- Natural Gas Markets Headed For A Crash?
- CSU Hurricane Forecast Trimmed Once Again
- The Famous Four Words: It’s Different This Time
- GM Jolts Electric Car Debate With Volt Mileage Claim
- Every Energy Action Causes A Counter Reaction
- Laughs From the Energy Market
- Crude Oil Market Disconnect: A Problem Emerging?
- A Lesson About Saving Energy
Musings From the Oil Patch
August 18, 2009
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
Natural Gas Markets Headed For A Crash? (Top)
Natural gas prices after rallying on surprisingly strong labor market news have retreated in recent days as the prospect of full storage suggest the industry will be forced to curtail production unless demand picks up. At the end of July, natural gas in storage was almost 3.1 trillion cubic feet (Tcf), or about 25% above the 5-year average for volumes at this time of year. Estimates of full storage capacity range from 3.7 Tcf to 4.1 Tcf. At the date of this report from the Energy Information Administration (EIA), there were 10 weeks left to the storage injection season meaning that without a strong pick up in gas demand or a collapse in production, domestic gas producers are facing the eventuality of all having to curtail their production. When that happens, we should expect a meaningful drop in natural gas prices.
Exhibit 1. Natural Gas Prices Continue To Struggle
Source: EIA, PPHB
This industry-wide predicament was highlighted by Aubrey McClendon, CEO of Chesapeake Energy (CHK-NYSE) on his company’s earnings conference call. Mr. McClendon, the poster child for aggressive gas production management during periods of weak gas prices, announced his company was not planning to curtail production since it expected storage to max out and thus they, along with all other producers, would be forced to shut in flowing gas volumes. For the first time, Chesapeake was not about to exhibit discipline in supporting gas prices for the benefit of producers who did not curtail their production. Does this suggest that leaders of the natural gas industry are prepared to ignore production economics to demonstrate a point to their fellow producers?
We have been watching and writing about the travails of the domestic gas business as the collapse in the drilling rig count does not seem to have dented gas production as everyone assumed. Since we last opined on the gas market, the Energy Information Administration (EIA) has released its monthly gas production estimates gleaned from their Form 914 survey of operators. These surveys, reportedly providing the industry with more accurate production data, started in 2005. The only problem is that the data is still dated as the latest monthly estimated production volume figure released was for May, some 60 days old.
The May 914 gas production was 62.84 billion cubic feet per day (Bcf/d), down from the revised April monthly data showing production of 63.35 Bcf/d. Many analysts, gas producing company executives and forecasters jumped on this decline as confirmation the long-anticipated gas production decline was underway. On closer examination, however, we can’t be totally sure because there have been a number of other recent months when the initial monthly gas production estimate was revised lower. The initial May production estimate now is virtually identical to the revised December 2008 estimate.
The initial gas production estimate for April was revised down, but only from 63.37 Bcf/d to 63.35 Bcf/d. The revised April production estimate was down from the March revised figure by approximately 200 million cubic feet per day (MMcf/d), but it was essentially flat with the revised February production estimate of 63.58 Bcf/d. Can we take solace in the May production estimate decline? Is the recent monthly revision pattern being reduced a sign that when the May estimate is revised it too will show even lower production?
Since January 2005, there have been 52 revisions to the initial monthly production estimate. One revision showed no change. Of the remaining revisions, 33 were higher than the initial estimate and 18 were lower. Increased estimates were made nearly two-thirds of the time. Admittedly, there were stretches when the revisions were always up, just as there were stretches when they were all lower. At the moment, we appear to be in a period marked by mostly lower revisions, but we can’t find any rhyme or reason why historical patterns of revisions shifted from mostly up to down or vice a versa.
Given the data history showing such a strong bias in favor of increased monthly production estimate revisions, we remain skeptical in calling for a further reduction for May’s initial estimate.
The other concern we have had about the gas production scenario is the developments in the drilling rig market. We, along with everyone else, watched with horror last fall as the domestic drilling rig business entered a freefall. We and others have wrestled with determining exactly how far down the rig count would go in this market correction and when it might bottom. More recently we have begun focusing on the pace and shape of the rig count’s recovery.
One aspect of the drilling industry decline that has been of particular significance for the gas business has been the difference in the type of drilling rigs that were being laid down. This interest has gained significance by the emergence of the gas-shale plays. Data has shown that wells drilled horizontally in these gas-shales have tended to be more prolific than wells drilled vertically. The guiding principal behind the significant initial production volumes coming from gas-shale wells has been the successful marriage of horizontal drilling technology with improved formation fracturing capability. Drillers have been able to rapidly drill long lateral well sections in the heart of many of the gas-rich formations. Well stimulation technology has enabled the development of multiple stage fracturing applications within the same well bore. Together these technologies have produced gas wells with initial production volumes multiples of conventionally drilled and completed gas well volumes.
We showed in our last Musings drilling and production data for Fayetteville gas shale wells derived from Southwestern Energy’s (SWN-NYSE) financial reports. The data, covering a two-year period since early 2007, showed significant progress in drilling time, drilling performance and well production. The length of time required to drill the wells fell from 20 days to 12 while the lateral distance drilled increased 84% to almost 3,900 feet. At the same time, the 30-day average production rate grew from 1,006 MMcf/d to 2,373 MMcf/d.
