Musings from the Oil Patch – January 31, 2012

• Are We Missing The Critical Issues Of Keystone Decision?
• Obama’s State of the Energy Union Speech
• Ramping Up Natural Gas Production And The Treadmill
• Energy In The State Department In Light Of Keystone XL
• Some Key Points From Early Look At 2012 Energy Outlook
• Health Of Houston Economy Improving, But Troubles Exist
• An Additional View On Mercury And CFL Bulbs

Musings From the Oil Patch
January 31, 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

In early November we first wrote about the then-upcoming decision by the U.S. Department of State on whether to grant a permit for construction of the Keystone XL pipeline.  We noted the decision was coming at about the same time as the Congressional Super Committee’s decision would be announced about steps to remedy the federal government’s budget crisis.  Because President Barack Obama had already told a television reporter he would be making the pipeline decision, we knew this permit had become a political “hot potato.”  We concluded our article with the following observation: “We suspect both decision dramas will have twists and turns we haven’t imagined, so stay tuned. But also, don’t be surprised if one of those twists results in merely kicking the can further down the road given the pressures of the upcoming election.”  How right that observation turned out to be. 

In mid-November we witnessed the Obama administration’s kabuki dance in order to delay making a decision on the Keystone XL pipeline permit in order to defuse the anger of the liberal wing of the Democratic Party, which is heavily dominated by environmental sympathizers.  While pleasing one constituency, the President also said all the right things to mollify his union supporters who lost jobs that would have developed. 

To remind people of what happened, first we had the State Department’s Inspector General announce he was going to investigate how a consulting firm that reportedly worked for TransCanada Inc. (TRP-NYSE), the owner of the pipeline, was hired by the government to vet the project.  That investigation vaporized once TransCanada disclosed the consultant had been hired by numerous federal agencies to vet other company projects, but had never worked for the company.  This particular consulting firm was one of several proposed to the State Department as being qualified to evaluate the project.  The State Department made the hiring decision based on the firm’s credentials and its ability to get up to speed quickly on the issues surrounding the project.  In other words, TransCanada had nothing to do with hiring the consulting firm other than to suggest it was competent and qualified to evaluate the project.

Since President Obama’s election team knows it needs the support of the liberal base of the Democratic Party, the pressure grew to quickly find a way to delay the decision until after the election to avoid angering at least one key support group.  Fortunately, along came the Nebraska legislature, which wanted to have the pipeline re-routed around the sandhills region of the state and the Ogallala Aquifer, in order to pacify locals concerned about possible pollution from an oil spill.  Once the state legislature mounted an effort to require re-routing the pipeline, the State Department was off the hook because it could claim that any new route needed additional environmental studies that would extend the review time until well after the election.  Voilá, President Obama was excused from having to make a decision. 

The lack of a decision angered Congressional Republicans and others focused on the economic benefits that would come from the construction project especially because the project was not only “shovel ready” but didn’t require government funds.  The House Republicans seized the decision postponement as an opportunity to legislate a decision.  They accomplished this by attaching a rider to the payroll-tax two-month holiday extension legislation being approved by the Senate.  A battle erupted between the House and Senate over this provision.  A political compromise was negotiated shortly before Christmas that led to the bill’s approval with the pipeline rider.  President Obama signed the legislation into law, after objecting to it, and thereby started the 60-day clock for rendering a decision. 

As we have subsequently learned, never underestimate the creativity of politicians – people who can stop clocks, pass laws that don’t apply to themselves and retroactively raise your taxes – to twist the facts for their own benefit.  To Mr. Obama’s chagrin, the “do-nothing” Congress had actually done something!  Now the administration would have to make a decision on an issue it wished to avoid.  It was time for Plan B! 

Since TransCanada had agreed with the State of Nebraska to discuss a possible pipeline re-routing to avoid crossing the politically and environmentally sensitive sandhills area, the State Department claimed it wouldn’t have sufficient time to assess a new route and make a recommendation within the 60-day time limit.  This, despite the fact the State Department had studied the project for three years, had examined 13 proposed routes and determined that the one it had been about to approve in November was the least environmentally-damaging, and had prepared three environmental impact statements supporting the project in order to deal with the constant criticisms of the Environmental Protection Agency.  Since the State Department said it couldn’t reach a conclusion that the Keystone pipeline was in the national interest within the time limit, Secretary Hillary Clinton recommended that the application be denied.  In his statement announcing the denial and justifying his decision, President Obama stated, “…the rushed and arbitrary deadline insisted on by Congressional Republicans prevented a full assessment of the pipeline’s impact, especially the health and safety of the American people, as well as our environment.”  It is clear from this statement that the decision is not based on the merits of the pipeline but rather is a judgment about the product it would transport.  This decision was not about the sandhills or the aquifer it was about the use of “dirty” oil, which in the eyes of the environmental movement should be banned.  President Obama clearly agrees.

