Musings From the Oil Patch, April 10, 2012

• Aggressive Regulation And BSEE’s Unlimited Powers
• The Mystery Of Why Gasoline Demand Has Collapsed
• Low Nat Gas Prices And The SEC Shale Gas Investigation
• “Definition of ‘Undeveloped Oil and Gas Reserves’
• Are Texas Tornadoes Linked To Global Warming?
• The Visibility Of The Real Cost For Clean Energy In Rhode Island
• A Milder 2012 Hurricane Season Forecast

Musings From the Oil Patch
April 10, 2012

Allen Brooks
Managing Director

Note: Musings from the Oil Patch reflects an eclectic collection of stories and analyses dealing with issues and developments within the energy industry that I feel have potentially significant implications for executives operating oilfield service companies.  The newsletter currently anticipates a semi-monthly publishing schedule, but periodically the event and news flow may dictate a more frequent schedule. As always, I welcome your comments and observations.   Allen Brooks

In our last Musings we discussed the presentation at the 40th Annual National Ocean Industries Association (NOIA) meeting in March dealing with the proposed extension of offshore regulation to oil service companies by the Bureau of Safety and Environmental Enforcement (BSEE).  Since that meeting there has been a development that should increase the pressure for oil service companies to respond to the regulatory expansion. 

In early March an initiative was undertaken by NOIA to challenge the extension of BSEE’s jurisdiction to service companies.  Under the guidance of several members, and with the help of lawyers Bob Thibault and Paul Smyth of the law firm Perkins Coie, a letter was sent by NOIA President Randall Luthi to Admiral James Watson, the director of BSEE, challenging the jurisdiction of the agency to extend regulation to service companies operating offshore.  The four-page letter included in its final paragraph a suggestion that BSEE could reverse and revoke its statements and actions, or it could at least proceed with a formal rulemaking process that would enable the industry to have  input into those final rules.  But the key demand was that the agency responds to the letter and “provide detailed and fully supported justification and authority of its announced extension of BSEE jurisdiction beyond federal lessees and their designated operators.”  That request asked for a formal response by April 10th. 

On March 30th a response was sent by BSEE.  The two-page letter sets forth the broad authority that the agency believes grants it the jurisdiction over service companies offshore.  BSEE cites the OCS Land Act and implementing regulations, 30 C.F.R. Chapters 2 and 5.  It concludes that “BSEE has broad legal authority over all activities conducted under federal offshore leases, whether such activity is engaged in by lessees, operators, or contractors, and we can exercise such authority as we deem appropriate.”  The agency then cites two examples where the regulations apply to “all operations conducted under OCSLA” or “any person [who] fails to comply with any provision of this subchapter, or any regulation or order issued under this subchapter.”  Based on its interpretation of the statutes BSEE goes on to state, “The ‘any person’ language of section 24(b) makes it clear that persons other than lessees and operators can be subject to the Secretary’s rules or orders.” 

So there service industry – you are now subject to regulation if you perform any service offshore.  What does this mean for those companies who sell equipment for offshore work?  If they perform any maintenance, one could conclude that they too are subject to regulation.  To us, the scary thing about this sudden bureaucratic regulatory power-grab is that everything is up to the discretion of BESS and its inspectors, many of whom, due to the rapid growth of the agency, lack experience and probably even sufficient training.  It could be that BSEE inspectors are to the offshore oil industry as TSA inspectors are to airline passengers.  That’s truly scary!

The last paragraph of the BSEE letter is what bothers us the most about this regulatory expansion.  It says:

“We currently are in the process of developing a policy regarding the circumstances in which BSEE will exercise its existing authority over service companies and contractors conducting on-lease activities.  BSEE is committed to ensuring that everyone, including service companies and contractors, is committed to higher standards of safety and environmental protection on the OCS.” 

So BSEE is going to develop a “policy” about when it may act, but it won’t be done under a rulemaking procedure nor will companies be consulted.  Secondly, BSEE is suggesting that everyone should be held to “higher” standards of safety and environmental protection offshore.  So “higher” than what?  Are these standards going to be new safety and environmental standards, or merely arbitrary ones? 

