Musings From the Oil Patch, February 28, 2012

• Did The Oil Sands Win Over Europeans With Report?
• Wind Energy An Obama Favorite But Is It A Real Winner?
• Hurricane Damage To Wind Turbines Draws Skepticism
• Blackmailing Utilities To Support Green Energy
• Keystone Liked By Many But Needs Better Industry Friends
• GM Profits Sign Of Bailout Success and Industry Health

Musings From the Oil Patch
February 28, 2012

Allen Brooks
Managing Director

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

Last week the battle over the “dirty” oil from the oil sands reached a crescendo with the release of a study claiming that on a global scale, oil sands carbon emissions are not as bad as those that would be released by burning all the world’s coal resources.  Moreover, the study’s conclusion shows oil sands emissions are actually less than those from other heavy crude oils being burned.  This report came merely days before a decision requiring greater environmental offsets for use of the fuel was to be rendered by the European Union (EU) Fuel Quality Directive Committee composed of experts from each of the 27 member countries of the EU.  This committee was considering a proposal to revise the EU Fuel Quality Directive that has a mandatory target for fuel producers and suppliers to reduce greenhouse gas emissions (CO2) by 6% from 2010 levels by 2020. 

While the proposal would not have banned the importation and use of oil sands bitumen, it would have assigned it a carbon footprint that is 23% greater than that of conventional crude oil.  This would force users of oil sands bitumen to make significant improvements in their operations to offset the additional carbon emissions or buy green credits from others under the mandatory greenhouse gas reduction target.  For all practical purposes, the ruling would have been the equivalent of a ban.  For Canada, this would be a problem as other governments around the world might use the EU determination as grounds to ban or restrict the use of this bitumen.  That would shrink the markets available for this rapidly expanding output, with potentially significant implications for Canada’s and Alberta’s economy and employment.

The Committee failed to approve the policy as the vote was 89 for, 128 against with 128 abstentions.  The Committee was using a qualified majority voting system that awards more votes to larger country members.  Belgium, Germany, France, Cyprus, the Netherlands, Portugal and the U.K. all abstained.  Had the proposal received 255 votes the ruling would have gone immediately into law.  The proposal will now be considered in June by the Council of Europe, which is composed of the ministers from the 27 member countries in the EU. 

The new study conducted by researchers Andrew Weaver and Neil Swart and published in Nature magazine, calculates the climate impact of producing the oil sands bitumen against other fuels.  Dr. Weaver is the Canada Research Chair in Climate Modeling and Analysis at the University of Victoria and a recognized Canadian climate expert who was a lead author with the UN Intergovernmental Panel on Climate Change (IPCC).  Dr. Weaver and his doctoral student decided to go looking for the figures to respond to a claim made during Congressional hearings on the Keystone pipeline by NASA scientist and author James Hansen, a global warming proponent, who called the oil sands “the biggest carbon bomb on the planet.”  He also said that if the Keystone pipeline was approved it was “game over” for our population.  The study prompted immediate environmental and media attention as the conclusions by such a noted climate scientist challenged the “proven science” and the linkage to man-made global warming. 

To understand the thrust of the research study and its conclusions, we quote from Dr. Weaver’s blog.  “We asked the question as to how much global warming would occur if we completely burned a variety of fossil fuel resources. Here is what we calculated for the following resources:

“1.tar sands under active development: would add 0.01°C to world temperatures.
“2.economically viable tar sands reserve: would add 0.03°C to world temperatures.
“3.entire tar sands oil in place which includes the uneconomical and the economical resource: would add 0.36°C to world temperatures.
“4.total unconventional natural gas resource base: would add 2.86°C to world temperatures.
“5.total coal resource base: would add 14.8°C to world temperatures.

“In other words: Coal presents a climate challenge 1500x greater than that presented by the oil sands.”

The chart in Exhibit 1 from the study shows the relative contribution to increased global temperatures from burning all the resources for each specific fuel.  While it is impossible to see, there is a slight heavy black line at the top of the Unconventional oil bar that represents the impact from burning the proven oil sands reserves.  The Alberta oil sands bar represents the impact of burning all the oil

Exhibit 1.  Global Warming Contribution Of Fuels

Source:  Weaver & Swart, Nature

sands resources including the proven reserves.  One thing not considered in this study was the greenhouse gas emissions from the extraction and refining processes for each of these fuels.  Some environmentalists have tried to make a lot about that omission given their view that all the oil sands output is mined, which really represents a small portion of total production that will become smaller going forward.

There are several points about this study and the EU debate that need to be made.  While Dr. Weaver’s conclusions have been seized upon by the supporters of the oil sands development, he pointed out that it was not being given a “get-out-of-jail-free” card.  Dr. Weaver still believes we need to break our addiction to fossil fuels and he is opposed to the Gateway pipeline to move oil sands bitumen to Canada’s west coast for export.  He sees too many potential environmental problems including the risk of ship accidents, along with the need for the country to honor the wishes of the First Nation populations over whose land the pipeline would have to travel and who are opposed to it.  Dr. Weaver is also concerned that the development of the oil sands will leave North Americans complacent about the need to develop less polluting energy sources.

