodies varies inversely with supply, then the decline in the first half of 2013 would suggest that more vehicles were being scrapped.  That trend would be supported further by a posting on the ARS, Inc. web site of an article pointing out that in June used car prices experienced a significant decline taking prices to their lowest level for the year.  Declining used car prices would suggest that increased scrapping would likely have occurred during the second half of 2013, unfortunately the figures are not yet available. 

Exhibit 8.  Prices Of Auto Bodies Crushed For Scrap

Source:  ARS, Inc.

So what does the future hold for American drivers?  The Detroit auto show highlighted numerous autonomous driving vehicles such as the Google (GOOG-Nasdaq) car.  While these vehicles were presented as road-ready, the manufacturers acknowledged that it will be years before they will enter service.  While technical issues are slowly being resolved and some of the important technology is already being introduced into existing vehicles – self-parking, lane stability and rear-end monitoring, for example – the cost of the sensors and the computing information necessary for dealing with real-world driving conditions along with legal and liability issues still remain to be addressed. 

Exhibit 9.  Google Self-Driving Car

Source:  Google

While musing about self-driving cars, we were shaken back to the reality of the future – minicars.  If you believe the auto manufacturers, our future will include having a significant portion of the fleet represented by minicars in order for the industry to meet the government’s fuel-economy standards.  In the mid-1970s, in response to the energy crisis during the Nixon administration, the government instituted corporate average fuel economy (CAFE) standards to push the auto industry into improving the mileage performance of the nation’s auto fleet.  In 2009, when the auto industry was on its back, the Obama administration used its auto industry bailout to push the companies to agree to a 54.5 miles per gallon (mpg) CAFE standard by 2025.  The fleet fuel-efficiency is heavily impacted by the number of electric and hybrid vehicles sold that are over-weighted compared to conventionally-powered vehicles in the calculation of the fleet average.  Electric and hybrid vehicles were favored by the Obama administration as part of their green-energy agenda.  In fact, they are so favored that the CAFE target will never actually be attained.  If the fictional credited-vehicles with their ultra-high mileage ratings were ignored, and the average was based on the true number of vehicles sold, then the true CAFE rating would fall about 20% short of the target.  As we have learned from our research, the 54.5 mpg “target” was selected by the Obama administration because of its “headline” value, and it was manipulated to push the green car agenda.

The auto industry indicated that besides new power-trains, they would need to reduce vehicle weight.  According to a study prepared by the Massachusetts Institute of Technology, the average vehicle required to meet the 2025 fuel-efficiency standard would have to weigh 2,976 pounds compared to the 4,041 pounds for the average vehicle in 2013.  The only vehicles that are in that target weight-range today are the minicars, which weigh about 2,500 pounds.  It is important to understand that much of the weight that has been added to American vehicles over the years has been in response to mandated safety improvements.  That point was demonstrated when a couple of weeks ago the Insurance Institute for Highway Safety released the results of its small overlap front crash test for minicars.  Only one of 11 models tested received an acceptable rating.  The ten remaining vehicles, including the Toyota Prius C, were rated “poor” or “marginal.”  So is our future the vehicle in Exhibit 10?

Exhibit 10.  The Safest Of The Minicars?

Source:  Insurance Institute for Highway Safety

A recent business writer’s column postulates that the auto industry will use the 2017 mid-term review of the fuel-efficiency rules, a concession the companies secured during the negotiations over the rules in 2009, as an opportunity to redo the 54.5 mpg CAFE mandate.  When we examined the fuel-efficiency mandate at the time that standard was announced, we concluded that the future of the automobile business would result in a large proportion of the fleet being made up of electric vehicles and hybrids and a very small portion of sedans, SUVs and cross-overs.  We didn’t focus on the potential for minicars, but based on the crash results, and the photo in Exhibit 10, we doubt car buyers will be happy with them, either.  If you believe that the fuel-efficiency mandate won’t be altered, you have the next three years to select the vehicle you will want to drive in the future before the industry’s offerings are reduced.

