Musings From the Oil Patch – January 24, 2007

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

The OPEC Conundrum

 

On January 31, the oil ministers of the member countries in the Organization of Petroleum Exporting Countries (OPEC) will meet in Vienna to discuss what actions they should take with their crude oil production quotas.  Unless the geopolitical tensions in Nigeria and Iran are reduced to a degree that causes global oil prices to ease, OPEC members will face a significant conundrum when looking forward.  That conundrum is reflected in the recent International Energy Agency (IEA) monthly oil report covering the market at the end of 2005 and the forecast for 2006.  The IEA cut its fourth quarter 2005 estimate of oil demand by 400,000 barrels per day (b/d) due to the impact of the hurricanes in the United States in sharply lifting crude oil prices and resulting in a demand falloff.  Some of that demand falloff may have been weather related, but it probably didn’t account for a major portion of the reduction.  The fourth quarter reduction resulted in a full-year demand reduction of 100,000 b/d to 83.3 million b/d. 

 

The IEA left its forecast for 2006 oil demand unchanged at 85.1 million b/d, an increase of 1.8 million b/d, or 2.2% over 2005.   OPEC needs to assess the veracity of this forecast in light of the impact of the sharp spike in global crude oil prices in response to the militant actions in Nigeria and the geopolitical tensions over Iran’s reactivation of its nuclear energy development program.  If the spike in oil prices early in the fourth quarter of 2005 caused a demand cut, how much of 2006 demand might be lost due to the current oil price spike?  On the other hand, keeping OPEC’s production high may be the best insurance policy that crude oil prices don’t soar even higher.

 

The IEA’s 2006 outlook is based on the assumption that Chinese and U.S. energy demand will remain strong.  The IEA points to the sharp recovery in December’s demand in China that helped boost that market’s yearly growth to about 3%.  However, recent statistics from Chinese government agencies cast doubt on that growth forecast.  The Chinese government says that their demand was flat in 2005, which would be sharply lower than every other demand estimate.  The lack of transparency in the Chinese energy market compounds the risk in energy forecasts.  Despite that risk, the IEA sees a healthy demand in 2006 that will need more OPEC oil.

 

Because the IEA sees less growth in non-OPEC oil output in 2006 from its prior forecast, it cut its supply growth forecast by 7%, or 100,000 b/d, to 51.4 million b/d.  In 2005, non-OPEC supply was flat with 2004 due to the impact of the hurricanes in the Gulf of Mexico, high maintenance in the North Sea and delays in bringing new fields on stream.  The IEA’s rationale for strong growth in 2006 is based on the full year impact of new field start-ups late in 2005, a large number of new field start-ups in 2006, and a recovery in the Gulf of Mexico and the acceleration in Russian oil output. The cold weather so far in January in Russia is taking a toll on its production, however.  Even with more non-OPEC oil in 2006, the IEA still looks for OPEC to supply an incremental 200,000 b/d in both the first and second quarters of this year.

 

The IEA appeared to try to send a message to OPEC in its monthly oil report.  It is forecasting a 1.9 million b/d demand drop in the second quarter, which is traditionally the seasonally weakest demand quarter due to the end of winter oil needs.  The IEA forecast is consistent with OPEC’s statements that it expects about a 2 million b/d demand drop in that quarter.  Given this seasonal pattern, oil producers usually cut their output during the latter part of the first quarter to prevent a significant overload of oil on the market during the second quarter that could contribute to a collapse in oil prices.  The IEA described the “old oil market mantra” of a weak second quarter demand as a reason to cut production as a “myth.”  They said that the oil demand falloff has traditionally been viewed as a Sword of Damocles held over the market.  The IEA tried to point out that shifting geographical demand patterns, geopolitical uncertainties and the need for maintaining robust inventories mitigated the need for production cuts in the second quarter.  Of course, this advice is spoken by the oil consumer watchdog agency – do they have an agenda?

