Musings From the Oil Patch – April 15, 2008

• Economic Reality Hits IEA Oil Demand Forecast
• U.S. Gasoline Demand To Fall This Summer
• Q1 Results Show Commodities and Stock Disconnect
• 2008 Hurricane Forecasts: What Have You Done For Me Lately?
• Airlines Hammered By Rising Fuel Costs

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

Economic Reality Hits IEA Oil Demand Forecast

 

In the International Energy Agency’s (IEA) latest monthly oil report it revised down its estimate for crude oil demand in 2008.  While it indicated a reduction of 310,000 barrels a day (b/d) in the 2008 forecast bringing estimated annual demand to 87.2 million b/d, it also increased its 2007 demand by 140,000 b/d to reflect a revised Former Soviet Union (FSU) demand estimating methodology and baseline data revisions.  This means the true net change is closer to a 450,000 b/d drop in the demand forecast.  From the IEA’s original 2008 forecast made last year, this new estimate represents just over a 40% reduction.  Measured from the IEA’s prior forecast, the revision is a mere 23.5% cut.  What we do know is that this revision marks the largest reduction in a forecast by the IEA since its 2001 revision following the 9/11 attack. 

 

Exhibit 1.  The IEA Reduces 2008 Oil Demand Again

Source: IEA, PPHB

 

As we have often pointed out, the IEA has not done a particularly good job in estimating annual demand growth.  In the 1990s, the agency was consistently too pessimistic about demand growth.  This pattern held through the early years of this decade.  The conservative nature of forecasts was demonstrated most emphatically when it missed 2004’s explosive demand increase driven largely by China’s seemingly insatiable oil thirst.  In hindsight, it appears that since the 2004 forecasting debacle, the IEA has become intent on not underestimating China’s consumption growth and how it might affect global demand.  Based on the IEA’s latest comments about the possible legitimacy of the decoupling theory of Asian economic activity from the recessionary climate of the United States and Europe, it clearly bases its forecast on continued Chinese oil consumption growth.  The IEA seems to be firmly in sync with the historical oil demand pattern demonstrated by the chart in Exhibit 2.

 

Exhibit 2.  Will China and India Follow The Pattern?

Source:  Agora Financial

 

The IEA’s rationale for reducing its 2008 crude oil demand estimate is the impact of global financial and credit markets on the economic outlook for the United States and other industrialized countries, primarily those in Western Europe.  The IEA based its oil consumption reduction on the recently released World Economic Outlook projections from the International Monetary Fund (IMF), which cut the economic growth estimates for the U.S., European region and other industrialized countries.  The IMF lowered its forecast for 2008 world economic growth to 3.7% from its prior estimate of 4.2% growth.  Interestingly, the IMF also reduced its forecast for economic growth in China this year and next, however, the forecasts remain well above expected growth rates anywhere else in the world.

 

Exhibit 3.  Latest IMF World Growth Forecast Is Down

Source:  IMF, PPHB

 

The greatest risk is that these IMF forecast reductions are only the start of repeated reductions as more economic details become available and financial market turbulence continues unabated and possibly even spreads.  That risk was expressed by the head of the IMF’s office of analysis and advice when he said, “Further, world growth would achieve little pickup in 2009, and there is a 25 percent chance that the global economy will record three percent or less growth in 2008 and 2009, equivalent to a global recession.”  Should that scenario unfold, then the IMF’s outlook for global economic growth will likely need to be reduced, but more importantly, world oil demand growth would fall.

 

From its 2008 United States economic growth forecast for a 2.8% increase made last spring, the IMF’s new growth projection is barely one-fifth of that total.  The IMF has reduced its expectation for U.S. economic growth to only 0.5%.  But possibly more damaging for oil markets is the fact the IEA is now forecasting only 0.6% economic growth in 2009 for the United States.  If that is the case, it will be hard for the U.S. economy to be a significant driver of global energy consumption for some time. 

