Musings From the Oil Patch – August 22, 2006

• Oil Price Is In the Eye of the Beholder
• Massachusetts Pols: The Gang that Can’t Shoot Straight
• CERA’s Supply Report Highlights Peak Oil Debate
• Venezuela Distancing Itself from the U.S.
• Balanced Reporting by Business Week

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

Oil Price Is In the Eye of the Beholder

 

A recent article in The New York Times discussed the issue of why oil prices remain so high in the face of record petroleum and refined product inventories, flagging energy demand growth and growing oil supply.  The article focused on a report written by analyst Ben P. Dell of Sanford C. Bernstein & Company that cites the flood of institutionally-managed money going into commodities as the prime reason for the relentless rise in oil prices. 

 

According to Mr. Dell, “You’re growing supply.  You’re growing inventories.  And demand growth is slowing.  But the price keeps going up.”  He believes the massive amount of money from institutional investors, primarily pension funds and other typically conservative institutions, pouring into commodities in recent years is the driving force behind high oil prices.  The investment rationale is that this asset class (commodities), although volatile, provides portfolio protection since commodities have tended to perform well when stocks and bonds have been weak.

 

Many investors have assumed that the movement in commodity markets reflects a greater involvement in this sector by hedge funds known for their aggressive trading patterns.  However, many energy specialist investors have used, and are continuing to use, petroleum futures as a way to leverage, or hedge, their equity positions.  Many of the more conservative institutional investors are playing long-dated futures as they see both arbitrage opportunities and positive long-term trends that can make these strategic hedges profitable.

 

The article noted that the continued upward move in petroleum futures prices has presented investors with arbitrage opportunities due to the concept of contango.  One example cited by a commodities trader in the article was the opportunity on August 4 to buy heating oil in New York Harbor for $2 per gallon and store it and sell it for December delivery at $2.24 per gallon.  The $0.24 spread not only covered the cost of storage and interest expense on the trade, but returned a reasonable profit for the buyer.  These types of arbitrage trades exist at times throughout the petroleum product spectrum and will encourage investors to play those trades helping to boost inventories at different points in time. 

 

Looking at the historical relationship between inventories and oil prices, William H. Brown III, president of WHB Energy Research, says that oil should be selling for $27 per barrel.  According to Mr. Brown, the impact of passive long-term investors “is in my view $33 per barrel,” with geopolitical events accounting for the balance of the gap with the current futures price.  Mr. Dell believes that oil prices could weaken when storage facilities reach capacity that could happen within four to six months, or in the midst of this coming winter.  He believes when this happens, oil prices are headed for $50 per barrel, or lower.

 

Exhibit 1.  Prices Don’t Reflect Inventory Levels

Source: EIA, PPHB

 

As one would expect, the article countered with a number of other energy market observers who agree that passive long-term investors have impacted futures prices.  However, they disagree with the magnitude of their impact.  Mr. Edward L. Morse, chief energy economist at Lehman Brothers, and formerly oil economist at Hess Energy (HES-NYSE), is quoted as attributing maybe $10 of the per barrel price to the actions of these passive long-term investors.  That is quite a bit different from $33. 

 

We question the ability of looking at past relationships between inventory levels and crude oil prices to determine the appropriate level for current oil prices.  While we hate to use that well-worn and dangerous phrase, “it’s different this time,” it may actually be different. 

 

Exhibit 2.  Inventories Near Record Levels

Source: EIA, PPHB

 

When we look at the volume of total petroleum inventories in the United States since 1990, excluding oil in the strategic petroleum reserve, today we are close to that 1990 peak.  If one examines the movement of inventory levels, there was a slow, but steady decline until 2003, with the exceptions of the late 1990s and 2001 when economic slowdowns and warm winters undercut demand growth.  Since 2003, inventories have been building steadily highlighting the conundrum the people quoted in the article are grappling with.

 

We have also plotted the number of days of inventory supply against the level of inventories.  This is a measure of how many days at current demand today’s inventory could supply.  The days supply line has been declining from above 60 days in the early 1990s to a low in the mid 40s in 2005.  We have since climbed back to around 50 days of supply.  The drop in days supply shows that we have handled higher petroleum demand growth with little increase in inventories as we have been able to achieve a better inventory turn rate, meaning the logistics system for meeting final demand has become increasingly more efficient.  The low days supply level in 2005 was partly due to the impact of hurricanes Katrina and Rita on refinery operations.  The current days supply level of around 50 is probably a more sustainable level.