Had the permit denial been based on issues dealing with the pipeline’s proposed route or its construction, the rationale for rejecting the permit would have been different.  It would have referred to the risk of the pipeline crossing the Ogallala Aquifer or going through the sandhills ecosystem of Nebraska.  But neither of these issues nor any other local issues were cited in the denial statement. 

Exhibit 1.  Large Ogallala Aquifer Expanse

Source:  High Plains Underground Water Conservation Dis. # 1

The Ogallala Aquifer is an important source of water for farmers, ranchers and residents in the eight central plains states it underlies and is one of the most important aquifers in the entire country.  The Ogallala covers 175,000 square miles and spans South Dakota, Nebraska, Wyoming, Colorado, Kansas, Oklahoma, Texas and New Mexico.  In 1990, the Ogallala Aquifer contained an estimated 3.270 billion-acre feet of water, of which about 65% was located under Nebraska, 12% under Texas, 10% under Kansas, 4% under Colorado, 3.5% under Oklahoma, 2% under Wyoming and 1.5% under New Mexico.  Most of the residents in this region depend upon the aquifer for their drinking water, and the farmers there produce about a fifth of America’s agricultural output.  About 95% of the water pumped from the aquifer is used for irrigation. 

Exhibit 2.  Keystone XL Pipeline Route

Source:  NRDC

The initial route proposed for the Keystone XL pipeline would have traversed the northeast corner of the Ogallala aquifer in Nebraska and part of the sandhills region of the state.  Would a pipeline crossing the aquifer present a risk?  Certainly, as all pipelines present some risk of leaks, but this pipeline was designed and would be built with more safeguards than any prior pipeline.  There are already more than 22,000 miles of pipelines – almost all carrying crude oil or refined petroleum products – that cross the aquifer.  And none of them were built to the standards of the Keystone XL line.  As shown by the map in Exhibit 4, the only area of the aquifer without many miles of pipeline is the sandhills region of Nebraska.  There are about 2,000 miles of pipelines in Nebraska, but certainly not the concentration seen in the rest of the aquifer. (Exhibit 3.)

Exhibit 3.  Keystone In Ogallala In Nebraska

Source:  TransCanada

Exhibit 4.  Miles Of Pipelines In Ogallala Aquifer

Source:  R Squared Energy Blog

According to a statement from TransCanada CEO Russ Girling, the company has mapped eight routes for the pipeline through Nebraska with one route that totally avoids the sandhills and the Ogallala Aquifer and six routes that minimize the mileage through the sandhills region.  That would not be good enough, however, because this battle is over oil, and in particular, the growing supply of bitumen extracted from the oil sands in northern Alberta, Canada.  While some protestors raise the issue of the safety of the aquifer in the event of an oil spill, the history of other pipeline spills in aquifers and in geology similar to that of the sandhills suggest a spill is likely to have only a minimal impact. 

Exhibit 5.  Sandhills Region Of Nebraska

Source:  Wikipedia

TransCanada’s research on pipeline spills projects that over the next 50 years, there could be 11 such spills, each releasing more than 50 barrels.  On the other hand, a research paper by John Stansbury, a professor of environmental and water resource engineering at the University of Nebraska puts the risk at 91 spills of 50 barrels.  The question is what happens if there is a spill?  The only comparable pipeline spill occurred in 1979 that spilled 450,000 gallons (approximately 10,700 barrels) of crude oil near Bemidji, Minnesota.  Initial remediation efforts removed 75% of the oil.  The pipeline company cleaned up an additional 30,000 gallons between 1999 and 2004.  About 80,000 gallons remain in the soil and aquifer, but some of it has been degraded by microbes.  The United States Geological Survey (USGS) has used the site as a research laboratory.  It has drilled holes to monitor the spilled oil.  After two decades, the test wells show that the oil had migrated between 130 and 160 feet downslope within the aquifer.  It has not moved much since then.  Dissolved hydrocarbons in the aquifer have moved farther, about 660 feet downslope.