We view this letter and the philosophy enunciated by Admiral Watson, both in his presentation at the NOIA meeting and in the letter, in the context of a recent statement by former Bureau of Ocean Energy Management, Regulation and Enforcement (BOEMRE) director Michael Bromwich in an interview with a reporter for The Houston Chronicle.  Mr. Bromwich said, “If you’re going to be a credible regulator, you’ve got to be aggressive in your enforcement.  We all need to see evidence of aggressive enforcement.”  Of course the purpose of his interview was to announce the launching of the Bromwich Group, a Washington-based consultancy aimed at advising companies on revamping their operations.  The revolving door has barely stopped spinning!  What better way to ensure your new venture has business than to encourage your successors to be aggressive!

But we suggest that BSEE might want to keep in mind the recent Supreme Court unanimous slap-down of the Environmental Protection Agency’s (EPA) heavy-handed enforcement actions under the Clean Water Act when that law didn’t give them the power they were exercising.  Maybe BSEE should also consider the recent string of reversals on water pollution actions related to shale gas developments by the EPA and the U.S. District Court’s dismissal of the EPA’s air quality suit against Texas as examples of the need to follow the rules versus being overly aggressive. 

There was a small gathering of NOIA members with the Perkins Coie attorneys in Houston last week to discuss the BSEE response to the NOIA letter.  That response has started a clock ticking for any formal response and challenge to the proposed BESS actions.  The meeting discussed the possibility of formation of an ad hoc group to respond, either through the rulemaking process or a court challenge.  In one case, the response time is 60 days and in the other possibly as short as 45 days.  There was also a discussion about the creation of a more formal organization such as the Shallow Water Coalition that challenged the federal government’s Gulf of Mexico drilling moratorium following the Macondo blowout. 

We know that many of the readers of Musings From the Oil Patch are engaged in the management and operation of energy and energy service companies that work offshore and will be impacted by these proposed new, and arbitrary offshore regulations.  For offshore service companies: If you didn’t know it before, you should understand it now, your world has changed!  You are now subject to regulations you’ve never experienced before with the attendant impact those rules will have on your company – its management, governance and operations.  Becoming engaged in understanding and helping shape those regulations may be the best course of action.

In the last Musings we wrote about the challenge of understanding why gasoline demand has collapsed in recent months at the same time the economy is recovering and new car sales are ramping up.  In that article we focused on the acknowledgment by the Energy Information Administration (EIA) that it had misestimated gasoline export volumes and as a result may have overstated the magnitude of the year-to-year decline in domestic gasoline consumption.  Unfortunately, based on the chart on the EIA’s website showing the impact on export volumes from its prior estimation methodology and its current one, we still have a ways to go before this change will correct the data reporting problem – assuming the EIA doesn’t make further adjustments in its estimating procedures. 

Exhibit 1.  Gasoline Use Has Collapsed Recently

Source:  EIA, PPHB

As can be seen from Exhibit 2, there has been a significant increase in monthly gasoline export volumes since the switch to the new methodology in August of last year, and there is a noticeable difference between the monthly export figures from the Petroleum Supply Monthly, which gets its volume figures from the Census Bureau, and the 4-week average volume estimate derived from an historical analysis of five years’ worth of data from the Weekly Petroleum Supply Report.  By using the latter analysis, export volumes were estimated to be lower than the monthly data report projected, which had the effect of leaving the domestic volume too high.  With higher estimates for export volumes, domestic demand is reduced making the year-to-year comparison less stark. 

Exhibit 2.  Impact Of New Gasoline Export Model

Source:  EIA

While we suspect this flaw in the statistical methodology has impacted the outcome, we also remain convinced there are structural changes underway in the gasoline market that have impacted, and likely will continue to impact, consumption.  As shown in Exhibit 3, there has been a decline in total vehicle miles driven in the United States since the financial crisis in 2008.  But the growth rate in vehicle miles driven had been slowing before the peak.  The two factors impacting vehicle miles and gasoline consumption that we have focused on are the age mix of drivers along with their driving habits and the impact of the Internet and social media on driving habits.  A number of surveys have shed light on these issues.