Exhibit 2. SWN Shows Significant Drilling Gains in Gas Shales
Source: Southwestern Energy 10-Ks, PPHB
Given the growing importance to the nation’s production of natural gas from wells drilled horizontally, we examined overall gas production figures versus measures of drilling rig activity. When gas production is paired with gas-oriented drilling rigs, one sees a dramatic fall-off in rigs since last fall with barely any movement in the Form 194 monthly gas production volumes so far this year, based on the initial monthly production estimate.
Exhibit 3. Gas Production Not Falling With Rig Count Drop
Source: EIA, Baker Hughes, PPHB
On the other hand, if we match the same Form 914 gas production volumes against the number of active horizontal rigs, we also are hard pressed to see any impact from the downturn in drilling.
Exhibit 4. Gas Production High Despite Fewer Horizontal Rigs
Source: EIA, Baker Hughes, PPHB
On the other hand, if we plot the percentage of all rigs drilling horizontally, there is a pattern of a steady increase as gas production increased and as it is holding steady now.
Exhibit 5. Gas Production And Horizontal Rig Percent In Phase
Source: EIA, Baker Hughes, PPHB
While we were wrestling with this data, we came across an interesting article by Arthur Berman published in World Oil and republished by the Association for the Study of Peak Oil in its latest newsletter. In the article, Mr. Berman re-analyzed well production data from the Barnett Shale, the initial stimulus for the gas-shale drilling explosion. He updated the data from the roughly 2,000 horizontal wells that he initially studied two years ago. Based on this new study of well performance, he concluded the following points: there is little correlation between the initial production rate and the well’s ultimate recoverable reserves; the life of average well production is shorter than predicted; the volume of commercially-recoverable gas has been over-stated; core areas of the play do not provide higher recoverable reserves; recoverable reserves from horizontal wells are no greater than reserves in vertical wells; and average well performance has decreased consistently since 2003 for horizontal wells.
The key finding of the study, and a point that will hearten those who are arguing that the fall-off in gas production is imminent due to the drilling collapse, is that the overall ultimate recoverable reserves from horizontal wells decreased by 30% from Mr. Berman’s earlier projection. Additionally, he found that the average ultimate recoverable reserve estimate per well fell from 1.24 Bcf to 0.84 Bcf. These findings reflect the fact that “most wells do not maintain the hyperbolic decline projection indicated from their first months or years of production.” What Mr. Berman found was that wells experienced an abrupt negative departure from the hyperbolic decline as early as 12-18 months, but more likely in the fourth of fifth year of the well’s production. This conclusion may temper the expectation of a significant fall-off in gas production given the drilling rig cutback.
What Mr. Berman discovered in updating his study was that the decline curves are rapid and more severe than previously thought, so the ultimate amount of reserves recovered from producing wells is less than originally thought. For those who believe in the long-term positive outlook for the oil service industry, this finding is highly supportive. On the other hand, the fact that these gas wells don’t fall off their hyperbolic decline curves as quickly as some people have thought (or hoped for) may signal that the domestic land rig count might experience another downturn when natural gas prices hit the wall as gas storage capacity fills to the brim. Or possibly the rig count will experience a much longer and more gradual recovery than currently expected.
Additional findings from Mr. Berman’s study point to less favorable production economics from horizontal wells. Mr. Berman focused a part of his study on the wells in the “sweet” spot of the Barnett formation, or those wells located in Tarrant and Johnson counties in and around Ft. Worth, Texas. This area comprises about 9.5 million acres. What he found was that this sweet spot did not produce appreciably higher ultimate recoverable reserves per well than the overall play. Horizontal wells only resulted in about a 31% improvement in reserves recovered compared to their 2.5-times greater cost; not a positive for profitability. This conclusion suggests that many of the claims about low costs associated with the gas-shale plays may prove inaccurate. According to Mr. Berman, “If every operator in the Barnett Shale was hedged at a netback gas price of $8/Mcf, only 31% of horizontal wells would break even or make money. At $6/Mcf, only 15% of wells would reach this commercial threshold.” Does this analysis suggest that many of the gas producers are deluding themselves about how successful they are progressing in developing gas shales? Will the new gas-shale plays really have better economics? Are producers who suggest they have superior acreage positions and better technology really exceptional? Maybe they are all citizens of Garrison Keillor’s Lake Wobegon where everyone is “above average.”
CSU Hurricane Forecast Trimmed Once Again (Top)
As we write this article the first tropical storms of the season have formed In the Atlantic basin and Gulf of Mexico. The latest forecast from the Colorado State University (CSU) for this year’s tropical storm season authored by lead scientists Dr. Phillip Klotzback and Dr. William Gray of the Department of Atmospheric Science shows another reduction from their prior forecasts. The team now looks for a total of 10 tropical storms with only four becoming hurricanes and two of them significant hurricanes (Category 3, 4 or 5).