 

The IMF’s projection for the Euro region has a similar trajectory.  It started forecasting a year ago 2.3% growth, which was barely lowered to 2.2% last October, but now stands at 1.3%, or fully one percentage point lower than the starting point.  Again, just like for the United States, the IMF expects Euro region economic growth to only be 1.1% in 2009, lower than this year’s estimate.  Japan, the other major world industrial market saw its 2008 economic growth forecast cut by about a half a percentage point (1.9% to 1.4%) from last April to now, but the growth projection for 2009 is put at 1.5%, or up marginally.

 

 

 

 

 

Exhibit 4.  IMF Forecasts Slowing Economic Growth

Source: IMF, PPHB

 

In contrast to the IMF forecast, the Peterson Institute is more optimistic about a pickup in economic activity in 2009.  We do not know what lies behind its more optimistic forecast.  Should this forecast come to pass, rather than the gloomier IMF forecast, then it is possible that global oil demand could be stronger in 2009 than it is projected to be in 2008.  Regardless of which forecast proves right for 2009, both forecasts call for lower 2008 economic activity and we suspect they may still be too optimistic.

 

Exhibit 5.  Peterson Institute Is More Optimistic About The Future

Source:  Postcards From Cape Town

 

The IEA continues to forecast that economic decoupling has occurred between the advanced economies, or those of the most industrialized countries of the world, from the developing economies, principally China and India.  The IMF estimated that China’s economic growth in 2007 was 11.4%, but the Chinese government just announced an upward revision to its earlier estimate of growth of 11.4% to 11.9%.  If true, that makes the IMF’s projection of only 9.5% growth in 2008 a much bigger fall than if that country’s economy had grown only at the lower rate.  Once again, the IMF expects the slowdown in China to persist into 2009 with its initial projection calling for only 9.2% growth.  The lower 2008 and 2009 forecasts appear more realistic now that China has allowed its currency to float upward in value against the U.S. dollar that makes its imports more expensive and its exports cheaper.  This move would suggest that the economic planners in China (it is a semi-planned economy) are worried about the country’s competitive position in the global economy.  That fear may be a function of the growing population of China and its increasing urbanization.  Unless China’s economy can create more jobs, it is hard to imagine this population transition will continue smoothly. 

 

Exhibit 6.  Urbanization Is A Major Theme in China’s Future

Source: The Wall Street Journal

 

If the Chinese economy is beginning to reflect a material slow down in its exports, as reported by government officials and the media, a primary driver of the country’s economic prosperity is being weakened.  We also wonder what changes, if any, the Chinese government may impose on the country’s political structure and its economy following the end of the Olympics in late August.  We know the government has been more concerned about inflation since late last year, but its primary response has been to cap consumer prices and admonish local companies to increase output despite reduced profitability.  This strategy has been particularly true in the energy market where the government has fixed the price of diesel fuel and ordered local companies to increase their diesel production despite the profit squeeze from rising global crude oil prices. 

 

The greatest problem the Chinese economy is experiencing is the impact of inflation and rising wages.  The economic miracle of China was built on its abundant supply of cheap labor.  Now, however, as labor costs are escalating, the Chinese economy is becoming based more on the assembly of consumer products with the vast majority of components coming from neighboring countries that have lower labor costs than China.  That economic evolution puts China at greater risk of losing global market share for consumer products to those economies that have cheaper labor costs than China. 

 

Exhibit 7.  Inflation Is A Growing Chinese Fear

Source: U.S. Global Investors

 

Offsetting that risk is the continuing growth of China’s cities to house its rising population and the country’s need to add and improve its infrastructure.  The chart in Exhibit 8 shows the projected demand for aluminum this year by select countries and regions.  Clearly China is the leading market for this important construction and consumer product material.

 

Exhibit 8.  Aluminum Is An Energy Intensive Product

Source: U.S. Global Investors

 

With the IEA marking down its forecast for oil demand this year, the incremental volume of oil that will be consumed this year is getting closer to the historic demand growth over the past 19 years.  (See Exhibit 1.)  Increasingly, this long-term benchmark of slightly over one million barrels a day of annual demand growth raises questions about what happened in 2004 and the historic relationship between economic growth and oil demand displayed in Exhibit 2.  The forecasters continue to focus on the economic growth of China and India, but they also pay attention to the entire Asian region.  Economic growth in this region has strengthened and appears to be getting stronger as the rest of the industrialized world weakens.  However, when oil forecasters prepare their models, they always assume that economic trends and government policies remain constant.  But in most of the Asian countries, governments have adhered to policies calling for subsidizing consumers’ food and fuel costs.  This artificial reduction of prices acts to boost demand, although it helps assure the continuation in office of the current government. 

