Musings from the Oil Patch – January 5, 2010

• Will Energy Be As Important In The Next Decade As Last?
• October Gas Production Dampens Bullish Price Case
• The 2009 Drilling Rig Correction – A Retrospective
• Will We Get That Colder Winter Weather?
• A Picture Of Our Post Peak Oil Food Supply

Musings From the Oil Patch
January 5, 2010

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

We awoke last Friday morning to the start of a new decade.  We had been noticing for several weeks before that many articles were appearing in the media reviewing the prior decade’s most important events – whether they were in politics, business, entertainment or sports.  One theme that emerged was the difficulty reviewers had in deciding what to call the past decade.  We saw references in the Financial Times and The Houston Chronicle to terms such as “Noughties” and “Aughties.”  On a web site seeking names for the decade, people suggested all sorts of ideas including “00’s,” “Zeros” and “Forgetful.”

A year-end stock market wrap-up column on CNN Money.com suggested that names such as “Naughty Aughties” or “Awful Aughts” or even “Zilches” were appropriate given the amount of wealth destroyed during the decade.  The writer seemed to settle on the “Uh-Ohs” as they labeled their charts with that term.  Paul Krugman of The New York Times wrote a column last week on the decade in which he called it the “Big Zero.”  While we haven’t come up with a catchy monocle for the decade, we tend to think it will be known as the “00’s” in keeping with the conventional description of the 60’s, 70’s, and so forth.  Regardless of what we call it, we are certain about one fact − energy played a significant role in the last decade.

A chart showing the performance of the broad stock market averages over 2000-2009 reminds us how bad the last 10 years were for the nation’s investors.  During that time the Dow Jones Industrial Average fell 8%, but that was considerably better performance than either the broad-based S&P 500 Index that declined 23% or the tech-heavy Nasdaq that dropped 44%.  The near-by chart documents these performances.

Exhibit 1.  Substantial Investor Wealth Destroyed In Decade

Source:  CNN Money.com

As the reviewer pointed out, the last decade was marked by recessions at either end, including one that rivaled the Great Depression, along with accounting scandals, poor business decisions and greed running wild.  The energy business was involved in some of those events as a timeline for the decade shows.  But what stood out to us when we started examining the period in greater depth was just how well energy investments performed.  We need to point out, however, how important it is to have the trend as your friend: In this case, that trend was generally rising oil and gas prices.

Exhibit 2.  Trend In Oil & Gas Prices Helped Investments

Source:  EIA, NYMEX, PPHB

As shown in the accompanying chart, crude oil and natural gas prices started out the decade at lower levels then they ended.  During the decade, however, there were extended periods when prices seemed to be stagnant.  For crude oil that seemed to be from the beginning of the decade until mid 2004 when the Chinese economy’s need for oil not only escalated but it became a central focus for both that government’s economic planning efforts and the global media’s attention.  As global oil consumption climbed during the decade, the world’s ability to satisfy that growth was continually under pressure.  As in all free markets, the rationing mechanism of price is how we balanced demand and supply.  As the oil supply/demand balance tightened in the middle of the decade, and forecasts called for continued growth in demand, oil prices slowly started on an upward course that would eventually take them to an all-time peak of $147 per barrel in mid 2008 just before the collapse of global economies.  The subsequent fall to lows last seen before the emergence of Chinese oil demand shocked the industry, for it only to be whip-sawed by a recovery that took oil prices back to near $80 a barrel by the end of 2009. 

For natural gas, which started 2000 at around $2 per thousand cubic feet (Mcf), the volatility of prices during the first three years of the decade would fail to convey how much gas markets would eventually change.  From the $2 lows of 2000 and 2002, gas prices would quickly climb by over threefold to the $6 to $7/Mcf range where they traded from 2003 to nearly 2008.  Then, taking their lead from the upward trend in crude oil prices, natural gas prices soared to nearly $14/Mcf before collapsing along with oil prices as the global recession and credit crisis undercut demand and energy company access to capital.  As opposed to the recovery in crude oil prices in the early months of 2009, natural gas became a victim of the industry’s drilling and technological success in exploiting gas shale resources that saw gas production continue to grow in the face of falling prices and curtailed drilling.  An increase in gas demand heading into the 2009-2010 winter has given gas markets some hope that the recent recovery in prices will be sustained, but the latest production data for October casts some doubt over that view.