Exhibit 6. Activity Forecasts Have Continually Declined
Source: CSU Dept. of Atmospheric Science, PPHB
The official forecast says they “anticipate a below-average Atlantic basin tropical cyclone season in 2009,” which is attributed to the development of El Niño in the Pacific Ocean. The new forecast also anticipates below-average probabilities for major hurricane landfalls on the U.S. coastline and in the Caribbean.
As the El Niño phenomenon developed this year, the CSU forecasters pointed out the potential for its dampening effect on tropical storm formation when issuing earlier forecasts. The CSU team has been gradually reducing its projected number of storms by category and the corresponding number of storm days. With reduced expectations for the number of storms this season, especially since two of the storm season’s six months have passed with no storms, the probabilities of major hurricane landfalls have also declined, but by a smaller reduction than the number of storms since projecting a storm’s path before it forms is difficult. As we all know, it only takes one storm making landfall, and it doesn’t have to be among the strongest storms, to cause loss of life and extensive damage while creating extreme chaos.
Exhibit 7. Major Hurricane Landfall Chances Reduced
Source: CSU Dept. of Atmospheric Science, PPHB
Despite the challenge of predicting landfalls, the CSU forecasters have been issuing probability forecasts for a few years for each of the 11 coastal regions of the United States and 205 coastal and near-coastal counties from Brownsville, Texas, to Eastport, Maine. The team believes developing better landfalling forecasts is an important benefit of their work since it allows earlier and presumably better storm preparation.
In the current forecast, for the first time, the CSU team prepared landfall probabilities for the 18 coastal states using data from 1856-2008. They have also prepared landfall probabilities for the Mid-Atlantic and Northeast U.S. regional groupings of states. The CSU forecasters showed how the historical landfall probability for both hurricanes and major hurricanes for selected states and regions is reduced by the formation of El Niño.
One of the interesting phenomenons impacting the formation of hurricanes appears to be the relative warmth of the Atlantic basin coupled with the strength of El Niño. From May to July, the tropical Atlantic has warmed by 0.25-0.5°C. Despite this warming, the Atlantic remains slightly cooler than the 1995-2008 average. What also has been learned from the historical data is that the ratio of named storms forming south of 23.5°N and east of 75°W with
Exhibit 8. El Niño Years Bring Lower Landfall Chances
Source: CSU Dept. of Atmospheric Science
storms forming north of 25°N changes considerably between neutral and La Niña years to El Niño years. The CSU forecasters have determined that from 1950-2008, approximately 45% of all storms form north of 25°N in a La Niña year or a neutral year compared to 60% of all storms forming north of 25°N in El Niño years.
The CSU report contained a chart showing the number of storms and their tracks below that cut-off in the six warmest El Niño years and the six coldest La Niña years. The ratio between the aggregate numbers of storm days during La Niña years to those in El Niño years is 4.1:1, a significant difference. Based on this data and the CSU team’s assessment of the future weather patterns that will be in existence during the mid-August to mid-October period, it believes conditions facilitating the formation of Atlantic basin hurricanes will be moderated.
Exhibit 9. Hurricane Tracks in 6 Warmest and Coolest Years
Source: CSU Dept. of Atmospheric Science
The other forecasting change the CSU team has introduced is a two-week forecast rather than its traditional monthly forecast. We assume this change is an attempt to be timelier in its forecasting than it has been in the past. Shortly after issuing the revised 2009 hurricane seasonal forecast, the CSU team issued a forecast of the August 6-20 period. The team believes this will be a below average period compared to the historical data for 1950-2000.
Exhibit 10. Hurricane Tracks and Record for Aug. 6-20 Period
Source: CSU Dept. of Atmospheric Science
The team’s forecast is backed additionally by a chart from the National Oceanic and Atmospheric Administration (NOAA) showing the current forecast period compared to the climatology record, which shows storm activity traditionally picking up in early August. Activity peaks in early September but continues strong until the latter part of October.
Exhibit 11 We Are Entering The Height of Hurricane Season
Source: CSU Dept. of Atmospheric Science, NOAA
While we can take some comfort in the revised CSU forecasting team’s outlook for a below-average storm season, the fact we are just entering the peak seasonal storm period should be a reminder to be on your guard and ready for action. This is the latest formation of the first storm. In 1992, the first storm developed late in the season. It was Hurricane Andrew that devastated south Florida.
The Famous Four Words: It’s Different This Time (Top)
Recently investors have been jumping on natural gas producing company stocks as gas prices climbed above $4 per Mcf. In late July and early August, global economic statistics, and especially economic data for the U.S., showed what appeared to be an ending of the recession. As additional data seemed to support that view, crude oil and natural gas prices began rising reflecting investor expectations that increased economic activity would boost demand. So, despite high and rising gas storage volumes and crude oil inventories, commodity prices rose.
The weak employment data a week ago followed by extremely weak retail sales figures, especially after adjusting for the boost from auto sales stimulated by the Cash for Clunkers program, and Friday’s surprisingly weak consumer sentiment data have thrown investors into a questioning mode. But in the stock market over the past week, natural gas producer stocks were starting to breakout from their recent trading ranges. This stock price trading pattern in the face of weak near-term natural gas industry fundamentals suggest this time “it won’t be different.”