 

Food prices have started to jump resulting in government actions to restrict exports of rice supplies and reduction in food import fees and restrictions.  Asian governments so far have avoided financial devastation from rising fuel costs, but one has to wonder how much longer these fuel subsidies can be sustained with global oil price well over $100 per barrel.  The trend in the impact of subsidies on the economy of Indonesia shown in Exhibit 9 points out the peril the Asian countries risk should their finances weaken or commodity prices continue to escalate.  That scenario would put at risk all the forecasts for economic activity and energy demand.  This is a risk to the global petroleum industry that it cannot, and should not, ignore.

 

Exhibit 9.  Indonesia’s Subsidy Burden Is A Risk

Source: U.S. Global Investor

 

 

U.S. Gasoline Demand To Fall This Summer

 

It is hard to believe that one of the more traditionally optimistic energy forecasting groups, the U.S. Energy Information Administration (EIA) arm of the Department of Energy is actually projecting a fall in gasoline demand this summer.  The EIA recently released its summer forecast and said it foresees gasoline demand being 36,000 barrels per day lower at 9.404 million barrels per day compared to last year.  That drop is equal to a 0.4 percent fall, which for many people would seem to be so minimal a decline as to be not worthy of note.  However, it would mark the first summer in which gasoline demand fell since 1991. 

 

The EIA attributes the expected demand drop to a rise in gasoline prices to a June monthly peak of about $3.60 per gallon.  For the entire summer driving season that spans from April through September, the EIA sees gasoline prices averaging $3.54, an increase over last year of 61 cents a gallon.  They acknowledge that in some parts of the country, gasoline pump prices will exceed the $4 per gallon threshold.  According to the EIA, the driver behind higher gasoline prices is the year-over-year increase in the cost of crude oil, which they see averaging $97 per barrel this summer versus $67 per barrel last summer.  The EIA has since increased its expectation for the average crude oil price to $103 a barrel for all of 2008.  But crude oil prices are now trading in the $110 a barrel range, which suggests that there will have to be a meaningful drop in oil prices before the end of the year, and really this summer, in order to meet their summer crude oil and gasoline pump price forecast.

 

Exhibit 10.  Gasoline Demand Has Weakened With High Prices

Source: EIA, PPHB

 

The EIA’s forecast leaves us scratching our head somewhat.  On the fundamental side of crude oil and gasoline supplies, there appears to be plenty of evidence to suggest that prices should be heading lower now, not later in the summer.  Growing supplies and faltering demand are usually the cause of lower prices.  As of April 1st the start of the summer driving season, gasoline inventories were estimated to be 224 million barrels, up 23 million barrels from a year ago and the highest in 15 years.  Crude oil inventories are also at high levels.  These conditions raise questions why prices haven’t fallen already?  It must be due to those pesky speculators. 

 

Another troubling aspect behind the EIA’s forecast is its outlook for the U.S. economy.  The EIA expects economic activity to decline in the first half of this year and then improve so that the economy ends 2008 with annual growth of 1.2%, the lowest rate since 2001.  That would be in sharp contrast to the recently released IMF economic forecast that calls for the U.S. to be mired in a recession (negative GDP growth) for all the second half of 2008, and even for the first quarter of 2009. 

 

 

Given the latest U.S. jobs report that estimated a loss of 80,000 jobs in March and revised the number of jobs down for both of the prior two months of the year, one is hard-pressed to see a quick turn around in economic activity.  According to a paper presented at the recent EIA energy modeling conference, only about 35% of vehicle miles driven are work-related, the balance are associated with social or family related travel.  In an economy where people’s incomes are being squeezed by higher food and fuel costs, it is hard to see that these discretionary trips are not at risk.