Flash back to December 2009.  The United Nations was convening another session on climate change in Copenhagen, Denmark and President Barack Obama, in his first year in office, indicated he would stop by on his way to Oslo, Norway to pick up his Nobel Peace Prize and deliver a speech and help force the parties reluctant to reducing greenhouse gases to reach an agreement.  We know these climate conferences are pretty heady affairs but in researching this article we were unprepared for the entire scope of this conference.  It turns out this event is actually multiple conferences intertwined including: The 15th session of the Conference of the Parties to the UNFCCC; the 5th session of the Conference of the Parties serving as the Meeting of the Parties to the Kyoto Protocol; the thirty-first session of the Subsidiary Body for Implementation (SBI) and the Subsidiary Body for Scientific and Technological Advice (SBSTA); the tenth session of the Ad hoc Working Group on Further Commitments for Annex I Parties under the Kyoto Protocol (AWG-KP); and the eighth session of the Ad hoc Working Group on Long-term Cooperative Action under the Convention (AWG-LCA).  No wonder so many people attended. 

According to the official release, nearly 115 world leaders (and their entourages) attended the conference and more than 40,000 people, representing governments, nongovernment organizations; inter-governmental organizations, faith-based organizations, media and UN agencies, applied for credentials.  We have no idea exactly how many actually showed up, but based on media reports about this and other similar gatherings, If you secure credentials, you’re considered a celebrity so you should attend. 

People may remember that President Obama had promised to attend the conference and deliver a speech while on his way to Oslo for the Nobel award ceremony, but instead changed his mind and planned on skipping the conference when it appeared there would be no agreement.  Who wants to be part of a failed foreign policy

initiative?  As the conference progressed, however, prospects of some form of agreement grew.  President Obama decided to make a quick trip over to try to cement the deal.  After an overnight flight, he skipped one meeting with the leaders of developing nations in Africa but he did deliver an 11-minute speech to the delegates.  The speech was considered disappointing by many and even mocked by some world leaders, but most of them were not fans of America anyway.  Even environmental movement leaders were unimpressed with the President’s speech. 

When the leaders of the major powers of the world convened a meeting, Chinese Prime Minister Wen Jiabao sent his deputy, a diplomatic affront to the other world leaders.  He was sending a message about the role that China would play in the ultimate agreement.  Following hours of discussion, the leader of India left but proceeded to a meeting one floor below involving himself and the heads of Brazil and South Africa.  Also in attendance was the Chinese prime minister.  At some point President Obama and Secretary of State Hillary Clinton went looking for Wen Jiabao and discovered the closed-door meeting.  Commenting that he didn’t believe they should be negotiating deals in secrecy, the President and Secretary of State burst into the room.  The meeting was restarted and led to a watered-down agreement that President Obama hailed, along with other leaders, but which ultimately failed to win approval from the conference delegates.  President Obama left the conference early, and before a vote on the agreement, in order to arrive home before a huge snowstorm hit the East Coast and Washington, D.C.  This failed climate agreement was President Obama’s second unsuccessful visit to Copenhagen.  He and First Lady Michelle Obama had made an overnight trip a few weeks earlier, during October, to lobby the International Olympic Committee to award Chicago the 2016 Olympic Games, but also with no success. 

Last week we found out some interesting developments about the Copenhagen climate change conference that will do little to endear President Obama and the United States to the many world leaders who attended.  This news may even explain why the President made his quick trip, and also how he knew where to find the Chinese prime minister and the closed-door meeting.  We learned from a leaked document by Edward Snowden, the rogue National Security Agency (NSA) employee that the agency had spied on the world leaders attending the conference.  The disclosure was reported by The Huffington Post and was commented on in a report from Politico.  We reproduced the full text of the article below.