Exhibit 6.  Dunes Of The Sandhills Region

Source:  Wikipedia

The geology of the sandhills region is different from the Minnesota spill area.  It is more compact.  Therefore some water experts believe the extent of an oil spill in the sandhills will be less than in the Minnesota spill.  According to testimony before the House Natural Resource Committee by Ogallala hydrologist and University of Nebraska at Lincoln Professor Emeritus Jim Goeke, if the groundwater was affected it would be measured in the tens of feet or hundreds of feet.  Based on data from other historical oil releases affecting groundwater, the movement of dissolved hydrocarbons is confined to less than 300 feet.  This does not mean that oil spills in aquifers are not bad things, but the point is that they are not necessarily disastrous.

The map in Exhibit 7 shows the saturated thickness of the Ogallala Aquifer.  Saturated thickness describes the thickness of an aquifer.  This interval is determined by subtracting the elevation of the base of the aquifer from the elevation of the water table at a point of interest.  The water table is a term used to describe the uppermost surface of sediments that are 100% saturated.  As seen from the map, there are places in Nebraska where the saturated thickness exceeds 1,000 feet, which has stimulated the concern. 

Exhibit 7.  Substantial Water Under Nebraska

Source:  High Plains Underground Water Conservation Dis. # 1

The amount of water that may be recovered in an aquifer is dependent primarily on the areal extent, the saturated thickness and the specific yield of the aquifer.  Specific yield is a hydrologic parameter related to the volume of water an aquifer will yield as a result of gravity drainage.  As an example, at 15% specific yield, each cubic foot of water saturated aquifer volume will yield 0.15 cubic-foot of water as a result of gravity drainage. 

Exhibit 8.  Estimating Water In Aquifer

 

Source:  High Plains Underground Water Conservation Dis. # 1

At the end of the day, the battle over the Keystone pipeline is less about possible harm from an oil spill to the Ogallala Aquifer or to the sandhills ecosystem than it is about continued use of oil, and especially the dirty oil from Canada.  What has not been focused on by those opposed to the Keystone pipeline’s oil is the impact it will have on the United States energy supply security.  In contrast to the rant from protestors that all the oil coming via the pipeline will be exported, an examination of the health of the U.S. refining business offers a contrasting view.  First, oil sands output is an effective substitute for the heavy Orinoco oil coming from Venezuela or the Maya crude imported from Mexico, and now the heavy crude oil coming from Brazil.  Second, refineries on the East Coast are shutting down due to poor economics leaving that region more dependent on imports for refined petroleum products.  An alternative supply arrangement would increase product shipments from the Gulf Coast via the Colonial pipeline.  The expansion of Gulf Coast refineries currently underway will enable the industry to increase product supply to the East Coast, helping to reduce imports, and to increase exports of more valuable refined product.  Not only would this benefit the U.S. energy supply situation, it would also help our balance of trade.

Refiners face several problems.  Supplies of Mexican Maya oil have been in decline due to the oil industry problems of our southern neighbor.  Without a reversal of Maya production, U.S. Gulf Coast refiners will be forced to seek other sources of heavy oil, for which their plants have been reconfigured to use efficiently.  They are likely to switch to heavy oil from Brazil and Saudi Arabia, or additional supplies from Venezuela, a country headed by President Hugo Chavez who holds the U.S. in high distain and has actively embraced policies designed to hurt our country.  (Remember this is the foreign leader our President shook hands with and accepted a copy of his book while attending the Organization of American States meeting several years ago.)

Venezuela has its problems with oil exports.  Due to a lack of oil industry investments due to the Chavez regime siphoning off industry cash to finance social programs to help the government remain in power, Venezuelan oil production has fallen to 1990 levels.  At the same time domestic consumption has grown, limiting export volumes.  Without high oil prices, rising oil demand and falling production would have caused more serious economic problems in the country some years ago. 

Exhibit 9.  Production Down And Consumption Up

Source:  EIA

When we look at the destination of Venezuelan oil exports, the United States is the largest customer.  Gulf Coast refineries imported an average of 830,000 barrels per day through the first 11 months of 2011.  Some 34% of Venezuela’s crude oil exports goes to the Caribbean for processing, meaning the oil is shipped to various refineries on the islands there.  The refined product output is shipped to markets such as the United States and Western Europe.

Exhibit 10.  Most Exports Head To U.S.

Source:  EIA

Much the same story exists for Mexico and its heavy Maya crude oil that dominates the country’s oil export volumes. 

Exhibit 11.  Maya Heavy Oil Is Primary Export

Source:  Pemex

While Maya crude oil represents about three-quarters of the country’s exports, nearly 80% of the volume heads to the United States. 

Exhibit 12.  Bulk Of Mexican Exports Go To U.S.