Exhibit 12. Gas Producer Stocks Trading With Gas Prices
Source: Yahoo.finance.com
Most of our career was spent as a fundamental energy industry securities analyst. As a result, we focused on industry fundamentals and their impact on company revenues and profit margins that generated earnings per share that ultimately drive stock valuations. Experience taught us to always pay attention to what the price action of the stocks might be telling us. If stock prices were falling while we were predicting rising earnings, we knew either we were wrong about our estimates or investors were being presented an outstanding buying opportunity. Without reciting stock market war stories, we have been burned and rewarded by acting on our fundamental belief in the face of stock prices sending different signals. Skeptics to our arguments would always say, “It’s different this time.”
People looking at the chart above would focus on that last down-tick in the gas stock index and say “the stocks are rolling over.” That means they will be trying to catch up with falling natural gas prices. On the other hand, if one were to draw a line connecting the March low and the July low, the current price remains above that line suggesting there is support for the gas stock index even at slightly lower prices. If the stock price action is correct that we are in an up-trend, then the analysts must be missing the strength of the upcoming economic recovery, or some other event is out there that could dramatically change natural gas pricing. Maybe we will experience a “V-shaped” economic recovery and investors don’t want to miss it. People might argue that the 40+% rally for the broad stock market indices have already negated the “don’t want to miss the rally” argument. The significance of being out of the market in the early months after a stock market bottom is highlighted by the data in the following chart.
One cannot rule out the potential for a hurricane damaging Gulf of Mexico gas production or disrupting Gulf Coast pipelines, or possibly the Gulf Coast LNG receiving terminals. Maybe we will have an early cold winter or a serious outage of coal-fired or nuclear power
Exhibit 13. Stocks Post Big Gains In Early Recovery Months
Source: T. Rowe Price
plants that result in a firing up of all the available gas-powered electricity generators in the country. No matter what we think we know about our industry, we always remember that the collective knowledge of the stock market is more often right than what any one individual believes. That said, there is a fundamental case arguing that the U.S. and global economic recovery will be much weaker than in past recession recoveries and energy demand will remain weak.
The critical aspect of the negative fundamental case is the weak financial health of consumers who drive nearly 70% of economic activity in this country. During the 1990s and 2000s, consumers were encouraged to take on substantial amounts of mortgage and consumer debt to fund their life-styles. The booming economy contributed to rising home prices that encouraged homeowners to tap their growing home equity to fund consumer and vehicle purchases. We contend that until the housing and automobile industries are stabilized and begin growing again, any economic recovery, and importantly a recovery in energy demand, will be delayed or at best muted. Let’s understand why this is the case.
The following two charts show the rise in American consumer debt – mortgage and consumer – and the corresponding fall in the personal savings rate. The trends reflect the “live and spend for today because the future will only be better” mantra that guided citizens during the past 15 years.
Exhibit 14. American Debt Loads Swelled In Past 15 Years
Source: T. Rowe Price
Exhibit 15. American Savings Rate Fell As Citizens Spent
Source: T. Rowe Price
Besides borrowing and drawing down personal saving resources, Americans turned their homes into automated teller machines (ATMs) to fund home improvements, large consumer purchases and general spending on things like vacations, etc.
This debt load created serious economic problems when the home asset bubble burst in 2007. The reason for the problem was the shift over time in the amount of equity supporting mortgage debt. As other markets – hard assets, the stock and bond markets, etc. – came under significant pressure with the mortgage crisis building, we entered the first stage of the economic contraction that has become the longest recession since the 1930s Great Depression.
Exhibit 16. The Use Of Homes As ATMs Climbed In 2000s
Source: T2 Partners LLC
Exhibit 17. Equity As Percent of Mortgage Debt At Record Low
Source: T2 Partners LLC
All of the cheap money made available to fund home purchases created a building boom. The following charts show that new home starts were at levels only previously experienced in the months following the end of the recessions of 1970-71, 1974-75 and 1982-83. But in this boom, the high rate of new construction had lasted for years and not after the recession when new construction tends to catch up with growing housing demand.
Exhibit 18. Housing Starts At Record Levels For 2000s
Source: T2 Partners LLC
The collapse in housing construction has been a major contributor to the economic recession and the fall of energy consumption. During the boom years, existing home sales soared and the inventory of existing homes was low. As the housing bubble burst, sales of existing homes slowed and the inventory of homes began climbing.
Exhibit 19. Home Sales Dropped As Inventories Climb
Source: T2 Partners LLC
The New York Times financial columnist, Floyd Norris has regularly focused on the health of the housing market. As he shows, housing starts are down substantially from the 1976 rate and have collapsed by 75% from the last peak. But possibly more disconcerting is that the average unsold new home is approaching its one-year anniversary demonstrating just how overbuilt the market has become.
Exhibit 20. Aging New Homes Show Why Building Will Lag
Source: The New York Times
During the housing boom, homeowner vacancy rates were low, but they began climbing as the housing bust developed. Vacant homes are a drag on energy consumption.