 

OPEC’s view of oil demand in 2006 is slightly less robust than that of the IEA.  OPEC is looking for an increase of 1.6 million b/d of growth, or 1.9%.  This is a slight upward revision to OPEC’s prior view due to the assumption of a more optimistic view of the world economy for 2006.  Despite this upward revision, the January 2006 OPEC monthly oil report carries a bullet-point in its highlights section that reflects the challenge in making a demand forecast for this year.  It also highlights the risk to complacent assumptions about the security of oil demand growth in 2006.

 

“It remains unclear whether this solid start to the year will be maintained throughout 2006.  The problem of global imbalances has only worsened during 2005 and a substantial adjustment in trade balances is needed to forestall disruptive volatility in currency markets.  Both the USA and China may face fluctuations in asset prices as higher interest rates absorb the liquidity of households and businesses.  The US housing market is a particular cause for concern.  Many Asian economies remain dependent on a rather narrow range of exports and any retrenchment by the American consumer could have a significant impact on Asian growth.  Global monetary conditions will tighten in 2006 and may impact housing, equity and investment confidence.  In today’s integrated economy any financial volatility might affect activity on a global scale – especially in the current climate of optimistic expectations.”

 

Our best guess is that OPEC elects to leave its production quotas unchanged at the end of January.  There is so much political and economic uncertainty that high oil prices are a great risk to OPEC’s long-term market share objectives.  However, we do expect the OPEC oil ministers to be back in Vienna, or some other desirable location, next month.  That would be in keeping with the intense focus OPEC has maintained on the global oil market for over a year.

 

Should We Worry About an Inverted Yield Curve?

 

During much of the second half of 2005, investors were watching the flattening of the yield curve and wondering what it meant.  The yield curve is a plot of the interest rate on U.S. Treasury debt securities against their maturity dates.  The typical curve reflects the traditional demand by lenders for a higher return on their money as the length of time of the loan increases.  The logic is that during the term of the loan the reinvestment of that money would likely earn a higher return than now; therefore the lender should be compensated for the risk of this happening.

 

Exhibit 1. Normal Yield Curve

 

Source: Investopedia.com

 

 

As the yield curve began to flatten during 2005, investors started to worry about the impact rising short-term rates could have on future economic activity.  As the Federal Reserve has been involved in an ongoing program of raising short-term rates from 1% to 4 ¼%, the cost of all other loans has increased.  The rise in mortgage interest rates has been the topic of much debate about its impact on the red-hot housing market that has been particularly important in driving the U.S. economy for the past few years. 

 

As we approached the end of 2005, the debate began to switch to the impact of an inverted yield curve, where short-term rates exceed longer term rates, on the economy.  The yield curve actually inverted briefly during the last week of 2005.  Inverted yield curves are seen as heralding economic slowdowns at best and recessions at worst.  If true, then most of the economic forecasts for 2006 calling for robust growth would prove wrong, with significant implications for energy markets. 

 

Exhibit 2. Inverted Yield Curve

Source: Investopedia.com

 

Much also has been made of the flattening of yield curves in Japan and Germany along with the inverted yield curve in Great Britain.  This suggests that the persistence of very low long-term interest rates in the face of solid economic growth and rising short-term interest rates, or the conundrum that Federal Reserve Chairman Alan Greenspan has described, has become a global phenomenon.  Will this condition produce a global economic slowdown or recession?  While it remains to be seen, some studies have shown that since World War II, the flattening of the yield curve, as measured by the difference between rates on 3-month and 10-year government debt in the five largest economies – the United States, Japan, Germany, Britain and France – have issued false alarms of recession 38% of the time. 

 

So what is the record of inverted yield curves on economic activity and the stock market?  More important, what is the record as it relates to the oilfield service stocks, which is about the hottest stock market segment at the present time? 