Given the decade’s upward trend in oil and gas prices despite periods of stagnation, energy equities were favored by many investors.  As the nearby chart shows, three broad indices of energy sector stocks showed strong outperformance versus the broad stock market over the entire decade.  Interestingly, energy stocks almost always outperformed the overall stock market throughout the decade.

Indices representing three of the broad energy sector segments are displayed in the chart in Exhibit 3.  The Philadelphia Oil Service Stock Index (OSX) represents the oilfield service companies while the XOI (Amex Oil Index) and the XNG (Amex Natural Gas Index) are representative of the larger oil and gas companies and the smaller exploration and production (E&P) companies, respectively.  For the entire decade, the OSX and XOI indices generated nearly the same performance for investors.  The XNG index considerably outperformed the other two energy stock indices reflecting the greater ability of smaller E&P companies to grow both their asset

Exhibit 3.  Energy Stocks Were Good Investments In 2000-2009

Source:  YahooFinance.com, PPHB

values through successful exploration and development results and their production as they are usually starting from small bases.  With the help of rising oil and gas prices and optimistic expectations for future commodity prices, E&P companies seem to have the best of both worlds in the stock market.

While all of this appears intuitively rational in hindsight, there were many times during the last decade when one seriously questioned the ownership of any of these energy stocks.  Those questioning times arose when investors became focused on potential problems with the health of the future economy.  One of those first questions came as we started the decade with fear of what the Y2K event might do to global economies and thus their energy demand and even the ability of energy companies to operate in the future.  January 2, 2000, proved that we had little to fear – either because we had anticipated and corrected all the potential problems or Y2K was over-blown.  But as the energy saga of the decade got off to a good start, we soon found ourselves dealing with the issue of deregulation in the California energy market, which most thought would be a good thing.  Few saw the restructuring of California’s energy business as a potential triggering event that would create havoc for years.  The year also brought us a hard-fought presidential election whose outcome would continue to influence the energy business for the balance of the decade.  Little did we understand that outcome as we anxiously watched the hanging chads in the Florida vote re-count.

By the next year, with a new president from Texas with an oil industry background installed in office, energy executives looked forward to better days for their business.  But that summer California began to experience power supply disruptions as electricity demand appeared to be outstripping the industry’s ability to satisfy it.  A major beneficiary of this power market turmoil was a Houston-based company, Enron, which saw its stock price soar to a peak of $90 a share that year.  But as California dealt with rolling brownouts and isolated blackouts, the trading of electricity fell under intense regulatory and political scrutiny.  With this scrutiny came questions about the accounting behind Enron.  Before the year was over, Enron was gone.  The bankruptcy of Enron, one of the largest in the history of the country, despite a desperate last-ditch call to the White House for help that was never answered, opened up a new chapter for energy markets, especially the electricity sector.  It was a chapter marked by public scorn for energy companies and glee over the perp-walks of energy company executives.

But the events in early 2001 rapidly faded into the background when the U.S. was attacked on 9-11.  The event and its immediate aftermath triggered a global recession and a fall in worldwide energy demand.  While the specters of political unrest and economic distress became dominant themes, another event with seemingly less ominous implications happened.  Economists at the investment banking firm of Goldman Sachs (GS-NYSE) coined the term “BRIC” as shorthand for designating the significant role that four developing/recovering economies would play in the world’s future.  Brazil, Russia, India and China were identified by these economists for the first time as all having similar forces at work that would promote high growth rates for their economies that would begin to pressure global commodity markets.

For the energy business, the geopolitical events spawned by the 9-11 attacks were played out during 2002 in Venezuela where the nation’s oil industry executives went on strike to challenge the power of the country’s socialistic and charismatic ruler, Hugo Chavez.  Mr. Chavez wanted to make various changes to how the oil company worked, and especially how its money was controlled.  Venezuela’s oil production and oil exports fell rapidly reducing the government’s flow of income.  At the end of the day, Mr. Chavez won and Petroleos de Venezuela SA (PdVSA) was broken.  Competent management and technical talent were exiled and replaced by people with less operational skills but highly loyal to the country’s leader.  The defeat of PdVSA emboldened Mr. Chavez who looked for other sources of income to support his socialist government.  The operations of western oil companies in Venezuela became an easy target and the first steps on the road toward their nationalization were taken.

In 2003, Operation Iraqi Freedom began as the United States set out to seek retribution against the source of the power behind the 9-11 attack and to influence the Middle East’s tolerance for sponsoring terrorist activity.  For the energy industry, the war did little to disrupt markets, although it did add slightly to global oil demand as the troops needed fuel to prosecute the war and to sustain them in the region.  But some thought the war was all about oil.