With respect to the EU debate, it is interesting that it is even ongoing since no oil sands bitumen is exported by Canada to Europe.  On the other hand, European countries import Venezuelan, Angolan and Middle Eastern heavy oils that create as much or more carbon emissions than oil sands bitumen.  Without classifying all these heavy oils as dirty and assigning them greater carbon footprints, the EU opens itself up to being taken to the World Trade Organization (WTO) by Canada.  According to the WTO, nations must adhere to the “national treatment” rule that means a country cannot discriminate against imports in favor of “like” domestic products.  Numerous cases at the WTO have determined that “likeness” is based on the intrinsic nature of the goods and not how they were made.  Likeness is determined by physical properties, usage and whether the goods compete in the same market.  The question will come down to whether a different standard can be applied to oil sands bitumen that is “like” conventional fuels in terms of physical and chemical properties, end-usage and competes in the same fuels market.

Exhibit 2.  Oil Sands CO2 Below Other Heavy Oils

Source:  IHS CERA, April 2011 Special Report Oil Sands,
Greenhouse Gases and European Oil Supply:  Getting
The Numbers Right

The oil sands battle is but one of many wars over fossil fuels underway.  Joe Romm of Climate Progress and a leading global warming proponent puts the argument against the oil sands in the following language: “There are big pools of carbon that the world must not burn.  Since the United States is responsible for more cumulative CO2 emissions than any other country and has to cut emissions by more than 80% in four decades to do our fair share to avert catastrophe, it’s quite safe to say that from America’s perspective, the huge pool of unconventional oil vastly dirtier than conventional oil up north is definitely on the no-burn list.”  He claims this is a reasonable summary of the case against the oil sands that has been made by Dr. Hansen.

Mr. Romm uses the chart in Exhibit 3, taken from a forthcoming paper by Dr. Hansen to substantiate his point about pools of carbon that shouldn’t be burned.  We suggest you look at the emissions from Unconventional Gas bar on the far right side of the chart, which is as tall as the coal emissions.  Unconventional gas is about to move to the center of the stage in the battle over fossil fuel development.  If you thought all the battles over hydraulic fracturing

Exhibit 3.  Attack On Unconventional Fuels

Source:  Climate Progress

were winding down, be prepared because the war is just beginning and it will be led by one of the highest profile global warming proponents.

Every president works hard to achieve his agenda, but maybe none has worked as cynically as our current president.  Since coming to office, President Barack Obama has pushed a “green energy” agenda that is promoted by a large portion of the Washington establishment – from the Energy, Interior and Treasury Departments to the Environmental Protection Agency (EPA) and school lunches.  School lunches?  Why yes.  If you haven’t been paying attention, the war on obesity – a continually evolving definition – has been linked to the sins of fossil fuels that enabled people to move to the suburbs to escape the cramped and dirty conditions of the cities.  By doing so, however, those urban refugees became gasoline addicts.  Moving to the suburbs with their green lawns and trees forced people to commit to the automobile.  That shiny new car is cited as the primary contributor to obesity among our youth due to depriving them of the opportunity to exercise by having to walk or ride bikes to school.  Furthermore, the automobile facilitated that great social invention – the drive-through.  It’s ok to drive through at the drug store or maybe even at a liquor store (we have).  The problem is that the biggest beneficiary of this invention has been the fast food industry – the purveyor of high caloric, salty and trans-fat loaded food, which lies as the root of all our health woes. 

While the obesity/fossil fuel link is a relatively new development, Mr. Obama’s love for green energy and distain for fossil fuels is long-standing.  In his recent State of the Union address, the President shocked his supporters by seemingly embracing fossil fuels as he announced he was calling for exploiting more than 75% of the nation’s offshore oil and gas resources.  He went on to extol the virtues of shale gas, and even claimed that the breakthrough technologies responsible for its success had been developed by government R & D.  The President’s green-energy supports fear his pivot on energy.  They noticed that Mr. Obama delivered his State of the Union speech without once mentioning climate change. 

