Musings From the Oil Patch – November 11, 2008

• Is The U.S. Recession Nearing An End?
• Are Investors Turning Their Back On The Stock Market?
• Prozac Needed for Manic Depressive Stock Market
• Frozen North Energy Business Cooling Off
• Oil Price Breaks Another Barrier On The Downside
• Canada And The Energy Card
• Vehicle Miles Follow Gas Prices Down – Set To Change?

 

 

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

Is The U.S. Recession Nearing An End?

 

Late last week as dismal economic data was being released, the head of the National Bureau of Economic Research’s (NBER) recession determination team suggested that the United States economy was in a recession.  He was basing his view on the employment data for the past ten months coupled with various other economic statistics that point to a substantial slowing in economic activity.  On Friday, the government’s employment statistics were released showing that 240,000 Americans had lost their jobs during the month of October, approximately 40,000 more than had been anticipated by economists.  The October unemployment rate also jumped to 6.5% from its prior 6.1% rate.  Possibly the more troubling figure was the government’s revision to its estimates for the number of jobs lost in both August and September.  In August, the number of lost jobs was revised up by 43,000 and in September the job loss total was increased to 284,000, a 125,000 jump. 

 

During this year, the Department of Labor has done a woeful job in estimating the number of jobs being lost in the economy each month.  As shown in Exhibit 1, the government has consistently had to revise upward its prior monthly estimate for the number of jobs lost each month.  For the first nine months of 2008, the 354,000 additional job losses discovered were slightly more than 60% of the initial job loss estimates.  Based on the ten months of steady deterioration in the labor market, Martin Feldstein, the NBER head of the recession dating committee has suggested that the evidence is convincing that the United States is in a recession and it likely started sometime in the fourth quarter of 2007 or the first quarter of 2008. 

 

 

Exhibit 1.  Labor Department’s Dismal Forecasting Record

Source:  Bespoke Investment Group

Source:  Bespoke Investment Group

 

For the NBER to officially declare a recession, the U.S. economy needs to demonstrate two consecutive quarters of negative economic growth.  As it becomes clearer that the preliminary economic statistics have overstated the health of the U.S. economy so far this year, the likelihood of the country slipping into an official recession grows.  The job of the NBER is to review the past economic data and determine exactly when the country’s economy fell into a recession.  The NBER is always backward looking and often quite late in determining the official starting date for a recession.  That proclivity is demonstrated in Exhibit 2 that shows the record of U.S. recessions since 1980 and their duration.  Importantly, the chart shows the date that the NBER officially announced that a recession had commenced.  As can be seen, in three of the four recessions of this modern era, the NBER pronouncement came within a few months of the ending of the recession.  Is it possible we may be about to experience this phenomenon again?  Or will this recession follow the pattern of the 1981-1983 recession when the call by the NBER was made before half the recession period was over?

 

Another interesting issue to examine is the length of modern era recessions.  If it is a certainty that the United States has entered a recession, then knowing when it started is important for determining when it might end.  The average length of U.S. recessions since 1900 is 14.4 months.  If the recession began at the start of 2008 based on industrial production and employment data, then it is likely the recession should end by spring of next year. 

 

 

 

 

 

 

Exhibit 2.  NBER Recession Calls Often Close To The End

Source: Bespoke Investment Group

 

As the chart in Exhibit 3 shows, recessions in the pre World War II era lasted roughly 19.1 months while those after the war lasted only 10.2 months.  The difference in the length of time is probably due to two factors – the performance of the Federal Reserve with its sophisticated monetary management tools and the increase and speed in dispensing economic data and knowledge that allows manufacturers to adjust their output quicker.  If we are talking about the 2008 recession mirroring the record of the post World War II era, then we could be looking at the recession ending in the next few months.  But if this recession is more like those experienced in 1973 and 1981 (the recessions most economists and businessmen are comparing this one to) then we are looking at roughly a 15-month duration, which again puts us into next spring for its ending.

 

Exhibit 3.  Recession Since WW II Have Been Shorter

Source: Bespoke Investment Group

 

The International Monetary Fund (IMF) has recently completed a

 

study about the outlook for global recessions – how long they last and what causes them.  Based on the study, the IMF concluded, “Recessions preceded by banking crises last twice as long on average as those not triggered by a financial crisis, and the loss of output was about four times as great.”  This conclusion would support the view that this recession will be longer and more severe than the typical recessions in the post World War II period.