A series of events in 2004 set the tone for energy markets for the balance of the decade.  That was the year that China’s oil demand growth exploded onto the public’s radar screen.  China’s oil demand made it onto the front pages of global newspapers because the International Energy Agency (IEA), the body charged with projecting energy demand and helping western country governments manage their energy markets, totally missed anticipating the increase. 

Exhibit 4.  2004 Oil Demand Growth Influenced Decade Trends

Source:  IEA, BP, PPHB

The pressure on China to construct facilities for the upcoming Olympics and for the Chinese government to build infrastructure throughout the country in anticipation of showing it off to the crowds coming for the event boosted oil consumption well beyond any prior increase China had ever experienced.  It is important to note that China had only recently become an oil importer so the surge in oil demand put unusual pressures on the global oil industry and its ability to deliver supplies to the country on a timely basis.  The shortage of electric power nationally was offset by the use of portable power generators burning diesel and swelling China’s need to import more fuel.  This added to China’s energy problems as the country was short of refining capacity thus needing to import refined product, not just more crude oil.

This was also the year that Hurricane Ivan roared through the Gulf of Mexico doing damage to offshore drilling and production facilities and heightening concerns about how vulnerable the U.S. energy industry was to severe storms.  And 2004 marked the first time that Goldman Sachs’ energy analysts discussed the potential of a “super spike” in oil prices.  They suggested that a spike driven by demand and supply issues could boost global oil prices to a high of $95 a barrel sometime within the next few years, although they were officially only predicting an oil price in the $40 a barrel range for 2005. 

If the events of 2004 did not get everyone’s attention, 2005’s events certainly did.  The fallout from the explosion in global oil demand growth the prior year, driven by China’s need for more oil, resulted in a growing focus on the ability of the petroleum industry to meet this accelerating oil consumption growth coming from the developing economies led by the BRIC countries.  Matt Simmons took on the world’s largest oil supplier, Saudi Arabia, with claims that “the sheiks had no robes” as his analysis of published papers by Aramco (the state-owned oil company) engineers pointed up serious production problems within the country’s bedrock oil supply sources.  The thesis underlying Twilight In The Desert engendered a fierce debate within the world petroleum industry, eliciting a determined publicity campaign by the Kingdom to discredit the book and to ease energy consumer concerns about the Kingdom’s ability to meet the global oil needs of the future.  The idea of Peak Oil when we can’t meet growing oil demand became firmly implanted in the minds of citizens around the world with, for many, scary scenarios of a world heading back to caves and clubs. 

The Peak Oil debate was further fueled by a revised Goldman Sachs super spike forecast that oil prices could reach $105 a barrel.  Support for both positions was provided by the efforts of the CNOOC Ltd. (CEO-NYSE) to buy U.S.-based Union Oil of California.  While it seemed that the Chinese really coveted Union Oil’s Southeast Asian oil and gas assets, the bid produced a nationalistic uproar in Washington that ultimately led to domestic giant Chevron (CVX-NYSE) buying the company.  People wondered, if China was willing to risk political repercussions in battling the U.S. government in order to buy an oil company with actual crude oil and natural gas assets, could Peak Oil and rapidly escalating oil prices be far off?

While industry players contemplated these geopolitical trends, nature created its own challenges with back-to-back major hurricanes – Katrina and Rita.  Between them they devastated New Orleans and much of the Upper Texas, Mississippi and Alabama Gulf Coasts.  But more importantly, these two storms devastated the Gulf of Mexico and coastal oil and gas infrastructure including a large part of the nation’s refining capacity.  As the nation recovered from these events, the vulnerability of Gulf of Mexico petroleum operations to hurricanes became a focal point in industry efforts to rebuild.  New standards for operating drilling rigs offshore were instituted.  But the greatest challenge was the reconstruction of the offshore gas pipeline network. 