 

What is interesting is to look at the days supply line plotted against the price of oil.  While days supply dropped during the early 1990s, there was little impact on oil prices.  When the market recovered from the debacle caused by the Asian currency crisis in 1998-99, oil prices climbed as days supply dropped sharply.  Note that in the early 2000s, as oil demand weakened and days supply climbed, oil prices weakened.  It seemed that when days supply fell below 50 days, oil prices reacted to the upside.  However, the steady climb in oil prices in recent years cannot be explained merely by the level of days supply.  Maybe there is another explanation.

Exhibit 3.  Below 50 Days Supply Drives Oil Prices Higher

Source: EIA, PPHB

 

One investment strategist suggested that the rise in global oil prices is due to the weakness in the U.S. dollar.  He suggests that $30 of the current oil price is due to the weaker dollar.  He pointed out that all commodities are at 25-year highs and the one common thread is the weak dollar.  An analyst from PFC Finance suggested that this was an interesting thesis but it ignored the dynamics in the energy market of supply and demand.  As he put it: China is the common thread to high commodity prices.

 

In response, the investment strategist pointed out that China’s economy has been expanding at unusually high growth rates for 28 years, or since Chinese Premier Deng opened up his economy to Western investment.  The strategist further pointed out that the price of oil was stable during periods of U.S. dollar strength.

 

We looked at the prices of several commodities over the past few years when the U.S. dollar was weak and China’s demand was strong.  We are not sure that we can separate out the impact of these two factors.  However, most commodity prices along with oil have reached 25-year highs.

 

Exhibit 4.  Aluminum Demand Has Driven Up Prices

Source: The Rude Awakening

 

Exhibit 5.  Copper Is Another Commodity in High Demand

Source: The Rude Awakening

 

When we looked at the rise in crude oil prices, we began to think about its potential correlation to the emerging debate about a peak in global oil production capacity.  We recently read an article written in May 2006 that made the point that if you went to Google and entered the words “Peak Oil” into its advanced search feature, you would get back 7 million items.  On a web site, we found an article from October 3, 2005, where the author said his Google search of “Peak Oil” produced 2 million items. 

 

For the fun of it we did a Google search on “Peak Oil” on August 13 and got back 36 million items.  An increase in peak oil references of that magnitude in such a short time seemed beyond comprehension.  However, the more we thought about it, the more we recognized that the topic of peak oil has become much more of a mainstream news topic, so the dramatic increase in references is entirely possible. 

 

Those 36 million peak oil references further stimulated us to review the history of peak oil.  In 1996, the M. King Hubbert Center for Petroleum Supply Studies was established at the Colorado School of Mines.  It issued its first quarterly newsletter discussing the dynamics of peak oil on October 8, 1996.  The center is named for the geologist who, when working for the U.S. Geological Survey, predicted that the peak in U.S. Lower 48 crude oil production would occur in 1971.  The accuracy of that forecast, and its methodology, has created a cottage industry in forecasting the peak in global oil production. 

 

In 1997, Colin Campbell, a retired geologist for Royal Dutch Shell (RDS.A-NYSE), authored a book, The Coming Oil Crisis, which was based on the Hubbert model and focused on the impact of depletion in existing oil production and the lack of new oil discoveries, all in the face of growing demand.  Depletion, a concept that oil and gas fields steadily lose some of their productive capability as they produce, has moved from an esoteric financial concept generating debate in tax circles to a real physical factor.  Depletion is akin to human aging, meaning that as people become older, they cannot run as fast or lift as much weight or sustain activity at as high a rate for as long a time as younger people.  To sustain production we need new, younger oil fields.

 

The following year, Colin Campbell teamed with another geologist, Jean Laherrère, to publish an article in Scientific American dealing with the growing global oil supply problem.  The book and the article sparked an early debate about the potential for peak oil with serious ramifications for the United States and world economies.  At about this same time, the management team at EOG Resources (EOG-NYSE) began incorporating a chart in their presentations showing depletion’s impact on vintages of U.S. natural gas production.  The chart was used to educate investors on the reasons behind the rising cost of replacing natural gas reserves. 