Exhibit 3.  Declining Trend In Vehicle Miles Driven

Source:  Federal Highway Transportation Agency

If one examines Exhibit 4 showing the historical growth of the U.S. population, the number of vehicle registrations and licensed drivers, it becomes clear that some of the past trends are changing.  For example, in recent years there has been a decline in the number of vehicles in America.  At the same time, there has been a flattening in the growth rate for licensed drivers at a time when our population was growing at its historical rate.  It is interesting to note that it required just 17 years for the number of licensed drivers to increase from 100 million to 150 million (1965-1982), yet 23 years were needed to add the next 50 million drivers (1982-2005). 

Exhibit 4.  Changing Trends In Vehicle Market

Source:  Department of Transportation

In Exhibit 5, we see similar changes in growth trends for the number of registered vehicles, licensed drivers and driving-age population.  In that chart, during the last half of the 1990s, there was a noticeable increase in the driving-age population, yet no comparable rise in the number of licensed drivers.  This suggests that a portion of the driving-age population has not secured driver’s licenses, which would likely be the youngest age group that is just entering that populations segment.

Exhibit 5.  Decline In Percent Licensed Drivers

Source:  Department of Transportation

Several studies of Federal Highway Transportation Department data for licensed drivers by age and sex substantiate that these teens are the drivers who are not procuring licenses.  We will explore some of the reasons later, but first we want to address the gasoline consumption question.  As shown by Exhibit 1 (page 4), high gasoline prices have impacted gasoline consumption as people are driving less.  The most recent weekly data from the MasterCard SpendingPulse survey that measures gasoline sales showed the latest weekly demand being down 1.5% from the prior week, while it fell 7% from the same period a year ago.  This marked the 53rd straight weekly decline in gasoline consumption.  A survey showed that Americans under the age of 40 were driving significantly less than 10 years ago, but the unemployed people in this age group had reduced their driving by between 19% and 24%.  That trend prompted the surveying firm to question whether the American car culture was waning as younger Americans have become more environmentally aware. 

Exhibit 6  Driving Trends By Age

Source:  theenergycollective.com

The decline in driving by younger drivers is shown clearly in Exhibit 6 where the blue line shows miles driven per year per capita for 1995, the red line for 2001 and the green line for 2009.  What it shows is substantially fewer miles driven by 18-39 year olds in 2009 compared to prior years.  The magnitude of the declines between 1995 and 2009 (purple) and 2001 to 2009 (blue) confirm this trend. 

One explanation is the sharp decline in the percentage of younger Americans who are obtaining their drivers’ licenses during the 25-year period 1983-2008.  While the percentage is down for Americans from 18 years old to 40, the corresponding licensure trend has increased for drivers 50 years and older.  Some of this increase probably reflects middle-aged drivers maintaining their licenses as they grow older. 

Exhibit 7.  Teen Driver Participation Declining

Source:  theenergycollective.com

To further understand the impact these licensed driver trends might have on gasoline consumption, we looked to see how miles driven varied by age.  Unfortunately, there is not the granularity in miles driven by age as there is for licenses (Exhibit 8). 

Exhibit 8.  Miles Drive By Age And Sex

Source:  theenergycollective.com

What this data shows is that the most miles driven are racked up by those in the 20-54 year age bracket.  Individuals in the 16-19 and 65+ age groups drive about the same number of miles annually, but there is a marked difference in the number of miles driven by sex, especially for the older group.  The data suggests that there shouldn’t be much difference in gasoline consumption, based on miles driven per year, between teenagers and American drivers 65+ years old.  While that may be what the statistical averages show, we believe that as people age their energy consumption declines, which is consistent with other energy surveys, and especially for gasoline.  The more important question becomes what may happen in future years as the American population ages? 