 

Exhibit 11.  Weak Economy Jeopardizes Vehicle Travel 

Source: EIA

 

We found it interesting to note that in recent years, the EIA has been plagued with the same problem the International Energy Agency (IEA) has suffered from, which is over-estimating demand and having to revise downward its previous forecasts.  The most recent monthly demand revisions for 2005, 2006 and first nine months of 2007 show how the prior demand estimates proved too high.  The revised demand figures for 2007 are reflecting a time period when the first wave of economic and credit market problems were emerging.  The litany of economic and financial problems, highlighted by rising foreclosures, escalating inflation, increased job losses, falling consumer and business confidence and stagnant average incomes, grows and has become increasingly worse each month suggesting that the EIA forecast for only a modest fall in gasoline demand may prove optimistic. 

 

There were several other interesting points made in the paper about factors influencing gasoline demand.  One was the impact of the growth of suburbs as a force for increased miles driven in commuting as people move further away from jobs to secure cheaper housing.  The other was the trend in the percentage of trips driven alone versus the use of mass transit and telecommuting.  It would be nice if there were more up-to-date information about travel patterns, but clearly Americans value their personal transportation freedom that comes from driving alone to work.  Based on media

 

Exhibit 12.  Higher Oil Prices Lead To Negative Demand Revisions

Source: EIA, PPHB

 

stories from interviewing customers at gasoline stations, we are learning about more creative travel patterns and attitudes developing as consumers try to combat the high cost of gasoline. 

 

Exhibit 13.  Americans Value Their Automobile Freedom

Source: EIA

 

The growth during the past 20 years in commuting distances reflects a desire among Americans to have newer and bigger homes and oftentimes access to better schools and living conditions.  The commuting distance gain has coincided with the great real estate bubble in this country that is currently wrecking havoc on our credit and financial markets.  We doubt, however, that the solution to these problems will entail a mass migration of Americans back to close-in neighborhoods or to urban centers, although that can’t totally be ruled out.  Could that be a black swan?

 

 

 

Exhibit 14.  Suburbs Have Altered Commuting Patterns

Source: EIA

 

One of the trends stimulating growth in gasoline consumption, besides population increases, has been the reduced burden on consumer incomes from gasoline purchases.  Coupled with more efficient automobiles, relatively less-expensive gasoline has contributed to a growing trend in more miles per year driven by the average vehicle. 

 

Exhibit 15.  Driving Has Become Less Costly

Source: EIA

 

Although the efficiency of the American vehicle fleet appears to have bumped up a little in 2007, it has largely been declining since the mid 1980s due to the growing share of the fleet represented by light trucks that are less fuel-efficient.  Rising fuel costs coupled with the new mandated fleet average fuel-efficiency requirements and the emergence of a number of hybrid vehicles with significantly greater fuel-efficiency ratings should lead to further fleet efficiency gains.  The question is whether these efficiency gains will be offset by increased miles driven.  Our guess is that weak economic conditions might dampen any joy riding.

 

Exhibit 16.  Trucks Are Hurting Our Fleet Fuel Economy

Source: EIA

 

Increased fuel-efficiency gains may be helped along from the growing push by state and local governments to reduce carbon emissions.  Besides new vehicle emission standards, begun by California and being adopted by other states, the push for congestion pricing of highways may further stimulate a shift to smaller, more fuel-efficient vehicles and hybrids.  The push for congestion pricing by New York City Mayor Michael R. Bloomberg, which was recently attacked by New Jersey Governor Jon Corzine, was rejected by New York State Democratic politicians.  As a result, the city will lose federal funds and the fee revenues it would have received that would have enabled it to expand its subways and bus routes, both more environmentally friendly transportation options.  But even car-happy Houston is being subjected to a debate by Harris County Commissioners over whether to employ congestion pricing on the new toll lanes being constructed on the rebuilt Katy Freeway.  (There’s an incongruous concept.)  This action was rejected when it was proposed as a solution to the current overcrowding on the Westpark Tollway, and threats by drivers to avoid the tollway in favor of city streets. 