Exhibit 21. Vacancy Rates Climb As Energy Consumption Falls
Source: T2 Partners LLC
The challenge for the economy and the credit crisis that exploded last year was the rise in home mortgage defaults and their impact on the country’s financial institution balance sheets. The following chart shows the record of resets for subprime mortgages, which produced the initial wave of defaults wiping out many financial institutions’ equity bases. That experience contributed to the federal government’s need to bail out many banks and financial lenders. While the chart is somewhat dated (spring), the red line shows where we are and that most of these problems are now behind us.
Exhibit 22. Subprime Mortgage Resets Caused Credit Crisis
Source: T2 Partners LLC
The problem credit markets and the economy still face is the resets of Alt-A mortgages in which people with lower credit scores (680 and below) were able to get mortgages with less documentation (referred to as low doc/no doc loans). These loans have been popularly referred to as “liar loans” since there was little documentation of the incomes and assets of borrowers. As the following chart shows, we have barely begun to deal with these problem loans. Their peak will come at the end of 2012 and start of 2013. Do we have sufficient financial strength to absorb this wave of potential foreclosures?
Exhibit 23. Alt-A Loan Problems Are On The Horizon
Source: T2 Partners LLC
So while many people are enthralled by recent comments by certain large homebuilders that they are starting to see buyers coming back and residential property sales are picking up, the same cannot be said about the automobile industry if we exclude the euphoria over the Cash for Clunkers program.
Vehicle sales fell to below nine million units early this year. That sales collapse contributed to the bankruptcies of Chrysler and General Motors. The problem is that auto sales were running at a 16-17 million unit a year rate during the 2000s. A lower sales rate was bumped up after the 9/11 attacks through low or no interest loans. The continuation of low cost loans and extended loan terms sustained new vehicle demand. But now vehicle sales are at recession lows and manufacturers are looking for help.
A new study predicts that the new “normal” annual sales volume of 14-15 million units will not be reached until 2013 at the earliest. One reason why we are not going to see a big snapback in vehicle sales is their correlation to new home purchases and the use of home equity loans to fund past vehicle purchases. A Deutsche Bank study says that the percentage of homes in this country where the amount owed on the mortgage exceeds the home’s value will rise from 26% in March to 48% in 2011. The absence of home equity funds will cut into new vehicle sales, especially in those states where real estate
Exhibit 24. Auto Sales Are At Recession Lows
Source: T2 Partners LLC
markets are still under severe downward price pressure.
Exhibit 25. Vehicle Sales Supported By Home Equity Loans
Source: T2 Partners LLC
One reason the credit crisis developed was recognition by the financial industry that debt was a ticket to increased profits. The following chart clearly showed that as Americans began ramping up their debt, financial industry profits as a percent of gross domestic product climbed from under 1% to about 2.5% during the 2000s.
Exhibit 26. Rising U.S. Debt Load Ginned Up Financial Profits
Source: T2 Partners LLC
The significance of these financial industry profits is shown in the following chart. Financial industry profits and wages as percent of total corporate profits and total wages and salaries increased by two times or more from the 1980s to mid 2000s. Is it any wonder that financial stocks led the stock market boom that extended from the early 2000s to the mid 2000s?
Exhibit 27. Financial Profits and Wages More Than Doubled
Source: T2 Partners LLC
This quick analysis of the causes of the economic recession and credit crisis and where we are today gives us pause about what to expect in the eventual recovery. We do believe the economy is in a bottoming phase, which means we will see both “good” and “bad” economic data points but slowly the good will begin to outweigh the bad. As the drop in the latest consumer sentiment reading showed, consumers are not confident about the future. Part of that comes from the uncertainty about what will happen to our economy under the Obama administration and the Democratically-controlled Congress. People are concerned about their jobs. Executives are worried about their company cost structure and taxes. The health care debate also has people upset and fearful of its impact on their lives. As we rebuild our savings, we will take out anywhere from $1 trillion to possibly $2-3 trillion of spending out of the economy each year, yet the government is trying to stimulate consumer spending. That means large purchases will be delayed – fewer new homes and vehicles, both of which are heavily energy intensive. Energy prices may be driven higher by production depletion rates or fear of future inflation and U.S. dollar debasement, but maybe not by rising energy demand.
GM Jolts Electric Car Debate With Volt Mileage Claim (Top)
General Motors issued a press release early last week making dramatic claims about the performance potential of its electric car model, the Chevrolet Volt. Part of the reason for making these claims is the company’s program to try to distance itself from its recent bankruptcy and begin to position the image of GM as a progressive automaker in tune with the “green-car” movement, which is fully supported by its government bosses. Of course, before GM went bankrupt under the guidance of the Obama administration’s automobile czar, the Volt was called uneconomic.
The Volt, expected to arrive in dealer showrooms in 2011, will get 230 miles per gallon (mpg) in city driving according to GM’s claims. The mileage will be achieved by using only battery power with a gasoline generator to re-charge the battery while driving. The Volt mileage would be four-times better than Toyota’s leading hybrid vehicle, the Prius, which gets somewhere between 48-51 mpg. This performance improvement comes with a roughly $18,000 price tag – the premium for the $40,000 estimated price of the Volt versus the current Toyota Prius sticker price of $22,000. The Volt is designed to operate on battery power for its first 40 miles before having its gasoline engine kick-in. Of course, the key to the Volt’s energy efficiency performance is city driving because the frequent braking in stop-and-go driving produces sufficient energy to sustain the car’s lithium-ion battery charge.