Source:  Pemex

The biggest challenge for Mexico is that Maya crude oil production and the volume available for export has declined in recent years.  Exports appear to have stabilized since 2009, but down nearly 500,000 barrels per day from the export volume of 2006.  While Pemex has been able to stabilize Maya crude exports, without a change in its investment philosophy, the capability to sustain export volumes at current levels should be questioned.  For U.S. Gulf Coast refiners, concern over future Maya supplies is forcing them to seek alternative heavy oil supply sources to process in their refineries.  That search has them more closely examining the potential for utilizing Canadian oil sands output – the stuff that the Keystone pipeline would haul down to the Gulf Coast.

Exhibit 13.  Mexican Oil Exports Declining

Source:  Pemex, PPHB

There are some serious questions being raised about whether the Keystone permit rejection by President Obama is a violation under the North American Free Trade Agreement and under the U.S. membership in the World Trade Organization.  Moreover, according to the nonpartisan Congressional Research Service report of January 20th, “[I]f Congress chose to assert its authority in the area of border crossing facilities, this would likely be considered within its Constitutionally enumerated authority to regulate foreign commerce.”  This report has given some legislators hope that Congress could take over the approval process for the Keystone pipeline permit from the Executive Branch.  The problem is that the Democratically-controlled Senate would probably block such legislative action.

We are anxiously awaiting the report the President must deliver to justify his determination about the Keystone pipeline permit.  Under the rider legislation, he must deliver a report no later than 15 days after the date of determination, meaning it should be coming any minute.  Also under the law, the President cannot rely on environmental issues as grounds to reject the permit, although he did in his statement announcing his decision.  The law specifically states under Title V – Other Provisions, Subtitle A – Keystone XL

Pipeline, Sec. 501(c)(A) “the final environmental impact statement issued by the Secretary of State on August 26, 2011, satisfies all requirements of the National Environmental Policy Act of 1969….”  Any modification required by the Secretary of State will not require a supplement to the final environmental impact statement.  And in (C) “no further Federal environmental review shall be required.” 

This point was raised by Mary Anastasia O’Grady, the writer of the Americas column on the Opinion page of The Wall Street Journal.  Ms. O’Grady covers political, economic and social developments of the countries in North, South and Central America.  As she wrote in her January 23rd column, “Congress anticipated that Mr. Obama would try to use the complex process of environmental study as a fig leaf for further delaying the pipeline.  But if the law is to be followed, since the president failed to make a national interest determination as specified in the rider, it means that ‘the permit for the Keystone XL pipeline…shall be in effect by operation of law.’  The only question is whether Mr. Obama can be made to obey the letter and the spirit of that law and whether Republicans will try to enforce it.” 

In Mr. Obama’s State of Union address a few days later, he seized on the phrase of “try all of the above” when referring to the nation’s need to develop American energy.  This has been the Republican energy mantra, but it was recently co-opted and used in a report of the President’s Council on Jobs and Competitiveness headed by Jeffrey Immelt, chairman of GE (GE-NYSE).  Amazingly, that report was presented merely hours before Mr. Obama signaled he would be rejecting the Keystone XL permit.  So “all of the above” means all of the above except for a shovel-ready, major pipeline construction project that will employ thousands of workers (the only dispute is how many thousands), not involve any federal government money and will insure a long-term supply of oil from our neighbor to the north.  Can anyone explain why Keystone isn’t part of the “all of the above” designation?

At one point during President Obama’s State of the Union Speech, we expected to hear him break out in song with a “yippee-i-ya-i-ya, yippee-i-o.”  We’re not sure whether he is a big Tex Ritter fan or not, but for a while, it seemed Mr. Obama was trying to out-Texan his successor, George W. Bush, when he waxed eloquently on the conventional oil and gas production gains of the past few years.  This time, Mr. Obama didn’t want to blame Mr. Bush for all the economic failures of the past three years, but rather he wanted to take all the credit for America’s recent oil and gas production gains.  Cynically, one might say these are all due to the Halliburton exception that supposedly exempted hydraulic fracturing from regulation, something that has been aggressively attacked by Mr. Obama’s supporters. 

This was the new energy president speaking!  Much like Al Gore claimed he invented the Internet, Mr. Obama took claim for inventing shale gas.  The reality is that while the federal government played an important role in the evolution of techniques for drilling and extracting natural gas from shale formations, the effort started under former President Gerald Ford in the 1970s.  A recent article in The Washington Post by the two heads of the Breakthrough Institute, a nonpartisan public policy think tank in California, points to a number of Department of Energy and Gas Research Institute funded research projects that helped Mitchell Energy and other oil and gas companies attempting to solve the mysteries of unlocking gas from shale formations.  Many of these projects, based on our research, were advances on existing industry technology.  We are cautious in questioning the writers’ view that this was all government sponsored research since the article was defending government funding of clean energy development such as undertaken by Solyndra. 

