• Active 2008 Hurricane Season Ends
• Managing For The Future – But Just For How Long?
• Is The Rig Count About To Enter Freefall Territory?
• Nantucket Wind Power Farm Final Approval Near
• 2008 Hurricanes: Further Global Warming Support?
• Private Equity and Leverage – Changing The Model?
• Clean Energy Outlook Brightens As Ethanol Fades
• Are Somali Pirates OPEC’s New Best Friend?

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

Active 2008 Hurricane Season Ends

December 1st ended the 2008 hurricane season, which marked another year characterized by above-normal activity for tropical storms.  The Atlantic Basin experienced 16 named storms during the 2008 season, which included two intense storms – Gustav and Ike – that caused significant damage to the U.S. Gulf Coast and its oil production infrastructure.  Of the 16 tropical storms this year, eight were hurricanes while five were major hurricanes.  This year was the 10th in the past 14 years to produce above-normal storm activity.

People will be anxiously awaiting the early forecasts for tropical storm activity in 2009 as oil industry participants are becoming accustomed to having to plan for the potential of disruption to drilling and production activity in the Gulf of Mexico.  The petroleum industry had barely restored all its damaged producing capacity from 2005 hurricanes Katrina and Rita when it was hit by a series of storms this past year from which it has still not fully recovered.  The early forecasts for 2009 will be issued by the various prediction centers starting in mid December.

The track of the 16 named storms experienced in 2008 is displayed in Exhibit 1.  The colors of the tracks reflect the level of the storm during that portion of its travel from formation to the ending of its tropical storm level. 

Examining what happened during 2008’s hurricane season provides some interesting perspective on where in the tropical storm cycle we are currently operating.  This season started early as Arthur formed on May 31.  During the years 1944-2005, the average date for formation of the season’s first named tropical storm is July 10th. 

Exhibit 1.  The Track of Named Tropical Storms of 2008

Source: Colorado State University, Unisys Weather

This season saw a total of 16 named storms.  Since 1995, 13 of the last 14 storm seasons have experienced more than the historic average (1950-2000) of 10 named storms.  Since aircraft reconnaissance began in 1944, only 2005 with 28 named storms, 1995 with 19 named storms and 1969 with 18 named storms have had more than the 16 named storms of 2008.  The eight hurricanes experienced in 2008 exactly equaled the average number of hurricanes experienced during the period 1995-2007.  The five major hurricanes of 2008 have only been exceeded seven times since 1944. 

There were 84.75 named storm days during 2008, which was more than twice the number experienced in 2007 despite there being only one additional named storm.  This was the seventh highest seasonal total of named storm days since 1944.  The 29.50 hurricane days experienced in 2008 was also more than two times the number in 2007.  Amazingly, there were no Category 3, 4 or 5 hurricanes making landfall in 2008.  This was only the second year since 2002 with no Category 3 or greater storm with the other year devoid of major landfalling hurricanes being 2006.

After having an early start to the 2008 hurricane season, the fall was particularly active, too.  There were three named storms in October.  There have only been eight years since 1944 that have had more than three named storms in October.  Since 1944, there have been only four other years with a major hurricane.  Those other four years included 1956 (Greta), 1985 (Kate), 1999 (Lenny) and 2001 (Michelle).  Hurricane Paloma (Category 4) was the second strongest November tropical storm ever with a maximum sustained wind speed of 145 miles per hour trailing Hurricane Lenny that attained 155 mph winds.

Exhibit 2.  The Track of U.S. Landfalling Named Storms

Source: Colorado State University

This year was the first year on record with five consecutive months (July through November) that had a tropical storm that achieved major hurricane intensity.  This record reflects just how unique was the 2008 tropical storm season.  There were three hurricanes that landed on the U.S. Gulf Coast, which was the most since 2005 when four hurricanes landed.  Prior to 2005, the previous year with three or more hurricanes making U.S. landfall on the Gulf Coast was in 1985 with four storms.  Interestingly, there were no hurricanes making landfall along the Florida peninsula and the East Coast of the United States .  This marked the third year in a row without a hurricane hitting this region.  There were six named storms in row, Dolly through Ike, making landfall on the U.S. coast, matching the record achieved in five prior years – 1971, 1979, 1985, 2002 and 2004.

Hurricane Bertha, a July tropical storm that reached Category 3 hurricane status, remained a tropical storm or greater for 17 days (July 3-20), which was the longest-lived July tropical storm on record in the Atlantic Basin.  Tropical storm Fay in August made landfall on the Florida peninsula four times that also set a record. 