It was quite interesting that GM only made its mileage claim for the Volt based on city driving. Once the vehicle gets on the highway and has to travel more than 40 miles it needs to rely on its gasoline-powered generator that will significantly reduce the vehicle’s energy efficiency rating. The vehicle’s performance will also be hurt by the amount of cargo carried and even the number of passengers, let alone the impact of turning on the car’s air conditioning.
Many auto and environmental analysts have weighed in on the GM Volt mileage claims – both favorably and questioningly. One analyst pointed out that if you drove the Volt less than 40 miles per day, then the car’s energy efficiency rating would be either zero mpg or infinite. Because the Environmental Protection Agency (EPA) has not tested the Volt, the mileage claims are really conjecture on the part of GM, although it claims it is calculating the mileage based on an EPA formula. The EPA has supposedly suggested it is possible the Volt will use “as little as” 25 kilowatt hours for charging for every 100 miles driven in the city. That estimate takes into account the benefit of city driving charging for vehicles. The downside is that the Volt needs to be charged for eight hours twice a day.
GM claims that based on today’s electricity costs, the 40-mile charge will cost about $0.40, or $0.01 cent per mile. Based on this cost estimate, it will cost a Volt owner about $1.20 to drive 100 miles while a gasoline powered car will cost roughly $10 based on gasoline at $3.00 per gallon for a vehicle averaging 30 mpg, or roughly eight times the cost of the Volt.
One analyst estimated that if the U.S. auto fleet shifted totally to Volt vehicles, it would cut the nation’s gasoline consumption to about one-eighth of its current level. The analyst went on to say that even if only half the fleet was converted to Volts, the U.S. would save about half its gasoline consumption. Besides the impact of reduced gasoline, since the Volt will be manufactured in the United States, there would be no auto import bill. Therefore, the analyst estimated the U.S. economy would receive the equivalent of a $2 trillion per year economic stimulus. That would certainly have a significant impact on the pace of U.S. economic activity.
A number of people have gotten into the business of speculating on the economic advantage of gas-powered vehicles compared to the battery-run Volt. One analysis compared the cost of driving a Toyota Corolla versus the Volt to see how many miles the Volt needs to drive to offset its premium price. The analysis assumed that the comparison would be made starting in 2011 after the Volt is delivered. Therefore, they compared the Volt’s estimated sticker price of $40,000 against the current Corolla price of $15,350 inflated by 3% per year until 2011. Even after the federal government’s $7,500 subsidy for buying a Volt, there is still a $16,690 differential.
The 2011 futures price for gasoline is $3.09 per gallon, or about 16% above the current spot price of $2.647. Current electricity prices are 1.3₵ per mile for the battery-powered mileage versus an estimated 11.9₵ per mile for the Corolla. Assuming the full cost differential between the two vehicles, the Volt needs to be driven 229,000 miles to offset the price premium. With the $7,500 tax subsidy, it only needs to be driven roughly 158,000 miles.
Another analyst took this data and extended the analysis saying that it was unrealistic to assume that gasoline pump prices would stay at $3.09 per gallon for future years. They showed that even with electricity prices rising by 33% over the time period, if gasoline prices averaged $4 per gallon, the miles driven required to offset the vehicle price premium would drop to about 124,000 miles. If gasoline prices averaged $5 per gallon, the mileage figure declines further to 99,000 and then to only 82,500 miles if gasoline pump prices average $6 per gallon.
The most interesting analysis took an entirely different tack. If you took the price premium of $16,690 and invested that money at 10% per year (hard to get in today’s low interest rate environment without assuming a lot of principal risk) then you have $1,669 a year to buy gasoline. At the $3.09 per gallon figure used in the prior analysis, you could buy 540 gallons, which at an average efficiency rate of 26 mpg, would allow one to drive a vehicle for 14,020 miles. Obviously that mileage would decline as gasoline prices increase each year, but at the end, one would still have the nearly $17,000 to apply to the purchase of a new vehicle. Also if the comparison vehicle got better mileage, then the money would allow more miles to be driven.
One environmentalist pointed out that the electric car would be much more efficient because it experiences less mechanical wear and tear. More importantly, they believe that unless the car is driven in states such as Pennsylvania, Ohio and West Virginia that primarily rely on coal to generate their electricity, or in Hawaii that uses diesel fuel for electric generators, the Volt would be much more environmentally friendly. As was pointed out by another analyst, 100 gallons of gasoline produces one ton of CO2 while 1.5 megawatts of electricity from the power grid are responsible for an equal amount of carbon. The Volt’s 40 miles of battery-powered use consumes 8.5 kilowatts of electricity meaning that it could have 175 charges per ton of CO2, or go about 70,000 miles. The analyst estimated that a gasoline-powered car would need to average 70 mpg to be equivalent.
At the end of the day, it appears electric cars are going to be in the news given the Chevy Volt hype. We think it is premature to be making absolute comparisons, partly because we don’t know what breakthroughs in battery technology might happen before electric cars hit their stride as a possibly competitive vehicle. Nissan, with a new electric car entry coming believes they will capture 10% of the American vehicle market by 2020. Electric cars are fast becoming a fact of life.