What we know about gas shale technology developments is that Halliburton Company (HAL-NYSE) pioneered hydraulic fracturing of oil and gas wells over 60 years ago.  The Washington Post article discusses two Department of Energy employees who were granted a patent in 1976 for an early-stage directional drilling technology that supposedly was the precursor to horizontal drilling.  Yet the earliest patent for directional drilling was granted in 1891, and progress to improve the technique was advanced in 1929 and 1944.  The ultimate key to horizontal drilling success was the improvement on the Russian downhole drilling motor technology utilized in the 1960s.  Horizontal drilling really emerged as a technique in the 1970s during the boom in the Austin Chalk formation that extends from Central Texas into Louisiana.  That boom, like many previous oilfield booms, ended when crude oil prices crashed in the mid 1980s.

As President Obama was praising the accomplishments of the oil and gas industry during his term in office, the facts are not quite as compelling as he suggests.  In his speech, he made the statement, “American oil production is the highest that it’s been in eight years.”   The statement is correct, but between 2009 and now, oil production is only 300,000 barrels per day (b/d) higher.  Importantly, the growth in oil production has all been all on private land and not federal acreage. 

Mr. Obama also said, “…last year, we relied less on foreign oil than in any of the past 16 years.”  This was another accurate statement, but another one that when examined more closely is questionable.  The ongoing recession and the high price of oil have contributed to less oil demand in this country.  If we average the two middle weeks of January 2009, when Mr. Obama was inaugurated, to the last two weeks of this January, overall oil demand (measured by the change in weekly product supplied) is down over one million barrels per day, or 5.4%.  Gasoline, the major petroleum fuel category, was off almost 600,000 b/d, or a decline of 6.9%.  These demand declines, coupled with the rise in domestic oil production, explain the nearly 4.3

Exhibit 14.  Oil Production Down On Federal Land

Source:  IER

million b/d decline in net crude oil and refined petroleum product imports between mid January 2009 and the same period in 2012.  That is a decline of 35.7%! 

Mr. Obama made two statements about leasing land for oil and gas exploration.  He said, “Over the last three years, we’ve opened millions of new acres for oil and gas exploration, and tonight, I’m directing my administration to open more than 75 percent of our potential offshore oil and gas resources.”  The facts are that when Mr. Obama was inaugurated, the industry had access to 100% of the potential offshore oil and gas resources.  Moreover, the Obama administration has been making it more difficult to lease federal onshore lands as shown by the chart in Exhibit 15. 

Exhibit 15.  Fewer Leases Under Obama

Source:  IER

The Obama administration wants to claim that it is doing positive things offshore, but it has prevented the state of Virginia from being able to lease its offshore acreage.  It also is only holding the June 20, 2012, central Gulf of Mexico lease sale because existing law requires it.  That is also true with respect to its new five-year offshore leasing plan.

Exhibit 16.  Gas Production Up On Private Land

Source:  IER

When it came to natural gas, President Obama was very positive about the state of the industry and its potential for helping the future economy.  He talked about the 100-year supply of natural gas.  He also said that his administration will work to make sure that this natural gas resource is developed safely.  That is being applauded by the petroleum industry as support for hydraulic fracturing.  The President went on to make the point that the administration will require the disclosure of the chemicals used in fracturing conducted on federal land.  The President also commented that the successful development of our gas shale resources could employ 600,000 workers by the end of the decade.  Once again, however, the facts are that the growth in domestic natural gas production is occurring on private rather than on federal land.  And that divergence in growth trends is very dramatic as presented in the chart in Exhibit 16.

After having attempted to co-opt the Republican talking points on energy, President Obama returned to his other campaign themes in the speech.  We wish that President Obama would acknowledge that the success in the domestic oil and gas business during the past half decade is due to high oil prices and the revolution in gas and oil shale extraction despite his administration’s actions.  As the production data shows, the industry’s gains have come in the private and not the government sectors.  An enlightened federal energy policy could change that dynamic and potentially drive our domestic energy industry to even greater heights.  While Mr. Obama claimed the phrase, “all of the above” for his energy strategy, his actions don’t support its meaning.

The Energy Information Administration (EIA) will soon be reporting natural gas production data for the final months of 2011.  Based on the 10-month data available, and assuming that the October volume of about 2 trillion cubic feet (TCF) is sustained in November and December, the industry will have produced roughly 23 Tcf of gas in 2011, an historical record as shown by the chart in Exhibit 17.  A quick analysis of this performance by Art Berman shows that between 1973 and 2011 there has been a vast increase in the number of producing gas wells.  Also, these wells have very high decline rates compared to those of 1973 vintage wells.  The selection of 1973 is because that was the historical production peak for dry natural gas of 21.73 Tcf. 