While Mr. Obama’s environmental supporters were downbeat following the State of the Union speech, a few weeks later they were heartened when he presented his budget calling for large spending increases for the Energy and Interior Departments and the EPA in furtherance of the green agenda.  Included in the proposed spending increase spending was $310 million for the SunShot Initiative, designed to make solar electricity cost-competitive with traditional energy, without subsidies, by 2020 and $95 million for wind energy technologies.  Mr. Obama is again pushing the extension of the wind energy Production Tax Credit (PTC) and an extension of the Treasury Cash Grant Program (Section 1603 of the American Recovery and Reinvestment Act) that expired in 2011.  Under the PTC, wind power developers receive a tax credit of 2.2-cents per kilowatt-hour of electricity produced during the first ten years of operation.  A 50 megawatt wind farm operating at an average capacity utilization of 30% would generate 131,000,000 kilowatt-hours of electricity per year.  The wind farm’s owner would receive a PTC of $2,891,000 per year, or $28,910,000 over 10 years.  Section 1603, however, allowed wind turbine owners to take a cash grant equal to 30% of a project’s capital costs up front ($100-120 million project cost, 30% = $30-36 million) that came directly from the U.S. Treasury – whether or not the turbine ever produced any electricity.  This tax credit removes the performance risk for the developer and allows marginally economic projects to get built even if all the capital from private investment sources is not present.  There is no expectation of having to repay any of his tax credit money back.  Because the money is taken up front rather than annually, there is no incentive for developers to keep up the costly maintenance, so the turbines can eventually be abandoned. 

Exhibit 4.  The Barack Obama National Wind Farm?

Source:  Wikipedia Commons

The Interior Department recently came out with its environmental assessment giving its blessings for development of wind energy projects offshore New Jersey, Maryland, Delaware and Virginia.  This approval should make it easier for companies to secure offshore leases, although site specific environmental approvals would still be needed.  The bigger hurdles for offshore wind are costs and financing, along with technical challenges.  The Interior Department, at the direction of the Obama administration, developed the National Offshore Wind Strategy, which has a goal of installing 10,000 megawatts of wind generating capacity by 2020 and 54,000 megawatts by 2030.  Those scenarios include development in both federal and state offshore areas, including along the Atlantic, Pacific and Gulf coasts as well as in the Great Lakes and Hawaiian waters. 

The great attraction for the Atlantic coast is that its shelf area is large so that turbines can be placed far enough offshore so as to not be an eyesore for residents, but close enough to not present significant technological challenges for the industry to install and maintain them.  For the offshore market that can be a significant issue, which suggests that the first offshore wind farms will likely be along the East Coast.  It may have been the administration’s announcement of its environmental assessment that prompted the release by North Carolina Governor Bev Perdue of the final report of the Governor’s Scientific Advisory Panel on Offshore Energy.  The panel’s work spanned two years and involved not only meetings and working sessions for the members and its staff but also three public meetings seeking input from the state’s citizens.  The panel concluded, “This panel’s work is an essential step in assessing the impact of offshore-energy development in North Carolina.  But taking the next steps to develop offshore energy will require a united effort to assess the impacts on North Carolina’s economy, communities and natural resources, to promote economic development of offshore energy that boosts North Carolina’s economy and to establish North Carolina as a leader in offshore-energy development.” 

Exhibit 5.  N.C. Has Large Close-in Wind Potential

Source:  Governor’s Scientific Advisory Panel on Offshore Energy

The panel found that North Carolina has the largest offshore wind resource on the east coast.  “The offshore-wind industry may offer significant opportunities for renewable energy generation and for economic development and job creation.”  This conclusion was based on the state’s extensive coastline and its offshore wind resources.  As shown in Exhibit 5, the potential sites for offshore wind development are fairly close to the coast and importantly to interconnections with the power grid. 

Shortly after reading about the North Carolina report and examining its conclusions, we learned about a new study published in the National Academy of Sciences magazine, which was prepared by researchers from Carnegie Mellon University suggesting that hurricanes could destroy a significant number of offshore wind turbines if they are located along the Atlantic and Gulf coasts.  The authors focused on the likelihood that a hurricane could topple turbines in waters where projects are under consideration or development.  This becomes an important research consideration because of the frequency of hurricanes that target areas where the government believes it is appropriate to place wind turbines.  It is also important because 20 offshore wind farms have been proposed for the U.S. coastline.

Exhibit 6.  History Of Global Hurricanes 1851-2007

Source:  AccuWeather.com

The chart of the tracks of hurricanes recorded from 1851 to 2007 shows three “hot” spots around the globe – the Atlantic and Gulf coasts of the U.S., the Pacific coast of Mexico, and Southeast Asia.  It is important to note that for about a third of the time period identifying hurricanes was not always possible, regardless if accurate records of the storm paths were kept.  It is possible there were many more storms than recorded in the past because they did not intersect with population centers or ships at sea.  Regardless of missed storms, there is little doubt that the planned location of U.S. offshore wind farms makes them targets of future hurricanes.  The flip side of the analysis is that where the number of offshore wind farms is growing – around England and off the coast of Northern Europe – there are no hurricanes.  There are sometimes violent storms, but they tend to be rarer than hurricanes and not as severe.

The Carnegie Mellon study examined the potential damage for a 50-turbine wind farm off the coasts of four states: North Carolina, New Jersey, Massachusetts and Texas.  The authors fed historical data about hurricane occurrence and intensity into a probabilistic model.  They simulated potential damage to the turbine towers over several 20-year periods and then took an average of their results.  The towers were based on those currently in use to support 5 megawatt offshore turbines. 