 

A critical ingredient in estimating the possible length of the recession and how quickly it may end is consumer attitudes since the consumer represents the backbone of the American economy.  Consumer spending accounts for roughly 70% of the nation’s gross domestic product, however part of that spending has come from liberal use of credit, an ingredient that may no longer be as plentiful as in the past.  Based on the most recent economic data, inflation adjusted (real) consumer spending has fallen significantly in three of the last four months, with September’s data showing a 0.4% drop. 

 

Exhibit 4.  We Can’t Lose The American Consumer

Source:  The New York Post

 

Consumer spending measured in current dollars showed a 0.3% year over year decline in September, the largest drop experienced in four years (June 2004), after being flat in both July and August.  The third quarter GDP data from the Commerce Department showed that consumer spending fell at a 3.1% seasonally adjusted annual rate.  This was the first significant pullback since 1991 and the largest quarterly drop since 1980.  With a deteriorating labor market, one should be prepared for further consumer spending weakness.

 

Exhibit 5.  Real Spending Down In Three Of Last Four Months

Source: Haver Analytics

 

Another negative sign for consumer spending is the record low reading for the consumer confidence index at 38%.  This low reading is below the 43.2% prior low recorded in 1974.  Consumer attitudes have been impacted by the credit market turmoil and concerns about the security of their jobs. 

 

Exhibit 6.  Consumer Confidence At A Record Low

Source:  Bespoke Investment Group

 

The rapid deterioration of the labor market reflected by the recent monthly jumps in unemployment coupled with growing economic weakness in major business sectors such as autos, technology and construction is prompting economists to now forecast that the U.S. unemployment rate could rise to a high of 8% before very long.  If reached, then the unemployment rate would be back into territory last experienced during the 1982 and 1974 recessions.

 

Exhibit 7.  Is Unemployment Headed To Record High Territory?

Source:  InvestorInsight.com

 

Increasingly the economic data suggests that the 2008 recession will be more comparable to those experienced in 1973-1974 and 1981-1983, and this will have an impact on U.S. and global oil demand. 

 

 

Are Investors Turning Their Back On The Stock Market?

 

In our last Musings we suggested that an un-quantifiable risk was that investors might turn their back on the stock market, which could hurt the performance not only of energy equities but equities in general.  Just recently, the American Association of Retired People (AARP) reported that one in five workers over 45 years old stopped contributing to retirement savings plans sometime during the past year.  They also reported that the value of American 401(k)s has fallen by more than $2 trillion over the last 16 months.  This damage

 

Exhibit 8.  Business Week Calls Market Bottom With Cover

Source: Business Week

estimate was supported by data in a report for Congress prepared by the Congressional Budget Office that said since mid 2007, the average retirement savings account is down over 20%.  This estimate did not include the most recent several weeks of stock market deterioration.  While we haven’t gotten to the absolute discontent with equities experienced in 1979 and demonstrated by the Business Week cover highlighting the death of equities, we are rapidly approaching that point.  That cover nearly marked the absolute bottom for the stock market.

 

In that Musings we showed a chart of the stock market performance against a forecast made a decade ago by the money management firm GMO’s chief executive, Jeremy Grantham.  He forecast that the stock market would provide a real return of a loss of 1.1%.  As Mr. Grantham said in the GMO quarterly report, at the end of September the market’s return (S&P 500) was zero but after three days in October the index had met and even exceeded his firm’s forecast.  Since then, the market has continued to deliver negative returns to investors.

 

Exhibit 9.  GMO Called For Decade Of No Return

Source: GMO

 

Investors have been inundated with the message from investment firms that they need to think about investing long term.  This message has grown stronger with the collapse in the stock market related to the credit market turmoil.  Unfortunately, the experience of investors in the early years of the Great Depression showed that either one took quick action to salvage some of their wealth or they needed to hold on to their stock investments for a very long time to recover the value.  Exhibit 10 shows what happened to the Dow Jones Index following its 42% fall in 1929, which is about the same drop experienced by the index this year.  As shown, if investors did

 

not sell on the quick bounce after the index fell they lost 80% of the value over the next two years.  If they continued to hold on, investors would have recouped their original investment some 22 years later, a sobering thought.  We are certainly hoping that this stock market will be more kind than to repeat that experience.