Exhibit 3.  2008 Forecast Record of Colorado State University

Source: Colorado State University

One of the better forecasts made for the 2008 season was that of Phil J. Klotzbach and William M. Gray, professors in the Department of Atmospheric Science at Colorado State University.  The record of all their 2008 tropical storm forecasts is presented in Exhibit X.  As can be seen their forecasts from December 2007 through August 2008 proved fairly accurate.  In most cases the forecasts made in April, which were only increased in the August forecast update after part of the season had already been experienced, were pretty close to the actual results for the year.  For example, the CSU forecast was upped to 15 named storms, eight hurricanes and four intense hurricanes, which compared with actual results of 16, eight and five.  The CSU forecast for named storm days (80) and intense hurricane days (9) were very close to actual results of 84.75 named storm days and 8.50 intense hurricane days.  The forecast for the number of hurricane days of 40 was quite wide of the actual total of 29.50 days.  But when all the forecasting variables are assessed, one has to tip their hat to the forecasting team at CSU for the accuracy of their efforts.  We will be very interested in their December 10th forecast for 2009’s hurricane season.

Managing For The Future – But Just For How Long?

An item in a recent Barron’s newspaper caught our eye.  It detailed how one shareholder at PHH (PHH-NYSE), a 2005 spinoff from Cendant and a stock we once researched back in the 1970s, is upset with how management is running the company.  PHH originates, purchases and sells home mortgages and runs vehicle fleets for corporations.  The company’s share price has fallen this year from slightly above $30 last year to about $7.50 as the credit crisis dried up mortgage originations and the deal for the company to be purchased by General Electric (GE-NYSE) and Blackstone (BX-NYSE) for $31.50 earlier this year fell apart. 

Pennant Capital Management, which owns 9.7% of PHH shares, filed a 13D two weeks ago stating the following:  Pennant “has become increasingly concerned that the company has been seriously mismanaged and poorly positioned by its board of directors and senior executive management.”  It claims that they have “managed the company for long-term growth and client relationships rather than for profitability, near-term results and capital efficiency.” 

Pennant claims that in the current market environment PHH does not have the luxury of long-term focus, which has put it “in peril.”  Pennant is concerned because the stock is trading at 20% of stated book value and PHH may have trouble refinancing a $1.3 billion credit facility maturing in January 2011. 

So what does Pennant propose for PHH?  It wants the company to add a former executive from Freddie Mac (FRE-NYSE) to its board and create a special committee of non-management directors to oversee the CFO’s strategic review of the business.  Pennant states that if PHH ignores its request, it “will actively consider all available steps to ensure that the board refocuses senior management on the immediate and pressing task of turning the company around and creating shareholder value.”  While shareholders may be pleased that someone is trying to create shareholder value, for executives and boards of directors this effort by Pennant raises questions about what is the appropriate timeframe for measuring corporate performance. 

In a market where stock prices have been crushed, regardless of whether the company is financially solid with attractive growth prospects or not, activist shareholders may be able to rally support for very short-term actions to boost the share price at the expense of the long-term health of the company.  The challenge managements and boards of directors may be facing is whether they can afford to ignore any steps that might boost near-term earnings.  Will that include the use of dubious accounting policies or questionable business practices?  How might the use of increased financial leverage factor in to corporate business strategies?  Maybe, just maybe, with stock prices down, more companies will be inclined to examine “going private” as the best way to solve this dilemma.  Despite the lack of readily available credit, private equity and sovereign wealth funds may become much more active in restructuring certain industries – and energy is certainly one with attractive possibilities.

Is The Rig Count About To Enter Freefall Territory?

Barely a month ago, Wall Street analysts became concerned about a drop in the U.S. rig count due to weakening commodity prices, and in particular natural gas prices, and the impact of the credit crisis on producer access to capital.  The talk initially was about whether the rig count would fall by 100-200 rigs or experience a more severe correction of 300-400 rigs.  As soon as investors began to focus on the impact of the larger drop, market conditions worsened with crude oil falling to the $50 a barrel level in response to weakening global oil demand.  Falling oil prices and a further tightening of credit markets caused analysts to begin to think that the rig count drop might be even greater than they had been thinking.

Recently, the view began to target the potential for a 600-rig drop during the seasonally weak early months of 2009.  Last week the prospect of a 700-800 rig drop emerged as a possibility and as that view began to gain some traction, the oilfield service stocks began to dive.  The Philadelphia Oil Service Index (OSX) fell Thursday by 11.06 points to 104.14, a decline of 9.6%.  Intraday the OSX dropped 13.47 points to 101.73, a fall of 11.7%.  It dropped further early in Friday’s trading (to the 98 level) as crude oil plunged into the $41 a barrel range. 

The Baker Hughes domestic rig count peaked in September and then slumped some, although some of that fall off may have been related to the impact of hurricanes Gustav and Ike on oilfield activity.  The rig count then rallied back to within 2% of the peak count before starting its current slide.  In the prior two weeks (excluding the week ending December 5), the rig count has started to fall like a rock, declining by 51 and then 45 rigs.  These drops were 2.6% and 2.4%, respectively, of the active rig count the prior week. 