 

Exhibit 3. Yield Spreads and the Stock Market

Source: The Big Picture

 

Historically, the record of the stock market’s performance after the yield curve has inverted is mixed.  In the seven periods over the past 30 years when the spread between 10-year and 2-year notes has been negative for the better part of a month or more, the S&P 500 has risen four times and fallen three.  The biggest gain occurred in a near 6-month span that ended in June 1989, when the S&P 500 Index rose by 15.7%.  The largest loss was seen in 2000, when the measure fell by 5.3% from February to December. 

 

Exhibit 4. Inverted Yield Periods and Stock Market Performance

Source: The Big Picture

 

We looked at the same yield curve phenomenon for the oilfield service stocks.  Rather than use an energy index, we used the stock price of Schlumberger (SLB-NYSE), which is the largest market capitalization company in the industry and therefore highly liquid.  We only had stock price data going back to late 1981, so we couldn’t compare the two earlier periods when the yield curve inverted.  We used weekly data for both Schlumberger and the 2-year and 10-year interest rates.  When we calculated the yield spread, we found some differences compared to what is reported in other studies.  For example, the previously cited study of inverted yield curve versus the stock market said that there was a period extending from January 1989 to October 1989.  Our study showed an inverted yield curve from December 1988 to July 1989 and then again from August 1989 to October 1989.  Likewise, we found another period in March 1990 to April 1990 that was not identified by the other study.  So Exhibit 5 shows a chart of Schlumberger’s stock price performance and the periods of inverted yield curve that we identified.  We are not sure that our data produces significantly different conclusions than the earlier study, however. 

 

Exhibit 5. Schlumberger Stock and Inverted Yield Curve Periods

Source: FRED, Yahoo.com, PPHB

 

What is interesting is that in the four most recent periods of inverted yield curves identified by the prior study, Schlumberger’s stock price demonstrated either a significantly more pronounced performance compared to the S&P 500 during the periods, or moved in the opposite direction.  The more significant out-performance of the Index came during the 1980s periods when it is likely Schlumberger was reflecting the deterioration of the industry early in that decade and then the recovery from a vastly depressed condition at the end of the 1980s.  In 1998 and 2000, Schlumberger’s stock price performance was exactly opposite that of the S&P 500, which is not surprising as energy’s strength or weakness has been inversely correlated with the health of the economy that is reflected in the performance of the stock market. 

 

 

 

 

 

 

 

 

 

Exhibit 6. Schlumberger Performance vs. Inverted Yield

Source: The Big Picture, PPHB

 

One thing we looked at with respect to the oilfield service stocks was how long from the time the yield curve inverted to the stocks peaked.  Based on our analysis, the two earlier periods experienced long times (16-18 months and 18-20 months) before the stocks peaked.  In the two recent periods, the time between the inversion of the yield curve and the peak in the stocks was almost immediate or only 4-5 months.  In the first of the most recent periods, the fundamentals of the industry were falling apart as the Asian currency crisis was causing an implosion in oil demand.  In the later period, the stocks had experienced a correction in what appears to have been an extended up trend for the stocks. 

 

Exhibit 7. Peak Time After Inverted Yield Curve

Source: The Big Picture, PPHB

 

So what conclusion should we draw about the future performance of stock prices and, in particular, oilfield service stocks?  It would seem that one must try to anticipate what impact the inverted yield curve may have on the economy and overall stock market.  High oil and gas prices, coupled with rising interest rates, are likely to take a toll on economic activity.  That should suggest future underperformance of the economy and the stock market.  Based on past performance, we would expect energy stocks to continue to outperform – at least until economic fundamentals change.  A big question is whether last week’s performance of the Philadelphia Oil Service Stock Index (OSX) has achieved a significant portion of the outperformance of energy stocks versus the overall stock market?  Or, was last week only the beginning of another period of energy stock leadership in the stock market?  We believe both trends will continue for a while.

 

Nigerian Violence – Signaling a Changed Environment?