“TOP TALKER – NSA REPORTEDLY SPIED ON COPENHAGEN CONFERENCE: The Huffington Post reports: "The National Security Agency monitored the communications of other governments ahead of and during the 2009 United Nations climate negotiations in Copenhagen, Denmark, according to the latest document from whistleblower Edward Snowden. … The document indicates that the NSA planned to gather information as the leaders and negotiating teams of other countries held private discussions throughout the Copenhagen meeting. ‘[L]eaders and negotiating teams from around the world will undoubtedly be engaging in intense last-minute policy formulating; at the same time, they will be holding sidebar discussions with their counterparts – details of which are of great interest to our policymakers,’ the document states. The information likely would be used to brief U.S. officials, such as Secretary of State Hillary Clinton and Obama, among others, according to the document. …

"The revelation that the NSA was surveilling the communications of leaders during the Copenhagen talks is unlikely to help build the trust of negotiators from other nations in the future. … National Security Council spokeswoman Caitlin Hayden declined to comment directly on the Snowden document in an email to the Huffington Post, but did say that ‘the U.S. Government has made clear that the United States gathers foreign intelligence of the type gathered by all nations.’"

If the information gleaned from the spying was used to brief Hillary Clinton and Barack Obama, we wonder what role it played in the conference outcome.  Hopefully, the NSA intelligence produces more successful results than the American climate change efforts at Copenhagen.

When BP Ltd. (BP-NYSE) introduced its latest energy outlook, CEO Bob Dudley previewed the study’s conclusions with comments in which he asked and answered three questions.  First was whether there would be enough energy to meet demand; second, could we meet growing energy demand reliably; and finally is the world’s energy supply sufficient, secure and sustainable?  To the first question, Mr. Dudley said the study results say “yes.”  The study concludes the answer to the second question is “maybe.”  It is the third question that creates the greatest challenge for the industry and society because it requires substantial changes in how we use energy and which energies we elect to use.  The will to address those issues and shift the mix of energy supplies used around the world will determine how best the challenge of carbon emissions can be addressed.  Mr. Dudley’s, and obviously BP’s, answer is to institute a carbon tax, even though it is not working particularly well in Europe.

The BP Energy Outlook 2035 calls for energy demand to grow by 41% between now and 2035 with two-thirds of that growth in developing economies.  The study also sees carbon emissions rising by 29%.  That increase comes from BP’s forecast that gas and coal will account for 54% of global energy demand with renewables,

Exhibit 11.  Struggle To Change Global Supply Mix

Source:  BP

despite rapid growth, only accounting for 7% of future energy demand.  In order to cut carbon emissions more, the challenge will be to shift energy demand from coal to natural gas, but that will be no easy task as Europe has found out.  Mr. Dudley pointed to the environmental benefit of the shale gas revolution in the United States that drove domestic gas prices below the cost of coal and led to a significant increase in the use of gas for generating electricity.  The result was that 2012 carbon emissions in the U.S. were below those of 1994, a scenario virtually no one predicted.  The knock-on impact was felt in Europe where cheap US coal, evicted from its domestic power generation market by cheap shale gas, arrived and gained business that contributed to higher emissions in the UK and Germany.

In 2008, the European Union introduced a 20-20-20 by 2020 strategy that set forth goals to cut emissions by 20%, boost renewable energy use by 20% and establish a goal of a 20% increase in energy efficiency by 2020.  In response to high energy costs that have shackled European economies and contributed to increased carbon emissions, the EU has revised its environmental agenda.  The plan requires the member states to reduce their greenhouse gas emissions by 40% from 1990 levels by 2030, which is an extension of the 20% reduction by 2020.  Importantly, the 2030 targets do not include another mandatory goal to increase the amount of energy EU member countries generate from renewable sources.  Additionally, there are no plans set forth about how to boost energy efficiency. 

The new plan proposes a goal to produce 27% of energy from renewables by 2030, but it is left up to the individual countries as to how to meet it.  As one official acknowledged, this structure reflects the regulator’s recognition that renewables are no longer “a small baby” that needs sustenance to survive and grow.  Implicit in the strategy is an ok to member states to exploit their shale resources. 

Additionally, as commented on by EU energy commissioner, Gunther Oettinger, “The 2030 framework sets a high level of ambition for action against climate change, but it also recognizes that this needs to be achieved at least cost.”  That position immediately became the target of renewable energy and climate change groups who accused the EU of looking backwards rather than where it wants to go.  The policy shifts, however, recognize that the 20-20-20 plan was contributing to the weak economic recovery in Europe that has done significant social harm.  The seven-year experience with that plan has demonstrated the potential problems of government mandates without any flexibility.  That leads to a misallocation of resources and higher costs. 