 

Exhibit 10.  Why Investors Need To Think Long Term

Source: Agorafinancial.com

 

Some stock market analysts are comparing the American financial and stock market environment to that of Japan’s in the 1990s.  While we won’t belabor the similarities and differences between today’s U.S. financial markets, government tools and attitudes, and this county’s economic health with Japan’s at that time, investors should be aware that Japanese investors have experienced a zero return from their stock market (Nikkei 225 Index) over the past quarter century.  That’s a significantly worse performance than the U.S. stock market.

 

Exhibit 11.  Japanese Investors Have 25 Years With No Return

Source: Bespoke Investment Group as of Oct. 29, 2008

So should American investors despair based on the stock market history of the 1930s and 1940s and the Japanese experience of the past 25 years?  We don’t believe so.  Between 1928 and 2007, there were 20 years with negative returns for the Dow Jones Industrial Average.  With a quarter of those 79 years showing annual losses, one might be inclined to sit out the stock market.  On the other hand, if one measures returns over five-year intervals, then there have been only five periods during this long span when investors would have experienced negative investment returns.  If one can find attractive investments, and the fact that long-term, astute money managers are increasingly finding reasonably valued stocks, then the market may be attractive.  The latest semi-annual survey of money managers conducted for and reported on by Barron’s showed that 62% of those surveyed believe the stock market is currently undervalued.  Likewise, 69% think that stocks will be the best performing asset class in 2009. 

 

Exhibit 12.  Longer Term Returns Should Be Investor Focus

Source:  Prieur du Plessis

 

What may have been the most interesting question asked in the survey was one quizzing the money managers about what needed to change to make them more bullish on the stock market in the next six months.  The most popular answer was improved credit market conditions (37%) followed by improved corporate profits (25%) and lower stock prices (15%).  Since the poll was taken a couple of weeks ago, the first and third responses have been happening.  Better corporate earnings is probably a while off, but the stock market is a discounting mechanism meaning that it will begin to pay for improved future earnings prospects at some point.  Unfortunately, unless oil and natural gas prices rise soon, energy stocks probably have a longer period of being an unattractive investment sector.  That condition will last until either a catalyst to boost earnings emerges or stock prices fall to levels that discount

 

substantially lower near-term earnings.  As that happens, stock prices should stabilize and then start rising as investors begin to focus on when higher earnings might emerge.  Is that 2010?

 

 

Prozac Needed for Manic Depressive Stock Market

 

If the stock market volatility of the past six weeks hasn’t worn you down, the middle of last week had to be depressing.  On Election Day, the stock market roared ahead with the Dow Jones Index climbing by 305 points for a 3.3% daily advance.  The Standard & Poor’s 500 Index rose by 39.45 points, or 4.1% that day.  That was the largest presidential Election Day rally in the stock market in 24 years, or since the stock market began staying open on Election Day. 

 

Stock market commentators attributed the index’s rise to a general “good feeling” that one major investor uncertainty was being resolved with the election.  They also speculated that most investors expected Sen. Obama to emerge victorious.  On that issue, these commentators were right, but the following two days saw the market’s euphoria related to the resolution of the presidential campaign evaporate into the greatest two-day stock market correction following an election and one of the top two-day corrections ever. 

 

Exhibit 13.  2008 Saw Largest Post-Election Stock Market Drop

Source: Bespoke Investment Group

On Wednesday, the Dow Jones Index fell by 486 points, or 5%, which was followed by a 443 point drop on Thursday, or another 4.8% drop.  Over the two days, the stock market, as measured by the Dow Jones Index declined by 9.8%, before rallying on Friday.  The two-day stock market decline measured by the change in the S&P 500 Index was 10.02%.  As reflected in Exhibit 14, this two-day decline was the 17th to occur since 1929, but the magnitude of the decline was the most mild of them all.  Making that observation is difficult given the pain and anxiety generated by those days, but the figures demonstrate that this drop was barely a double-digit decline.  The largest two-day declines were marked by Black Monday in October 1987 at close to a negative 24.5% change followed by the Black Friday drop in October 1929 when the index fell by almost 22%.  What made this current market drop so un-nerving was that it followed such a huge rally on Election Day.