 

Since mid December, the political situation in Nigeria has deteriorated with serious violence and destruction in the oil patch signaling potentially a changed environment.  Shortly before Christmas, a products pipeline running between Warri and Lokaja in the Delta State was attacked spreading fear of a shortage of refined products in the country.  Another products pipeline about 12 kilometers from Warri near Adeji was set on fire, but the police arrested about 20 suspects.  In early January, 12 people were killed in a gun battle with police after they discovered an illegal crude oil bunkering operation at the swamp facilities belonging to Pan Ocean Oil (CAD-TO).

 

Exhibit 8. Nigeria is Home to Massive Oil Reserves

Source: Rigzone

 

Violence was increasingly directed toward Royal Dutch Shell (RDSB-NYSE) the major operator in the country.  On December 20, an 180,000 b/d pipeline at Agba-Okwan Asarama in the Opobo channel outside of Port Harcourt was attacked forcing Shell to declare force majure on its production there.  Responsibility for the attack was claimed by the Martyrs’ Brigade, which claims to be a splinter group of the Niger Delta People’s Volunteer Force.  This was the start of an escalation in violence directed against Shell and the Nigerian government by increasingly militant groups.  What appears to be different about the recent violence is that the groups attacking have larger, more politically motivated demands as opposed to most of the past violence where the perpetrators merely wanted money or concrete actions to improve the living situation of specific people.

 

On January 11, Nigerian rebels attacked the Shell EA platform and kidnapped four workers from a vessel owned by Tidex, a subsidiary of Tidewater, Inc. (TDW-NYSE).  Additionally, rebels attacked the Benisede flow station and three pipeline points.  Five Shell workers were hurt in that attack, which forced Shell to shut down the flow of the Trans-Ramos pipeline, a 106,000 b/d line, after the rebels blew up the line.  These latest attacks and the kidnapping were waged by a group called the Movement for the Emancipation of the Niger Delta.  This group has made significant demands on Shell and the Nigerian government. 

 

In a recent email, the Movement demanded control over the Niger Delta’s oil wealth, the payment of $1.5 billion by Shell to the Bayelsa province for pollution damage done by its operations over the years; all foreign oil companies and workers leave the country and the release of three prisoners, including two Ijaw leaders.  One of the Ijaw prisoners is the former governor of the Bayelsa State who was arrested in December for money laundering. 

 

The Ijaw are one of the leading ethnic groups in the Delta region and has caused uprisings in the past seeking money and greater political power.  The last time this group created serious trouble, which resulted in a disruption of 40% of Nigeria’s oil production, was in 2003 prior to the country’s last elections.  So far, the month-long violence has disrupted about 221,000 b/d of production, or one-tenth of the production of the world’s eighth largest oil exporter.

 

In the Movement’s email, was a statement that they planned to become more aggressive in their tactics and were expanding their target list to include all the major oil companies operating in the region.  Specifically, the group named Total (TOT-NYSE) and the Agip subsidiary of the Italian oil company, Eni (ENI-NYSE).  Chevron (CVX-NYSE) was also said to be a target.  All three companies dismissed the statement, as did ExxonMobil (XOM-NYSE) that reportedly had some loading operations disrupted.  The latest report says that ExxonMobil was loading oil from its facilities under significant military protection. 

 

Over the weekend, a letter was being prepared for delivery to the oil companies by the head of the 50,000-member National Union of Petroleum and Natural Gas Workers union that was to be co-signed by the 45,000-strong white collar workers’ Petroleum and Natural Gas Senior Staff Association of Nigeria union, calling for an immediate increase in security protection, or for the oil companies to prepare to face a strike.  If this were to happen, it could shut down all of Nigeria’s oil and gas production.

 

The latest news from Nigeria suggests that the kidnapped workers may be released soon.  That would be good news, but it does little to defuse the potential powder keg in the Niger Delta. 