When we have written about the stock market performance of oilfield service stocks, we have focused on the similarity of their track record since the start of 2000 to that of the 1973-1983 period.  We thought we would look to see how the Baker Hughes rig count fared in the same comparison.  The result is presented in Exhibit 4.  It shows a very similar pattern – the peak in the rig count has come almost exactly to the week of that historical period peak.  The rig count did not rise as much as it did in the 1970s.  We also indexed the rig counts to see how they compared.  That chart is in Exhibit 5 and shows a similar pattern. 

Exhibit 4.  Current Cycle Rig Pattern Steadier, Less Dramatic

Source:  Baker Hughes, PPHB

Exhibit 5.  Current Cycle Rig Count Index Avoided Boom

Source:  Baker Hughes, PPHB

What we thought would be interesting was to see how this rig count correction would look if we applied the pattern of the 1982-1983 decline period.  That forecast is displayed in red for each of the two exhibits – the raw rig count and the indexed rig count (Exhibits 6 and 7).  Based on the forecast, the rig count, which peaked in September at slightly over 2,000 working rigs would fall to a low of about 1,000 rigs, or approximately a 50% correction.  That pattern suggests that the estimates of the magnitude of the rig count drop might prove to be conservative.  On the other hand, the 1982-1983 rig count drop initially fell by over 2,000 rigs but then rallied by about 300 rigs.  It subsequently fell by about 700-800 rigs before hitting bottom in 1983 and starting to head back up.  The rig count eventually sank a lot lower in 1986 when Saudi Arabia waged its war against fellow OPEC members who were cheating on their production and crude oil prices fell to the $10 a barrel level, but that’s another story.

Exhibit 6.  2000s Rig Fall Doesn’t Appear As Severe

Source:  Baker Hughes, PPHB

Exhibit 7.  Rig Count Correction Could Exceed That of 1970s

Source: Baker Hughes, PPHB

Based on our methodology, the rig count should decline by slightly over 1,000 rigs from the peak to the trough.  Since the rig count has already fallen by 165 rigs, the 800-rig drop estimate recently made by Nabors Industries (NBR-NYSE) could prove pretty accurate, albeit not pretty.  On the other hand there is a mitigating factor that could help prevent the rig count from falling as far – steeper natural gas production decline rates.  Unfortunately, natural gas production continues to grow at a significantly stronger rate and forecasts call for more LNG coming to the U.S. as international gas producers will shift cargoes to here to support the gas pricing strength in Europe and Asia.  More LNG along with growing domestic production does not auger well for natural gas prices in the future, which is important to support a higher drilling rig count. 

While we are not sure where the rig count may bottom out, we still are taken aback by the idea that the timing of the two rig-cycle peaks appears so close, especially when one remembers that we are talking about a 25-year gap between them.  We will watch the rig count in ensuing weeks to see whether our forecast proves accurate, but it appears for the near term the direction of the rig count is straight down.

Nantucket Wind Power Farm Final Federal Approval Near

A front page story in The Boston Globe indicates that knowledgeable observers believe a drive by the Bush administration to complete the award of a lease for the Cape Wind turbine power farm located offshore in Nantucket Sound means the project’s approval is very close.  According to a spokesman from the Minerals Management Service, a part of the Interior Department, his agency is planning to release its findings on the final environmental review of the nation’s first offshore wind farm project soon and they are expected to be favorable.  Following that step, Interior Secretary Dirk Kempthorne would then have to wait 30 days to make the decision official and award the license allowing the project to be located in federal waters.  Both supporters and detractors of the project believe the Bush administration wants this lease awarded prior to inauguration day, January 20, 2009.

Exhibit 8.  Cape Wind First Offshore U.S.

Source:  The Boston Globe

While the lease award is a major step forward, there remain other approvals needed before the project can begin construction, although most of these are presumed to be minor hurdles and all indications are that they will all be approved.  The two largest potential hurdles that could further extend the 7-year approval process include a possible legal challenge to the process for granting the lease and the current credit crisis, which might make raising the necessary funds to build the project difficult to secure.  Massachusetts has a requirement that a certain percentage of the state’s electricity come from renewable energy that ensures that wind power will have a market and may help Cape Wind secure the support of financiers who might also be attracted to having their name associated with the nation’s first offshore wind project.

The legal battle over Cape Wind’s project has largely been fought, but the group of homeowners from Cape Cod and Nantucket and Martha’s Vineyard islands that has included Massachusetts Senator Edward Kennedy and former Massachusetts governor and Republican presidential candidate Mitt Romney remain convinced that the value of their homes and the region’s tourist-based economy will be harmed by the view on the horizon of the wind turbines.  That possible view is shown in the computer-aided depiction presented in Exhibit 9. 