Exhibit 9.  Older Drivers Swamping Teens

Source:  DOT, PPHB

Based on the demographics from the U.S. Census Bureau, there has been dramatic growth in the number of Americans who are 70 years old or older.  In 1983, the total number of teenage and 70+ drivers were essentially equal, but by 2010 (the latest data available) there had been more than a doubling of oldsters with no appreciable growth in the number of teenagers, meaning there has been a significant increase in the relative importance of this older group of drivers for gasoline demand. 

Exhibit 10.  Older Drivers Are More Important

Source:  DOT, PPHB

The impact of these older drivers is shown in Exhibit 10.  The oldest driver group has increased its share of total drivers by nearly four percentage points while teenagers declined by two percentage points.  That amounts to a nearly six percentage point swing.  If we assume that 70+ aged drivers don’t drive the average number of annual miles suggested by the data for 65+ drivers in Exhibit 8 (page 8), we then conclude that there will be a permanent reduction in miles driven by this group even though there will be more adults in this age category.  On the other hand, as this older group accounts for a larger percentage of all drivers, and not just at the expense of teenagers, the younger peak age drivers who account for the greatest number of miles driven will also be declining.  All of these demographic trends on driving come before we consider the impact of more fuel-efficient vehicles in the fleet and other economic and social changes underway.

If we consider the population and recent projections from the Census Bureau, we can develop a feel for what may happen to future gasoline demand as a result of the demographic trends.  In 2010, there were 21.8 million people in the 15-19 age range compared to 28 million who were 70+.  By 2015, there is projected to be about 500,000 fewer teenagers but three million additional older adults.  The spread between these two age groups becomes even wider by 2020 when there will be 22.6 million teenagers but 36.9 million who are 70+.  As a result, the count of 6.2 million more 70+ adults in this country expands to more than 14 million by the end of 2020.  To our way of thinking, there has to be a negative impact on miles driven and gasoline consumption from this trend.

In a new study published in the journal Traffic Injury Prevention, two professors associated with the University of Michigan Transportation Research Institute found that having a higher proportion of Internet users was associated with lower licensure rates among young people.  The researchers compared data for 14 other countries to that of the United States and found that half of the other countries showed a similar age-related pattern of change in U.S. driver licensing – a decrease in young drivers and an increase in older drivers.  Canada, Great Britain, Germany, Japan, Norway and South Korea all have seen similar licensing declines.  On the other hand, Israel, Finland, Poland, Latvia, Spain, Switzerland and the Netherlands have experienced an increase in both young and older drivers over time, although the increase in the younger age group was smaller.

According to the research, in 1983, a third of all licensed drivers in the United States were under age 30.  Today, that is only about 22%.  Also, about 94% of Americans in their 20s had a driver’s license in 1983, compared to about 84% in 2008.  The conclusion of the study was that “…countries with higher proportions of Internet users were associated with lower licensure rates among young persons, which is consistent with the hypothesis that access to virtual contact through electronic means reduces the need for actual contact among, young people.”  This conclusion is borne out by results from other surveys.  A 2011 survey by Zipcar found that 68% of licensed drivers under age 35 sometimes choose to spend time with friends online rather than driving to see them.  J.D. Power and Associates found that young adults care more about their cell phones than their cars.  And the Gartner research firm found that 46% of drivers aged 18-24 would choose Internet access over owning a car.

These conclusions are consistent with the changes in social media and their impact on the mobility needs of younger people.  But there is also the impact of the Internet on jobs and how that might impact driving patterns.  A new study on the employment effects of Internet and wireless technology improvements found some interesting data.  According to the McKinsey Global Institute, the Internet contributed about 3% to global GDP growth in 2009 and was responsible for 21% of the U.S. GDP growth over the last five years.  Furthermore, a recent study by the World Bank found that among high-income countries such as the United States, every 10 percentage-point increase in broadband penetration is associated with an additional 1.21 percentage-points of economic growth.  While we haven’t seen research specifically showing that the increase in Internet use or greater access to cell phones has cut down on driving and thus gasoline consumption, intuitively we have to believe that is the case.  We base our conclusion on changes we personally have made in recent year to our shopping habits.  It is often easier to shop for things on Internet web sites and have them shipped to our home rather than for us to drive to the store.  That along with bunching errands together into one single trip rather than making multiple trips reduces miles driven, albeit not materially.  But if millions of people adjust their driving habits just as we have, there will collectively be a meaningful impact. 