The underlying oil and gas market dynamics set in place by events of 2004 and 2005 were slowly lifting commodity prices and providing encouragement for producers to step up spending.  In 2006 there were several general events along with some specific petroleum industry events in the news.  On the broader scale, the bird flu cut energy usage in Asia as economic and transportation activity suffered.  In the Americas, Mr. Chavez was re-elected despite a concerted effort by opponents.  In the United States, we welcomed our 300-millionth citizen.  At Prudhoe Bay in Alaska, the 400,000 barrel per day oil flow was shut down as minor spills appeared due to holes created by corrosion in the Alaskan Pipeline.  In Europe, the

Exhibit 5.  E&P Spending Did Well During Last Decade

Source:  Citicorp, Lehman Bros., Barclays Capital, PPHB

first of what would become an almost annual event occurred when Russia shut off the flow of natural gas moving through the Ukraine destined for Western European countries.  While the cutoff was nominally over the transit fee paid by Ukraine, the issue was largely about preventing a small country from having control over its larger and more powerful neighbor’s energy business and its income.  Another major event in 2006, at least locally, was the trial of Enron executives including its chairman and ceo, Ken Lay and Jeff Skilling, who were ultimately convicted.  In one of the more bizarre twists of the Enron story was that while awaiting sentencing, Mr. Lay died at his vacation home in Colorado, erasing his conviction. 

The subprime mortgage crisis emerged in 2007, which would eventually lead to the recession of 2008 and the global credit crisis that undercut energy demand growth.  But before that happened we were treated to the UN’s Intergovernmental Panel on Climate Change’s report on the dangers of global warming and the need to control carbon emissions.  The UN report was followed by former vice president Al Gore’s movie, “An Inconvenient Truth,” presenting visual images, some computer generated as we learned later, of the environmental horrors awaiting Planet Earth caused by global warming due to human burning of carbon fuels.  The IPCC and Mr. Gore were awarded the Nobel Prize that year for their efforts to alert the world to the dangers of man-caused global warming.  While the world was watching the emerging debate over global warming, climate change was renamed to enable the inclusion of any “abnormal” weather event as support drastic civic action.  Concern elicited about Peak Oil and the growing acceptance of commodities as a legitimate investment asset class for investors began to alter the energy landscape.  Oil prices had risen steadily throughout 2007 and the trend was drawing greater media attention.

As we moved into 2008, rising oil prices were being driven by growing demand, but they were also being lifted by hedge funds and other investors betting on the growing shortage of future oil supplies in the face of relentlessly rising consumption.  Government investigations of commodity speculators became a frequent scene in Washington.  Were they the ones driving oil prices higher?  Or was it Goldman Sachs’ latest prognostication that crude oil prices could hit $200 a barrel in the foreseeable future?  Others, including Mr. Simmons offered suggestions that oil at $400 or even $500 a barrel would be cheap in the future world of limited oil resources they foresaw.  A positive development from high oil prices was a growing recognition that the U.S. possessed significant potential hydrocarbon resources off its coasts that have been off-limits for exploration and development.  For the first time since the Santa Barbara oil spill in 1969, Americans were in favor of opening up these offshore resources for the oil and gas industry to explore.  This public sentiment switch may have resulted from the jump in gasoline pump prices.  Americans, however, were also attacking the high gas prices by changing their driving habits and after years of steadily increasing, mileage driven began to fall.

Exhibit 6.  High Gasoline Prices Have Altered Driving Habits

Source:  FHWA, EIA, PPHB

The IEA contributed to the oil price rise when it released the results of its detailed study of the world’s 400 largest oil fields showing that their average production decline rate was 9.1% per year rather than the approximately 4% decline the agency had been using previously when forecasting future oil supplies.  The IEA study clashed with the 4.5% decline rate that Cambridge Energy Research Associates (CERA) claimed.  In general the industry and forecasters accept the IEA’s higher decline rate.  Spring and summer brought significant economic news as one of the larger investment banks, Bear Sterns, failed and then the global insurer, AIG, had to be bailed out by the Federal government.  These events highlighted the growing scope of the systemic problems in the U.S. economy and global credit markets. 
In one weekend in mid September, the entire financial and energy worlds changed.  Hurricane Ike roared ashore over Galveston, Texas nearly wiping the entire city off the island as the storm of 1900 had done.  Ike caused additional damage to the Gulf Coast petroleum infrastructure adding to the unrepaired damage from hurricanes Katrina and Rita in 2005.  The same weekend that Galveston was hit, the world watched the failure of Lehman Brothers and the near total breakdown of global credit markets.  Combined these events hastened the slowing in economic activity that had been underway and forced companies across the spectrum of industry to curtail spending and implement survival strategies further constraining economic activity.