 

As the rebels stepped up their demands, one has to wonder if this is merely another event in a growing trend of oil-rich, but economically poor countries, or countries that remain poor due to political corruption and theft, where the people are rising up to demand a greater share of the petroleum wealth being generated by high oil prices, or the start of a global trend?  Nigeria has been a case study in oil wealth going to a select few – mostly political leaders.  As these leaders age (many are in their 70s) will they be able to retain their power?  You can add Nigeria to the growing list of countries including Venezuela, Bolivia, and now Peru, where political agendas are driving actions against the oil industry.  This rise of populism puts the oil companies in the middle of a gigantic political and economic struggle, and they will likely be the loser.

 

Shell and India in New Venture

 

Shell and India’s Oil and Natural Gas Corporation (ONGC) have signed a memorandum of understanding that covers potential joint operations.  These operations could involve finding, securing and producing oil and natural gas internationally, as well as activities within India.  This is an “umbrella memorandum” that has “an extremely broad horizon and spans upstream and products” according to a spokesman for ONGC.  “ONGC provides the opportunity, Shell the expertise,” he said. 

 

Within India, the agreement envisions a wide range of potential joint operations including bidding on exploration and production licenses, finding ways to bring ONGC’s natural gas reserves to market, using Shell’s technology for extracting residual reserves from older oil fields and developing coal conversion technologies.  At the present time, Shell is developing a liquefied natural gas (LNG) terminal in India’s western state of Gujarat, but has had problems in establishing the price of the gas.  Shell has also been granted permission to market transportation fuels in the country.  This agreement with ONGC may facilitate Shell’s entry into the market and the LNG terminal could be supplied by ONGC gas reserves.

 

The memorandum also would allow for the joint construction of oil refineries, petrochemical plants and product terminals and depots.  It would enable the partners to establish a bitumen business, and to supply oil products, marine fuels and lubricants.  Shell will also co-operate with ONGC to improve its health, environmental and safety procedures. 

 

As Saad Rahim, an analyst at PFC Energy, a Washington-based petroleum consulting firm, is quoted as telling the Financial Times, “This is the first deal of its kind where you have a major international oil company and a major national oil company working across the spectrum of the oil industry.”  In a world where the opportunities for major oil companies to replace and expand their hydrocarbon reserves in mature regions are severely limited and areas with significant reserve potential are off-limits, working relationships between major integrated oil companies and national oil companies may become the wave of the future.  This view was supported by comments of Ricardo Rodriguez, Manager of Investments – Shell Technology Ventures, at a conference on energy venture investing in 2006 hosted by MIT Enterprise Forum® of Texas.  Rodriguez made the point that oil companies in the future increasingly will have limited access to global hydrocarbon reserves.  Therefore, the only differentiating factor between oil companies is their technology, and that factor may enable a company to grow when its competitors may not be able to. 

 

Given that Shell is still chasing its leading competitors – ExxonMobil and BP plc (BP-NYSE) – and recovering from its reserve reporting fiasco, this memorandum of understanding with ONGC may be a ticket to new reserves and markets it might not otherwise be able to access.  What could the implications be of this type of industry evolution?  It might mean that the major oil companies become even more geographically selective where they work.  They could become smaller companies by shedding less profitable markets and businesses as they focus on fewer, more profitable opportunities.  They could evolve into higher tech companies by emphasizing the development of new technologies through increased R&D spending, reversing a trend that has existed for many years.  We must be careful to take one agreement and extrapolate into an altered path of evolution of the oil industry, but we would give it a 50-50 chance of it happening over the next 10-15 years.

 

Gazprom Eyes UK Gas Market

 

Gazprom’s (OGAZPF.PK) deputy chairman, Alexander Medvedev, speaking at the Handelsblatt Energy Conference in Berlin last week, said, “We’re monitoring the (UK) market, but aren’t considering making a bid for Scottish Power (SPI-NYSE) at the moment.”  His comments added fire to the rumors that had been circulating in European financial markets for the past few weeks.  Despite his statement to the contrary, Medvedev’s comments sent the stocks of potential utility takeover candidates up sharply last Wednesday.  Centrica (CPYYY.PK) was up 2.6%, while Scottish Power, also the subject of takeover talks with Germany’s E.On (E.ON.AG-NYSE), advanced 0.8%. 