The last noteworthy social trend is the desire of young adults to live in dense, urban neighborhoods.  According to the results of a study by RCLCO Consumer Research, 77% of Generation Y plans to live in an urban area.  More than half of them would trade the size of their homes for proximity to shopping or work.  A rule of thumb is that doubling the density of a neighborhood will reduce miles driven by 20%, although much of the reduction is a result of dense neighborhoods being more likely to have public transportation as well as nearby shops, entertainment and employment.  The Midtown area of Houston, which has been redeveloped over the past thirty years, is a good example of an urban area that attracts younger adults by its proximity to work, shopping and entertainment.

How much of the reduction in gasoline consumption that we have experienced recently is due to each of these many factors?  It is impossible to sort that out definitively.  What we believe, though, is that these trends are firmly established and will contribute to a steady decline in miles driven and gasoline consumption by individuals.  That said we are still talking about the United States using nearly 8.5 million barrels per day of gasoline, a substantial volume.  Gasoline use is not going away, but its influence in the domestic energy market will diminish over time. 

We recently attended a seminar hosted by Fulbright & Jaworski L.L.P. dealing with challenges facing boards of directors and, in particular, issues related to the Securities and Exchange Commission (SEC) and enforcement.  The seminar, conducted in an Oprah Winfrey-style interview format, included as guests, David Woodcock, the director of the Fort Worth office of the SEC along with the general counsel of HCC Insurance Holdings, Randy Rinicella, the leader of the Houston forensic services for accounting firm PwC, Karyl Van Tassel, and the moderator, Gerry Pecht, a partner with the law firm sponsor.  As you would expect, the discussion covered a wide range of topics extending from problems that are emerging from the new rules of the Dodd-Frank legislation to questions about potential investor fraud that may develop from the recently enacted Jumpstart Our Business Startups (JOBS) Act signed into law by President Barack Obama. 

A question was posed about the subpoenas issued last year to several energy companies active in developing gas shale resources.  Those subpoenas came to light following a series of articles in The New York Times about the potential for there not to be as much natural gas contained in some gas shale reservoirs as the producing companies were suggesting.  According to Mr. Woodcock, these subpoenas were issued after reviews of the annual reports of the companies in light of the SEC revisions to the rules for reporting oil and gas reserves.  A report by the law firm Sullivan & Cromwell LLP discussed how the changes were to be implemented.  In that report, the law firm highlighted the most significant disclosure changes. 

“Prices used to estimate reserves for both reserves disclosure and accounting purposes will now be a 12-month average price, based on the first-day-of-the-month price for each month, rather than a single-day, year-end price.

“Alternative technologies may be used to establish proved reserves if they satisfy a new principles-based definition of ‘reliable technology.’

“Reasonable certainty for the purpose of estimating proved reserves is defined to mean a high degree of confidence or at least a 90% probability that the quantities will be recovered.

“Non-traditional resources, such as bitumen extracted from oil sands and oil and gas extracted from coal and shale, may be included in disclosure of oil and gas reserves.

“Optional disclosure of probable and possible reserves will be permitted.

“Conforming changes to Form 20-F will impose the same oil and gas disclosure requirements on foreign private issuers, resulting in a significant expansion of the required disclosures for non-U.S. oil and gas companies.”

The SEC’s disclosure review relates to the issue of the five-year time frame for the development of reserves in order to be included in a company’s estimate.  The Sullivan & Cromwell report addressed this issue in the following paragraphs, which highlight how the determination of oil and gas reserves has been liberalized from the way they were determined prior to the new rules.

“The new rules allow the inclusion of undeveloped reserves if there is reasonable certainty of economic producibility, regardless of whether the reserves are located in development spacing areas immediately adjacent to the development spacing area containing a producing well, or at a greater distance from productive units.  This represents a significant change from the current approach, which imposes a ‘reasonable certainty’ standard for reserves in drilling units immediately adjacent to the drilling unit containing a producing well, and a ‘certainty’ standard for reserves in drilling units beyond the immediately adjacent drilling units. 