 

Exhibit 6.  EOG Resources Highlights Depletion

Source: EOG Resources

 

The chart generated an increasing awareness on Wall Street and among investors of one of the critical drivers behind peak oil.  The natural depletion of producing reservoirs in the face of growing demand creates an increasingly larger burden for finding new supply each year merely to sustain level production.  Unfortunately, just as the peak oil debate was emerging from the shadows, the Asian currency crisis undercut global oil demand sending crude oil prices tumbling to around $10 per barrel.  Low oil prices crushed drilling in the United States, sending it to its lowest point in post-World War II history.  With low oil prices, concern about the potential of peak oil and its impact on global economies disappeared as consumers enjoyed sub-$1 per gallon gasoline in the United States.

 

Crude oil prices began to recover in 1999 when OPEC producers united to cut production in an agreement engineered by Venezuela’s new leader, Hugo Chavez.  After recovering to pre-Asian crisis levels, oil prices continued to climb as the fallout from the drop in drilling activity and the boost in demand from low prices contributed to a tightened global crude oil supply and demand equation.  In 2001, Hubbert’s Peak: The Impending World Oil Shortage, written by Kenneth S. Deffreyes, was published and The Oil Depletion Analysis Centre (ODAC) was founded in the U.K.

 

Around this same time, the Association for the Study of Peak Oil & Gas (ASPO) was founded with chapters in Sweden and Ireland.  Other chapters have been organized around the world.  In 2002, the first annual conference to discuss peak oil was held under the sponsorship of the ASPO. 

 

During this same period, Houston energy investment banker, Matt Simmons, stepped up his campaign suggesting a coming global oil supply crisis due to a lack of new discoveries and rising depletion rates for existing production.  He believed that a lack of solid data about the amount of global oil reserves was jeopardizing our future with potentially unrealistic assumptions for future supply.  By 2003 the debate began to focus on Saudi Arabia’s oil resources and their role in meeting long-term oil supply and demand forecasts.  These predictions called for the Kingdom to double its production by 2025.  As the intensity of the debate grew, a meeting between the reserve protagonists and the Kingdom was proposed. 

 

In February 2004 the Center for Strategic & International Studies hosted dual presentations representing the bullish and bearish cases for Saudi Arabia’s oil resources outlook, critical for the future of the global oil business.  Bearish analyst Matt Simmons discussed a litany of producing problems in Saudi Arabia’s oil fields gleaned by reading over 200 technical papers presented to leading industry conferences over the prior 30 years.  These problems pointed to accelerating depletion of the crucial oil fields accounting for the bulk of the Kingdom’s oil – and the key contributors to the world’s oil supply.  On the other side were representatives from Saudi Aramco’s E&P operations, the state oil company, who presented a bright 50-year production outlook for the Kingdom in which challenges were acknowledged but not considered serious or insurmountable.  The meeting did not settle the debate, but possibly raised more questions about the health of Saudi’s reservoirs.  A few months later the debate continued at a special panel debate hosted by the Offshore Technology Conference.  While Saudi Aramco was not a presenter, one of their engineers spoke from the floor during the question and answer session, further stimulating the debate.

 

Over the past two years we have had peak oil addressed by all the popular media.  Matt Simmons published his book, Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy, in 2005.  Proponents on both sides of the debate wrote innumerable papers and started blogs and organizations to push their causes.  Even the U.S. Congress got involved with hearings on peak oil. 

 

We are not attempting to take a stand on the peak oil debate in this article, but rather to point out the impact it may be having on crude oil prices.  As many of the knowledgeable people on this subject put it, we will not know if peak oil is reached until after the fact.  Moreover, we may not see an immediate drop in global oil output after peak oil is reached.  Short-term economic conditions might disguise peak oil by cutting demand below the peak for some brief period of time.  On the other hand, peak oil may merely reflect just the result of many years of underinvestment in the search for new oil and gas resources, so we may have a near-term production challenge, but not a sustained global oil shortage. 

