- The Future For Natural Gas In The U.S.
- Weak Recovery, Lower Financial Returns and Dividends
- IEA Oil Demand Forecast Ramped Down Sharply
- Hurricane Early Warning Prediction Phenomenon?
- If At First You Don’t Succeed, Try Alberta’s Plan
- Massachusetts & Rhode Island – Hotbed For Wind Energy
Musings From the Oil Patch
July 7, 2009
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 the last issue of the Musings we discussed issues affecting the outlook for natural gas. After a number of comments from readers, we have elected to continue this examination recognizing that there are a lot of issues and no exact answers. Part of our initiative in that article was to question the conventional Wall Street view that investors should be selling crude oil futures and buying natural gas futures. The rationale for that trade was that natural gas is historically about as cheap as it has ever been relative to the price of crude oil and that this price disparity would not last. So far the strategy hasn’t worked as crude oil futures have outperformed natural gas futures in recent days. The reason for those declines can be attributed to both the recent strength of the U.S. dollar that has made commodities less attractive as a physical hedge against further dollar deflation and growing concerns over the health of our economy.
Just because the price of natural gas is low doesn’t mean it has to rise. There are fundamentals underlying all commodities and natural gas and crude oil are no different. Let’s briefly review several of the key variables impacting the outlook for natural gas. First, gas in storage has been climbing rapidly to the point many industry participants worry about storage capacity becoming totally full before the end of the traditional summer storage injection season, which would drive natural gas prices down sharply in order to find consumers. A second issue is whether the U.S. is about to be swamped with deliveries of liquefied natural gas (LNG) since this country has more available storage than either Europe or the Pacific regions. LNG production capacity around the world is growing and consuming markets are cutting back their use. Third, the volume of
Exhibit 1. The Natural Gas As Cheap Trade Hasn’t Worked
Source: EIA, NYMEX, PPHB
natural gas resources in the United States may be significantly greater than previously thought offering up the prospect that the gas industry has a much longer and potentially brighter future. The key to these greater resources is American oilfield technology that has enabled producers to extract gas from formations previously thought un-producible. Fourth, the currently depressed natural gas price reflects the unusual economic environment that may be disproportionately hurting the gas business due to the deep depressions impacting the housing and auto industries – large consumers of natural gas and natural gas-derived products.
Because natural gas is the least “dirty” fossil fuel, many people see it fulfilling the role as the bridge fuel from the age of fossil fuels to the age of the next energy source, whatever that may be. The prospect of natural gas playing a much greater role in the U.S.’s, and possibly the world’s transportation sector has drawn attention from investors, government officials and gas industry participants. At the present time, natural gas provides about 20% of the fuel used to generate U.S. electricity, a power source that will grow if the Obama administration’s efforts to push the auto industry into mass producing electric cars as a way to reduce the country’s carbon emissions are successful.
Unfortunately, the Obama administration is not taking a more active role in pushing the use of natural gas as it has pinned its future hopes on renewable fuels such as wind and solar power. Currently the world gets 6% of its power from hydro sources and another 6% from nuclear power. The highly touted wind, solar and geothermal sources produce only 2% of the world’s energy. Pres. Obama is banking on the 2% sources of energy to offset the remaining 86% of energy generated by fossil fuels. At the same time, the share of world energy coming from nuclear power will decline as older units are removed from service and new ones are slow to be built, or are not replaced at all.
If natural gas is to play a greater role in the world’s transportation sector, what are the issues? One issue is the relative merits of fuel consumption between electric, hybrid (gasoline/electric) and natural-gas powered vehicles. Led by Boone Pickens and other gas industry leaders, there has been a big publicity push to get this country to embrace the use of natural gas as a transportation fuel. Gas can be used either in liquid form – LNG – or as a gas under pressure – compressed natural gas or CNG. We are not aware of any LNG-powered vehicles. According to the Natural Gas Vehicle Coalition, there are more than 120,000 CNG vehicles in use in the United States and nearly nine million worldwide. Most of the CNG vehicles used here are parts of company fleets or buses although there are a small number of CNG cars owned by individuals.