 

Exhibit 14.  Double-Digit Two-Day Post-Election Drop

Source:  Bespoke Investment Group

 

To gain a better understanding of the stock market’s volatility and what caused it, we thought the chart in Exhibit 15 that shows the performance of S&P 500 index sectors over the two days following the election might be of value.  Unfortunately, the table has a double entry for Energy, which dropped 10.38% during this time period, and, as a result, does not include the performance of the Utilities sector.  Even with this error, the takeaway from the chart is that only the most defensive stock market sectors – health care and

 

consumer staples – outperformed the overall market.  Financials continue to lead in the under-performance category marking continued investor concerns about the health of the sector and the continuing need for its member companies to raise additional capital to shore up balance sheets.

 

Exhibit 15.  Playing Defense

Source: Bespoke Investment Group

 

While the market rally since the end of October has helped reduce the year-to-date decline, the performance of stocks has not been particularly good.  The stock market, measured by the performance of the S&P 500 Index through October 28, showed that it is now the fourth greatest decline without a 20% rally.  As the fleeting days of October disappeared into history and stocks relentlessly fell, this market period slowly climbed on the list of the top ten market downturns without a significant rally.  Barely a week before this chart (see Exhibit 16) was produced; the current market downturn was in sixth place on the list.  The market’s drop in the subsequent five trading days pushed its ranking up to fourth place.  Since the Bespoke Investment Group has not updated the table, we did a quick calculation and found that through November 7th, the S&P 500 Index has now lost 40.5%, dropping it from fourth to eighth place on the list of greatest declines with a significant rally.

 

Exhibit 16.  This Market Period Moves Higher In The Rankings

Source: Bespoke Investment Group

For the stock market to stabilize, investors need to become more confident that the credit and financial crisis is ending and lending globally is resuming.  Without the availability of credit, a significant volume of global commerce struggles to be done.  Additionally, investors need to have some sense that the recession currently underway in the United States and most probably underway in several of the leading countries in Europe and possibly in Japan is in the latter half of its likely duration.  The problem is that financial analysts are still estimating substantial earnings gains next year for the companies in the S&P 500 Index that are not likely to be achieved.  Until the analysts become more skeptical of the revenue and earnings growth of these companies and adjust earnings estimates substantially lower, the stock market will appear to be cheap on a valuation basis when it actually may prove to be still too expensive.

 

The matrix of earnings estimates for the S&P 500 and possible P/E ratios reflects where the current market price was valuing the 2009 earnings estimate about a week ago.  With an earnings estimate of roughly $95 per share (the shaded area) and an index value of approximately 950 (the red box), the market is valuing the forward earnings stream at 10 times earnings.  However, if the earnings estimates are too high – say 20% too high – then the S&P 500 is trading somewhere in the 12 – 13 times earnings of $75.  Since the stock market has traded around 15 times forward earnings in recent times, the prospect of it being valued at two to three multiples lower begins to entice buyers.  It is this prospect that has attracted a number of classic value (buy cheap) investors such as Warren Buffett, Jeremy Grantham and Steve Leuthold.  All of these investors recognize that the stock market could go lower before stabilizing and heading up, but they are considering the current market’s valuation of solid companies and their prospects.  What they are finding is that for many of their investment targets the valuations are low enough to offset much of the risk of further stock price declines.

 

Exhibit 17.  S&P 500 Earnings Estimates Remain Too High

Source:  Bespoke Investment Group

The S&P 500 closed on Friday at 930 so the matrix is still fairly accurate.  The one additional issue is how bad earnings could be in 2009.  The worst case earnings estimate we have seen is for $60 for the index.  On that basis, the stock market is trading at 15.5 times that 2009 earnings estimate.  For some investors, they want to buy stocks when the market is trading more in the 10-12 times earnings, or based on the $60 estimate, the S&P 500 needs to drop a further 200-300 points, or 25%-30%.  That scenario says we could still have much more pain to experience in the stock market.