Exhibit 17.  Gas Production Headed To New Peak

Source:  EIA

To put the analysis into perspective, in 1973 there were 124,168 producing natural gas wells.  At the end of 2010 there were 487,627, or nearly four times those of 1973.  What this means is that four times the number of natural gas producing wells were required to boost domestic production roughly 10% above that prior production peak. 

After looking at the major gas producing state of Texas data, Mr. Berman wrote, “in 1972 Texas gas wells produced 7.5 TCF, from 23,000 gas wells (893 MCFGPD per well), and in 2010, Texas produced 6.4 TCF, from 102,000 gas wells (172 MCFGPD per well).  So, the average gas well in Texas in 2010 produced one-fifth of what the average gas well in Texas produced in 1972.”  To put the treadmill analogy into perspective, in 1972, there were on average about 350 rigs drilling in Texas versus the 659 working in 2010, or not quite double the earlier number.  Of course, these drilling rigs were drilling both oil and gas wells, and in the earlier period, a larger number of dry holes than today due to vastly improved seismic techniques for identifying drilling prospects. 

When we examine two charts from the Texas Railroad Commission showing historical drilling trends in the state, it becomes clear that the explosion in crude oil prices in the early 1970s was driving drilling activity then.  Natural gas prices, at least for gas destined for

Exhibit 18.  More Rigs Today Than In Early 70s

Source:  Texas Railroad Commission

sale to pipeline companies in the interstate gas transmission market, were low and not stimulating much drilling.  More of the gas drilling in Texas then was directed toward supplying customers within the state, and thereby not regulated by the Federal Power Commission.  Intrastate natural gas prices were substantially higher than interstate gas prices and more in line with high oil prices then. 

Exhibit 19.  New Wells Now Equal Early 1970s

Source:  Texas Railroad Commission

It is interesting to note how the improvements in drilling technology and exploration target identification have helped the industry grow production in an environment where the quality of the producing wells has been deteriorating.  One has to wonder when, or if, these drilling technology trends will be unable to overcome the deteriorating (challenging) nature of oil and gas producing formations.  At that point, whether you call it Peak Oil, the end of cheap energy or the end of the Age of Oil, the reality will be the same; commodity prices will rise, and rise sharply.

We read with great interest an interview in Energybiz magazine with Carlos Pascual, the former ambassador to Mexico who has been tapped by Secretary of State Hillary Clinton to head up the new Bureau of Energy Resources within the Department of State.  Much of the interview dealt with the relationship between the U.S. and China over energy and energy technology.  We found two topics of particular interest.  One dealt with the role of this bureau and the other was the energy initiatives for linking Mexico, Canada and the United States.  We have reproduced the questions and answers below with commentary afterword.

Energybiz: What are the objectives of the Bureau of Energy Resources and what kind of resources will be devoted to it?
Pascual: Our objective is to bring enhanced energy security to the United States.  That means energy that is affordable, supplies that are available and supplies that are reliable.  The resources that we bring to bear are the diplomatic and policy capabilities of the U.S. government.  We will work with suppliers of oil and gas on how to maintain market stability.  We can play a strong role in policy leadership on how to bring commercially viable models to extend energy and electricity services to the 1.3 billion people in the world who don’t have access to electricity.

Energybiz: Are there any initiatives that can link Mexico, Canada and the United States on the energy front?
Pascual: Absolutely.  One of the issues that we’ve begun discussing with our Canadian and Mexican counterparts is how to develop the most appropriate and effective power interconnections across the three countries.  Mexico has strong power generation capacity, lots of hydro power and a strong commitment to introduce more renewable power, particularly solar and wind.

The first question and answer seems to point up the hypocrisy of the State Department’s denial of the permit for construction of the Keystone XL pipeline.  The oil from Canada is affordable, available and reliable, meeting the standard this Bureau is establishing.  Will the Canadian oil destabilize the U.S. or Canadian energy market?  I don’t think so.  We will anxiously await the mandatory report justifying the State Department’s denial recommendation, especially since it cannot rely on environmental grounds for its decision.

We were also intrigued about the Mexican energy business.  Clearly, Ambassador Pascual has a unique perspective, but we must admit we were not aware of Mexico’s strong power generation capacity, hydro power and commitment to expand renewable power.  Much of this must have been obscured by the drug war underway in the country and along the U.S.-Mexico border.  We did think Ambassador Pascual might have had a comment about Canada, which happens to be our major energy supplier.  We can’t determine how much of his answer was designed to minimize the Canadian role in a unified North American energy market, but diplomats almost always are careful to “stay on message” just like politicians. 