The reason most of the CNG vehicles are in company fleets or buses is because they can return to a central location every night where they can be fueled and serviced. Finding CNG filling stations is a significant challenge. A company called FuelMaker has developed a system called Phill that is the world’s first home-based fueling appliance, which can be mounted either inside or outside on garage walls and allow natural-gas powered vehicles to be refilled overnight directly from a homeowner’s existing natural gas supply line.
Although cars can be retrofitted to use CNG, there is only one commercial CNG vehicle available for purchase in the United States, the Honda Civic GX. This is a natural gas-powered version of the popular Honda Civic, but the buyer will pay about $3,000 more for the GX version, although he may be eligible for a $4,000 tax incentive. CNG vehicles are allowed access to the same parking and car pool lanes that hybrid vehicles get to use.
Natural gas is about 90% methane, which has a much higher octane rating than gasoline. This allows for higher compression ratios in the cylinders making for greater burning efficiency in the engines. CNG burns so cleanly that it rivals hybrids in producing very low levels of smog-forming pollutants. CNG vehicles, however, tend to have higher greenhouse gas emissions than hybrids. According to reports, the Civic GX emits nearly 30% more greenhouse gases than the Civic Hybrid during a typical year of driving.
What about the economics of CNG vehicles? When gasoline was about $2.25 per gallon, the average price of CNG in the United States was $1.99 per gallon of gasoline equivalent (GGE), since gas is actually sold in a gaseous state. The $0.26 per gallon price differential looks attractive, but CNG vehicles get lower efficiency than hybrid vehicles. A Civic GX averages about 32 miles per gallon (mpg) while the hybrid version gets about 43 mpg, some 34% greater efficiency. Since the GX version needs more fuel to operate, even though CNG is cheaper per gallon, the vehicle’s cost per mile to operate will actually be higher. Without the investment to develop the fueling infrastructure all renewable fuel vehicles need, it is hard to see that CNG vehicles will gain a large share of the automobile market. CNG may play a greater role in the market for company fleets and local buses, but that remains a relatively small market.
The key issue for the success of hybrids (gasoline/electric) and electric vehicles is the development of battery technology that will enable cars to go longer distances and at faster speeds between battery recharges or swap-outs. Hybrids are going through their own transition from vehicles that recharge their electric power source from their gasoline engine and/or the braking action during driving in which the motor turns into a generator and dumps the manufactured power into the battery bank.
According to the General Accounting Office (GAO) in a recent report, “For plug-ins to realize their full potential, electricity would need to be generated from lower-emission fuels such as nuclear and renewable energy rather than the fossil fuels – coal and natural gas – used most often to generate electricity today.” Besides, battery costs must significantly fall while gasoline prices remain relatively high.
To understand the impact of hybrids on energy and emissions, the GAO cites the Electric Power Research Institute study done for the State of Texas that stated: “Electricity provided by coal for plug-in vehicles with a 20-mile all-electric range had slightly greater carbon dioxide emissions than the hybrids that exist today. Therefore, the futurist plug-ins are best suited to reduce global warming releases in regions where electricity is now provided by low-carbon sources.” To have a greater impact on greenhouse gas emissions, the transportation business must move to all-electric vehicles and that means significant progress must be made in battery technology. Also, that electricity used to charge the vehicles must come from low-emission power sources.
At the present time, the automobile industry uses nickel metal batteries in its electric and hybrid vehicles, but it wants to shift to lithium-ion batteries that hold charges longer, but cost considerably more. This transition will be important and companies that develop the best battery technology should be very successful. That explains why Berkshire Hathaway (BRK-A-NYSE) has invested in a Chinese battery company and why the Kleiner Perkins venture capital firm has a major effort behind battery technology.
Another aspect of the battery challenge is how to develop a standardized battery pack that would enable the service industry to develop battery swap-out locations when vehicles cannot take the time to recharge from plug-in electric outlets. One has to wonder whether the automobile industry will evolve the same way the electronics industry has with battery rechargers, none of which are inter-changeable.