 

With all the efforts to mandate improved vehicle fuel performance and reduced greenhouse gas emissions and congestion pricing to cut vehicle idling times, we seem to be finding that the basic economic principle of higher prices works to lower demand.  We’ll continue to monitor this condition as it may indicate how much our lifestyles will have to change to deal with these twin problems of oil demand and greenhouse gas emissions. 

 

 

Q1 Results Show Commodities and Stock Disconnect

 

The April Fools’ Day stock market rally reflected a “good riddance” view from most investors and traders to the end of 2008’s first quarter.  As shown in Exhibit 17, the Philadelphia Oil Service Stock Index (OSXX is symbol on chart) finished the first quarter trailing the Dow Jones Index (DJIA) but ahead of the S&P 500 index (S&P 500) and well ahead of the service companies’ customers, the oil companies (XOI).  After starting the year off strongly as crude oil futures prices climbed above $100 a barrel for the first time ever, they soon fell sharply, along with the overall stock market, as credit market problems reinforced fears of a U.S. economic recession that would lower oil demand and thus oil prices.  Commodity prices coupled with demand generate oil and gas company cash flows, but more importantly, they influence the expectations operators have about future prices and ultimately their spending attitudes.  From the oil and gas company capital spending sums come the oil service company future revenue and earnings.

 

Exhibit 17.  Oil Service Stocks Performed In-line With Market

Source: Big Charts, PPHB

 

What is amazing in analyzing the performance of commodities versus their stock market counterparts is the sharp disparity in performance.  A closer look at which commodity-related stocks produced a positive performance in the quarter can easily be explained by either the underlying performance of their related commodity, specific company events and/or stock market conditions. 

 

The two commodity stock sectors that produced positive results in the quarter were the natural gas related stocks and the gold and silver mining companies.  In the case of the natural gas stocks, investors were surprised by their response to rising natural gas prices that rose well ahead of expectations.  Gas prices were driven partly by colder weather, but more importantly by the absence of as much liquefied natural gas (LNG) imports as anticipated.  The lower volumes of LNG resulted from the cold weather in Europe, Japan

 

Exhibit 18.  Mixed Quarter For Commodities and Stocks

Source: U.S. Global Investors

 

and Korea and their more aggressive bidding for LNG cargoes that diverted some originally destined for the United States.  As cold weather persisted throughout the quarter in these foreign markets and LNG volumes arriving at U.S. shores fell, investors sensed the need for higher gas prices to guarantee greater domestic gas supplies.  The natural gas industry responded by raising the price it was willing to pay for new supplies in order to replenish the rapidly falling storage volumes. 

 

The absence of LNG import volumes has been partly offset by increased domestic production – the result of the successful and continuing effort to exploit unconventional gas shales throughout the country – and higher pipeline imports from Canada.  In fact, Canadian gas volumes arriving in the U.S. set or tied all-time records.  Despite these record imports, gas storage volumes have continued to fall.  As of April 4, 2008, the amount of gas in storage was 351 billion cubic feet (BCF) below last year and 23 BCF below the 5-year average storage volume for the industry at this point in time.  The impact of these radically different industry fundamentals than expected at the end of last year is responsible for the strong natural gas-related stock price performance as investors raised earnings estimates for the companies.

 

In the case of the gold and silver stocks, investors know that this is the more highly leveraged way to play the strong move in precious metals prices.  As gold crossed the $1,000 per ounce and silver the $17 per ounce price thresholds, new record levels, the earnings potential of mining companies grows substantially.  Since most of these precious metals mining companies have small market capitalizations, the earnings estimates jump and drive share prices higher. 

 

Exhibit 19.  Gas Storage Volumes Continue to Fall

Source: EIA

 

What was more interesting was that coal, basic metals and mining, oil service and the broad S&P energy index all produced negative returns in the quarter.  This makes us think that what has been going on in the commodities markets is due to the continued deterioration of the value of the U.S. dollar rather than an expectation of a new wave of demand.  A weak dollar versus other foreign currencies boosts the value of internationally-traded commodities.  With investors seeking a safe haven for their funds as stock markets around the world collapsed in response to the seizing up of global credit markets they were willing to chase commodity markets higher while avoiding the related stocks.  Indications are that the stock market conditions and investor attitudes are improving, which suggests we could be about to witness a reversal in commodity markets.  Unfortunately, falling commodity prices will not boost the related stock prices.  Investors functioning in a more normal investment climate will equate weak commodity prices with reduced earnings growth rates for the related companies and that spells flat to lower stock prices. 