The Energy Information Administration (EIA) presented the early release of its 2012 Annual Energy Outlook (AEO2012).  The report presents a comprehensive forecast of energy markets through 2035.  The gist of the report is that we live in a nation that suddenly discovered an abundance of natural resources that will make the country’s energy future much less threatening than what was thought before.  Domestic oil and natural gas are predicted to continue to grow, which will help to keep energy costs lower than they otherwise might have been.  Equally important is that the EIA sees U.S. energy-related carbon dioxide emissions below their 2005 level through 2035. 

Exhibit 20.  CO2 Emissions Lower Than Peak

Source:  EIA, AEO2012 Early Release

Domestic crude oil production has grown from 5.1 million barrels per day (mmb/d) in 2007 to 5.5mmb/d in 2010.  Projections are that oil production will continue to grow reaching 6.7mmb/d in 2020 before starting to decline.  The forecast projects that despite this production decline, oil output will still remain above 6.1mmb/d through 2035.  Oil production growth, coupled with more efficient use of liquid fuels plus additional supplies of biomass and alternative liquid fuels, will enable net petroleum imports to shrink from 49% of the total in 2010 to 36% in 2035.

Natural gas production is projected to continue growing, driven by the gas shale revolution.  Gas shale production is anticipated to climb from 5.0 trillion cubic feet (Tcf), or 23% of total U.S. dry gas production, to 13.6 Tcf in 2035, or 49% of production.  This optimistic production outlook will support the United States becoming a net exporter of liquefied natural gas (LNG) by 2016, a net pipeline exporter in 2025 and an overall net exporter of natural

Exhibit 21.  Higher Oil Output Helps Cut Imports

Source:  EIA, AEO2012 Early Release

gas in 2021.  All of these conditions will occur while domestic natural gas prices remain lower than in other global markets.  One has to wonder at what point global gas prices begin to exert upward pressure on domestic prices. 

Exhibit 22.  Gas Production Up Due To Shale

Source:  EIA, AEO2012 Early Release

It is important to understand that the EIA has always had an optimistic view of domestic oil supplies but a more pessimistic view of natural gas.  While domestic oil production is growing, a big reason for the decline in net oil imports is a more realistic view of oil consumption growth.  In the case of natural gas, the EIA was one of the leading cheerleaders for our need to build many LNG import terminals.  Now that we have a surplus of natural gas, even though the agency marked down its estimate for gas shale resources in this report, it remains a leading cheerleader for gas exports.  We continue to worry about when the inflection point in natural gas prices arrives and just how producers and consumers react. 

We recently attended the MIT Enterprise Forum Texas luncheon that featured two local economists discussing the outlook for the Houston and national economy.  The two presenters were Dr. R.W. (Bill) Gilmer, VP in charge of the El Paso Branch of the Federal Reserve Bank of Dallas and Nathaniel Karp, Executive Vice President and Chief Economist for the U.S. from BBVA Compass Bank.  As we listened to Dr. Gilmer discuss the pluses and minuses for Houston, we thought about the potential weaknesses that could hurt the economy of the city in the future and undercut the pillars of growth that were put in place following the 1980s oil price bust. 

For those who lived through the 1970s energy boom and the 1980s bust, we remember the vulnerability of the Houston economy as it had become almost entirely dependent on the energy business then.  When global oil prices collapsed, energy industry jobs dried up, unemployment soared and many people either lost or abandoned the homes they could no longer afford, leaving neighborhoods with vacant houses and overgrown lawns.  From the ashes of that bust, Houston recovered by building a more diverse local economy while, at the same time, not abandoning the energy industry.  The manned space effort received greater attention along with significant expansion of the Houston Medical Center.  Houston also focused on increasing its nascent technology industry with companies such as Compact Computers, Texas Instruments and BMC Software, to name a few.  Our medical research effort created start up biotechnology companies and the State of Texas helped growth local universities and community colleges.  Through the 1990s and 2000s, Houston’s economy grew with a healthy mix of industries contributing.

Exhibit 23.  Houston Economy Has Been Healthy

Source:  Gilmer

Dr. Gilmer’s talk was titled “Energy Carries the Load: Gulf Coast Economy Surges in 2012.”  He pointed out that Houston’s economy was being helped by the growing U.S. economic recovery, but global growth was becoming more important from a trade and energy perspective.  As he pointed out, expensive oil was helping upstream activity, and correspondingly, employment.  At the same time, low natural gas prices, while a minor drag on upstream activity, was actually creating a boom for petrochemical expansion plans that have boosted Gulf Coast construction activity.  To demonstrate this point, Dr. Gilmer had a table listing a dozen plant expansion projects primarily on the Gulf Coast that will add about 18 million pounds annually of new ethylene capacity by 2017 to the industry. 