As Alfred Marcus, professor of strategic management at the University of Minnesota, discusses hybrids and electric vehicles, “If the U.S. had a goal that 50 percent of all vehicles on the road in 10 years would be some form of hybrid, gasoline consumption could go down by a quarter.” With the Obama administration behind an effort such as Dr. Marcus describes, coupled with the expanded ethanol mandate, is it any wonder why the Energy Information Administration is projecting a meaningful decline in America’s future gasoline demand?
The problem with the goal discussed above is that before the recession, the U.S. vehicle fleet replacement rate was about 14 million vehicles a year. With a domestic fleet of 250 million vehicles it would take nearly 18 years to fully replace the fleet. With lower vehicle sales now and likely for a number of years into the future, the time to turn over the fleet will increase to something like 20+ years.
According to a study by The California Cars Initiative, an effort to develop electric vehicles, even if the rate of market penetration of plug-in electric vehicles is ten times that of the hybrids (21% versus 2.2% in ten years) they will not achieve a meaningful position in the fleet until 2025-2030.
Exhibit 2. Electric Vehicles Need Time To Impact Fleet
Source: CalCars
To appreciate the challenge facing the energy industry and government policy makers, it should be noted that it has taken decades to substitute one form of primary energy for another and 100 years for a given energy source to achieve 50% market penetration. This information is from Primary Energy Substitution Models: On the Interaction between Energy and Society (C. Marchetti, 1977). At the rate we are consuming hydrocarbon resources, we may have only about 50 more years before we are working with half our current energy supply. That will put increased pressure for scientists and engineers to develop new energy sources and to modify our use of existing energy.
The few population models that also take into account fossil fuel depletion assume that the global population tops out at the point of peak fuel availability and then stabilizes at that level or declines naturally as economic development promotes lower fertility rates and renewable fuels and greater energy efficiency grow to fill the gap. The reason these models assume this scenario is that the alternative is too difficult to comprehend. More than likely we will wind up with a global population much smaller than anyone forecasts at the present time, which will give us some breathing room, but not something we can plan on.
As the future evolves we will probably see much greater changes in the world and the energy business than we can envision. Moreover, these changes are likely to happen faster than any of us can imagine. Of all the existing fuels, natural gas will probably experience the greatest change as its role in the global energy supply mix shifts. Will its role grow, stay the same or decline? We have much more analytical work to do to attempt to sort out how much of an impact hybrids and electric cars may have on the consumption of natural gas, either through direct consumption or through increased demand for electricity fueled by natural gas. We will continue investigating how these changes might occur and what impact they may have on the energy market in future Musings.
The latest U.S. economic statistics point to a very weak economy, which Obama administration officials acknowledge with signals of the possible need for a follow-on economic stimulus bill. At about the same time, San Francisco Federal Reserve Bank President Janet Yellen said the recovery should start in the second half of 2009 but it will be extremely slow through 2010 and into 2011. The “green shoots” phenomenon that was the hype of the prior several months is starting to wear out and might morph into the taunt it was originally. The term was first used by Norman Lamont, British Chancellor of the Exchequer, who proclaimed he saw the beginning of the end of the 1990-1992 recession, which turned out to be premature. Te political opposition taunted him with his phrase “green shoots.”
Recently, some European economists called the recession over based on production data from a number of countries, but an interesting analysis done earlier this year, and just updated, questions whether any recovery is underway. The two economists, Barry Eichengreen, professor of economic and political science at the University of California – Berkeley, and Kevin O’Rouke, professor of economics at Trinity College, Dublin, Ireland, wrote a paper in early April comparing the current economic crisis with the Great Depression. They updated their analysis in early June and showed the performance of the two periods on a number of economic and financial measures. We have presented some of the charts below, although the full articles with additional charts can be accessed at www.VoxEU.org.
While Wall Street bulls have seized on the strength of the latest Chinese manufacturing data, the composite of world manufacturing data continues to more or less track the downturn of the 1930s. As the June update shows, the rate of industrial output decline has slowed, but it still is tracking the Great Depression pattern.