Even with the granting of the federal lease, the Cape Wind approval process will not be finished.  It still needs final Massachusetts backing that would come in early 2009.  The state’s Office of Coastal Zone Management must approve the project and there are several remaining local permits required.  Cape Wind is moving to gain a “composite” permit that will enable them to wrap all of these

Exhibit 9.  Computer-aided Depiction of Cape Wind Turbines

Source:  The Boston Globe

remaining permitting issues into one, allowing for a quicker approval process.

The federal process also requires that the agency finalizes federal regulations governing offshore wind projects, which is scheduled to be completed before the end of December.  The MMS’s draft environmental review report indicated the agency’s plan to approve the Cape Wind project even though certain approvals have not been finalized.  There were three final approvals required, one of which was issued within the past several weeks.  The U.S. Fish and Wildlife Service recently forwarded a report to the MMS that the Cape Wind project would not jeopardize the survival of two bird species protected under the Endangered Species Act, the piping plover and the roseate tern.  The Coast Guard must still issue a final ruling on navigation issues while the Federal Aviation Administration (FAA) needs to deal with any possible air safety issues.  The Interior Department may issue the lease with the analyses of the Coast Guard and FAA included even though these conclusions were not a part of the final environmental impact statement report.

Cape Wind has indicated that it hopes to have the $1 billion wind farm project in operation by 2011.  The turbines are capable of producing about 170 megawatts of power a year, equivalent to almost three-quarters of the average electricity demand for Cape Cod and Nantucket and Martha’s Vineyard islands. 

2008 Hurricanes: Further Global Warming Support?

In 2005, four major hurricanes (Dennis, Katrina, Rita and Wilma) battered the United States coast line.  Those storms followed four

Southeastern landfalling storms in 2004 ( Charley, Frances , Ivan and Jeanne).  As a result, the media and various scientists began making claims that global warming was the cause of this perceived increase in the number and intensity of hurricanes hitting the United States .  This season’s three Category 2 hurricanes landing on the Gulf Coast further stimulated the arguments. 

The argument is that the recent increase in the number of tropical storms (hurricanes) and their greater intensity has been directly related to the three-decade rise in carbon emissions that have contributed to higher sea surface temperatures.  These arguments were addressed in a section of the 2008 tropical storm forecast review report prepared by Phil J. Koltzbach and William M. Gray of the Department of Atmospheric Sciences at Colorado State University (CSU).  We suspect this section was authored by Dr. Gray as he has devoted most of his time in recent years to the study of climate change and tropical storms and trying to improve the accuracy of forecasting tropical storm landfall locations. 

In the CSU report, the authors demonstrate that the rise in the number of hurricanes and their intensity has not shown increases in recent years to justify those claims about global warming and higher sea surface temperatures except in the Atlantic Basin.  The challenge for most of these global warming linkage arguments is that one cannot hold the relationship of the number of Atlantic Basin storms and their intensity as supporting the global warming case because the increase has been limited to that one portion of the globe. 

The meteorologists at CSU point out that there has been an increase in the number of Atlantic Basin major hurricanes during the 14-year period of 1995-2008 (average of 3.9 storms a year) compared to the 1.5 average storms per year of the 25-year period of 1970-1994.  They ascribed this difference primarily to the rise in the multi-decadal Atlantic Ocean thermohaline circulation (THC) pattern that is not directly related to global sea surface temperatures or CO2 gas increases.  Rather the temperature increase is believed to be driven by changes in ocean salinity.  This dynamic also has been called the Atlantic Multidecadal Oscillation (AMO). 

In a global warming or global cooling world, the atmosphere’s upper air temperature should warm or cool in unison with sea surface temperatures.  The data, however, doesn’t support that assumption.  In the 25-year period of weak cooling in the Atlantic Basin from 1945-1969, there were 80 major hurricanes (Category 3, 4 and 5) with 201 major hurricane days.  During the subsequent 25-year period of 1970-1994 when global warming was underway, there were only 38 major hurricanes (48% fewer than the prior period) and 63 major hurricane days (31% fewer). 

If the 50-year record of 1959-2008 when global warming has been evident is compared with the 50-year period of 1900-1949 for named storms, hurricanes and intense hurricanes (Category 3, 4 and 5), the

Exhibit 10.  Cool Period Has More Storms Than Warm Period

Source:  Colorado State University

recent period experienced declines rather than increases.  As shown in Exhibit 11, there were 22 fewer named storms, 16 fewer hurricanes and six fewer intense hurricanes between the two periods at the same time the average global temperature has increased by 0.4o Centigrade.  That data would appear to destroy the global warming and tropical storm increase argument.