“Under the proposed rules, a company would have been prohibited from assigning proved status to undrilled locations if a development plan had not been adopted indicating that the locations are scheduled to be drilled within five years, unless it disclosed unusual circumstances that justify a longer time. Several commenters objected that large, complex or remote projects commonly require more than five years to develop. In response to those comments, under the adopted rules undrilled locations may be classified as having undeveloped reserves even where drilling is not scheduled to begin within five years, if specific (not necessarily ‘unusual’) circumstances justify a longer time.”

In light of the decline in natural gas prices, the SEC is questioning what impact there has been on the intent of producers to develop these reserves and whether any change or potential for a change in plans has been accurately described to investors.  It should be noted that in the Sullivan & Cromwell discussion they note that producers can include reserves that won’t be drilled within the five-year time frame as long as the circumstances that limit their development are “specific” and not “unusual.”  A sharp decline in commodity prices that impacts the economics of the development of reserves is not an acceptable excuse for non-development, regardless of how painful the action of writing down the value of the previously claimed reserves may be. 

With natural gas spot prices about to fall through the $2 per thousand cubic feet threshold, investors and analysts are questioning when producers will be forced to acknowledge the changed economics and have to write down already-booked reserves, and just how painful it will be for the companies and their share prices.  The shift in price determination from the prior single–point to a 12-month average alters that determination, especially in cases where gas is sold with contractual prices substantially higher than spot prices.  However, the longer this low-priced condition extends, the greater the pressure will be for producers to reflect the current pricing environment in their reserve calculations.  All of this has the SEC concerned that its liberalization of the proved reserves calculations may have led to abuse by certain producers, which means that their reserve value disclosures did not adequately warn investors of the potential inflated value in the company’s assets. 

According to Ms. Van Tassel, oil and gas producers who received SEC comment letters regarding their annual report disclosures were four-times more likely to have had included a comment about the text of their reserve disclosure.  We suspect this reserve disclosure issue will receive greater focus as the year progresses given the level of natural gas prices and the deteriorating financial condition of producers.  If you raised money since the revisions to the reserve disclosure, the regulatory risk may be elevated.

Last Tuesday, the area surrounding the Dallas Ft. Worth Metroplex was battered by a number of devastating tornadoes.  Most of America was treated to news broadcasts showing video of one of the storms roaring through a truck depot and tossing 18-wheel trailers hundreds of feet into the air.  The damage from the storms was extensive, although the media misrepresented the impact when it reported 600 homes were destroyed.  The count includes all homes that suffered damage, whether they were totally destroyed or had only a few roof shingles blown off.  Thankfully, there were no deaths from the storm, which is attributed to early tornado warnings. 

The media coverage of the tornadoes and resulting damage provided opportunity for some meteorologists to try to link the storms to climate change.  One cable channel weather woman, a former Weather Channel meteorologist, had this to say, "That’s kind of the climate change we are seeing. You know, extremes are kind of ruling the roost and really what we are seeing, more become the norm.”  This was further amplified by a CNN weather anchorman who reported, "This global warming is really kind of a misnomer.  It’s global climate change. So…severe is more severe.”  The problem with these statements is that they have no basis in fact and even the United Nations Intergovernmental Panel on Climate Change (UNIPCC) says so.  In its recently issued UNIPCC Special Report On Extremes, the agency stated the following.

• “There is medium evidence and high agreement that long-term trends in normalized losses have not been attributed to natural or anthropogenic climate change.

• "The statement about the absence of trends in impacts attributable to natural or anthropogenic climate change holds for tropical and extratropical storms and tornadoes.

• "The absence of an attributable climate change signal in losses also holds for flood losses"

The statistics show that the North Texas region has experienced about 30% of its tornadoes in the month of April, so these storms are not that unusual.  The historical record of U.S. tornadoes also shows that the number experienced has been declining over time, so the linkage to climate change doesn’t exist.