Exhibit 3. World Industrial Output Falls Like 1930
Source: VoxEU.org
To add additional support for the world industrial output chart, the two authors tracked a number of individual country industrial outputs. We have presented the charts for four of the largest European countries. Germany and the UK have generally tracked their Great Depression downturn patterns. On the other hand, Italy and France have seen their industrial output collapse. The fall-offs have been much worse than experienced during 1929 and 1930. Italy remains in a precarious economic condition due to its debt level and its internal political problems.
Exhibit 4. Europe Is Following Or Below Historical Pattern
Source: VoxEU.org
When we look at the performance of four large non-European economies, it seems that the North American countries – Canada and the United States – are on track with their Great Depression performance while the others are falling well behind. Those two countries – Chile and Japan – started out following their historical pattern, but are now either well below or about to diverge significantly from their past performance. Again, the performance of these economies is significant because of their importance to the overall global economy. For those who do not know, Chile is about to be invited into the OECD community of the 30 largest developed economies.
Exhibit 5. Non-European Economies Are Tracking History
Source: VoxEU.org
When we look at the volume of world trade, it is falling well below the decline experienced during the Great Depression. Not only is trade down, even though world trade was boosted earlier this year by the commodity stockpiling by China, global protectionism is building suggesting further trade weakness. Several high profile World Trade Organization cases have recently been lodged and others are being threatened. In addition, the stimulus programs of various governments around the world contain provisions designed to protect domestic industries at the expense of imports and trade. How much more important “beggar thy neighbor” government policies become as an impediment to global trade remains to be seen.
Exhibit 6. World Trade Falling Faster Than In Past
Source: VoxEU.org
The challenge for economists and investors is to understand the possible future tracks the global economy might take in the future. We prepared a chart that shows the normal course of economic output – either for the world or an individual country – compared to its trend line growth potential. When actual output falls below trend line growth, governments act through either fiscal (tax, spending and investment actions) or monetary (flood the market with credit or currency) policy steps to boost output. When the economy grows faster than its trend line growth, we enter a period of economic boom.
Exhibit 7. How The Economy Might Play Out
Source: PPHB
In the chart we show a point (marked by a star) for the “green shoots” phenomenon and the start of three possible alternative scenarios for future growth – a double-dip recession, stagnation and a growth recession. At this point no one knows how the economy will progress, but most expectations are that it will follow one of these three scenarios, although it is possible the economy could continue on the path of actual output. Expectations, however, are that there is almost no prospect the actual output scenario will be followed. Each of the three alternative scenarios suggest weak future economic activity and, almost by definition, weak energy demand growth.
Exhibit 8. Consumer Spending Ramping Up As Wealth Falls
Source: Agora Financial
A key reason why this economic recovery will be slow is the rise in the U.S. consumer savings rate that is reducing spending. For much of the past two decades, consumers spent more than they earned and met the shortfall by borrowing on their homes’ equity. The collapse in housing prices and the stock market drop that destroyed substantial amounts of citizens’ retirement wealth will have a long-lasting impact on spending. Since last year, the consumer savings rate has climbed to about 6% as people are determined to rebuild savings for retirement and/or to offset possible future job losses. This boost in the savings rate from the negative rate it reached in 2005 takes money directly out of U.S. personal consumption.
Exhibit 9. Home Prices Continue To Fall But At Slower Rate
Source: Agora Financial
Exhibit 10. Stock Market Collapse Destroys Substantial Wealth
Source: dshort.com
The fall in home prices and the stock market has a negative wealth impact on consumers. Studies have shown that consumers cut their spending by 5-7 cents for each $1 of housing wealth lost. This means that with about a $6 trillion loss in housing wealth means about a $300 – $420 billion decline in consumer spending, or roughly 3.0 to 4.2 percentage points of disposable income. There is a similar impact on spending from the fall in stock market wealth. We have had an $8 trillion loss of market wealth. That equates to a spending reduction of 3-4 cents each year for every $1 of stock market wealth lost. The bottom line is that American consumers will be spending considerably less in the future from their disposable income regardless of whether they exercise further conservatism from fear of possible future job losses. Is it any wonder why the economic recovery has been modest? Basing our economic recovery on revitalizing the American consumer to go back to borrowing and spending is idiotic and doomed to failure. We need a capital investment program but that is not likely to happen as long as the Obama administration is determined to raise taxes and eliminate investment incentives for businesses and high net worth individuals who tend to invest in risky ventures. The prospect of stronger energy demand in this scenario is almost non-existent.