 

Exhibit 7.  Peak Oil Debate Driving Oil Prices Higher

 

Events associated with the Peak Oil phenomenon

 

Source: EIA, PPHB, various

 

Mr. Dell and Mr. Brown may be depending upon history to guide them in their analysis of the global oil market, but that history might be based on fundamental physical factors that no longer work.  The investing by long-term passive institutional investors suggests that they believe that new long-term factors are assuring higher oil prices for the future.  What we know about the history of commodity markets is that high prices eventually bring forth additional supplies.  What we don’t know is when they will arrive.  What we have learned in our 35-year involvement in the energy industry is that developing significant new oil and gas supplies has consistently taken longer and cost more than we initially anticipated.  So far, we have always been able to develop those supplies over time.  But like our annual stress test, as the treadmill’s incline rises, the difficulty in keeping up our pace grows.  Likewise, as oil depletion rates accelerate, the challenge for replacing this annually disappearing supply grows.  To offset depletion and meet global oil demand, the annual volume of new oil that must be found and developed will be a challenge for the global oil industry.  The peak oil debate will go on until the facts either prove it up, or we find significant new supplies.  Prudence dictates that we should prepare for peak oil’s eventuality.

 

Massachusetts Pols: The Gang that Can’t Shoot Straight

 

Politicians are often guilty of speaking before thinking, especially when it comes to politically volatile issues.  This seems to be the case in Massachusetts where the Legislature passed a bill during its closing sessions aimed at stopping the construction of a liquefied natural gas (LNG) terminal in Fall River.  However, the legislation includes language that jeopardizes the state’s existing energy supply by blocking shipments to the state’s existing LNG terminal in Everett, which supplies about 20% of the New England region’s gas supply and up to 35%-40% on peak demand days in the winter. 

 

Massachusetts Gov. Mitt Romney has advised the Legislature that it needs to remove the language, which he termed a “poison pill” for the state.  In a letter Romney wrote to the House and Senate, he reiterated his opposition to the construction of the Weaver’s Cove, Fall River terminal because he opposes building new energy facilities in close proximity to residential neighborhoods. 

 

The bill passed by the Legislature would impose restrictions on the passage of LNG tankers under Massachusetts bridges as an attempt to stop the Weaver’s Cove terminal by restricting its supply.  However, LNG tankers also must pass under bridges in their journey from Boston Harbor to the Everett terminal.  The sponsor of the legislation inserted the language to push the federal government into developing alternative LNG sites that aren’t in densely populated areas.  He would like to see LNG delivered to offshore terminals such as those proposed off Gloucester or Boston Harbor’s Outer Brewster Island, or as far away as Rhode Island and Canada. 

 

Gov. Romney correctly points out that the proper way to influence federal government action is through legal action and not by passing state legislation.  Moreover, both the governor and the bill’s sponsor acknowledge that this legislation might be unconstitutional since federal courts have ruled that energy regulation is the domain of the federal government. 

 

In Rhode Island, there is an active opposition to building any LNG terminals onshore in the state or in neighboring Massachusetts.  A recent letter to the editors of The Providence Journal by one of the leading political action groups in Rhode Island ranted against the dangers of LNG and the potential for “incinerating cities such as Providence and Newport.”  The opposition only wants LNG terminals to be built either offshore or in other regions with the gas piped to New England.  Recent editorials by Massachusetts and Rhode Island papers are acknowledging that New England is rapidly growing short of natural gas supply with negative implications for the region’s growth and its electricity supply.  How to solve the problem is unclear, and will likely require a solution unpopular for some residents.  In watching and listening to the debate, we are reminded of the Road Runner cartoons in which he runs so fast that he misses the turn in the road and winds up suspended in air off the edge of the cliff.  When he realizes where he is, he falls like a rock.  We are not sure that New England has gone off the cliff yet, but it is rapidly approaching that turn in the road.  We expect New England politicians to be bringing out the band-aids soon since they can’t, or won’t, come up with a non-NIMBY solution.

 

CERA’s Supply Report Highlights Peak Oil Debate

 

On August 8, 2006, Cambridge Energy Research Associates (CERA) published its July 2006 benchmark field-by-field analysis of worldwide hydrocarbon liquids production capacity.  The report’s conclusion is that world oil and liquids production capacity will grow significantly through at least 2015.  The report has triggered another round in the debate over whether the world is at, near or has passed global Peak Oil production. 