As the recession of 2008 transitioned into 2009 and deepened in the first half of the year, comparisons with prior recessions became the norm.  Trying to fathom just how bad this recession could be and then how it might end and an economic recovery commence became the focus of government efforts.  For energy markets, investors seized on oil as a commodity that would always have value regardless of the value of the U.S. dollar, or any other currency, in which it was priced.  However, as the value of the U.S. dollar fell, oil prices rose as investors bought futures contracts to help preserve the value of their money.  Additionally, many investors and speculators began betting that oil demand would eventually recover – it was only a matter of time – and with reduced investment in finding and developing new oil resources, the current surplus productive capacity would be wiped out sending oil prices higher.  So based on these hopes, oil prices started their remarkable climb from the low $30 a barrel range in March to slightly over $80 in a matter of seven to eight months. 

The story for natural gas was quite different as the demise of the U.S. auto industry and the depression in new home construction, two large consumers of natural gas, created a falling demand scenario.  At the same time, the unlocking of gas shale resources saw the industry begin to grow its annual production for the first time in years.  Growing production and falling demand became a recipe for falling natural gas prices.  For the first time since the 1950s, America witnessed the natural gas industry out trying to create demand for its product.  The use of gas as a transportation fuel and greater use as a cleaner substitute fuel for power generation were loudly touted with mixed results. 

When looking back over the past decade, we can see significant changes to the energy market in the United States.  While domestic oil production has steadily declined since it peaked in 1971, the impact of high oil prices during much of 2008 and part of 2009 has led to increased production.  Energy executives are optimistic they can continue to boost oil production, or at least hold the volume steady.  Natural gas represents another positive trend as the ability of the industry to solve how to produce gas from the shale resources has lead to increased production after years of steady declines.  Can that trend be continued?  The gas shale resource base suggests we can if we assume that economic conditions for natural gas remain positive – reasonably high prices and few restrictions on the use of hydraulic fracturing to open up the shale formations.  The significance of this trend was confirmed by ExxonMobil’s (XOM-NYSE) agreement to purchase XTO Energy (XTO-NYSE) for $41 billion in stock and debt assumption.  So after kicking off the decade with its purchase of Mobil Oil in 1999, ExxonMobil closes the decade with another transformational move.  If crude oil was the story of the 00’s, then natural gas is destined to be the story of the next decade.

Exhibit 7.  Oil And Gas Production Rose In Recent Years

Source:  EIA, PPHB

As the decade ended, the energy landscape had shifted dramatically once again.  In our estimation, the future for energy will more likely be dictated by regulation than free markets.  Profitability in the energy industry is and will remain under attack as the industry’s “robber baron” identity makes it an easy target for higher taxation.  Energy companies will be forced to take steps to fight that increased taxation such as done by Ensco (ESV-NYSE) that elected to relocate its operations and incorporation outside of the United States.  While energy stocks proved to be outstanding investments over the last ten years, we wonder if they are now entering a period of increased regulation, slowing demand and lower profitability that will reduce future stock market valuations.  As we have often pointed out, energy stocks were great investments in the 1970s, only to be pounded by the industry collapse of the 1980s.  Could history repeat?  Yes.  But then again there is no certainty it will.  Check back with us in January 2020.

The Energy Information Administration (EIA) released its estimate of natural gas production for October drawn from the Form 914 filings by producers that showed an increase that nearly wiped out the production decline recorded in September.  The production estimate for Lower 48 Land gas of 56.00 billion cubic feet per day (Bcf/d) increased by 1.06 Bcf/d from September or 1.9%.  This gain nearly wiped out the decline in Lower 48 Land gas production estimated for September of 1.31 Bcf/d, or 2.3%.  The gain was disturbing to those energy analysts who have been estimating that a supply decline due to the fall in land drilling activity would boost gas prices next year into the $7.50 per Mcf range or higher. 

The Lower 48 Land October data showed production increases for all states reported independently except for Texas.  This performance was in sharp contrast to the September production data that showed all states except for Louisiana falling compared to August.  The analysts are now trying to assess whether the EIA data is correct or whether their models are wrong.  They have been scouring the landscape looking to see where they can identify gas production that was brought back into the market reflecting the better gas prices available in October.  Their preliminary conclusion is that they underestimated how much gas had been removed from the market in September that was reversed in October. 