 

 

Frozen North Energy Business Cooling Off

 

The leading Canadian oil service industry associations have recently issued their forecasts for drilling activity for 2009 and they have revised their prior outlooks for the balance of 2008’s activity.  These new forecasts call for lower drilling and rig activity against a backdrop of oil producer budget cut announcements and postponements of long-term capital projects.  Talisman Energy Inc. (TLM-NYSE) announced it will spend less in 2009 than its $5 – $5.3 billion budgeted for capital projects this year.  The company said it has not finalized its budget for next year, but with lower commodity prices and higher provincial royalties, money will be shifted from conventional exploration and drilling in Alberta in favor of greater emphasis on unconventional drilling in gas shale formations in British Columbia and the United States. 

 

The 2009 Canadian oilfield outlook has been hurt by the Alberta decision to raise royalty rates.  The impact, coupled with weak natural gas prices, has made much drilling in Alberta marginal.  In fact, last month, Murray Edwards, vice-president of Canadian Natural Resources Ltd. (CNQ-NYSE), Canada’s second-largest gas producer said that Alberta has “the least attractive regime for conventional natural gas in North America right now.”  The royalty change has caused EnCana Corp. (ECA-NYSE), Canada and North America’s largest gas producer, to scale back its drilling in Alberta during 2008 in favor of stepping up its spending to about $1 billion on acquiring land in various U.S. gas shale plays.

 

Canadian Natural also slashed spending on its Horizon oil sands project, the company’s biggest development ever, because of spiraling costs and lower oil prices.  This decision marks another in a growing list of major capital projects associated with boosting Canada’s oil sands output that are being delayed.  A total of seven upgraders to turn the oil sands bitumen into a higher quality crude oil are scheduled to be built in “Upgrader Alley” near Edmonton, representing a C$93 billion investment.  At this point, only one project, already underway, is currently scheduled to move forward.  While these huge capital projects are expensive, take a long time to construct and won’t yield returns for a number of years, the uncertainty about the direction of crude oil prices over the next several years and concerns about credit markets makes moving forward highly risky.  As Canadian Natural’s COO Steve Laut put it,

 

“We are not going to build in a high-price environment for a moderate-price world.” 

 

Both the Canadian Association of Oilwell Drilling Contractors (CAODC) and the Petroleum Service Association of Canada (PSAC) issued reduced oilfield activity forecasts for Canada in 2009.  The forecasts project lower numbers of wells being drilling next year – down 6% for CAODC and down 10% for PSAC.  The two organizations count drilling activity slightly differently because each focuses on the industry measure of greatest significance for its members’ businesses – whether it is wells being drilled (drilling rigs) or wells completed (completion services and equipment). 

 

CAODC is projecting wells drilled in 2009 to total 14,325, down 6% from its revised 2008 estimate for 15,223 wells.  The 2009 well forecast reflects a 25% decline from the 19,144 wells drilled in 2007.  A recent industry activity high point was experienced in 2006 when the industry drilled 22,127 wells.  Based on its new forecast, CAODC is anticipating its members’ drilling rigs to achieve roughly a 39% utilization rate for 2009, down from 42% this year.  They see a winter drilling peak in the first quarter of 2009 of 56% and a spring breakup low during the second quarter of only 17%.  It also expects additional drilling rigs to exit the Canadian market for other geographic regions bringing the available fleet down from a winter high of 887 rigs to a 2009 year-end low of 880. 

 

Interestingly, in the recent CAODC forecast update, they highlighted that the average number of days required for drilling wells in Canada this year has climbed to a high of nine from the 7.4 days averaged in 2007.  This rising trend has negatively impacted the CAODC wells-drilled forecast for 2008 and 2009.  The real meaning of the change in trend is that very shallow wells, primarily in Alberta, are not being drilled, which reflects the deteriorating economics for drilling new natural gas wells.  These shallow gas wells often require only a day or less to drill and, as a result, have a disproportionate impact on the industry-wide average length of time needed to drill wells.  Its impact is largely on drilling contractors since their rigs are not occupied, but for most oilfield service companies these shallow gas wells consume little in the way of services, so the service sector is less impacted by the change in average days needed to drill wells.  When, and if, shallow natural gas well drilling picks up, the average well time will decline to more historic averages that are much closer to seven days than nine.