According to the researchers’ model, Category 3 or greater hurricanes (those with wind speeds of 50 miles per hour or more) could buckle up to 46% of the traditional turbine towers.  Hurricanes of that severity are not rare in the United States.  According to weather records, every state in the Gulf Coast and nine of the 14 states on the Atlantic Coast were struck by a Category 3 or greater hurricane between 1856 and 2008. 

The riskiest of the four locations investigated, with a possibility of a 60% chance that at least one tower would buckle in a 20-year period and a 30% probability that more than half the towers would be destroyed, was off Galveston County, Texas.  The second riskiest location was Dare Country, North Carolina where there is also a 60% probability of one tower being destroyed, but only a 9% chance that more than half of the turbine towers would be destroyed.  Wind farms off Atlantic County, New Jersey and Dukes County, Massachusetts were considered less risky.

What’s the solution to protect against this potential storm damage?  First would be to build in less risky areas.  The mid-Atlantic and New England regions are less exposed because they experience fewer and less intense hurricanes.  The second strategy would be to build smarter turbines.  That means turbines that can always point into the hurricane-force winds, which reduces the potential for them to buckle, rather than being hit broadside.  The problem is that keeping a turbine pointed into the wind during a hurricane is complicated.  Wind speeds vary and they change direction in a matter of a minute or two.  Turbines would need strong motors to be able to turn quickly enough to cope with the changing winds.  They also would need to be able to sense the wind direction.  Lastly, many of the turbines run on grid power, which is often lost during hurricanes, so they would need battery backup adding both capital and maintenance costs to the project.

The study produced a chart showing the risk of a Category 3-4-5 hurricane making landfall along the U.S. Atlantic and Gulf coasts.  As shown in Exhibit 7, the risk is greatest along most of the Gulf Coast, the tip of Florida and the Outer Banks of North Carolina.  Two of these three locations are where companies or politicians would like to see offshore wind farms located. 

Exhibit 7.  Probability Of A Hurricane Hitting Land

Source:  Carnegie Mellon University

We suspect that the study may not have taken into account the variability of hurricanes depending upon the climate phase that is dominating the Atlantic Basin weather.  In periods of cooling as experienced during 1945-1969, the number and frequency of major hurricanes was much greater than that experienced during the warming period of 1970-1994.  This detail could be very important because, as the authors of the study point out, their work only examines the probability of damage to a single wind farm in an area.  To the extent that a utility was drawing power from multiple offshore wind farms, what is the possibility of damage to all of them?  That answer would dictate how a utility utilizing offshore wind would need to plan for sufficient backup power to deal with wind turbine damage that couldn’t be repaired quickly.  This is just another consideration offshore wind energy supporters have failed to analyze or even discuss.

Exhibit 8.  Cooling Could Bring Many Storms

Source:  Klotzbach and Gray, CSU
Since the governor of North Carolina has trumpeted the offshore wind potential of her state, we thought it would be interesting to examine the number and path of major hurricanes that have landed on the state’s coastline.  If they build offshore wind farms we certainly hope the future weather resembles the pattern of the 1966-2010 years rather than the earlier 45-year span. 

Exhibit 9.  N.C. Is Risky If Storms Follow 1921-65

Source:  Klotzbach and Gray, CSU

If it weren’t for those pesky details of hurricanes, utilization and cost, offshore wind power would seem like a winner even with coastal residents hating the visual pollution.  But as we watch the President extol the virtues of his green energy agenda, we are starting to believe we are Dorothy with her three companions starting down the yellow brick road in the Land of Oz.  In this case, we are accompanied by President Obama (the virtualist), Sec. Chu (the theorist) and Administrator Jackson (the restrictionist).  What we are afraid of is that when we get to the Emerald City, Oz will be just as disappointing as in the movie.

The New York Times was one of the many media publications to carry stories on the Carnegie Mellon University study about the potential damage hurricanes could cause for offshore wind farms.  In reading through the comments attached to the article on the paper’s web site, we were struck by the skeptics who questioned who was paying for the research.  They were obviously convinced that energy companies were promoting the study to try to beat down support for President Obama’s green energy agenda.

For those who are interested, the following institutions are funding the RenewElec project at Carnegie Mellon University that sponsored the research for the report.  Funding came from The Doris Duke Foundation, The RK Mellon Foundation, The Heinz Endowment, The Electric Power Research Institute, and The National Energy Technology Laboratory.  In addition, the National Science Foundation funds the Climate and Energy Decision Making Center that supported several of the authors.  The study’s lead author, Steve Rose, is partially funded by an EPA grant.  We don’t see any oil companies in that list.

The largest, investor-owned electric utility in Massachusetts, NSTAR (NST-NYSE) has had its proposed merger with Northeast Utilities (NU-NYSE) held hostage for over a year by the administration of Governor Deval Patrick (Dem).  Approval of the merger was held up until the company agreed to some rate protection for its customers and, more importantly, agreed to invest in green energy projects.  The primary deal was NSTAR’s agreement to buy more than a quarter of the power output from the offshore wind project, Cape Wind, one of the highest profile clean-energy projects in the country. 