 

Skeptics of the veracity of these rumors have been pointing out that it was not Gazprom’s ability to make acquisitions that they questioned, but rather they questioned the company’s priorities.  At the present time, Gazprom appears to be focused on developing its Baltic Sea pipeline to Germany, and possibly building an extension to the UK, plus improving its position as a reliable gas supplier to Europe.  This has become more important as the company deals with its reputational fallout from the contract problems with the Ukraine over New Year’s Day.  Gazprom needs to demonstrate its reliability as a gas supplier to Western Europe, before being in a position to take on a stake in a market it presently does not serve. 

 

Arctic Weather Grips Russia Straining Energy Supplies

 

Arctic cold weather has gripped Russia since January 16, causing the deaths of at least 40 people and diminished fuel supplies to Europe as supplies were retained to meet the heating and electric power needs of the country.  Depending upon the measurement, this period either marks the coldest weather experienced in Moscow

 

since 1925, or 1978-79, or ever.  Last Wednesday, temperatures in Moscow reached a low of -23C and a high of -16C, some 30 degrees below the historical average.  The all-time low in January in Moscow is -42C, experienced in 1940. 

 

Last Thursday, the -31C high in Moscow, followed by a -34C low on Friday helped the city set a record for the longest period of extreme cold on record.  The prior longest period of sub-30C weather was three days in 1950.  Friday’s low marked the fourth consecutive day of sub-30C temperatures for Moscow.

 

In Sura in central Russia, the high of -38C is fully 50 degrees below its historical average.  The temperature there dropped to a low of -46C early Thursday morning.  Across Russia the Arctic weather has made this the coldest winter in 25 years.  While Moscow, in the western part of Russia, was hitting a low of -45F, temperatures were at -57F in central Russia and -65F in Siberia in eastern Russia. 

 

Exhibit 9. Winter Weather Impacts Russian Energy Supplies

Source: Moscow.com

 

The impact of this severe weather has strained Russia’s electricity system, transportation network and oil and gas output.  In Moscow, power consumption reached a 15-year high of 15,760 megawatts.  Across the country, electricity output reached 146,000 megawatts, also a 15-year record.  RAO Unified Energy Systems, the electricity monopoly, has worked to ease the strained power system.  It has cut back power to 250 nonessential companies in the Moscow region.  Electricity supply has been reduced to casinos, gaming halls, outdoor billboards and the night-time flood lights at construction sites.  In addition, ATM machines have been turned off to save power, although many were icing up.  Trollybuses and trams have stopped running because overhead power lines have become so brittle that they are snapping when flexed.  The result is that record numbers of people now are taking the Metro subway. 

 

In Siberia, where winter weather often helps boost oil production, the extreme cold has resulted in a reduction of 200,000 b/d of output.  At Yamalo-Nenetsk Autonomous Okruy in Siberia, the temperature dipped to -61C (-78F), an all-time record low.  Gazprom has claimed it has not reduced gas shipments to Europe, although customers have reported reduced volumes.  Gazprom has reportedly dumped an extra 750 million cubic meters of natural gas into its system, drawing on its storage, to help meet the demand for heat and electricity.  A problem has been that in many places hot water pipes are bursting with the cold, leaving residents and businesses without heat and power.  Even with central heat, many residents are using portable electric heaters and even their ovens to try to heat their apartments above 55F. 

 

Extraordinary measures have been taken across Russia to protect zoo animals.  Reports are that many zoo animals have been given shots, or even buckets, of vodka to help keep them warm.  In Lipetsk, 250 kilometers south of Moscow, the elephants at that zoo have been provided two liters of vodka a day and the monkeys are being given wine three times a day.  At the Moscow Zoo, the animals have been moved indoors, including the polar bears.