Exhibit 8.  Land Gas Production Recovered In October

Source:  EIA, PPHB

The more troubling aspect of the October data following the optimistic production decline reported for September is that wellhead gas production does not appear to be falling as fast as most analysts had anticipated.  One possible explanation is that many of the drilled-but-uncompleted wells are starting to enter the supply picture as producers are anxious to boost their production to demonstrate to investors that they can show growth that would support or help boost their share price.  Increasing production in a rising natural gas price environment should lift share prices and make it easier to access capital for future drilling efforts.

There is another possible conclusion, however, which is that the EIA’s data is wrong.  But that raises a question of why producers would be reporting incorrect data.  Maybe what we are learning is that forecasting models can’t capture all the moving parts of the domestic natural gas market.

Exhibit 9.  Gas Production Not Falling As Fast As Gas Rigs

Source:  EIA, Baker Hughes, PPHB

From the peak in November 2008, gas production from the Lower 48 Land market has declined 1.79 Bcf/d, or 3.1%.  On the other hand, the decline from the peak to the lower output in September was 2.91 Bcf/d or 5.0%.  The difference between the September and the October data demonstrates the problem with the lack of response to the drilling downturn, assuming the October data is not revised down.  From November 2008 to October 2009, the gas rig count measure as reported by Baker Hughes (BHI-NYSE) was down by 776 rigs, or almost 52%.  Since then, the monthly average gas rig count has risen by 35 rigs, or nearly 5% from October to December.  To the last week of the year, the gas rig count only added two rigs above the December monthly average so the percentage increase is unchanged.  The significance of the gas rig count increase is that with gas production falling very slowly despite the dramatic drilling rig count drop, any increase in working rigs is likely to be adding to production at a time when the supply/demand balance in the natural gas market is out of balance in favor of supply over demand.  If winter heating demand is stronger than expected or industrial and commercial gas demand picks up, then the natural gas supply/demand balance will become more balanced.  Without that happening it is hard to see how natural gas prices can hold on to their winter highs.  We will be watching for the EIA’s gas consumption data later this month as an indication of how unbalanced the domestic natural gas market may be.

When we began to focus on the potential for an industry correction in the spring of 2008, we never anticipated that it would be as severe or as swift as it turned out to be.  When the drilling rig count was in its freefall period early in 2009, we began to look for analog time periods to see if we could gauge the severity of this downturn.  After comparing various historical drilling rig corrections, we settled on the 1981-1986 period as the one we wanted to model.

To demonstrate our choice, we show the current rig downturn as of early in 2009 that we then projected based on the pattern of the 2001-2004 downturn.  The green line shows how the rig downturn actually developed.  It is evident from examining the lines that for part of the year, the forecasted downturn followed the actual rig decline quite closely.  But then the rig drop continued while the forecast called for the pace of the downturn to moderate and eventually to turn up.  Although the pace of the downturn remained steady, the bottom of this correction occurred at almost the same point that the 2001-2004 correction bottomed.  Since the bottom, the pace of the current rig recovery has been steeper than during the earlier correction.

Exhibit 10.  Current Rig Correction More Drastic Than 2001

Source:  Baker Hughes, PPHB

The 1981-1986 correction obviously spanned a five-year period as opposed to the 2001-2004 period and it experienced several recovery periods as industry dynamics acted to support oil prices and provided other drilling incentives that extended the entire correction period.  In the United States, we experienced a change in federal offshore leasing rules in 1983 (from nominated acreage to area-wide) that opened up substantially more acreage for drilling.  Because of government regulation of crude oil and natural gas prices in an attempt to prevent consumers from being burdened by rapidly rising prices, often the price declines being experienced outside of the U.S. were not passed on immediately to the domestic market thereby keeping prices more stable.  By 1986, however, global oil prices collapsed and domestic prices also caught up with international prices completing the oil and gas industry correction. 

Our assumption in selecting the 1981-1986 rig correction as our model for the current downturn was that the magnitude of the oil and gas price fall in 2008 and the resulting economic recession was similar in scope to the decline experienced in the earlier period.  The one difference would be that this correction occurred faster than the earlier five-year correction.  The one common factor was that we expected the total decline in rigs to be similar between the two periods.  Nearby, we show a chart of the progress of the current correction against our forecast.  As can be seen, at the time we prepared the chart, the industry had already shed 1,076 rigs from the peak and we expected another 40 rigs to be released before the bottom would be reached.  That would mean the total of 1,116 rigs would be laid down.  In reality, the bottom came after 1,155 rigs had stopped drilling, only 39 rigs more than we had forecast. 