In 2008, Massachusetts passed legislation mandating that by 2020 its utility companies had to secure 15% of their power supply from green energy projects.  Today, Gov. Patrick wants 250 megawatts of solar power installed in the state by 2017, some three times the amount already in place.  He also wants 2,000 megawatts of wind power built.  Currently, the state has 44 megawatts.  As one can see, the governor needs to force utility companies to move forward on green energy projects if he doesn’t want his agenda to be a failure.

The separate, comprehensive merger-related agreements reached by both companies with both the Massachusetts Department of Energy Resources (DOER) and the Massachusetts Attorney General (AG) will guarantee substantial customer and environmental benefits, while allowing the utilities’ merger to proceed.  For NSTAR there will be a $21 million rate credit adjustment after which retail customer rates will be frozen for the next four years.  Additionally, NSTAR will enter into a 15-year contract to buy 129 megawatts of offshore power from Cape Wind.  This contract will complement NSTAR’s existing contracts for 109 megawatts of onshore wind and will help Massachusetts meet its clean energy goals. 

NSTAR will also issue a request for purchase (RFP) to enter into long-term contracts for 10 megawatts of solar power.  The company has also committed to reducing electric use 2.5% annually beginning in 2013 through the remaining term of the agreement.  And, NSTAR will put in place an electric vehicle pilot program in Massachusetts, building on work already done by Northeast Utilities.  According to the company’s press release outlining the merger agreement, “the pilot will be designed to help NSTAR understand the infrastructure requirements needed for a substantial increase in the use of carbon-free electric vehicles.”  The trade-off for these agreements with Massachusetts officials is that they must be approved by the Massachusetts Department of Public Utilities by April 4, 2012, enabling the merger to go forward. 

Having followed this merger effort and NSTAR’s battle with Massachusetts over its green energy demands, we found the statement by the company’s chairman a fascinating act of diplomacy.  Or maybe it was a Stockholm Syndrome bond between a hostage and his captors.  Tom May, NSTAR Chairman, President and CEO said, “Today’s announcement is the result of a year-long effort by the state agencies and the companies to reach agreements that appropriately balance all of the interests affected by the merger.  Benefits for Massachusetts customers are both immediate, in the form of a rate credit plus a four-year distribution rate freeze, and longer-term, with NSTAR’s purchase of clean power from Cape Wind, which together with our existing wind contracts will help meet the state’s clean energy targets.  We recognize that the climate change goals set forth by Governor Patrick’s Green Communities Act will require aggressive action and we think the best way to meet those requirements is through a diversified portfolio of renewable resources."  This statement is from the same executive who has fought the arm-twisting efforts of Gov. Patrick’s administration to force expensive offshore wind onto Massachusetts electricity customers at a time when there were multiple cheaper onshore and Canadian wind power sources available.  NSTAR fought Massachusetts over offshore wind while contracting to purchase sufficient clean energy supplies to meet its requirements under the state’s law.  Mr. May was working hard to meet regulatory requirements while protecting his customers from expensive power supplies; exactly what a good utility company executive is supposed to be doing.

Cape Wind, the 130-wind turbine project in Nantucket Sound designed to produce 468 megawatts of electricity, has been battling powerful forces such as the late Sen. Ted Kennedy and his wealthy friends and fellow politicians with summer homes on Cape Cod, Nantucket Island and Martha’s Vineyard who were opposed to the wind farm largely for visual pollution reasons.  These influential and powerful people were successful in placing many hurdles in front of Cape Wind and have dragged out the approval process for the project for over nine years.  In 2010, after securing a power-purchase agreement with National Grid (NGG-NYSE), which was recently upheld by the Massachusetts Supreme Court, for half the project’s output, Cape Wind was close to the point it could begin to secure the necessary financing to build the estimated $2 billion project.  However, it really needed to sell the remaining half of its output to be able to raise the financing, and thus the battle with NSTAR who had already secured most of the necessary wind and solar power supplies needed to meet the Massachusetts clean energy mandate at a substantially cheaper cost for its ratepayers. 

NSTAR will enter into a contract with Cape Wind to buy 129 megawatts of power at a similar price to that agreed to by National Grid.  It agreed to pay 18.7-cents per kilowatt-hour with a 3.5% escalation for each year of the 15-year contract life.  When National Grid signed its agreement in 2010, the base rate assumed the continuation of the 2.2-cents per kilowatt-hour production credit for wind farm operators.  That production credit is due to expire at the end of 2012, and while wind power advocates have pushed to have at least a two-year extension of the credit included in the payroll tax holiday legislation and/or the federal highway transportation bill neither has occurred.  Given the budgetary concerns in Congress, extension of the wind production credit even for two-years appears highly unlikely.  The Cape Wind contracts provide for the loss of that credit, suggesting that the base power rate will go up to compensate the wind project developer.