Every Energy Action Causes A Counter Reaction (Top)
The U.K. Department of Energy and Climate Change just published a report by former British energy minister Malcolm Wicks commissioned by British Prime Minister Gordon Brown. In the report, Mr. Wicks says that “the time for market innocence is over” and that “the state must become more active: interventionist, where necessary.” Mr. Wicks argues that the historical business model of energy policy – that the market should be allowed to work freely as far as possible – is no longer workable. His view is shaped by the country’s rapid shift to import dependency on natural gas for powering Britain’s electricity generation plants in light of the sharp fall in its North Sea oil and gas production. Britain was self-sufficient in natural gas as recently as 2004, but now is projected to have to rely on imports for between 45% and 70% of the country’s needs by 2020. That may mean greater dependence upon Russian gas supplies down the road, but certainly more dependency on gas supplies from Norway and LNG supplies from the Middle East and Africa in the near-term.
Mr. Wicks is proposing that the U.K. government should look at setting objectives for the fuel mix for the country’s electricity generation. Setting these objections would involve specifying, within certain bounds possibly, how much supply should come from natural gas, nuclear, coal and wind. So far the government has signed up to that approach for renewable fuels, which are supposed to satisfy about 30% of the country’s electricity generation needs by 2020. So far, the government has not agreed to specifications for other fuels.
Compounding the discussion, and forgetting the criticisms levied by peak oil enthusiasts, is a recent projection from National Grid, which owns the country’s electricity and gas transmission networks, suggesting that power demand by 2016 would still be well below its 2008 level. The lower demand outlook is a function of the deep economic recession and the prospect of long-term demand weakness due to a slower than normal economic recovery and uncertainty about the government’s commitment to increasing the country’s energy efficiency.
According to published announcements, companies have either started or are planning construction of 30,000 megawatts (MW) of gas-fired generation, 8,100MW of coal-fired power, 1,800MW for onshore wind power and 9,200MW for offshore wind power. Two European companies have announced plans to build new nuclear power plants in Britain that envision adding 12,000MW of new capacity, but not before the end of 2017 at the earliest. Given that existing nuclear plants will be shutting down before then, the prospect is Britain will get less electricity from nuclear power by 2020 than it does now. All these new generating projects are confronting the reality that 10,000MW of coal-fired generation is expected to shut down by 2016 to comply with European Union acid rain pollution controls.
Given this report and the confusing realities of the British electricity generation market, a new report suggests that plans for Europe’s largest wind farm to be located in the Shetland Islands of Scotland could be at risk from an environmental point of view. The £800 million ($1.3 billion) project involves the construction of 150 large turbines and 68 miles of roads on a 187 square kilometer peat bog. The Scottish government is preparing to grant approval for the project, but concerns have arisen about the impact on the environment from the release of carbon by construction on the bog.
Exhibit 28. Undisturbed Peat Bog in Scottish Highlands
Source: Peter Hulme/Corbis, guardian.co.uk
Scottish peat bogs are comprised of water and saturated, un-decayed plants. Disturbing of bogs tends to lower their water level allowing peat to dry and oxidize releasing its carbon. Estimates are that Scottish peat bogs hold about three-quarters of all the carbon in British ecosystems, or the equivalent of around a century of emissions from the burning of fossil fuels. A single hectare of peat bog contains more than 5,000 tons of carbon, or 10-times the amount contained in a hectare of forest.
Viking Energy, the developer of the wind farm, says in its application that the “payback time” for the turbines from the carbon released during the project’s construction ranges from 2.3 years to 14.9 years. The high end of the payback period is equal to 60% of the estimated life of the wind farm. The risk in the construction is that a whole hillside of waterlogged bog or dried out peat slides and eventually oxidizes releasing the trapped carbon. Such an episode occurred at a wind farm in Derrybrien in Ireland in 2003 potentially canceling out the benefits of building the wind farm. In its filing, Viking Energy suggests there is zero risk of this happening although hill slides are a regular feature of Shetland bogs. Can anyone realistically believe that estimate?
Laughs From the Energy Market (Top)
Oil and gas explorationists in the U.S. energy business have come from a long line of optimists that have populated the country. Give them more resources and they’ll find more oil and gas.
Exhibit 29. Peak Oil Favorite Shows Optimism or Futility
Source: ASPO
One often wonders whether the global warming/climate change movement is really about saving the world, or rather about restricting the population from enjoying the fruits of technological progress coupled with the planet’s abundant natural resources.
Exhibit 30. Feeling Good While Wrecking Consumer Budgets?
Source: Creators.com, Carl Moore
Crude Oil Market Disconnect: A Problem Emerging? (Top)
Last week crude oil prices bounced back above $70 a barrel before closing at $67.51, down $3.01 on Friday. As the chart of oil prices for the past six months shows, there has been a strong recovery this year, especially following the correction in July. Last week, oil prices closed above $70 on three of the five days, and on Friday the week before, they nearly reached $73 a barrel. This price action came in the face of continued government reports of crude oil inventories building and Frontline (FRO-NYSE), a large oil tanker operator, saying that the volume of crude oil in ships being used as storage had increased from 80 million to 100 million barrels.