Exhibit 11.  We Looked For 1,116 Rigs To Stop Drilling

Source:  Baker Hughes, PPHB

Since the rig count bottomed in the 24th week of 2009, or late May, the industry has added 313 rigs to the working rolls, almost a 35% increase.  That increase has been driven by higher crude oil prices and accelerated gas shale drilling.  The big question for 2010 will be how the rig count will develop from here.

Exhibit 12.  Rig Count Has Recovered By More Than A Third

Source:  Baker Hughes, PPHB

The recent survey by Barclays Capital of domestic oil and gas industry exploration and production spending in 2010 projects a nearly 12% increase.  That increase is driven by expectations of healthy oil and gas prices in 2010.  If that happens, then we would expect to see a healthy recovery in working drilling rigs, but maybe less than a commensurate rise to the spending gain.  We would guess that unless oil and gas prices climb meaningfully higher than current levels, the rig count should experience a 9% rise, or just over additional 100 rigs working next year.  Higher commodity prices could push the rig count up closer to 1,400 rigs for more than a 200-rig gain.  Energy market conditions in the spring of 2010 may tell us whether our more conservative view of the rig count increase will need to be adjusted.

Energy investors have been cheered by the continuing wave of colder than normal weather that descended on the United States from Canada beginning during Christmas week.  While these investors were happy to see citizens struggling to dig out their vehicles from snow drifts and experience driving tie-ups due to snow, ice and cold, they really didn’t care about the impact on holiday shopping caused by the storms.  The cold contributed to large inventory drawdowns for both petroleum and natural gas and were greeted with glee!  We really are having a winter!

As readers may remember when we wrote earlier last fall about the contradictory outlooks for this winter’s weather – either the coldest in the past 10 years or a near-normal winter with certain areas actually experiencing warmer-than-normal temperatures – we said whichever scenario unfolded would impact commodity prices.  Now we are starting to see more of a consensus form that the nation will experience a colder than normal winter with increased demand for natural gas and heating oil.

The weather event that seems to be in control of our winter temperatures and precipitation is El Niño in the South Pacific.  Right before Christmas, Todd Crawford, the seasonal weather forecaster for WSI Corporation, a member of The Weather Channel Companies, was quoted as saying, “The combination of the current El Niño event, cold north Pacific, and weakened stratospheric vortex are favorable for a continuation of widespread below-normal temperatures across the U.S. for the upcoming season.” 

He cautioned, however, that, “There may be a relaxation of the current cold pattern in the Northeast during January, followed by a return to more consistent cold in February and March.  We are forecasting 2,475 gas-weighted heating degree days during the January-March period, approximately 2.5% more than last year and about 2% more than the 1971-2000 mean.”

Exhibit 13.  AccuWeather’s Winter Forecast Said Harder Winter

Source:  AccuWeather.com

In early fall, there were conflicting views of what would happen to the then El Niño phenomenon that had been helping to moderate the Atlantic Basin hurricane season making it one of the more benign in recent years.  AccuWeather’s Chief Meteorologist and Expert Long Range Forecaster Joe Bastardi called for a weakening El Niño that would produce a stormier and colder winter in the southern and eastern regions of the United States.  In fact, Mr. Bastardi suggested this winter could be the coldest and stormiest in many years.  The energy commodity bulls were roaring with approval.

On the other side of the coin was the Mike Halpert, deputy director of the Climate Prediction Center (CPC), a division of the National

Exhibit 14.  CPC Forecast A Warmer-Than-Normal Winter

Source:  Climate Prediction Center

Weather Service, who said, “We expect El Niño to strengthen and persist through the winter months…”  Based on this scenario, the CPC was forecasting warmer than average temperatures across much of the western and central United States.  They thought we should see below-average temperatures across the Southeast region and extending into the mid-Atlantic region as far north as Pennsylvania.  They expected above-average precipitation in the southern border states, especially Texas and Florida.  They anticipated that the Pacific Northwest and Ohio and Tennessee River Valleys would experience drier-than-average conditions.  For energy investors, the major population centers in the Northeast were thought to have equal chances of above-, near- or below-normal temperatures and precipitation. 

Exhibit 15.  CPC Said Only Certain Areas Would Be Wetter

Source:  Climate Prediction Center

We began to wonder about the forecasts when Pennsylvania experienced one of the earliest snowstorms on record in October.  We wondered whether that was a precursor of a colder and stormier winter, or merely an early winter event signifying nothing but a forecasting data point.  Since then we have seen several storms sweep across the country from the Plains states to the Northeast including the recent coastal blizzard that buried Washington, D.C. and Philadelphia before dusting up New York City and Boston. 