 

The CERA report is based on its examination of actual activity and production data covering existing fields and 360 new projects – 250 new non-OPEC and 110 new OPEC developments – expected to start production by 2010.  It concludes that the world’s production capacity will grow from 88.7 million b/d (mmb/d) in 2006 to 110 mm b/d in 2015.  This increase breaks down into OPEC growth of 12.9 mm b/d and non-OPEC growth of 8.7 mm b/d.  In the period to 2010, both OPEC and non-OPEC productive growth will be substantially faster than in the 2010-2015 period.  The authors of the CERA report, Peter M. Jackson and Robert W. Esser say, “These levels of growth depend on continuing high rates of investment.”  A reduction in oil prices could undercut that assumption.

 

Exhibit 8.  CERA’s Production Capacity Forecast

Source: CERA

The report’s authors noted that compared to their May 2005 report that projected a strong level of growth in production through to the end of the decade; it is actually growing more slowly.  Even with high oil prices that have stimulated E&P activity, the authors noted that “bottom-line capacity growth has not materialized quite as fast as was anticipated.”  They attribute this slower production growth in the face of continued high oil prices to aboveground disruptions. 

 

Based on their new study, there are four key conclusions from the report.  These conclusions are:

 

“▪The much-discussed ‘peak oil’ is not imminent, nor is the start of the ‘undulating plateau.’

 

“▪Contrary to what is widely believed, the overall proportion of lighter liquids is expanding faster than heavy and extra heavy crudes.

 

“▪Recent major aboveground disruptions have changed the outlook to 2015, but healthy growth of productive capacity has more or less absorbed the impact of these events.

 

“▪Productive capacity is still rising globally in both OPEC and non-OPEC and strong potential growth is still expected, with a gradual improvement in the supply-demand balance.”

 

Notice that the first conclusion was to dismiss the Peak Oil scenario.  CERA appears to be staking out the non-Peak Oil ground.  One has to wonder if that is an intellectually-honest opinion or a business decision.  CERA’s primary clients are the major integrated oil companies, including ExxonMobil (XOM-NYSE) and BP plc (BP-NYSE), two companies that continue to argue that global oil production growth can support world consumption of 110-120 mm b/d of oil, and that future oil prices are headed substantially lower. 

 

The report was barely off the press before criticism of the analysis was being issued.  That criticism is directed to the subtle shift in CERA’s approach to focus primarily on productive capacity and not on actual production growth.  Additionally, the CERA study introduces gas-to-liquids and coal-to-liquids fuels into the supply picture along with emphasizing an even stronger growth in natural gas liquids volumes than in its earlier study.  By making these changes and highlighting the potential supply growth from these non-crude oil fuels, CERA begins to blur the Peak Oil debate.

 

CERA also pointed out that there are a number of potential risk factors to its forecast.  The number one risk cited was project delays.  Throughout history, timing delays for technical, engineering and other reasons have often delayed projects.  The second key risk factor is increased costs.  We find this interesting since CERA has made much of its Upstream Cost Index that showed that even though capital expenditures have risen 68% between 2000 and late 2005, much of that increase was due to increased costs.  They point out that costs are rising at a faster rate in the first half of 2006 than in earlier years.  According to CERA, projects that were economic at $22 per barrel in 2000 now need a $35 per barrel price merely to achieve the same financial return in 2005.  They also acknowledge that some projects have been postponed by the higher costs.  The continued increase in oilfield service costs so far this year would appear to put more projects at risk.  Whether CERA has factored that into its analysis we do not know.

 

In a critique of the CERA report posted on The Oil Drum website (www.theoildrum.com) on August 12, Dave Cohen attempts to investigate CERA’s methodology and provide background for this latest report.  He first questions the 88.7 mm b/d productive capacity estimate.  Based on his analysis, CERA gets to its productive capacity number by adding together the Energy Information Administration’s (EIA’s) current global production estimate of 84.7 mmb/d and 2.5 mmb/d for supply disruptions and 1.8 mmb/d for maximum Saudi Arabian spare oil capacity. 

 

Mr. Cohen believes CERA’s use of the maximum Saudi spare capacity estimate is a way to help boost its numbers.  When he looks at the disruptions figures, he questions whether all of the possible disruptions fit the official definition of capacity as used by the EIA.  That definition refers to the maximum production capacity that “1) could be brought online within a period of 30 days; and 2) sustained for at least 90 days.”  Mr. Cohen questions whether Iraq’s potential capacity actually fits that definition given the chaos and terrorism in the country.