Exhibit 11.  Warming Sea Temperatures Not Cause of Storms

Source:  Colorado State University

Another argument made by the global warming linkage supporters is that the numbers of intense hurricanes that have landed on the U.S. coast have increased in recent years due to the rise in sea surface temperatures.  That argument, however, doesn’t appear to have merit as shown by the number of intense hurricanes that have landed on the Florida peninsula and U.S. East Coast over the last 86 years.  The CSU team divided the period into two 43-year periods – 1923-1965 and 1966-2008 – that cover the global cooling and global warming eras.  As shown by the charts in Exhibit 12, there were 24 intense hurricanes in the early period versus only seven in the latter.  The average number of intense hurricanes in the early period was 0.56 per year compared to only 0.16 storms per year in the latter period.

Exhibit 12.  East Coast and Florida Hurricanes Have Declined

Source: Colorado State University

The global warming supporters are also keen to lean on the rise of CO2 as being the principle cause of the increase in the number of hurricanes and intense hurricanes landing on the U.S. coast in recent years.  The problem with that analysis is that when one looks at the number of total major hurricanes that landed on the U.S. coast in those two 43-year periods compared with the level of CO2 during each period, there is an inverse relationship.  With CO2 concentrations of 310 parts per million (ppm) in the 1923-1965 period, the number of major hurricanes landing on the U.S. coast was 0.91 per year.  In contrast, in the following 43-year period (1966-2008) when the CO2 concentration rose to 365 ppm, the average number of intense hurricanes landing on the U.S. coast fell to 0.51 per year, or 44% fewer per year. 

Exhibit 13.  CO2 And Major Hurricanes Appear Inversely Related

Source: Colorado State University

What may have been a problem is that the global warming supporters are looking at such a small slice of time that they are distracted by the historical record.  The 2004-2005 storm activity was well within the natural bounds of hurricane variation.  What made these two years unusually destructive was not the high frequency of major hurricanes but rather the high percentage of major hurricanes that were steered over the U.S. coast by the upper air steering currents.  To examine this conclusion, the CSU analysts looked at other years when the number of storms was similar.

In 2005 there were a record 28 named storms with 15 hurricanes and seven major hurricanes.  The historical record of tropical storms shows several years with comparable numbers of storms.  In 1933 there were 21 named storms when there was no satellite or aircraft surveillance data.  The records show that all 21 of these named storms had storm tracks west of 60o West longitude where surface observations were more plentiful.  If the 2005 storm data is recast to eliminate those storms with tracks entirely east of 60o West, then there were only 21 named storms, a decrease of seven storms and in line with the number of storms in the earlier period. 

Reviewing the National Hurricane Center database that tracks storms back to 1875, there were six seasons with more hurricane days than experienced in 2005.  Those years were 1878, 1893, 1926, 1933, 1950 and 1995.  In all the prior years, five had more major hurricane days – 1893, 1926, 1950, 1961 and 2004 – than 2005.  The result of this review of history is that 2005 was not as much of an outlier as often as it is made out to be. 

The world is in an active tropical storm period as suggested by the AMO.  In contrast, the years 1970-1994 and 1901-1925 were quiet periods as indicated by the record of the AMO.  There have been a number of cycles of Atlantic Basin hurricanes observed as far back as the mid 19th Century.  Changes in the AMO have also been inferred from studies of the Greenland paleo ice-core temperature measurements back thousands of years. 

While the arguments about the relationship between global warming, its causes and impact on the climate of the planet will rage for a number of years, the reliance of Atlantic Basin tropical storm data appears to provide increasingly less ammunition than previously thought following the devastating hurricanes – Katrina and Rita – in 2005.  What often is lost in all these arguments is that measurement data is much greater today than in the past, especially in the period prior to the commencement of aircraft reconnaissance that started in 1944.  Satellite measurements also have added to our knowledge of and greater recognition of tropical storms.  But what may be the greatest contributor to the magnitude of storm damage is the increase in the population living along the U.S. coast and the concurrent growth in development, which has inflated the losses experienced from more recent hurricanes compared to earlier ones. 

An observation about the amount of damage caused by the storms of 2008 is creating a question about the value of the current hurricane rating system.  Hurricane Ike was only a Category 2 hurricane when it made landfall on the Texas coast line, but it caused damage way beyond that caused by Hurricane Gustav, another Category 2 storm when it landed on the Louisiana coast.  Hurricane Dolly landed on the south Texas coast as only a Category 1 storm, but since it landed in a relatively less developed area of the coast the damage caused was minimal. 