 

PSAC’s new well forecast for 2009 calls for the industry to complete 16,750 wells, down 10% from the 17,400 wells it anticipates to be completed this year.  Almost all the year-over-year decline will occur in Alberta where the new oil and gas royalties will cause producers to shift their spending to other more friendly tax regimes.  There are two points about this doom and gloom attitude in Canada.  First, much of the impact of lower drilling activity is being felt in the shallow-well market that does not typically generate as much oilfield service work.  Secondly, the slowdown in Alberta activity that has

 

accompanied the shift in spending focus by the larger companies to other provinces or internationally has caused lease prices per acre in Alberta to fall, opening up the opportunity for small E&P companies to acquire property for drilling.  We heard from one industry executive last week that in some areas, acreage prices had dropped by 90% from C$3,000 per acre to C$300.  That is one way to help improve drilling economics, especially if one believes that the drilling slowdown underway will cause future gas prices to climb as the rapid depletion of new gas well production, especially for the gas-shale wells, leads to a tighter supply/demand balance.

 

 

Oil Price Breaks Another Barrier On The Downside

 

Last week crude oil futures prices fell almost 14% over the two days following the presidential election while the stock market dropped 10%.  On Thursday, the oil price fell below $60 a barrel during the trading day before closing at $60.77.  That $60 price threshold was an important price marker.  The last time crude oil prices started with the number five was on March 21, 2007, almost 19 months ago.  The amazing thing about last week was that the euphoria of Election Day drove crude oil futures prices up over $6 a barrel to close at $70.13.  Less than 48 hours later oil prices had surrendered more than $10 a barrel. 

 

Exhibit 18.  Crude Oil Prices Have Collapsed Since July

Source: Bespoke Investment Group

 

From the peak last July to now, oil prices have fallen over 58% and given the most recent economic figures, it looks like they could fall further.  We have had one OPEC emergency meeting to reduce production and reports are that Saudi Arabia has actually reduced oil supplies to customers.  OPEC continues to talk about scheduling another meeting to cut production further to support oil prices.  The dilemma OPEC faces is highlighted by the estimated oil prices needed to balance government budgets for a number of OPEC member states. 

 

 

 

Exhibit 19.  Iran And Venezuela Desperate For High Oil Prices

Source: PFC Energy

 

As shown in Exhibit 19, Iran and Venezuela are desperate for OPEC to sustain high oil prices.  With current oil futures prices based on West Texas Intermediate that tends to trade at a higher price than most OPEC crude oils, even some of those countries with budget cushions are starting to worry about the course of future oil prices and the health of their economies in 2009.  The future course of crude oil prices will depend primarily on economic activity next year and its impact on oil demand.  Oil supply is probably less of a factor in setting prices.  Increasingly oil forecasters are cutting their 2009 demand estimates.  We understand that several forecasters are now calling for an absolute decline in global oil demand as projected consumption increases in Asia, Africa and Latin America will prove insufficient for offsetting the demand declines expected in Europe, Japan and the United States. 

 

Recent data on new orders for manufacturers shows significant fall-offs virtually everywhere in the world.  When economic activity started weakening in the United States earlier this year, the popular Wall Street view was that most Asian economies and India had decoupled and would be able to grow in spite of weak U.S. consumption.  As the second half of this year has unfolded, that assumption appears to have been wrong.  At the present time, only India is still in an environment marked by expanding orders for manufacturing.  Given the recent declines in orders experienced in India, even it is getting dangerously close to falling into contracting territory.

 

Exhibit 20.  Manufacturing Orders Show Global Contraction

Source: The New York Times

 

Until there are signs that economic activity is expanding, which will most likely depend on improved credit market conditions, oil demand will likely continue to weaken.  At the moment it is hard to forecast when those conditions might change, or what exactly the catalyst will be to alter current conditions.  We are confident they will change, but is the time frame only a matter of weeks, months or could it be several years? 

 

 

Canada And The Energy Card

 

From Election Eve on, we were in Calgary, Canada and found some interesting Canadian views about the United States.  Many Calgarians were aware of the dialogue during the U.S. presidential campaign about the North American Free Trade Agreement (NAFTA) and the desire of President-elect Barack Obama to re-negotiate it.  As a backdrop for this dialogue, the Democratic Party has agreed to push to re-negotiate NAFTA in return for voting and financial support from the unions.  The argument for trying to redo NAFTA is that it hurts manufacturing and has been the cause of union job losses.  The most visible example of this problem has been the U.S. automobile industry. 