Last week another polar vortex pushed very cold weather all the way down to the Gulf Coast sending temperatures to their coldest levels of the winter.  The cold air met a warm system streaming from the west and heading east toward the Carolinas and the clash produced freezing rain, sleet and even snow in places as far south as Baton Rouge, Louisiana and Atlanta, Georgia, where a gamble by local officials turned the city’s highways into giant parking lots and stranded hundreds of school children overnight.  The cold weather that stretched from the northern border of the country to the Gulf Coast boosted natural gas prices above the threshold of $5 per thousand cubic feet (Mcf) for the first time since 2010. 

Exhibit 12.  The Latest Polar Vortex

Source:  ImpactWeather.com

It has been very interesting watching natural gas prices during the two polar vortex episodes that happened within a two week span. 

Commodity traders had been quick to play the run-up in gas prices due to the winter weather, especially in the context of industry sentiment that gas prices will remain low into the next decade, at least as forecast by the Energy Information Administration (EIA) in its 2014 Annual Energy Outlook.  With that prognosis, it is expected that whenever the futures prices rise to or above the $5/Mcf level, we can expect producers to hedge some or most of their anticipated future output in order to lock in more attractive prices.  That was what we heard from the industry during the first polar vortex – lots of hedging was going on. 

This recent polar vortex coincided with the ending of one natural gas futures contract and the switch to the next month’s contract.  Many traders had shorted the gas contract when it crossed the $5/Mcf threshold and were waiting for the price to fall back before covering their short.  Unfortunately, the second bout of cold weather and ice/snow arrived just as the contract was expiring, coupled with a report from weather forecaster Accuweather that below-normal temperatures could be expected to last through March.  In a span of a few hours, the natural gas futures price for the near-month contract jumped by nearly 12.5% before settling back to $5.557/Mcf, a 10.4% gain on the day.  The next day, as the market settled down, the gas futures price dropped to $5.011

Last Thursday, the EIA reported that there was a draw from natural gas storage facilities of 230 billion cubic feet (Bcf) for the week ending January 24th.  Based on the cold weather for the recent week and a forecast of a sharp jump in heating degree days throughout the country, some energy analysts are predicting that the draw on natural gas stocks will approach 300 Bcf.  The cold weather forecast through March has set up the gas storage market for ending this heating season at a very low level that will support higher gas prices during the spring storage injection season.  Estimates are that we could see gas prices trade in the $4.50-$4.75/Mcf range during the spring, which are higher than what was anticipated as we entered this heating season. 

Accuweather elected last Thursday to get out in front of Phil, the furry forecasting groundhog from Punxsutawney, Pennsylvania, with a prediction that the nation is destined for six more weeks of winter.  We’re guessing they are anticipating a relatively clear morning on Super Bowl Sunday at Gobbler’s Knob near Punxsutawney as Phil needs to be scared by his shadow in order for him to scurry back into his hole and signal more winter weather.  Accuweather’s forecast calls for cold winter weather to extend from the upper Midwest across to the Northeast and Mid-Atlantic regions, where much of the nation’s population lives.  That means more gas demand for heating and electricity generation, which means further draws on gas storage. 

Exhibit 13.  Accuweather Beating Phil To The Punch

Source:  Accuweather

To appreciate how the great American shale revolution has changed the natural gas business, it is interesting to compare this winter so far with that of 2000-2001 when colder-than-expected temperatures drove a doubling in gas prices.  The different trends in natural gas prices are compared in Exhibit 14.  We have shown the six-month period from November 1st to April 30th for 2000-2001 against the same period so far this winter.  What one sees with the earlier period is that natural gas prices climbed from about $4.50/Mcf at the start of November to a peak in excess of $10/Mcf by Christmas before retreating and then bouncing back up to that peak in early January.  As the balance of winter unfolded, natural gas prices retreated rather quickly to the $7/Mcf level.  They then slid slowly down to the $5/Mcf range where they remained for the balance of the winter season.