As it appears that the fate of El Niño will dictate what happens during the balance of this winter it is interesting to see the frustration meteorologists are having with understanding the pattern of the current phenomenon and its impact on the balance of the winter.  Matt Rogers of the Commodity Weather Group has been focused on a possible warming thaw sometime in January.  Last fall he had been looking at analog years with El Niño events as a predictor for this winter.  He focused on 2002.  El Niño has grown stronger in recent weeks; we have seen sea surface temperatures (SST) soar by more than one degree Celsius.  This warming trend has had Mr. Rogers re-examining analog years.  This time he focused on 2002 and 1987, years when El Niño peaked early in the winter, which produced a cold-prevailing winter. 

As Mr. Rogers examined El Niño he found that the temperature anomalies were occurring further west than the ones in the analog years.  This meant that the weather phenomenon was actually further from North America than most other El Niños in the past.  This development sent him back to the 2002 and 1987 analogs in which El Niño peaked early.  He now believes that the current El Niño will begin to weaken by early January, but as he admits, we have been surprised before by the weather trends of 2009.

As support for his view of an early peaking in El Niño, he points to 2009 being the warmest NINO 4 on record.  NINO 4 represents the far western region of the Pacific Ocean where SSTs are measured.  As shown by the chart in Exhibit 16, 2009 was slightly warmer than either 2002 or 1987, the target analog years.  Mr. Rogers believes that this early peaking in El Niño may help explain why we are getting a stronger-than-expected warming response.  But when Mr. Rogers examined a compilation of forecasts by weather models for El Niño, the majority of them are predicting a fading trend.  Therefore, the consensus of these forecasters calls for a better chance for colder-than-normal conditions in the United States in the second half of this winter.

Earlier when Mr. Rogers looked at the history of weather conditions back to 1950 that combined a cold December and a warm El Niño, the winter of 1963 stood out.  That year had one of the coldest Decembers, which was married with a moderate El Niño.  The history of that winter season was a very cold December, a warm January and a cold February.  Overall that winter period was colder than normal, but it was achieved in a very choppy manner.  Could that be what happens this winter?  If so, it will certainly frustrate

Exhibit 16.  Hot El Nino Years

Source:  CWG

commodity forecasters but likely make commodity traders happy as they love volatility and shifting outlooks.

We have commented on several books in recent months that highlight how a world with limited oil resources will be forced to change.  The idea that people will no longer be able to live in the suburbs and forced to move into metropolitan areas because of the lack of gasoline and high fuel prices seems extreme to us.  The authors of these books believe that much about how Americans live must change as a result of Peak Oil.  One change they often point to is that our diets will be different as the cost to deliver certain foods will become prohibitively expensive.  Often cited are certain fish and seafood that come from foreign locations.  These authors also believe Americans will be reassessing how food supplies are grown – suggesting local gardens and farms will become our primary source of supply. 

We recently read Mark Kurlansky’s 2009 book,The Food of a Younger Land (Riverhead Books) that offers a peak at how we might be eating in an oil-constrained world.  The book was based on the lost WPA files.  During the Great Depression, the government was confronted with how to deal with stubbornly high unemployment.  The Works Progress Administration of the Franklin Roosevelt administration was created to develop projects that would employ workers throughout the economy on government payrolls.  As there were few employment opportunities for writers and poets in America at this time, the WPA developed a program to write about the eating habits, traditions and struggles of local people to feed themselves.  The project was called “America Eats” and it envisioned an organized effort to document eating in each state of the union.  The project was abandoned in the early 1940s because of World War II, and it was never resumed.

As Mr. Kurlansky taps the WPA America Eats’ files, readers will learn about food and dining experiences such as visiting automats in New York City (the author did as a 10 year old) and attending Coca-Cola parties in Georgia, possum-eating clubs in Arkansas and salmon feasts in Puget Sound.  He also draws on articles documenting Choctaw Indian funeral feasts, South Carolina barbecues and chuck wagon cooks.  The world of eating Mr. Kurlansky describes was simple, regional and focused on using locally available and often seasonal foodstuffs, many of them not current foods.  This world existed well before the national highway system, frozen food and fast food establishments.  It is an interesting read that sheds light on how we may have to change our menus in the future.

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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.