 

The U.S. automobile industry’s financial problems have forced companies to cut manufacturing jobs, which has hurt the Eastern Canadian economy where a number of auto assembly and auto parts plants are located.  In fact, the province of Ontario has been hurt to the point where it is eligible to receive payments from the rest of the country under the federal government’s program to help the “have nots.” 

 

A more damaging issue has been the Democratic Party’s efforts in support of climate change legislation to ban the use of “dirty” fossil fuels such as the oil produced from the Canadian oil sands.  Some more level-headed U.S. politicians have worked to derail that “dirty” fuels legislation, but given the overwhelming Democratic Congress and a Democratic president, that momentum may build. 

 

While we were in Calgary, we had discussions with various people in addition to attending a presentation by a former Canadian politician.  The topic of several of these conversations, in addition to the politician’s presentation, was that after the U.S. election Canada should play its energy card.  In the case of the Honorable Preston Manning, his suggestion for playing the energy card involved the Canadian federal and provincial governments developing a national sustainable energy policy that would help to counteract the growing issue of U.S. protectionism.  He believes that the U.S. needs Canadian oil and gas and will figure out how to deal with the “dirty” fuel issue.  But the prospect of Canadian oil and gas supplies being needed by the U.S. to solve its energy problems should be utilized by the Canadian government to protect Ottawa’s auto industry. 

 

We also had a conversation with a taxi driver who went on at great

 

lengths about Canada’s need to confront the United States over its energy use and double the prices of the oil and gas exported south of the border.  He actually thought that Canada should look to double the price of all goods sent to the United States – not a likely scenario. 

 

What we found most interesting in these discussions was the recognition that the United States clearly needs Canada’s natural resources and it was time for Canada to get as much as it can in this trade relationship.  That desire to extract maximum prices from Americans is being rationalized as a way to offset the potential of U.S. protectionism raised with the election of Senator Obama.  Let’s hope that our relationship with our good neighbor to the north does not deteriorate to that degree, but will the new administration be capable of turning its back on its supporters and promoters?

 

 

Vehicle Miles Follow Gas Prices Down – Set To Change?

 

The Department of Transportation’s Federal Highway Administration published its estimate of the miles driven nationwide by America’s drivers for the month of August.  The monthly total was 253.7 billion miles, down 15 billion miles, or -5.6%, from the August 2007 total.  Cumulative miles driven in 2008 are lower by 3.3%, or 67.2 billion miles, from the same period last year.  On the rolling 12-month cumulative total, the trend is decidedly down as demonstrated in the chart in Exhibit 21.  While the decline in miles driven reflects the impact of higher gasoline pump prices during the spring and summer of this year on consumer incomes and their propensity to use their vehicles, the change in driving attitudes was evident much earlier.  Unfortunately, most forecasters failed to see the inflection point in Americans’ driving habits. 

 

Exhibit 21.  Americans Drive Less Despite Lower Gas Prices

Source: DOT FHWA, PPHB

 

 

If one looks closely at the chart showing the monthly average pump price for unleaded gasoline nationwide, when prices reached about $2.25 a gallon there was a marked slowdown in the pace in the upward trend for miles driven.  As gasoline prices reached the $2.50 a gallon point that pace slowed more and finally began to decline on a year-over-year basis when pump prices started with the number three.  As gasoline prices climbed from $3.00 to in excess of $4.00 a gallon, the pace of miles driven fell even faster.

 

Since last summer’s gasoline pump price peak, they have declined dramatically and now call into question whether the American driver conservation ethic is at risk of being reversed.  Gasoline price peaked the week of July 7th at $4.114 a gallon and held steady the following week at $4.113.  They then began to slide – slowly but steadily until they reached the $3.648 a gallon level at the time of the arrival of Hurricane Ike.  Since Ike followed Hurricane Gustav so closely, the Gulf Coast refining industry was hit with an extended period of downtime as there was insufficient time to restart some refineries before Ike arrived.  Lack of gasoline supplies on the Gulf Coast impacted available supply in the Southeast region of the country all the way into the mid-Atlantic region.  Between September 8th and September 15th, gasoline pump prices jumped by $0.187 a gallon to $3.815, but then prices began to drop as fundamental demand weakness took control of the gasoline market. 