 

The critique also focuses on some of the key numbers in the analysis – in particular the growth of reserves.  CERA said, “It is true that total annual global production has not been replaced by exploration success in recent years, but production has been more than replaced by exploration plus field reserve upgrades.  In 1995-2003 global consumption of 236 billion barrels was more than compensated by exploration success and field upgrades that collectively added 144 billion barrels and up to 175 billion barrels, respectively.”  Mr. Cohen assumes that the research is supported by the IHS database since IHS owns CERA, but he wonders exactly where those numbers came from given other presentations by IHS professionals.

 

Based on a slide from a presentation entitled Role of Mature Fields in Meeting the Global O&G Supply Problem by Pete Stark of IHS, global exploration only replaced 60.8% of what was produced and consumed in 1995-2003.  When Pete Stark told a House subcommittee that peak oil was not a problem, he was relying on the 175 billion barrels of new reserves to offset the weak new discoveries performance.  Those new reserves came from the acceptance by the Oil & Gas Journal in 2002 of Canada’s classification of 174.4 billion barrels of oil sands as established reserves. 

 

 

Exhibit 9.  Canada’s Oil Sands Reserves Are Critical

Source: IHS

 

Additionally, an analysis of the total discovered resources, by year, shows that in the 2001-2005 period, only 50 billion barrels of liquids were discovered.  If the time period is extended back to 2000, then the total of discoveries increases to 76 billion barrels.  As Mr. Cohen points out using EIA data, the amount of liquids produced and consumed between 2000 and 2005 was approximately 175 billion barrels or the same amount as the entire OGJ oil sands reserves booked – all in a matter of six years.

 

Exhibit 10.  Discoveries Have Fallen Short of Meeting Demand

Source: IHS

Exhibit 11.  New Oil Discoveries Remain Weak

Source: IHS

 

In the CERA report, it says it is using a conservative 5% per year depletion rate for existing production.  A serious question is whether that rate is conservative?  CERA acknowledges that certain regional depletion rates may be higher, but the overall rate is conservative.  The North Sea oil depletion rate is now running at 7% per year, and there are serious questions about the potential production from

 

Exhibit 12.  Depletion Relentlessly Erodes Capacity

Source: CERA

 

Mexico’s Cantarell field, the second largest oil field in the world that is demonstrating potentially serious production problems.  We would also note that Core Laboratories (CLB-NYSE) announced during its first quarter 2006 earnings conference call that it had officially increased its Middle East carbonate reservoir depletion rate estimate by 25 basis points to 1.75% from 1.50% per year.  Carbonate reservoirs are the major source of oil produced in the Middle East.  We would note that once depletion rates are increased, they almost never go down.  The big question is whether the increase is the start of a series of future depletion rate increases with ominous results.

 

So what should one make of the CERA report?  We believe that serious analysts looking at the report will question some of the data and the forecasting assumptions.  If CERA wants to boost its revenues and profits, the report is for sale for $2,500, staking out a controversial position is not a bad strategy.  Additionally, on Wall Street we seldom penalize nay-sayers when, or if, they are wrong.  On the other hand, with a subject so critical for global economies, poor, or worse, misleading, analysis is a significant disservice.  The truth will not be known for some time, and maybe it will lie between the fear of the Peak Oil supporters and the optimism of CERA and ExxonMobil.  But if the peak oil scenario proves correct, we have little time to start making adjustments. 

 

Exhibit 13  The Risk of The Correct Forecast Are Huge

Source: Cohen, Khebab, The Oil Drum

 

 

Venezuela Distancing Itself from the U.S.

 

Venezuelan President Hugo Chavez has been working to reduce his financial dependence on the United States as he sees U.S. President George Bush as his primary political enemy in the region.  With an oil-dependent economy, Mr. Chavez needs to find other buyers for his oil before he can lower his dependence on U.S. oil consumers.  Mr. Chavez’s strategy has been to penalize U.S. oil companies working in his country through increased economic rent, while encouraging other foreign energy companies to invest.  The high price of oil has provided Mr. Chavez with income that has enabled him to take some long-term steps to accomplish his goal without hurting his domestic and regional social and political programs.  A recent deal with China to export 200,000 barrels of oil per day (b/d) marks one step in this program. 