Cape Wind executives have suggested that with 77.5% of its planned output now under contract, it is close to being able to secure financing for construction.  The problem remains that there are still several legal challenges and approvals needed besides the financing before construction can begin.  One of the approvals relates to the previous preliminary approval given by the Federal Aviation Administration (FAA) that the 440-foot tall wind turbines did not interfere with the navigation of planes in the area.  That approval has been withdrawn while the agency re-examines the project.  Cape Wind and its supporters suggest that the FAA merely needs to include some additional language in its approval to resolve the issue. 

Offshore wind has moved back into the spotlight as the Interior Department has issued an environmental assessment that there are no problems with leasing blocks in an area offshore the mid-Atlantic state for constructing wind farms.  This assessment is part of a program the Obama administration has pushed to accelerate the development of offshore wind.  It is interesting that this approval occurred after the one project in that area furthest along was shut down by its developer who also returned its power purchase agreement.  That project’s economics were undercut by cheaper natural gas, especially supplies from the neighboring Marcellus basin in western Pennsylvania, West Virginia and eastern Ohio.  The ending of the ability to turn the wind power production tax credit into immediate cash and the prospect of the termination of the wind production credit also contributed to undercutting the economics of this expensive clean power source. 

While states along the East Coast proclaim their attractive offshore wind resources, it seems that offshore wind will only be developed at the behest of government mandates.  We remain mystified as to how state governments can get away with blackmailing corporations to act against their legal requirement as regulated utilities to deliver power at the lowest possible cost to their ratepayers.  We have watched two states – Massachusetts and Rhode Island – literally rewrite their utility regulations to force the second-most-expensive electricity in this country to be supplied to the power grid.  It will be interesting to see who steps up with the money to finance construction of these wind farms and what role the federal government will ultimately have to play.  Could these offshore wind farms become the future wave of clean-energy bankruptcies? 

A new poll conducted by the Pew Research Center shows strong support for approving the Keystone XL pipeline, the oil sands pipeline President Obama rejected in January.  This pipeline to haul oil sands bitumen from northern Alberta to the U.S. Gulf Coast refining industry became the target of much discussion and debate in recent weeks.  That discussion has increasingly turned into dismay as people watched gasoline pump prices climbing toward $5 per gallon. 

According to the poll data, 66% of those who have heard about the Keystone pipeline permit rejection say the proposed pipeline should be approved.  That is in contrast to the 23% who say it shouldn’t be approved.  Among Republicans who have heard about the pipeline issue, 84% back it compared to 49% of Democrats.  Interestingly, the poll also showed that fewer Democrats than Republicans are familiar with Keystone.  Among independent voters, 66% back approval of Keystone, but that number drops to 46% among those independents who “lean Democratic.” 

We believe that as more Americans learn the facts about the Keystone pipeline and its benefits for the U.S. economy, they will back its construction.  Given this belief we were dismayed to attend a non-energy industry function at which an oil company senior executive spoke in support of the pipeline but, in our estimation, did a poor job of presenting the case for the line’s construction.  We do not mean to pick on Janet Clark, executive vice president and chief financial officer of Marathon Oil Corporation (MRO-NYSE), who was the speaker, but we wished for a more passionate and factual presentation to arm the attendees to make the case for why the pipeline should be built.  What we don’t know is who in the Marathon Oil organization is to blame for the weak presentation, nor do we know whether this presentation is representative of those made by other senior oil industry executives.  But if it is representative, then Keystone needs better friends.

Ms. Clark spoke at a lunch sponsored by the Houston chapter of the Association for Corporate Growth (ACG).  The program was focused on the Jesse H. Jones Graduate School of Management at Rice University.  The ACG chapter awarded two scholarships to students from the school.  Ms. Clark is a member of the board that oversees the school and it was clear that was partially why she was asked to speak.  She had a large audience of several hundred executives almost all of whom were non-energy.  In her presentation, Ms. Clark said she wished to talk about two important and timely energy topics – the debate over hydraulic fracturing and the Keystone pipeline. 

When she got to the Keystone pipeline, she put up a slide that was essentially an amalgamation of the two charts in Exhibits 10 and 11, showing on one map all the natural gas, crude oil and oil product pipelines crisscrossing the country.  She explained what the map showed and then said, “What’s one more pipeline?”  That line brought laughter and some applause from the audience.  We thought that was an interesting and attention-getting opening line.  The problem was she failed to follow through with factual information to educate the audience about why this particular pipeline should be built.