Exhibit 14.  Shale Gas Revolution Has Kept Prices Down

Source:  EIA, PPHB

This winter, natural gas prices slowly rose from the mid-$3/Mcf level to the mid-$4/Mcf level over November, December and early January.  With the advent of the polar vortex, gas prices rose more sharply, reaching the $5/Mcf level by the end of the week before last.  We expected that the sharp spike to $5.56 that occurred last Wednesday would not be sustained, and it wasn’t immediately.  But based on the magnitude of the cold weather experienced during the balance of the winter season and how it impacts gas storage levels, we could see sustained higher gas prices before we see a return to more normal winter pricing in the $4.50/Mcf range.  What will drive the price higher and sustain prices closer to $5/Mcf will be storage volumes.

We have compared the weekly gas storage levels during the two winter periods.  (See Exhibit 15.)  We have drawn arrows to show the slopes of the declines in gas storage volumes for the two respective winter periods.  It is evident that the current winter drawdown has become sharper in recent weeks, and is declining faster than in 2000-2001.  To put the gas storage market for the two periods into perspective, we note that the 2000-2001 winter started with 2,748 Bcf of gas in storage compared to 3,814 Bcf for 2013-2014.  That is 39% more storage, which reflects storage capacity growth over the past 13 years, in keeping with a larger gas market. 

Exhibit 15.  Gas Storage Dropping In Response To Cold

Source:  EIA, PPHB

The impact of the harsh cold weather has been a large storage drawdown in the past couple of weeks.  As of two weeks ago, the ratio of gas remaining in storage to initial gas storage volumes for the winter season was 63.5% compared to 52.8% back in 2000-2001.  The latest weekly drawdown brought the ratio comparison to 57.5% versus 48.5%.  What that means is the last weekly draw resulted in a 600 basis point decline in the storage ratio compared to only a 430 basis point drop in the earlier period.  If the draw for last week actually reaches 300 Bcf as projected by some analysts, then the storage ratio would decline to 49.6% compared to 45.1% in 2000-2001.  That means a 790 basis point drop versus only a 340 basis point fall, indicating that the pace of the storage drawdown is greater than during the past period.  This more rapid pace of drawdowns has been offset by the greater initial gas storage volumes.  Without that extra gas storage, natural gas prices would likely be sharply higher than now.  The rapid storage drawdowns should put a solid floor under current gas prices until storage is rebuilt in the spring.

The pace of gas storage injections will be influenced by both the rate of the nation’s economic growth and how much gas is consumed to support that growth, as well as how much higher natural gas production grows.  At the start of the 2000-2001 winter season, natural gas production in the United States was running at about 67.7 Bcf/day, compared to the latest government estimate (October 2013) that the nation is producing slightly over 83 Bcf/day.  U.S. gas production is barely growing now, reflecting the sharp curtailment of drilling for natural gas and the virtual total reliance for production growth coming from gas produced in association with crude oil and “wet” gas output. 

In the event of another polar vortex or just an extended period of below normal temperatures, natural gas prices could receive further support.  We doubt that gas prices will drop significantly anytime soon, barring a tropical heat wave.  A more normal temperature finish to the winter heating season could trip prices more than many currently expect as traders pick up their marbles and head to another game.

One energy market that has experienced a sharp price spike due to the winter weather is propane.  Propane, which is used for heating and cooking in various parts of the nation, was in tight supply heading into the winter due to increased demand required for crop-drying needs following the wet harvest season in the Midwest.  The crop-related demand had driven residential propane prices steadily higher from $2.30 per gallon in October 2013 to just under $3 a gallon at the start of 2014.  The first polar vortex that plunged the upper Midwest into an extended period of sub-freezing temperatures caused a spike in residential propane prices to $4 a gallon and led to the rationing of supplies in many locales. 

Exhibit 16.  Propane Prices Spike On Cold

Source:  EIA

The chart of propane stocks (Exhibit 17) shows that through September 2013, supplies were about at the mid-point of the five-year average.  It wasn’t until late fall that demand for propane for drying wet crops depleted available inventories.  The early cold weather this winter followed by the polar vortex event resulted in propane supplies falling below the low-range of supplies over the past five years, and helps explain the spike in propane prices. 