Exhibit 11.  Tornado Frequency In Decline

Source:  NOAA

The two counties, Dallas and Tarrant, which comprise the Dallas-Ft. Worth Metroplex, have experienced a total of 172 tornadoes over the past 60 years with 42 in the strongest EF 2-3-4 categories.  As the data in Exhibit 12 (page 16) shows, the most active month in this region is April, which has experienced 47 of the 172 total tornadoes and 14 of the 42 strongest ones, thus the timing of the recent tornadoes is not unusual, nor was their strength extraordinary. 

Exhibit 12.  30% Of Tornadoes In April

Source:  NOAA, NWS, PPHB

Equally impressive about this storm is that for all its furry and destruction, there were no lives lost, which is attributed to the early warning of the tornado potential and the quick response by people when they were sighted.  It was also fortunate that these tornadoes occurred during the day as opposed to night when people are unaware of the risk.  Over the past 60 years in these two Metroplex counties there have been five killer tornadoes that claimed 17 lives.  Fortunately, the latest tornadoes will not add to that total.

Exhibit 13.  Killer Tornadoes In DFW Metroplex

Source:  NOAA, NWS, PPHB

For as much as some of the climate change fear-mongers would like to whip up emotions about the possibility of climate change driving extreme weather events such as tornadoes, the facts and the science do not support them.  Increased media coverage, with the addition to the popularity of “storm chaser” videos, has left the public with the impression that everything we experience today is worse than ever encountered.  We always thought that enhanced memories came with age and reflection: witness the stories our grandparents told us about trudging through knee-deep snow up the hill to attend school in the winter.  But, it always sounded fishy when they had to go up hill to get home, too! 

On March 29th it was reported by the local Rhode Island media that the state’s Public Utility Commission had approved a rate hike for the principal electricity provider, National Grid (NGG-NYSE).  The 5.7% rate hike will boost by $4.25 the typical customer’s monthly bill that currently averages $74.  National Grid attributes the rate hike to the rising cost for renewable energy certificates it must buy to comply with the state law on the percentage of power the utility much get from clean energy.  The rate increase was implemented on April 1st.

We are waiting for the ratepayer backlash, which the PUC has helped to ensure by its mandate that the charge be set out on the customers’ bills as a separate line item.  We are guessing, although we don’t know for sure, their mandate is an attempt to deflect the outrage from the PUC and to the politicians in the state who approved this mandate.  This rate increase is even before ratepayers contemplate the impact of the offshore wind project, which is still a ways away, and its cost that will be spread over the bills of all electricity users in Rhode Island, regardless of whether they get their power from National Grid or not. 

For a state whose labor market is the second worst in the nation with an 11% unemployment rate, has several additional cities and towns facing the near-term prospect of bankruptcy while attempting to raise taxes to help bail themselves out, and with home prices down another 7.8% in February and foreclosures ramping back up, hitting people with a nearly 6% increase in their electricity bills for clean energy we doubt is going to go over well.  We will be interested in seeing the mood of the locals when we arrive there in about a month.

The tropical storm forecasting team of Phil Klotzbach and Bill Gray at Colorado State University (CSU) issued their first detailed forecast for the 2012 Atlantic Basin storm season.  Given their long-standing efforts to perfect a forecasting model for this meteorological phenomenon, the team introduced a new extended-range, early April statistical prediction scheme.  Their new model employs 29 years of past data and also utilizes analog predictors.  The bottom line is that these forecasters believe 2012 will be a below-average hurricane activity season due to the combination of a cool tropical Atlantic Ocean and the potential development of El Niño in the Pacific Ocean. 

The first CSU forecast of the year calls for 10 named storms to form with only four developing into hurricanes and just two of them becoming major hurricanes.  Not only are the forecasters expecting this hurricane season to be below-average, they believe the probability of at least one major hurricane (Category 3-4-5) making landfall on the U.S. coastline is below average, too.  At the present time, the model suggests the probability of a major hurricane landfall on the entire U.S. coastline is only 42%, which compares to the average for the past century of 52%.  If the target is just the entire East Coast, including the peninsula of Florida, then the probability is 24% versus a 31% historical average.  The probability of landfall on the Gulf Coast is also 24% compared to the historical 30% record. 