Exhibit 10.  U.S. Network Of Natural Gas Pipelines

Source:  EIA

Exhibit 11.  The Network Of Oil And Product Pipelines

Source:  American Oil Pipeline Association

Ms. Clark made the point that blocking the pipeline wouldn’t stop the development of the oil sands.  She pointed to Canada’s prime minister traveling to China shortly after the pipeline rejection to discuss trade deals – which had to include oil sands output.  If the oil sands are going to be developed and the trapped carbon released, there is no reason why the United States shouldn’t secure this oil for its refineries.  While this is an accurate point, she failed to educate the audience about the economic benefits for the U.S. from substituting cheaper Canadian oil for more expensive African or Middle Eastern oil.  Additionally, she could have explained the economic and political benefits from displacing Venezuelan oil.  She could have talked about the shutting down of refining capacity on the East Coast and the expansion of Gulf Coast refineries and how they could meet the petroleum needs up east.  Maybe now that Marathon Oil has spun off its refining business it isn’t appropriate for her to talk about it. 

My concern about Ms. Clark’s presentation is that if this was the best support for the Keystone pipeline, then it needs more help.  If senior oil industry executives can’t make a strong case for industry issues, even though in this case it is another company’s project, then the industry will never win in the court of public opinion.  We left the lunch shaking our head that a golden opportunity to educate an audience of influential people about this important topic had been lost.  The oil industry will always be blamed for high gasoline prices, pollution and supply shortages.  It needs to work harder and smarter to educate people, and when opportunities are missed, the entire industry suffers. 

The Obama administration gloated over the record profits posted by General Motors (GM-NYSE) a couple of weeks ago.  For all of 2011, the auto manufacturer generated a profit of $7.6 billion, an increase of 62% over 2010’s results.  The results were a record in the history of GM.  The previous record annual earnings were reported in 1997 when GM earned $6.7 billion ($9.4 billion in today’s dollars). President Barack Obama commented on the record earnings during a speech in San Francisco saying, “Today, GM is back on top as the world’s number-one automaker. It just reported the highest profits in the 100-year history of that company.” 

The President went on to praise GM workers in a statement that was later excerpted for his Saturday morning political comment from the White House.  In praising the GM workers, Mr. Obama said, “American workers, you’re the most productive on Earth. You can compete with anybody. You will out-work anybody, as long as the playing field is level. You can compete with any worker, anywhere, any time—in China, in Europe, it does not matter.”  What Mr. Obama failed to tell his audiences, either in San Francisco or for his Saturday morning comment, was that GM’s strong earnings performance was due to his administration’s intervention to impose a 50% wage reduction for new hires at GM and Chrysler, the other bankrupt auto manufacturer bailed out by American taxpayers.  He also failed to note that the taxpayer backed bailout stripped GM of its debt, health care obligations and many of its dealer costs.

As a result, many people missed the impact those actions have had on GM’s finances.  When you strip a company of its debt and most of its legacy healthcare costs, it should become highly profitable.  As the expression goes, if you can’t make money under those conditions, when will you make money?  Secondly, the praise from the President and stock market analysts was all about GM’s annual results with barely a mention of what happened in the fourth quarter.  Revenue in that quarter compared to the same quarter in 2010 did increase $1.1 billion, but net income was flat. 

When it comes to examining the results based on geographic performance, weakness in two areas – Europe and South America – continued to drag down overall results.  As measured by earnings before interest and taxes (EBIT), GM reported $7.2 billion from U.S. operations for the full year and $1.5 billion for the fourth quarter.  International operations, other than Europe and South America, generated positive EBIT for 2011 of $1.9 billion and $0.4 billion for the fourth quarter.  Europe lost $0.7 billion for the year and $0.6 billion for the fourth quarter, while South American operations lost $0.2 billion in the quarter and $0.1 billion for the year. 

By not making a direct reference to the most critical elements in the “saving” of the auto industry and crowing about the “success” of the auto industry bailout, Mr. Obama was disingenuous.  But since all politicians, and especially this President, are desperate to show that government spending and economic intervention steps actually had a positive impact on the recovery, they will stretch the truth about the benefits of their actions.  We have been treated to many statements about the number of jobs either added or saved through these politically driven actions.  A recent analysis conducted by Mark Milke a senior analyst with Canada’s Fraser Institute demonstrates that these explanations are wrong.  Mr. Milke concluded that the jobs saved at Chrysler and GM in Canada cost that nation’s taxpayers $90,000 and $474,000, respectively, for each job saved.  Was it worth that money to save these jobs?  More importantly, would all of these jobs, or even most of them, have been saved at little cost to the taxpayers if the companies had been ushered into conventional bankruptcy proceedings?

According to Mr. Milke, in 2009 in Canada, 5,420 companies went bankrupt with only two saved with tax dollars – Chrysler and GM.  The Canadian federal and Ontario provincial governments together loaned the auto companies $13.7 billion in fiscal 2009-10.  That equaled 38% of the $36 billion in corporate income taxes collected by both governments in that fiscal year.  After accounting for the partial loan repayments, the sale of government-held shares in GM and the present value of the GM stock still owned, Canadian taxpayers are out $810 million at Chrysler and $4.74 billion at GM. 