Exhibit 24.  Houston Ahead Of National Economy

Source:  Gilmer

Dr. Gilmer pointed out that Houston’s unemployment rate is not performing as well as the national rate because our employment pool is not shrinking, plus we are experiencing significant in-migration.  Note that the Houston unemployment rate has stopped declining in Exhibit 24.  He also pointed out that Houston’s real estate market was improving and the foreclosure backlog was being helped by our employment growth, suggesting that we are likely to see a stronger recovery in housing before a national recovery.

Exhibit 25.  Oil Service Industry Jobs Growing

Source:  Gilmer

Exhibit 26.  Manufacturing Jobs Below Last Peak

Source:  Gilmer

As Dr. Gilmer’s talk’s title suggests, energy is the industry carrying the load for Houston’s economic growth.  In other words, Houston may be experiencing an unbalanced economic recovery, and because existing national policies are hurting two of our major economic growth pillars, we need to be aware of the risk to our future growth.  In particular, the Obama administration’s decision to end manned space flight has taken a heavy toll on the Johnson Space Center.  The healthcare reform underway is raising serious questions about the nature of medical care in the future.  According to Dr. Gilmer, for the first time in modern memory, there are no construction cranes working in the Medical Center. 

The negative impact associated with the deepwater drilling moratorium and its aftermath are slowly easing, but the Gulf of Mexico will probably never return to the levels of activity seen some years ago.  The threat of implementing a cap and trade regulatory policy on energy use nationwide will have a negative impact on our energy industry.  These policy actions should be of concern to Houstonians worried about the future of their city.  As the fastest growing major metropolitan area in the United States, Houston could be entering a period of slower growth.  Will that help or hurt the overall national economic recovery?

In the last Musings, we wrote about the issue of mercury in compact fluorescent lamp (CFL) light bulbs compared to mercury released by burning coal to generate electricity.  There is about 5 milligrams of mercury in CFL bulbs, or as was described, about the amount to “cover a ballpoint pen tip.”  The bottom line of what we wrote was that the amount of mercury saved by electricity reductions due to the lower power demands of CFL bulbs exceeds the potential mercury that would be released from broken CFL bulbs.  We cited figures showing that in 2006, coal-fired power plants generated 1,971 billion kilowatts of power and released 50.7 tons of mercury and that 20% of the electricity was used for lighting.

One of our readers, Dave Agerton of Dave Agerton Consulting, wrote suggesting we might want to examine the impact of the release of mercury if all the light bulbs replaced each year wound up in landfills and are crushed releasing their mercury.  We noted that not all the light bulbs replaced each year are candidates for replacement by CFL bulbs, but Mr. Agerton did assume that in his calculations.  Eventually all light bulbs will become candidates for CFL replacement, but not until the lighting industry does more work on niche bulb markets such as colored lights or appliance bulbs.  We used Lester Brown of Earth Policy Institute’s estimate that there are 4.7 billion light sockets in the United States with about 1.6 billion CFL light bulbs in place.  Other estimates are that there are 5 billion light bulbs in use in the country with about 2.2 billion bulbs replaced each year.

In Mr. Agerton’s calculations, he assumed 2 billion CFL bulbs are deposited in landfills and as a result each releases its 5 milligrams of mercury, releasing a total of 11 tons of mercury annually.  He assumed that coal-fired power plants release 50 tons of mercury annually and that 20% of their output is for lighting releasing 10 tons of mercury into the atmosphere.  So we have 10 tons of mercury versus no mercury from incandescent light bulbs.  If the switch to all CFL bulbs cuts electricity demand in half, then only 5 tons of mercury is released from power plants, but then we have 11 tons from the crushed annual replacement bulbs, for a total of 16 tons of mercury released each year. 

It is hard to know whether the 100% switch to CFL bulbs will actually reduce the total mercury released.  The point of the analysis Mr. Agerton presented is that just because there is a small amount of mercury in each CFL bulb, when all of them release their mercury, the total amount released may exceed the volume of mercury saved due to a reduction in coal use from less electricity being needed by the switch in bulbs.  In the end, however, this analysis may prove academic as coal-fired power plants are being shut down and replaced by cleaner gas-fired plants or clean energy power. 

Contact PPHB:
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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.