Exhibit 17.  Propane Stocks Below Low History

Source:  EIA

Exhibit 18 shows a chart of long-term spot propane prices at the Mont Belvieu, Texas storage and distribution point for natural gas liquids, of which propane is an important one.  The chart demonstrates that propane prices have spiked during past winters.  In researching the propane market for this article we found a detailed analysis of the winter price spike in 1996-1997, which had similar demand drivers – low stocks at the start of the winter, increased late harvest drying demand and little expectation that stocks can be rebuilt before spring. 

Exhibit 18.  Propane Prices Have Spiked Many Times

Source:  EIA

In the 75-page study was an interesting chart (Exhibit 19) showing the price for propane at Mont Belvieu and Conway, Kansas, another major storage and distribution point, along with Midwest and East Coast residential propane prices.  Clearly, the price spike was felt at Conway, much as today. 

Exhibit 19.  1996-7 Propane Prices Jumped On Cold Weather

Source:  EIA

Demand for propane is met by domestic production from gas processing plants and refineries, net imports, and, during the heating season, by withdrawals from inventory.  Propane production and net imports do not vary seasonally like demand.  Instead, supply sources usually exceed consumption in the summer and below in the winter.  That enables stocks to build during summer months and for them to be drawn down during the winter.  When crop drying demand escalates late in the fall lowering supplies, the stock draw will be greater during the winter contributing to the potential for price spikes such as we are experiencing now. 

One of the significant aspects of the propane market is its disparate impact on geographic regions and income levels.  According to the latest census on space heating in U.S. homes compiled by the EIA as of 2009, there were 113.6 million homes in the nation of which 78.5 million are single-family, either detached or attached.  There are 28.1 million apartments and 6.9 million mobile homes.  Propane is used for heating in 5.6 million homes, 4.5 million single-family, 100,000 apartments and 800,000 mobile homes.  On a regional basis, there are 20.8 million homes in the Northeast, but only 700,000 use propane.  The West also has a low propane representation with about 800,000 users out of 24.8 million homes.  The South has the most homes with 42.1 million, of which 1.9 million use propane for heating.  The greatest propane penetration is found in the Midwest with 2.1 million homes burning the fuel out of 25.9 million homes in the region. 

Besides the regional disparity of propane is the disparity in the incomes of propane consumers.  Many of the homes that utilize propane for heating are households of low-income families.  These families are often dependent on government subsidies for heating bills, but not all.  The primary heating subsidy program is the Low-income Home Energy Assistance Program (LiHEAP).  We looked at Iowa to see the impact of this program.  In 2011, the program served 88,500 out of 234,000 eligible families.  There are 1.2 million families in Iowa, so about 7% of families are supported by the financial aid program out of approximately 18% of eligible families in the state.  While we haven’t had time to research all the details, the 1997 EIA study suggested that low-income families are disproportionately represented in homes fueled by propane, meaning that they are the most exposed to the spikes in propane prices.

Exhibit 20  Conway Propane Spike Reminiscent Of 1997 Winter

Source:  Global Hunter Securities

As shown in Exhibit 20, the supply/demand dynamics for propane today are similar to those that occurred during the winter of 1996-1997 discussed above.  (See Exhibit 19 on previous page.)  Once again there was the disparity of prices between Mont Belvieu and Conway, with the latter being much more sensitive to the heating demands and crop-drying induced supply shortages.  Some politicians suggest that the growth in exports of natural gas liquids (NGLs), of which propane is a part, may be contributing to the price spike.  If that relationship can be established, then the Congressional hearings over the exporting of crude oil and how much LNG exporting should be allowed will change in character in favor of increased protectionism, in our view.  Stay tuned for this debate, as it is sure to be lively.

Since about 36% of homes in America are heated with natural gas, the exposition in shale gas output that has depressed prices, despite the recent jump due to the polar vortex, has spared a large segment of the population from the budget-busting impact being experienced by families dependent on propane.  Those families are also potentially subject to a lack of propane supply, too.  Whether natural gas prices remain under control over the next 60 days will depend on the weather and how fast storage supplies are drawn down.  For those of us who rely on natural gas to heat our homes and cook our food, we should be counting our blessings right now.

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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.