The damage estimates made by the ISO’s Property Claim Service cover only insured damage, so the CSU, and other analysts, assume total storm damage will approximate twice the total of insured damage.  As shown by the estimates in Exhibit 14, Hurricane Ike caused more than four times the damage estimate for Hurricane Gustav while Hurricane Dolly was one-sixteenth of Ike’s damage estimate.  The principle reason for the damage difference between Gustav and Ike was the magnitude of the storm surge.

Exhibit 14.  Insured Damage Estimates for GC Hurricanes

Note: In billions of U.S. dollars as estimated by the ISO’s Property Claim Service

Source:  ISO Property Claim Service, Colorado State University

As a result of the damage from Ike, meteorologists are considering developing a new hurricane rating system that would give people a more accurate measure of the potential of a storm’s damage.  The present Saffir-Simpson hurricane rating system, developed in the late 1960s and early 1970s, has been used to characterize the strength of storms by measuring their wind speed.  What is becoming more evident is that a storm’s scale doesn’t predict the storm surge accurately, which is the more deadly and dangerous aspect of a hurricane.  A storm’s surge is related more to its areal size than its maximum wind speed.  With satellite measurements we are getting better at estimating the energy of storms.  Mark Powell, an atmospheric scientist at the National Oceanic and Atmospheric Administration (NOAA) has been working to develop a rating system for storms based on their integrated kinetic energy.  His system has a proposed scale of 1-5 that would be paired with the current rating system to give people a sense of the wind speed and the storm surge.  Whether the industry and the U.S. weather service will embrace this new system remains to be seen, but developing better ways to estimate the potential damage and life-threatening risk of a hurricane should be the overwhelming goal.

Private Equity and Leverage – Changing The Model?

In our last issue of the Musings, we wrote about a study Standard & Poor’s fixed income research group had prepared on global credit defaults.  The study was entitled: Default Autopsy Finds Traces of Private Equity DNA.  The conclusion of the study was that private equity sponsors seek above-average returns by taking on an exposure to higher-risk credits, i.e., companies that are in the lower end of the ratings spectrum where they have less room to maneuver to avoid financial problems.  In that write-up we were not providing our own analysis but rather discussing the results of the study and the comments of the lead author.  She speculated that S&P expected to see many more private equity-tied deals going sour as the economy worsened.

We received a number of comments about that article, almost all of them commenting that the greater defaults among private equity investments said more about its business model and less about the inherent risk of the underlying businesses.  We thought that the outpouring of sentiment was very interesting because much of it came from people who have been actively involved in private equity transactions.  One of the readers ticked off the action steps in the private equity “game” and how playing the game contributes, at least in his mind, to the higher default rate.

How do you play the private equity game?  First you target companies in industries with attractive growth prospects, or where consolidation could lead to the creation of dominant companies that would then have pricing power in a slower growth business.  When you go to buy one of these attractive companies with EBITDA growth prospects you use as little equity as possible, and obviously as much debt as possible, to improve the cash-on-cash return potential.  Then the private equity advisors/directors work to help management boost the company’s EBITDA.  Additional leverage is often used to fund the acquisition of smaller tuck-in acquisitions to help achieve the faster EBITDA growth.  The last ingredient in the game is to hopefully sell the company at a higher price/earnings multiple than the company was valued at when it was acquired.  Sounds simple, doesn’t it. 

Just last week, one of the oldest and largest private equity firms, Carlyle Group, with $40 billion of invested capital, announced it was cutting 10% of its staff – 100 out of 1,000 employees.  This is the first cutback for the 20-year old firm.  After aggressively hiring earlier this year, Carlyle is returning to its 2007 staffing level and even closing its Silicon Valley office that had been opened less than a year.  Barely two days later, British publicly-traded private equity firm, 3i, announced it was cutting 185 employees, or 17% of its staff, and closing seven regional offices – four in the UK and three on continental Europe – leaving it with 36 offices worldwide.  The staff and office reductions will cost the firm £18 million (US $27 million) and marks the first cuts 3i has made since 1990.  The cuts are in response to a 23% drop in the value of assets under management as 3i has pulled the plug on 40 companies in its portfolio of 2,735 companies valued at roughly £5 billion (US $7.5 billion).  The value of the portfolio has fallen by £761 million (US $1.2 billion) since last March. 

American Capital and its European affiliate, European Capital, have announced the closing of two offices and are cutting its staff by 19%.  Recently, two senior executives are leaving buyout firm Terra Firma after it was required to inject more cash into music company EMI. 