Exhibit 31. Oil Prices Have Recovered But Dropped On Friday
Source: Barchart.com
During the week, the International Energy Agency (IEA) released its monthly oil report in which it boosted its forecast for oil demand by 150,000 barrels per day (b/d) for 2009 and 90,000 b/d for 2010. The IEA is now projecting global oil demand this year should average 83.94 million b/d. That estimate is close to the one recently issued by the U.S. Energy Information Administration (EIA) of 83.76 million b/d. The EIA’s recent estimate was reduced from its prior projection that was even closer to the latest IEA.
U.S. oil demand is estimated at about 18.7 million b/d currently, or more than 22% of total world consumption. Despite near record oil storage volumes, a sharp economic recovery boosting oil consumption or a faster decline in U.S. oil production could put further upward pressure on oil prices. Estimates are that U.S. oil production is declining at about 4% a year, despite the recent rise in oil drilling. That decline rate is below the IEA’s recent study of global oil fields showing the world’s annual oil production decline is 6.7% a year, up from its prior estimate of about 3.7%.
The U.S. faces several challenges with its oil production. Without new discoveries, the production decline rate insures that America will not be able to satisfy more than 25% of its consumption needs by 2012 based on current consumption rates. In addition, the U.S. relies heavily on Mexico for oil supply and that country’s production is collapsing at an alarming rate. These two trends will, without a significant change in consumption, force a greater dependency on other foreign oil supply sources. The recent news about a potentially huge new oil resource located in the Bakken formation of North Dakota, along with the recent discovery of significant oil deposits in 103 wells drilled into the Three Forks-Sanish formation below the Bakken, suggest the country may get some help from new oil exploration and development efforts spurred by high prices. Whether these new oil plays can boost the country’s reserves by 10-times as suggested by some studies remains to be seen, but the discovery and development of these resources is a welcome event.
Exhibit 32. Canadian Heavy Oil/Oil Sands Deposits Are Huge
Source: Agora Finance
The evolving oil supply situation in the United States is good news for the Canadian oil sands development. This tar-like resource requires extensive energy to develop and convert into oil that can be refined by conventional refiners, but technology is working to reduce these costs. A new pipeline from the northern Alberta deposits to the heart of the U.S. refining industry is awaiting approval. Should it be given the green light, the U.S. could be looking at a much more secure oil supply future. The heavy oil and oil sands deposits in Canada, once developed to refinery-grade oil, are equal to seven times the reserves of Saudi Arabia on a barrel of energy equivalent basis. The only possible fly in the ointment is the Obama administration’s Buy American plan that has upset our trade relations with Canada.
A Lesson About Saving Energy (Top)
August marks the one year anniversary of Utah’s government implementing a switch to a four-day work week to conserve energy. State offices are closed on Fridays with employees working 10-hour days the other four days. Based on data recently released, the state estimates it has saved about 13% of its energy costs through the switch. Utah released data from the first nine months of the program for the 125 state-owned buildings showing the 13% savings on its electricity and gas bills. The state also estimates its employees have saved between $5 and $6 million in commuting costs.
Given the success of the State of Utah in saving energy, we thought we would look at what savings might come if the U.S. Postal Service carried out its recently suggested proposal to cut back mail delivery by one day a week in an effort to address its potential $7 billion deficit. According to Postal Service data for 2008, it operates 221,000 vehicles making it the largest civilian vehicle fleet. Postal Service employees drove an estimated 1.2 billion miles while using 121 million gallons of fuel. If you’re wondering, that means postal vehicles average 9.9 miles per gallon, suggesting there should be room for significant fuel efficiency gains with newer vehicles, and especially if they could be powered with alternative fuels.
Since the post office operates six days a week less an estimated eight holidays, we estimate the vehicle fleet consumes roughly 398,000 gallons of fuel a day. We know this isn’t exactly correct because postal trucks are hauling mail across the country every day and there is activity on every day the post office is closed. But based on that estimated work-day fuel consumption, cutting one day per week off mail delivery would save the Postal Service about 20.7 million gallons of fuel per year. If we assume the Postal Service does not pay federal gasoline taxes (we don’t know about state and local taxes) we estimate it would save close to $48 million a year at current gasoline prices, an amount that would not make a big dent in the projected annual deficit.
We read in one of the articles discussing the Cash for Clunkers, excuse me, the Car Allowance Rebate System (CARS), program that the 250,000 vehicles purchased in the first iteration of the program would reduce America’s gasoline consumption by 72 million gallons a year. Specific data released by the Department of Transportation on the first 80,000 cars sold under the program shows a 9.6 mpg improvement between the estimated fuel consumption for cars turned in versus those purchased. If the renewed CARS program removes another 500,000 vehicles, based on the earlier estimate the fuel savings from all cars removed would total 216 million gallons a year. The same article pointed out that the 72 million gallons of gasoline estimated to be saved was equal to about 4 ½ hours of U.S. gasoline consumption. Thus, the fuel savings from the 750,000 vehicles removed from the nation’s fleet would offset slightly more than half a day’s gasoline consumption.
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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.