Exhibit 11. The Stock Market Rally Has Hardly Helped Investors
Source: VoxEU.org
The net result of increased consumer savings and lower spending coupled with pressure on corporate profits has taken a significant toll on global stock markets despite their recent recoveries. Most of the recent stock market rises have been from severely depressed levels. The recoveries have been driven by investors who have become euphoric about possible “green shoots” showing the start of a global economic recovery. The big question is whether they have succumbed to Prof. Paul Samuelson’s famous statement that the “stock market has forecast nine of the last five economic recoveries.” Let’s hope this time the stock market has gotten it right, but I wouldn’t bet the house on it.
The one aspect of investing we are firmly convinced about is that given the economic outlook, we are facing a future with lower returns on investments. As a result, we anticipate investors will demand current income along with modest capital gains from price appreciation. We find the history of returns from the stock market an important guide for what company managements and boards of directors should be focused on for their long-term shareholders. Having a stable shareholder base of long-term investors rewarded with dividends could prove extremely important in a world of increased volatility.
Exhibit 12. Dividends An Important Part of Investor Returns
Source: Plexus Asset Management
The International Energy Agency (IEA) recently released its 2009 Medium-Term Oil Market Report showing a sharply reduced projection for oil demand growth. In the material used by the IEA economist charged with announcing the study’s results, it states that the projected oil demand for 2013 is now 3.3 million barrels per day (mmb/d) below the agency’s December forecast. What is more telling, however, is to examine the change between this forecast and the agency’s 2008 Medium-Term forecast that shows almost a 6.6 mmb/d drop in demand. In fact, if we go back to the 2007 demand forecast, although not all future years were forecast, the drop in projected oil consumption is even greater.
The challenging aspect of the IEA’s new forecast is its reliance on the highly optimistic global GDP growth projections of the International Monetary Fund (IMF). Its projections suggest that global economic growth once we recover from the current recession should average close to 5% a year. The IMF expects the world’s GDP to post negative growth of about 1.5% in 2009 but then show positive real growth of nearly 2% in 2010. In subsequent years, real GDP growth is expected to exceed 4% in 2011 followed by nearly
Exhibit 13. IEA Oil Demand Forecast Have Fallen Significantly
Source: EIA, PPHB
5% growth in each of 2012 and 2013 before slowing slightly to 4.6% growth in 2014. This global economic growth will reportedly be driven by strong gains in non-OECD countries as the OECD countries will experience growth barely over 3% at its peak in 2012.
The economic growth scenarios employed by the IEA in preparation of last year’s medium-term oil market forecast called for 3.8% growth in 2009, followed by 4.8%, 5.0%, 5.0% and 4.95% in 2010-2013. Clearly, the IEA forecast was made well before the economic and credit market problems of 2008 materialized, but that alone points out how questionable relying on very high global economic growth projections may be. The economic growth rates utilized in the 2008 study produced annual oil demand growth forecasts ranging from a low of 1% to a high of 1.9% in 2013, with an average growth over the period of slightly over 1.6% per year.
The latest IEA oil demand forecast was made before the passage by the U.S. House of Representatives of its historic cap-and-trade energy and climate change bill, now touted as a “jobs” bill. In the government’s projection of the impact of this bill on oil demand due to the increased use of renewable fuels, U.S. demand is projected to fall by over 1.8 billion barrels over 2012-2016. That demand decline equates to a 1.232 mmb/d per year on average. This could be a significant depressant on global oil demand growth, especially if global economic growth is actually lower than the IEA and IMF assume.