The private equity business has enjoyed a recent boom with the cost of debt historically low and a rapidly expanding global economy.  A financial research organization has estimated that during 2006 and 2007, the global private equity industry bought companies valued at roughly $1.4 trillion in debt and equity.  Adjusted for inflation, this total is about equal to one-third of all the LBOs ever completed.  Those statistics help explain why the private equity industry has been growing its staff and enjoying the fruits of the financial boom in high salaries and bonuses.  But now, one has to start questioning whether the private equity industry is on the cusp of change.  The venture capital industry has yet to fully recover from the dot.com bust in 2000 and, without the emergence of the clean energy investment boom encouraged by government mandate and tax credits, would still be struggling to find attractive investments for the sums entrusted to it.  Is private equity about to find the same challenge as venture capital, just as one of its members completes raising a buyout fund such as the Carlyle Group recently did with its new $14 billion fund? 

The telling issue about the future of the private equity industry is likely to be whether the high profile university endowment funds such as Yale and Harvard that have traditionally invested in hedge funds, private equity and venture capital cut back their allocations to these investment vehicles.  These universities are reporting huge hits to their endowments as a result of the credit market turmoil and its impact on all investment markets.  So far they haven’t reduced their non-traditional investment allocations, but Calpers, the California state pension plan, has told private equity firms not to issue additional capital calls, even though they are entitled to do so, because it is short of funds to meet its payment obligations to pensioners.  Job cuts, shunning capital calls and likely reduced allocations are signs of a possible inflection point for the private equity industry.

Clean Energy Outlook Brightens As Ethanol Fades

The Rice Alliance program held a lunch a few weeks ago for two partners from the venture capital firm Kleiner Perkins Caufield & Byers who head up the firm’s clean energy investment funds.  Kleiner Perkins is the home of Nobel Prize winner and former U.S. vice president Al Gore, the hero of the global warming movement. 

There are 17 partners at the firm dedicated to the clean energy technology investment fund.  So far, they have invested in 40 clean energy technology companies, but have only highlighted 16-17 publicly since the firm doesn’t want to give away its investment strategy or areas of focus. 

The speakers began by emphasizing the challenge of energy consumption and its relationship to carbon emissions, but more importantly the imbalances of power distribution in the world.  According to them the world’s power consumption is equal to about 13 trillion kilowatt hours.  They pointed out that the typical hairdryer consumes about 1,000 watts, so if you could imagine every man, woman and child on the planet holding a hairdryer in each hand, you get a picture of the world’s total power consumption.  They went on to point out, however, that because of power distribution, in the U.S. everyone has about five hairdryers while in the rest of the world 5-10 people share one hairdryer. 

The global challenge is that electric power consumption is growing at a rate in excess of the rate of growth of the global economy and almost 1.5-2.0 times that of demand growth for primary energy sources.  We know that in underdeveloped economies, the greatest way to impact the pace of economic development is to get electricity to the residents.  With electricity comes the ability to have lights that extend the work day and the social day.  Electricity enables the introduction of more environmentally friendly cooking methods and the use of refrigeration.  That latter development means that families do not have to devote as much time each day to obtaining food and preparing meals, freeing up significant amounts of time for other productive work. 

When looked at in its totality, the role of electricity in addressing the ills stemming from wide income distribution patterns globally becomes paramount.  The key is how to develop electric power supplies that are less polluting than the current sources used or their most lost likely replacement.  The Kleiner Perkins people see their clean energy investments as a way to develop these new technologies on a grand scale that enables them to “move the needle” on a planetary basis.  The speakers cited lighting technology as a good example of that ability.  The typical incandescent light bulb produces about 12 lumens per kilowatt while the peak LED light would produce 300 lumens per kilowatt.  Today’s existing LED technology is only at the 150 lumens per kilowatt level leaving significant upside from technological improvements while limiting, or even reducing, the amount of carbon emissions from fuel needed to generate the electricity. 

The greatest challenge these new clean energy technologies face is that they are trying to displace existing technologies that are well down the learning curve and have fully depreciated assets.  Since all the new clean technologies are not at that point, the Kleiner Perkins people believe there needs to be a governmental policy response to encourage the development of the new technologies. 

While suggesting that the government needed to be taking action in this area, the speakers were against it being in the business of picking and choosing which clean energy technologies should be favored.  Instead, they want to see the government establish a policy to “price” carbon in the energy world and then allow free markets to select the technology winner or winners and by default, the losers.  The speakers specifically cited the creation of the ethanol industry as bad government policy.  In light of the recent bankruptcies in the ethanol refining industry and their knock-on impact on the agriculture sector, the government’s bad policy move will cost this country even more than previously thought as a result of the ethanol mandate. 

For those who have not been paying close attention to the problems in the ethanol business, its projected growth stimulated farmers to plant more corn.  As the demand for corn exploded earlier this year due to increased needs from both the ethanol and food businesses, corn prices soared to record levels.  Ethanol refiners entered into long-term supply contracts with producers at these lofty prices just before gasoline demand collapsed and all commodity prices fell.  Along with commodity prices, ethanol prices dropped, also.  As ethanol refiners declared bankruptcy, these lucrative corn supply contracts were broken, or corn producers were not paid and have become creditors of the bankrupt refiners.  Now farmers are facing the twin dilemmas of not having enough money to see them through to next spring’s planting season and not knowing the level of corn demand next year as they plan for their capital needs and income requirements.  The farmers have become victim to another unintended consequence of the credit crisis.