 

 

2008 Hurricane Forecasts: What Have You Done For Me Lately?

 

The official start to the 2008 hurricane season is about six weeks away, June 1st, and several early forecasts for the number, intensity and possible U.S. coastal landfall odds have recently been released.  The most prominent forecasting team is from the Department of Atmospheric Science at Colorado State University, headed by Dr. Philip J. Klotzbach and Prof. William M. Gray.  Dr. Gray has been providing Atlantic basin hurricane forecasts since 1983 with this year marking his 25th year of prognosticating. 

 

Barely had the CSU team issued its forecast than the skeptics began to question its value given the accuracy of previous forecasts.  It appears that Drs. Klotzbach and Gray anticipated this criticism because on page 2 of their report, they spend four paragraphs addressing that very question: Why issue extended-range forecasts for seasonal hurricane activity?  Their answer is that it is possible to say something about the probability of a particular year’s hurricane activity being above- or below-average several months ahead of the season’s start.  According to them, the Atlantic basin has the largest year-to-year variability of any of the global tropical cyclone basins.  Moreover, people in the United States are quite interested in knowing what to expect from the weather – at least if you measure that interest by the amount of coverage of local weather by the media and cable TV channels.  However, the value of these forecasts varies by their results and is a reason why Dr. Gray has given up being the lead author of this study and is devoting greater time and attention to trying to improve the model’s success in predicting coastal landfall percentages.  Clearly, improving this forecasting model has greater economic, financial and social value.

 

The CSU team also acknowledged that it is impossible to precisely predict a season’s hurricane activity in early April, but people are curious about what the season might portend.  Therefore, they have revised their early April forecasting model – actually making it simpler – to improve its forecasting success.  In back-testing over 1950-2007, the new forecasting methodology correctly predicted an above- or below-average season in 45 out of these 58 years.  Over the past 13 seasons, the new methodology also demonstrated better hindcast skill than the prior forecasting technique, which failed to show statistical improvement over climatology.

 

A number of media reports, based on criticisms of these long-range hurricane forecasts by forecasters at the National Hurricane Center and Bryan Norcross, the hurricane specialist with CBS News, have come out sharply critical of the forecasting effort.  As one of the articles pointed out, all the forecasters missed their 2006 and 2007 forecasts by over-predicting the number of storms and had missed 2005 with too low a number of hurricanes.  The media finished its criticism by pointing out that the CSU forecasting team has roughly batted .500 over the past decade.  In that regard, we are struck by two thoughts – with no better a forecasting average, using actual and not made up data, we are about to rearrange the living patterns of the six and half billion people on this planet to prevent global warming predicted by a computer model.  Our other thought is that if the CSU forecasters’ success was for hitting a baseball, there is no telling how much George Steinbrenner would be willing to pay them to wear Yankee pinstripes.

 

The CSU team’s April Atlantic basin seasonal hurricane forecast for 2008 calls for an above-average storm season.  They are looking at 15 named storms; 8 hurricanes; and 4 intense hurricanes.  These numbers are up from the team’s December forecast.  These totals are consistent with the three other hurricane forecasts that have been made recently.  Those include one by Dr. Lian Xie, professor of marine, earth and atmospheric sciences at North Carolina State University who expects 13-15 named storms with 6-8 growing strong enough to become hurricanes.  Another forecast was prepared by the Tropical Storm Risk team of Professor Mark Saunders and Dr. Adam Lea of University College in London, England.  Their forecast calls for 14.8 tropical storms, 7.8 hurricanes and 3.5 intense hurricanes.

 

The last forecast was issued by Houston-based Weather Research Center’s President Jill F. Hasting.  Her forecast calls for 11 named storms with 6 becoming hurricanes.  The WRC forecast suggests a long hurricane season with a 30% chance of a storm forming in May and a 10% chance for December.  Additionally, it will be a rough season for the Gulf of Mexico oil patch as the forecast predicts a 90% chance of the oil blocks experiencing a tropical storm or hurricane this year.