 

Exhibit 22.  Gasoline Pump Prices Have Fallen Like A Rock

Source: EIA

 

From September 22nd when gasoline prices had resumed their downward trajectory, they fell like a stone.  In the following six weeks, gasoline pump prices fell by a total of $1.318 a gallon, or more than a third of their starting price.  It took a couple of weeks to get the price decline underway, probably due to the lagging supply impact from the hurricanes.  After an 8.6¢ a gallon drop, the next week’s decline increased to 14.8¢.  Then the weekly declines accelerated to 33.3¢, 23.7¢, 25.8¢ and 25.6¢ bringing the average gasoline pump price per gallon to $2.402. 

 

During our drive home from Rhode Island at the start of November, we frequently saw regular gasoline prices of close to $2.00 a gallon.  In fact, we purchased premium gasoline for $2.409 at one stop in Tennessee and have since seen premium pump prices below that level in Houston.  In other words, the pump price decline is probably

 

not over, but what impact the decline will have on driving habits is unknown.

 

Our final observation is that on the drive home a little over a week ago, the traffic was much lighter than it had been when we drove north two weeks earlier.  And remarkably there was substantially less truck traffic heading south than we encountered in July.  Do our recent antidotal observations support the recently reported extremely weak national economic activity measures?  If so, then we are probably looking at more months of lower driving activity as the economy impacts American consumer budgets.  That is not good news for gasoline and diesel consumption, and OPEC in particular.

 

 

Will Many Companies on Forbes List Make It Next Year?

 

We recently examined the Forbes magazine listing of the top 200 Best Small Companies for 2008.  There were 19 energy companies among that 200 companies, including oil and gas exploration and production companies and various engineering, oilfield equipment manufacturers, seismic equipment suppliers and fabrication companies.  When we reviewed the list, we had two observations.  First was that most of the oilfield service companies on the list for a second consecutive year had higher rankings this year than last year.  However, there were a couple of companies that had lower rankings this year.  With a slowing oilfield activity outlook for 2009, how many of them will make the list next year and will any attain higher rankings?  The second observation is related to the half dozen oil and gas exploration and development companies on the list.  Most of them had not been there last year.  As current oil and gas prices are lower than at any time since the spring of last year, we wonder how many of these companies will appear on the list in 2009.

 

The oil and gas producers dominated the top of the energy company rankings with five of the companies in the top 18 listings.  These five companies held the number one, six, nine, seventeen and eighteen positions.  The sixth oil and gas producer was ranked in the 103rd position.  Not one of these six companies appeared on the list last year, signifying the impact rising oil and gas prices have had on their profitability.  We expect that these companies are likely not to make next year’s list as their profitability is likely to be hurt by the drop in oil and gas prices since summer.

 

About a third of the oilfield service companies on the list had lower rankings in 2008 than in 2007.  On the other hand the remaining companies sported significant ranking improvements in most cases.  There was no real pattern for these companies other than two of them were seismic equipment companies with the other two companies representing an offshore platform fabrication company and a the leading provider of propants for use in well fracturing operations.  Once again, one has to wonder what might happen to the nine service companies with improved rankings this year in the face of a possible slowing in global oilfield activity.

An interesting ranking for these companies is contained in the column located on the extreme right hand side of the table contained in Exhibit 23.  This column lists the ranking of the boards of directors as determined by a comparison of each company’s performance on a number of corporate governance measures as determined by Risk Metrics Group.  The score is based on the relative performance of the company’s board based on measures such as its charter and bylaws, state of incorporation, executive and director compensation, board guidelines, company ownership and director education relative to companies in applicable stock indexes as of September 22, 2008.  A company score of 50 signifies that the company scored better than 50% of the companies in its index.  Thirteen of the companies scored 50 or worse meaning that they were outranked by most of the companies in their respective stock market indices.

 

 

Exhibit 23.  Energy Companies In 2008 Forbes 200 Best Small Company List

Source: Forbes, PPHB

 

 

Contact PPHB:
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Main Tel:    (713) 621-8100
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www.pphb.com

Parks Paton Hoepfl & Brown is an independent investment banking firm providing financial advisory services, including merger and acquisition and capital raising assistance, exclusively to clients in the energy service industry.