We were impressed with the policy prescription presented by the Kleiner Perkins partners at the Rice Alliance event.  While there are many issues still to be considered and debated about how to and at what level to price carbon, the idea of trying to provide a level playing field for energy suppliers would seem to offer the best solution for addressing the greenhouse gas emissions challenge.  Of course, there will always be the fundamental question of whether we are risking huge economic dislocations and societal costs in the name of solving a perceived rather than real problem.  It would seem, however, that a carbon pricing system should allow for a rapid adjustment to that price to mitigate making foolish economic policy decisions that could cripple the economy, especially given its fragile state.  I, and I imagine many others, would rather see the free market deal with sorting out the clean energy technology winners and losers rather than risking another “farm bill” in the guise of a “national energy policy” such as we experienced with ethanol.

The Obama administration will assume power at a critical point in time in the debate over our nation’s energy and climate change policies.  An ideologically-driven policy for addressing climate change at the expense of the appropriate utilization of this country’s great natural resource base could not only harm the economy forever, but also drive our energy and energy service industries out of the country.  While most people and the media will focus on the policies initiated by the Obama administration to address our economy and national security, what happens in the energy versus climate change struggle may have more long-term significance to our readers.

Are Somali Pirates OPEC’s New Best Friend?

As crude oil prices last Friday fell into the $41 a barrel price range, the lowest they have been in four years, OPEC members are struggling with developing a unified front to stop the price slide.  Their recent decision to reduce their production quota by 1.5 million barrels a day has not been totally implemented so its impact on the global supply of oil has not been fully felt.  Of course with global oil demand falling as rapidly as more countries slip into recession and economic activity wanes, OPEC may be in the position of trying to push on a string.  Given these market conditions, OPEC members decided to talk more about the market and the “fair” price for crude oil at their recent gathering, while postponing a serious decision about further production cuts until the December 17th ministerial meeting.

Exhibit 15.  Sirius Star A Bit Player In Drama?

Source: NRI

While the crude oil market has been falling, the pricing structure has shifted into contango, when the price of oil delivered well into the future is substantial higher than the normal future oil price should be.  The differential is designed to encourage oil buyers to purchase current supplies and store them for use later when the oil is more highly valued.  The shift of a market into contagion puts downward pressure on current oil prices because buyers want to pay a much lower price since they must pay storage costs while still facing somewhat of an uncertain future oil price, even though they can enter into forward sale contracts.  As a result, crude oil buyers are chartering VLCC (very large crude carriers) ships to store their crude purchases.  We have recently read that BP (BP-NYSE) and Royal Dutch Shell (RDS-B-NYSE), among others, have recently chartered tankers for crude oil storage. 

Some in the media have used this business strategy to revisit the myths of past oil price spikes that claimed crude oil owners had parked tankers outside of New York Harbor or in the Gulf of Mexico

Exhibit 16.  Routes Are Longer Without Suez Canal Option

Source: EagleSpeak

awaiting higher prices before arriving to unload their cargoes.  We thought, however, that Saudi Arabia had developed the most unique strategy to confront falling oil prices when its VLCC, Sirius Star, with 2-million barrels of crude oil, about a quarter of one day’s production of the kingdom, was captured by pirates offshore Kenya and held for ransom.  The ship was captured November 17th and moved to a location offshore Somalia while the pirates demanded a $25 million ransom.  The ransom was recently reduced to $12 million, but the ship has yet to be released.  Since the ship was owned by Vela International, the shipping arm of state-owned oil company Aramco, its daily operational cost is nominal – only the crew’s wages and normal daily expenses – as opposed to the daily charter fee that would be paid to an independent shipowner. 

Exhibit 17.  Pirates Ranging Far and Wide

Source: EagleSpeak

The question then becomes whether the ransom cost is viewed as the price for storage to take advantage of the contango market.  If so, can Saudi arrange more tanker seizures, or has the publicity of these pirate attacks eliminated this business strategy?  We still think, given that the Sirius Star was not headed into the Gulf of Aden, a known hot-bed of pirate activity, but rather was captured some 450-miles off the coast of Kenya on its planned route that would take it around the Cape of Good Hope, there is more to this capture than a plain old pirate attack.  Since OPEC can do little to boost global oil demand, getting supply off the market is its best hope for stopping the oil price slide.  In this effort, are Somali pirates OPEC’s new best friend? 

Exhibit 18.  Somali Pirates: OPEC’s Friend?

Source: Clip Art

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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.