 

The WRC forecast methodology utilizes a model called Orbital Cyclone Strike Index (OCSI), which uses the solar cycle to predict the risk for coastal residents each hurricane season.  The model is based on the premise that there are orbital influences that are reflected in the global circulation pattern on the sun as well as the global circulation pattern of the earth.  These influences are reflected in the 11.1 year sun spot cycle.  Based on this model, WRC has determined that 2008 is in Phase 1 of the OCSI.  They then look at the landfall records of similar seasons: 1878, 1889, 1901, 1913, 1923, 1933, 1944, 1954, 1964 and 1976.  The years 1986 and 1996 are also in Phase 1.  Four of the 12 years in Phase 1 had more than one Category 3 or greater hurricane make landfall somewhere along the U.S. coastline (1933, 1944, 1954 and 1996).

 

Based on the data from the first ten years in Phase 1, hurricanes moved over the oil blocks in the Gulf of Mexico in eight out of those years.  The map in Exhibit 19 shows all the storm tracks of hurricanes during the Phase 1 years studied. 

 

Exhibit 20.  There is a Substantial Record of Past Hurricanes

Source: Weather Research Center

The true value of hurricane forecasts, beyond satisfying the populace’s curiosity factor, is in trying to accurately predict landfall of storms on the coast.  As we know from hurricanes Katrina and Rita, making that prediction, even only hours before hand, is difficult.  The demand for earlier and better landfall predictions so that hurricane evacuations can occur and damage prevention actions be taken is growing, and therein lays the true value of the forecasts.  Unfortunately, improving these landfall projections is difficult, if not almost impossible. 

 

Dr. Xie’s projections call for 1-2 named storms making landfall in the southeastern coast of the U.S. with better than a 50% chance that one of the storms will be a hurricane.  For the Gulf Coast he sees 2-4 named storms, including one hurricane, making landfall.  The CSU team’s projections call for a 69% chance for a Category 3 or greater hurricane making landfall along the entire U.S. coastline (average for the last century is 52%).  For the East Coast including Florida, the probability is 45% (31%) and for the Gulf Coast from the Florida Panhandle is 44% (30%). 

 

At this point, I doubt anyone is prepared to ignore the upcoming hurricane season.  While the forecasters struggle to improve their accuracy, these predictions do serve the purpose of raising people’s awareness of tropical storms and hurricanes.  That awareness should lead to better planning by federal, state and local officials, but more importantly, for residents of coastal areas who can begin planning their escape routes and stocking their homes with necessities for surviving a storm.  So, while some media people may think one out of two forecasts right is no better than flipping a coin, we’d suggest that the heightened populace’s storm awareness has more value that flipping coins and guessing.

 

 

Airlines Hammered by Rising Fuel Costs

 

Do you remember the days when people dressed up in their finest to climb aboard an airplane taking them to places far away?  In past times, stewardesses wore white gloves, or in some cases hot pants.  But there was a time when travel by air was considered glamorous and special.  Now it looks and feels more like getting on the bus – but last time I checked, Greyhound didn’t charge for a second checked bag although they did charge for overweight bags.  Will the joy of air travel ever return like the swallows to Capistrano?  We doubt it because the name of the airline game is: Pack’em in and sell them cheap!  That’s not a lot different from Sam Walton’s original store motto of “Stack’em high and sell’m low! 

 

The airline industry probably experienced one of its worst periods ever last week.  Not only did American Airlines (AMR-NYSE) have to cancel thousands of flights while its mechanics re-inspected its MD-80 fleet of planes to meet strict Federal Aviation Administration guidelines, but five low-cost airlines shut down due to losses as escalating fuel costs destroyed their economics.  A sixth airline, Frontier Airlines (FRNT-NASDAQ), filed for bankruptcy but continues to fly as its problem seems to only be a cash flow issue.  A seventh airline – a charter company, Champion Air – announced it would be shutting down at the end of next month.  The commercial airlines included: Aloha Airlines of Honolulu, ATA Airlines of Indianapolis, Oasis of Hong Kong, Skyway Airlines of Milwaukee and Skybus Airlines of Columbus, Ohio.  While the media was replete with stories about the trials and tribulations of passengers with defunct tickets scrambling to get home, the reality is that the cost to fly, even in the cattle car section, is going to cost more in the future unless oil prices drop substantially. 