 

On August 16, Lyondell Chemical Company (LYO-NYSE) announced that it finally has reached an agreement to buy CITGO Petroleum Corp.’s, a subsidiary of Petroleos de Venezuela S.A. (PdVSA), 41.25% ownership in the 282,600 b/d Lyondell-CITGO refinery in Houston, Texas for $2.1 billion plus debt.  At the same time, Lyondell signed a five-year agreement to purchase 230,000 b/d of crude oil from PdVSA to supply the refinery.  Since the refinery was using Venezuelan crude oil prior to the transaction, it was only natural that Lyondell sign a contract to secure its raw material supply, at least for some period of time.  Pricing for this Venezuelan oil was above the market, meaning that Lyondell would have made more of a profit had it owned the refinery outright since the beginning of the year than it actually earned.

 

While this deal is a significant step in Chavez’s program to distance himself from the United States, he still needs to sell Venezuela’s crude oil to non-U.S. customers if he truly wants to effect a true separation.  On August 15, Elnusa, a subsidiary of Indonesian state oil company Pertamina, announced it will join with PdVSA and the National Iranian Oil Refining and Distribution Co. (NIORDC) to construct a $4 billion, 300,000 b/d oil refinery on the island of Java. 

 

According to reports, Elnusa will hold a 30% stake in the refinery, NIORDC will have 20% and PdVSA will hold 25%.  The remaining 25% is available for other interested participants.  Elnusa says that PdVSA will provide 150,000 b/d of supply while the remainder will come from Iran. 

 

There are two questions that come to mind with this announcement.  First, who will provide the money to build the refinery? Second, who is likely to be the other participant?  Clearly, of the three parties currently involved in the project, only Venezuela has the money to fund the refinery’s construction.  Indonesia, while a member of OPEC, has become a net oil importer since it has been unable to stimulate sufficient new exploration and development activity to offset depletion.  In addition, Indonesia has 220 million people

 

meaning it has little surplus money to fund significant petroleum development activity.  Iran, too, has a large population (three times that of Venezuela) so it has little surplus money to play with, also.  Speculation, based on comments from Elnusa, is that Japan likely will be the other participant.

 

Japan certainly has plenty of capital.  It also has stepped up its focus on investment opportunities in Indonesia as a key tenant of its evolving foreign policy.  Lastly, Japan is highly dependent on the flow of oil from the Middle East through the Strait of Malacca.  By purchasing a regional facility, Japan would counterbalance that dependence and help diversify its oil supply sources. 

 

The problems for Hugo Chavez’s efforts to distance Venezuela from the United States are the quality of its oil and the distance to non-U.S. markets.  Venezuela remains a prime oil supplier to the U.S., accounting for 1.47 mm b/d of imports, which is more than half of Venezuela’s daily output and 10% of U.S. imports as of May.  Venezuelan oil is particularly heavy and viscous.  It is difficult to refine and those refineries that use it have to be especially equipped to handle the low gravity oil.  Many of the U.S. Gulf Coast refineries are so equipped, as are a few refineries on the U.S. West Coast. 

 

In Venezuela’s earlier deals with China, the timing of oil flowing across the Pacific was tied to when China would be able to upgrade its refineries to handle Venezuelan heavy oil.  The plan envisioned shipping the oil through the Panama Canal, until a trans Panama pipeline could be constructed, to refineries on the West Coast with the refined product then shipped to China.  Thoughts were that this plan would need to operate for at least two years to provide sufficient time for China to upgrade its refineries.  The problem is that other Asian customers have not been quick to sign up to pay top-dollar for sub-quality Venezuelan oil that needs to be shipped long distances. 

 

Once again Mr. Chavez is heading to Asia to search for more customers.  It is interesting to note the timing of the Indonesian investment announcement and his trip.  Additionally, PdVSA’s R&D arm, Intevep, announced that Venezuela’s Orinoco oil belt could hold up to 1.3 trillion barrels of reserves.  Moreover, they say that new extraction methods being developed could ensure recovery rates of up to 30% from the current 8%-9% rates.  This would mean an additional 160 billion barrels of recoverable reserves, in addition to the current estimate of 235 billion barrels.  With this newly expanded resource base, Mr. Chavez can more easily seek out additional foreign investors for his oil sector on this Asian trip.