 

As the Russians would say: So far, so good.  Temperatures are warming over the weekend, but the winds have picked up keeping the windchill factor at about -25F, even though daytime highs are reaching zero Fahrenheit.  However, the forecast calls for the next blast of Arctic weather to hit this week and last until February.  As the death toll mounts and the power grid and fuel supplies are strained, how long this can go on before there is a major problem is anybody’s guess.

 

The latest controversy is the destruction of two gas pipelines and a major electric power line into the neighboring state of Georgia. As result of these events, Georgia has lost all its gas flow from Russia and about 25% of its electricity.  The country relies on Russia for all its gas needs, but has diversified its electricity supply to include power from Turkey and Armenia.  Georgia is working rapidly to try to diversify its gas supply by the end of 2006 when a network from the Caspian Sea is completed and supplies from Azerbaijan and Central Asia become available.

 

Initially, Chechnyan rebels were accused for blowing up the lines.  However, later the Georgia government accused Moscow of having the lines destroyed as political retaliation for the performance of Georgia’s energy business.  The Russians have announced that a criminal investigation into the destruction has been launched.  While it will take some time to sort out these claims, the result is that Georgia is left with one small gas pipeline supplying the country and a one-day supply of gas.  Repairs to the main gas line should only take three days, the reserve line repairs could take one month and the power lines about a week.  Because some of this gas supply flows through to power Armenia, it too has suffered some power outages.

 

This development will add further fuel to the debate about the reliability of Gazprom as a supplier to European countries.  Europe’s high dependence on Russian energy poses as risk to the continent’s future security of energy suppliers warned the IEA’s chief economist, Fatih Birol, while speaking at an energy conference in Berlin last week.

 

Windfall Profits Tax Alive and Well in California

 

A bill introduced by California Assemblyman Johan Kiehs has been approved by two key Assembly committees – the Appropriations and the Revenue and Taxation.  This sets up the possibility that the bill may be heard on the Assembly floor this week.  The bill would impose a tax of 2.5% on the profits of petroleum producers and refiners.  It would approve taxes on windfall profits if the annual profits of oil producers and refiners are above their average profit of the last five years.  The bill would be retroactive to January 1, 2005, which means it would capture the early 2000 period. 

 

Exhibit 10. Average WTI Crude Oil Prices

Source: IEA, PPHB

 

According to a written statement by Mr. Kiehs, “It is simply wrong for the oil industry to profit in the wake of a natural disaster.”  He went on to say, “If these companies report record profits by spiking the price of oil resulting in higher prices at the pump, then they will be subject to increased taxes.”  He estimates that the bill would raise $140 million in taxes in California’s fiscal year 2006-2007, $70 million in 2007-2008 and $90 million in 2008-2009.  It is easy to predict these windfall profits based on what has occurred to prices in the crude oil market over the past several years.  As shown by Exhibit 10, U.S. oil prices have more than doubled during 2005 and the first month of 2006 compared to the average of the prior four years. 

 

Notice that Kiehs’ bill takes no account of the capital investment required to find, develop and refine petroleum products in this country where the petroleum industry trails slightly the average return on investment of all U.S. industries.  To ignore the investment requirement of this industry and to punish companies for increasing their profits is more than short-sighted – it is downright dangerous.  One of the reasons we find ourselves in this tightly balanced global petroleum market is due to the many years when industry profitability did not justify reinvestment of capital.  Petroleum industry profits of the past several years are stimulating increased capital investment that should improve the global oil supply and demand balance leading to lower future prices.

 

China Missing Gas Use Target

 

The efforts by the Chinese National Development and Reform Commission (NDRC) to secure cheaper natural gas supplies may lead to the country falling short of its goal of doubling the share of natural gas in its energy mix by 2010.  The NDRC has been pressing foreign suppliers of LNG to offer lower prices to Chinese buyers in light of the country’s potential as a long-term market, but without success.  This failure may force some cities in China to shift their focus on future energy supplies to dirtier fuels such as coal despite the country’s efforts to improve its air quality.