 

During the second half of last year, as crude oil prices skyrocketed, taking jet fuel costs up, we were amused at the difficulty the airlines had in raising ticket prices.  Various airlines made valiant attempts to institute fare increases periodically, usually at the end of a week, only to see their efforts fail by Sunday night when some or all of their competitors failed to follow the hike.  What we learned from watching this exercise was how commoditized air travel has become.  Now the competition is whether you get any meal onboard or have access to pillows and blankets.  The recent fad has been the institution of a $25 fee for checking a second bag that has now become universal throughout the industry.  The other competitive move is to boost fares for those passengers who decide to travel within a very short time window.

 

It is pretty clear that when jet fuel prices climbed above $1.50 a gallon in 2004 that the future for airline profitability was in jeopardy.  In Exhibit 21 we show the price per gallon for jet fuel at Rotterdam since mid June 1986 to now.  That starting point (and its due to the availability of data not our selection) marked the low point for oil prices when OPEC imploded due to its members battle over market share, which was matched late in 1998 as the Asian currency crisis took its toll on oil demand.  At both those points in time, crude oil was flirting with single digits, but few people either felt sympathy for the oil companies or were worried about future oil supplies. 

 

Other than the spike to $1.50 a gallon during the run up to the first Gulf War in 1991, jet fuel had never cost more than about $0.50 to $0.75 a gallon.  The brief spikes above $1.00 a gallon were associated with economic good times and the impact on the airlines was moderated by high load factors and wage and employment concessions from the employees.  However, from 2004 on, jet fuel prices have climbed steadily, with periods of brief retrenchment, until they crossed the $3.00 a gallon price point some months ago. 

 

When we took a little closer look at jet fuel prices since the start of 2004, we found it interesting that the climb from $1.00 to $2.00 a gallon required about 18 months time.  In contrast, from $2.00 to over $3.00 was done in barely over three months.  Jet fuel price acceleration has been devastating on airline profitability.  That price climb has been associated with the jump in crude oil prices, so should they retreat anytime soon then the airlines may get a

 

Exhibit 21.  High Jet Fuel Prices Is A Recent Phenomenon

Source: EIA, PPHB

 

Reprieve.  Otherwise, look for more airline losses, higher air fares and further curtailments in service.  According to the reports of the six major U.S. airlines, in March domestic capacity, measured in available seat miles, fell by an average of 4.3% compared to a year ago.  At the same time, a Wall Street analyst predicted that the domestic airline industry would lose $1.9 billion this year. 

 

Exhibit 22.  Fuel Above $2 And Airline Profitability Disappeared

Source: EIA, PPHB

 

While researching the information about the airline industry, we were surprised to find how much more fuel efficient air planes had become since the start of this decade when measured by the amount of jet fuel consumed.  We have noticed when flying Continental Airlines (COL-NYSE) how many of their planes have those tipped wings.  Those devices are supposed to improve fuel efficiency by 3%-4%, which for airplanes is a significant amount of fuel.  Over the past few years, virtually all Continental’s planes have been retrofitted with wing tips and all new planes come equipped with them.  In addition, the new planes Continental has brought into its fleet are made of lighter-weight materials and the engines are more fuel-efficient.  The airlines are also adopting new operational procedures to reduce idling and taxi times, all with a goal of improving fuel consumption.  With all these new conservation efforts, unless there is a huge growth in industry capacity (we don’t expect that as marginally profitable routes are being eliminated rapidly) the declining trend in jet fuel consumption appears likely to continue.  That will be one more demand issue that could help to undercut the price of crude oil.

 

Exhibit 23.  More Air Passengers Yet Lower Jet Fuel Consumption

Source: Air Transport Association, PPHB

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Main Tel:    (713) 621-8100
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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.