As a presentation by a NOAA scientist about the 2011 hurricane season demonstrated, there have not been a lot of hurricane landfalls on the U.S. coastline since 1995, but as they, and all forecasters, point out, it only takes one storm hitting the shore to cause extensive damage and loss of life.  Notwithstanding that warning, however, the lower-than-historical probabilities for a severe hurricane landing on the U.S. coastline has to be considered good news – not only for residents but also for oilmen and all others who earn their livings from the coastal waters.

Exhibit 14  Not Many Hurricanes Hit U.S.

Source:  NOAA

The CSU forecasters issued a report early last December in which they announced they were abandoning their normal early 2012 forecast regime in lieu of providing a qualitative assessment of those conditions they believed would impact their traditionally more accurate spring forecast.  This change was in recognition that their forecasting record of the coming hurricane season made in December had not proven meaningful.  What they did do in their qualitative assessment report was to set forth four possible scenarios for the forces that influence the formation and intensity of tropical storms.  For each scenario, they assigned a projection of the number of resulting storms.  One scenario involved a continuation of the strong Atlantic Basin Thermohaline Circulation pattern that has been in place since 1995 along with the development of a significant El Niño.  They rated that scenario as having a 30% probability, the second highest of their four scenarios.  That scenario was estimated to produce 8-11 named storms, 3-5 hurricanes and 1-2 major hurricanes.  The April CSU forecast fits this December scenario.

The team analyzed the factors they are employing in their forecasting model and reached the following conclusion: “…based on the above information, our best estimate is that we will likely transition to neutral conditions in the next few weeks with a possible transition to El Niño conditions during the early part of the hurricane season.”  The forecasters warn that this transition needs to be monitored closely as the early spring is the time when the factors influencing this transition are most at risk of altering their trend, which might force them to have to adjust their model.  Although 2/3rds of forecasters who input to the European forecasting model, which the CSU team is using, expect a strong El Niño to develop this summer, it certainly is not a given and any change could impact the conditions that influence the formation and strength of hurricanes. 

Exhibit 15.  Analog Hurricane Years

Source:  CSU, PPHB

Another step the CSU team took in preparation of its forecast was to utilize analog years to modify their final forecast.  They found four years in recent history where the early spring meteorological conditions and the outlook for their development during the hurricane season were similar to current conditions and expectations for changes in the coming months.  Those years were: 1957, 1965, 2001 and 2009.  The details about the years are displayed in Exhibit 15.  Most of the information in that table is straight forward having to do with storm types and number of days.  However, most people probably are not familiar with the terms – ACE and NTC.  ACE (Accumulated Cyclone Energy) is a measure of a named storm’s potential for destruction by wind and storm surge.  It is a mathematical calculation of wind speed measured during intervals of the storm’s existence.  For 1950-2000, the average ACE reading is 96. 

NTC (Net Tropical Cyclone Activity) is the seasonal average of the various activity measures: Named Storms, Named Storm Days, Hurricanes, Hurricane Days, Major Hurricanes, and Major Hurricane Days.  The 1950-2000 value of this parameter is 100.  It is interesting that in three of the analog years, both ACE and NTC measures are below their historical averages as well as the number of storms, etc.  However, 2001 stands out because its record is well above the historical measures.  The average of all four years falls below the average measures.  Based on these analog years, the CSU forecasters have adjusted downward their model’s statistically-generated results.

Exhibit 16.  CSU Hurricane Forecast vs. History

Source:  CSU, PPHB

When we consider the CSU professors’ April forecast, it is interesting to note how closely the estimates are to the actual storm results experienced in 2009, which just happens to be one of the four analog years.  What also stands out is how different the 2009 hurricane season was compared to the two years before and the two years after.  It is equally interesting to contemplate just how different 2012 will be compared to recent history if the upcoming storm season unfolds as forecasted. 

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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.