The significance of this oil demand erosion in the United States is meaningful when relative growth rates in demand are taken into account. If world oil demand grows 0.6% per year, then based on 2014’s estimated demand of 88 mmb/d, annual growth would be 528,000 b/d. The annual average demand decline in the U.S. alone would be 2.3 times that overall annual growth projection. Even if one assumes that some U.S. oil demand erosion was factored in by the IEA, we are still looking at substantial headwinds for global oil demand growth.
In its analysis, the IEA points out that if oil demand growth is stronger or weaker than its modeling assumption then there can be a wide divergence in the amount of oil needed in future years. If oil demand grows at only 0.4% per year on the low side versus 1.4% annually on the high side there will be a 4.1 mmb/d demand difference in 2014, from 89.0 mmb/d to 84.9 mmb/d. Talk about ranges one can drive a fleet of 18-wheelers through!
Exhibit 14. GDP Growth Will Determine Oil Needs
Source: IEA
The more ominous take-away from the IEA medium-term oil demand forecast is its implications for global oil demand over the longer term. Under its economic and oil demand growth assumptions, it will be 2012 before oil demand exceeds 2008’s consumption, or a four-year period of weak demand. One needs only to remember 1979 to 1989 when oil demand fell for four consecutive years before recovering, however it wasn’t until 1989 that oil consumption surpassed 1979’s level. Are we in for the same possibility today?
In the 1980s there were two forces at work in the global oil market that magnified the fall in demand and inhibited the speed of its recovery: the deep economic recession of 1982-1983 and the increased use of nuclear power in the United States and Europe to
Exhibit 15. It Took A Decade For Oil Demand To Recover
Source: EIA, PPHB
generate electricity at the expense of petroleum. The shift in fuel sources for electric power generation, a one-time event, changed the United States and global energy fuel mix. Today, most people would point out that we employ petroleum fuel to generate only about 1% of electricity output. The potential impact from the increased mandate to use ethanol in gasoline and diesel fuels could be construed as a similar step-change in oil demand usage. Given the likelihood renewable fuel blending mandates will be increased in the future, ethanol may hit petroleum consumption in the same way that increased nuclear power impacted oil demand in the 1980s.
Equally and maybe more important, however, will be the impact on global oil demand from reduced fuel subsidies by governments in developing economies. China, for instance, just announced its third gasoline and diesel fuel price hike so far this year. While the price hikes have been done to attempt to restore profitability to state-owned oil company refining operations, the hikes will impact the high consumption growth rates of gasoline and diesel fuel. So far this year, China has increased gasoline prices by CNY 1,290 (US$ 187) per ton and diesel prices by CNY 1,180 (US$ 171) per ton. Those increases represent roughly 18%-20% price increases at the pump and bring some gasoline prices to over US$ 3.00 per gallon, which in the U.S. has been the threshold for meaningful driving reductions by Americans. Anecdotal reports in the Chinese media suggest that many drivers there anticipate driving less with the higher fuel prices. What the impact will be on new vehicle sales is uncertain, but the higher operating cost will figure into some buying decisions. At the same time, China is gearing up to be a world leader in electric vehicle sales that might begin by capturing a larger share of the local market due to higher gasoline and diesel fuel prices.
There is another consideration about the future compared to the 1980s history. During part of the 1980s when oil demand was falling and then only slowly recovering, real global GDP growth was at levels currently projected to be experienced during the next five years by the IMF and utilized by the IEA in its oil demand forecasts. If, as we fear, economic growth is not as strong as the IMF calls for, then oil demand cannot possibly grow as much as the IEA projects.
Exhibit 16. Falling Oil Demand Despite High Economic Growth
Source: IMF, IEA, PPHB
The turmoil in the global economy will have an impact on oil demand. How the cross-currents play out, just as during the 1980s, will depend upon a number of factors – credit markets, U.S. consumer spending patterns, automobile fuel efficiency, market penetration by alternative-fuel vehicles and government regulations, to name only a few. We understand the argument that more people in the world will mean more energy consumption, but what we don’t know is how much more demand, what particular fuels will be favored and whether there other forces that could impact the demand equation. The world has been very focused on Peak Oil. We, on the other hand, have been, and remain, concerned about the fate of global oil demand. The new IEA forecast is a sign for concern.