For all this $5.5 billion in taxpayer assistance, what has been the impact on employment at the two auto companies?  GM’s employment in Canada now stands at 10,000, down 2,000 from early 2009.  Chrysler’s employment over that time declined from 9,800 to 9,000.  By dividing the current subsidies provided by Canadian taxpayers by the auto companies’ employment, the value of the jobs saved can be established.  What would have happened if those jobs had been lost at the time of the auto company bankruptcies?  Across Canada in 2009, 259,000 full-time positions were lost, nearly half of them in Ontario (129,000).  Today, Canada’s full-time employment is 387,000 workers greater than it was in December 2009.  That includes 150,000 more workers in Ontario and 171,000 in Alberta.  The provinces of Saskatchewan and Manitoba each have 29,000 more workers.  Those provinces have added 10,000 more workers than the combined employment of Chrysler and GM. 

In late 2009, no Canadian banks would have loaned the auto companies any money, but in traditional bankruptcy there probably was debtor-in-position (DIP) financing available.  The politicians would argue that only taxpayer money was available, thereby it was the government’s obligation to help prevent a greater economic contraction.  On the other hand, we know that every recession does end and economies start to grow again.  The key questions are how long will it take for the recovery to begin and how much pain and suffering must be absorbed in the interim.  But a $5.5 billion cost to Canadian taxpayer is a stiff price.  In the United States, according to the latest estimate to Congress from the Treasury Department, American taxpayers are out $23.8 billion.  Based on the 47,000 GM employees, the cost for saving each of those jobs is $506,383. 

Before declaring the auto bailouts a success, it would be helpful if the politicians acknowledged the cost to the taxpayers for saving the auto company jobs.  But maybe more ominous is that the domestic auto industry may not be performing as well as the financial results suggest.  According to the Urban Institute, in 2011 with domestic vehicle sales hitting 12.8 million units, the throughput of the dealer network was 719 vehicles, up 10% over the 656 unit sales in 2010.  The institute estimates that if auto sales reach 13.95 million units this year, the average sales per dealer will set a new record beating the 784 unit record achieved in 2005.  The recent increase in dealer throughput in the past several years partially reflects the recovery in the auto market but also the shrinking number of dealers and car brands.  As a result, one should not be surprised by the uptrend. 

Exhibit 12.  Uptick In Dealer Sales Not Surprising

Source:  Urban Institute

The number of car dealerships rose to 17,767 in 2011, up 0.6% over 2010.  Since in a normal year there is about 2% attrition in dealerships, the growth in 2011 was unusual.  That said there were 29,386 franchises (the number of car brands a dealership sells) in 2011, down 2.4% from the 30,098 in 2010.  While dealer throughput has improved as the domestic car companies have reduced their networks, the growing inventory situation may reflect that a tougher market is developing.

At the end of January, according to Ward’s Automotive, the number of days of inventory for the industry was 67, down from 71 days in the year-before period, but up 16 days from the end of December.  Both Asia/Pacific and Europe cars were up month to month by 13 and five, respectively, while the domestic car companies were up 22 days to 86.  That represents nearly a three month inventory of cars on dealers’ lots compared to the historical pattern of about 60 days.  The Asia/Pacific and European car companies tend to maintain lower inventory levels because they have a pipeline of inventory arriving constantly.  Therefore, these foreign-based companies tend to maintain about 30-45 days of inventory.  The European car inventory is about in line with the historical pattern while the Asia/Pacific companies are slightly above their target probably reflecting the continued restoration of their inventory and manufacturing operations following their disruption due to the Japanese earthquake and tsunami last year. 

One measure of an improving automobile market is the ratio of inventory to sales.  The long-term ratio has been about 2.4 months of inventory.  In Exhibit 13, one can see that ratio since 1993, with the spectacular impact the financial crisis and recession had in 2008-2009 when the ratio shot up to nearly 4.5 months of inventory.  The ratio was quite low in 2011 helped by the Japanese car

Exhibit 13.  Inventory/Sales Signals Improving Market

Source:  Ward’s Automotive, PPHB

company problems, but now that the Japanese supply disruption is behind the companies, the inventory ratio is starting to show a rise at year end. 

Exhibit 14.  Production And Inventory Climbing

Source:  Ward’s Automotive, PPHB

When we look at the recent trend in auto inventories and production, we see both rising.  The days of inventory data cited above suggests that as the Japanese auto manufacturers return to normal and rebuild their inventories, they are starting to cannibalize the domestic car makers’ gains of the first three-quarters of 2011.  If gasoline prices continue climbing and the recent report that unemployment may be reversing its decline proves accurate, trumpeting the success of the auto industry bailout may not only prove premature but imprudent.  When focusing on the auto makers, one must always remember that the franchise dealer is his customer and not the retail buyer.  With vehicle inventory rising, one has to be prepared for possible car production schedule adjustments, or very aggressive sales incentives.  From an energy market prospective, auto sales need to remain high or go higher.  We will be keeping an eye on monthly sales, inventory and production figures.