 

As Mr. Chavez lines up other non-U.S. customers, look for him to continue to exit the refining and market business of PdVSA’s U.S.-based CITGO subsidiary and bring that capital home.  CITGO has already notified retail outlets that starting about a year from now they will have to secure other supplies.  The Chavez strategy will require him to enter into interim petroleum supply agreements, but those will be short term in duration.  As those agreements run off, Venezuela will have additional oil to ship to its new non-U.S. customers. 

 

One impact of this oil flow shift will be a change in the logistics business.  Current short-haul tanker routes between Venezuela and the U.S. will morph into longer voyages.  That means the timing of tanker trips will lengthen and larger ships will be in greater demand to offset these increased distances.  Mexico, with its Mayan heavy crude oil, should be a near-term beneficiary from Venezuela’s actions, but Canada’s oil sands heavy oil is the primary long-term beneficiary once the transportation system is in place and additional production commenced.

 

Balanced Reporting by Business Week?

 

The August 14, 2006, issue of Business Week carried a special report on Wall Street’s growing interest in clean-energy investing.  At the same time, the editors of the “The Business Week” section warned about the potential return of the boom-bust nature for energy companies.  Is this a reflection of trying to maintain a balanced view of energy investing, or a lack of coordination between editors and writers? 

 

The editors talked about the “high-octane second quarter” earnings posted by companies across virtually every sector of the energy spectrum.  As evidence of these strong earnings, they cited ExxonMobil’s (XOM-NYSE) profit of $10.4 billion, up 32%, among the integrated oil companies, Valero (VLO-NYSE) in the refining sector with a 124% profit gain, and Schlumberger (SLB-NYSE) and Noble Corp. (NE-NYSE) with 25% and 145% year-on-year earnings improvement, respectively, among the oilfield service companies.  The editors said to expect more quarters ahead of strong earnings gains.  But they cautioned investors that with many companies “ramping up multi-billion dollar expansions” the industry is primed to renew its boom-bust reputation in two to four years from now.  The editors’ advice was that “Investors might ponder that as they bid up share prices.” 

 

Some 24 pages deeper into the magazine, Business Week writers Emily Thornton and Adam Aston authored an 8-page special report on “Wall Street’s New Love Affair: Why some of the world’s smartest investors are betting billions on clean energy.”  According to the writers, global warming and oil prices are major factors weighing on the American psyche today and that both conservatives and liberals are embracing the imperative of energy independence.  As the authors put it, “You know a cultural movement is real when the money men get on board.” 

 

Beginning with a positive outlook for their story, the authors point out that in 1975 renewable energy accounted for 6.6% of total energy consumption, which has declined to only 6.1% in 2005.  As sobering as this assessment is, the article makes the point that Wall Street is merely betting that wind, solar, biofuels and other renewables will make up a bigger slice of the nation’s energy market and sufficient to provide attractive returns for these clean-energy investors. 

 

In 2005, $17 billion was invested in clean-energy projects, up 89% from 2004, according to New Energy Finance Ltd.  Worldwide, investment in clean-energy projects increased 62% to $49 billion compared with 2004.  The complaint heard on Wall Street is that this flood of money is driving valuations higher and making it difficult to find attractive clean-energy projects – always a sign of an impending correction.

 

The special report authors point out that the financial profits so far for green investments have been due to the sharp increase in crude oil prices, which could evaporate if a recession sends oil prices significantly lower.  They say that Wall Street is really targeting the scenario in which oil prices stay around current levels since the cost to produce a gallon of gasoline is twice that to produce a gallon of ethanol.  The cost to generate a kilowatt hour of electricity with coal or natural gas is 8¢ compared to 6¢ with wind power.  Wall Street is hoping that these spreads remain and that oil prices do not collapse anytime soon.

 

Implicit in the Business Week view of a potential return of the boom-bust environment for energy companies in two to four years is their belief that commodity prices are headed lower.  If so, then the key question for green-investors is how quickly they can recoup their investments before that judgment day of lower oil prices.  For stock market investors, there should have been a more prominent warning about this downside risk for green-investments in their special report.

(Top)

Contact PPHB:
1900 St. James Place, Suite 125
Houston, Texas 77056
Main Tel:    (713) 621-8100
Main Fax:   (713) 621-8166
www.pphb.com

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