A new study from researchers at the Georgia Institute of Technology have linked a variant of the El Niño weather phenomenon in the Pacific Ocean to more frequent hurricanes in the Atlantic Basin, particularly along the Gulf Coast and in the Caribbean. Scientists have known for some time that El Niño, the warm spell that turns up every four or five years in the eastern Pacific Ocean, reduces hurricane activity in the Atlantic.
Scientists say that they can detect warming in the central Pacific earlier than they can discern the development of El Niño, so this new phenomenon may help forecasters predict hurricane activity in the Atlantic with greater accuracy. They do admit, however, they are unsure whether this phenomenon is caused by global warming or that it had been undetected.
When an El Niño forms, warming of the eastern Pacific Ocean waters alters air flow patterns in the lowest portion of the Earth’s atmosphere (troposphere) over the area. One layer of air moves eastward and the other moves westward. Wind shear then develops over the Atlantic, inhibiting the ability of storms to turn into tight, powerful gyres. The warming patterns that occur in the central Pacific cause the wind shear to shift well to the west allowing Atlantic hurricanes to form relatively unimpeded.
The Georgia Tech researchers said the variant pattern was first discovered in the 1980s by Japanese and Korean researchers who named it “modiki” El Niño, or “similar but different” El Niño. While the researchers said it was difficult to determine whether the warming pattern was new because their observational record was relatively short and their climate models were imperfect. Kerry Emanuel, a climate expert at the Massachusetts Institute of Technology said he was impressed by the study, but believes that the phenomenon has been there and we just didn’t see it. Of course one could ask, what did the Japanese and Korean researchers see that Americans missed, or is this another example of trying to find more evidence to bolster the global warming case?
Canadian drilling activity is flagging due not only to the recessionary impact on oil and gas demand, but also due to weak producers’ cash flows and restricted access to investment capital to help fund new exploration and development programs. The traditional seasonal downturn at breakup this year was worse than at any time since before 2000. The Canadian land drilling rig count, as measured by Baker Hughes at June 26th, stands at 147 active rigs. This represents somewhere around 18% of the available rig fleet.
We have plotted the 2008 and 2009 rig counts along with the weekly high and low counts for the entire period of 2000-2009. So far, virtually all the weekly rig counts for 2009 have set decade lows, which is not surprising given the industry environment. As a result, when you look at the decade-low line on the chart you should note that the blue line going forward only reflects low rig counts through 2008, but given where drilling activity is centered at the moment, it is likely that many more weekly low counts will be established in coming months.
Last year, the Alberta government moved to alter its oil and gas royalty scheme with the aim of improving the attractiveness for exploring in the province. This new plan marks the fifth change in taxation of energy companies since 2007. Because of prior royalty
Exhibit 17. Canada’s Oilfield Activity Is At Decade-Low Levels
Source: Baker Hughes, PPHB
changes, Alberta had seen its attractiveness as the prime location for oil and gas activity decline. The plan changes put in place last year were designed to stimulate Alberta’s drilling activity, but no one expected the industry and economic changes that later unfolded. The Alberta government is now moving to extend its altered royalty scheme for a second year hoping to bolster industry activity and government revenues.
The Alberta royalty program consists of two programs – one for drilling and the second for production. The Drilling Royalty Credit provides a $200/meter royalty credit for new wells drilled based on total measured depth from April 1, 2009, through March 31, 2011. The new program extends the life of the royalty by one year from 2010 to 2011. The royalty is designed to assist small producers as it is determined on a sliding scale for each producer based on its 2008 oil and gas production in Alberta. The second program, the New Well Incentive Program, provides up to a maximum of a 5% royalty rate during the first year of production up to a maximum total production of 50,000 barrels of oil or 500 million cubic feet of gas.