 

The price of LNG has doubled over the past two years making it up to four times more expensive than coal in some parts of the country.  The fact that China has abundant coal reserves and some natural gas supplies has given the country alternatives that are not always available to other Asian LNG buyers.  China’s contracting actions suggest the country is not as desperate as South Korea and Japan in securing LNG supplies.  China’s actions have frustrated LNG suppliers who have elected to sell their gas to other consumers because of this battle over the price.

 

The NDRC has a four-point plan for companies buying gas supplies.  The plan stipulates that Chinese companies entering into long-term LNG supply contracts should also have equity in the upstream resource.  This is a condition that is often difficult to achieve in the current environment that is now more of a “sellers’ market” than 24 months ago.  This requirement may be one of the motivators for the recently stepped-up investment around the world by Chinese oil and gas companies.

 

In 2005, natural gas was estimated to account for about 2.5% of China’s energy market.  It was forecast to grow to about a 6% share by 2010 and then to a 10% share in 2020.  This goal is at risk as construction of LNG import terminals is lagging.  China has plans to build 10 LNG terminals by 2010, but only two have been approved and begun construction.  No new contracts have been signed with gas suppliers since 2002.  The second terminal, to be built in Fujian, may be delayed until 2008 over a continuing dispute over the price of LNG.  Two other terminals, in Shanghai and Ningbo, may also be delayed until late this decade due to pricing disputes.

 

 

How China resolves this LNG pricing issue will likely have an impact on the country’s energy demand.  It may impact how the domestic coal industry evolves, how China’s power industry is supplied in the future and even what happens to the economy and oil demand.  China’s gas policy will have many impacts and should be watched.

 

Long Oil Futures Strength Lifting Oilfield Service Stocks

 

A column in Saturday’s New York Times highlighted the fact that trends in the long-term crude oil futures market is probably what has driven the recent sharp rise in oilfield service stocks.  The three charts accompanying Floyd Norris’s column highlight this interpretation.  The first chart focuses on current crude oil futures and shows them trailing the peak they hit in the immediate aftermath of Hurricane Katrina.  But the second chart, showing the crude oil futures prices for oil in December 2007, shows that prices are higher now than during the post hurricane period.  This suggests that the geopolitical and industry trends that have spiked current oil prices are not expected to be cured by the end of next year. 

 

The relationship between the futures price trends and the oilfield service stocks is highlighted by the relative performance of oil prices and stock prices over the period since the end of 2003.  Between the end of 2003 and August 30, 2005, the near-term crude oil futures price rose by 115%, while the OSX climbed only 77%.  While not a shabby performance by the stocks, they failed to match the performance of the commodity.  Since then, the near-term crude oil futures price has fallen by 2%, but the OSX has climbed by 23%. 

 

Exhibit 11. Long-term Futures Prices Drive Energy Stocks

Source: Bloomberg, New York Times

 

As the strength in long-term futures prices suggests, the problems of the oil industry – supply and demand and geopolitical events – are not going to be solved anytime soon.  In order to try to solve them, the petroleum industry will need to step up spending that should boost the earnings of the oilfield service companies, making their stocks attractive investments.

 

But as Mr. Norris points out in the concluding paragraph of his column analyzing these trends, “It stands to reason that oil companies will be willing to invest more money in looking for oil, including projects that a year ago might have been deemed uneconomical.  And as high prices persist, that should spur efforts to cut energy use by companies and consumers alike.” 

 

What we find interesting – and somewhat surprising – is that there is little talk about the conservation impact on energy demand from high prices.  Everyone seems to have bought into the belief that global economic activity will not be hurt by high commodity prices because energy is such a small part of most developed nation’s GDP.  We remain skeptical of this universal belief.     

(Top)

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

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