Exhibit 18. Alberta’s Sliding Scale Royalty Program
Source: Alberta government, CIBC, PPHB
While these programs are welcome, they will probably have only a marginal impact on oilfield activity for the balance of the summer. The new royalties should help the shallow natural gas market and smaller producers. The extension of the plan may help producers and service companies by providing operators more time to plan for drilling programs in seasonally restricted or winter access only areas. This means that wells that might have not been drilled because they couldn’t be completed within the prior March 2010 deadline will now be drilled. This will be especially true for winter wells next year.
An additional aspect of the New Well Incentive Program is that the royalty increases linearly with rising gas prices, although at the present time prices seem to be struggling to sustain current levels. Should we see a rally in natural gas prices as the second half of 2009 unfolds, that would make it more attractive for producers to commence drilling under the new royalty scheme.
The newly extended incentives are designed to help producers recoup a percentage of their capital spending and the Drilling Royalty Credit helps. Producers, however, have to spend money in order to save money under the Alberta’s royalty program. If producers were unconstrained by cash flow limitations or had ready access to capital financing or were enjoying high energy prices, these royalty programs would likely have a greater impact. Unfortunately, producers are finding their cash flow constrained, they have great difficulty securing outside capital and natural gas prices are low. To see how well these incentive programs are working, one only needs to understand that they have been in place for three months, yet drilling remains at decade lows suggesting that capital and cash flow challenges are overwhelming the government’s improved incentives. Since Alberta gets 55% of its revenue from natural gas production taxes, low gas prices and high oilfield service costs are taking a serious toll on industry activity and government revenues.
The Alberta provincial government needs to re-examine its overall competitive position, a program that is underway and is targeted to be completed this fall. The province probably needs a simpler royalty scheme. There needs to be greater transparency and visibility in the province’s incentive program. Without these characteristics, Alberta’s ability to compete long-term for access to investment capital will be restricted. So far, the province appears to have been too focused on short-term stimulus efforts possibly driven by its budget revenue shortfall, currently estimated at $4.7 billion for 2009-2010.
Understanding that the oil and gas industry is a capital-intensive, long-term focused business that welcomes, and needs, stable government policies both on taxation and incentives is an important recognition. The Alberta Energy Department is performing its competitiveness review of conventional oil and gas, comparing the province’s regulations, land practices and royalty schemes with others. This is a joint government-industry effort. Its results cannot come too soon as the recently released Fraser Institute Global Petroleum Survey ranks Alberta 130 out of 143 jurisdictions for its fiscal terms. Alberta continues to rank highly in terms of geopolitical security. With huge shale-gas and oil sands deposits in Alberta, the province needs to repair its economic incentives in order to attract the necessary capital to develop these resources.
Surprisingly, we find ourselves this summer in the midst of an energy revolution. Only this time, the hotbed of the energy revolution is New England where offshore wind power has become the pot of gold at the end of the rainbow. In the past two weeks, Rhode Island Gov. Donald L. Carcieri (R) signed legislation that mandates National Grid (NGG-NYSE), the primary electric utility in the state, to buy a minimum of 90 megawatts of renewable power, enough to power 72,000 typical American homes. Most of the power is expected to come from two offshore wind farms planned to be built near Nantucket Island off the coast of Rhode Island.
Just last week, the State of Massachusetts released a draft plan to allow a series of small wind farms of up to 10 turbines each in state waters, which extend up to three miles off the coast. Larger wind farms could be built off Cape Cod near Cuttyhunk Island and adjacent to another tiny island several miles off Martha’s Vineyard.
Exhibit 19. Massachusetts Plans For Offshore Wind Farms
Source: Boston Globe web site
The Massachusetts draft plan gives the state’s six coastal regional planning authorities the option to build up to 10 wind turbines each in state waters at least one-third of a mile from shore. This would produce a maximum of 60 turbines statewide. Significantly, only the communities where these wind farms are located will have veto power over them, not neighboring communities. The proposed plan has received positive comments and support from environmental groups, although many are arguing that more sensitive areas should be off-limits entirely. The plan was produced in response to legislation Massachusetts Governor Deval Patrick (D) signed in May 2008. There will be five public hearings starting probably in September, and public comment will end in November. The plan should be approved before the end of 2009.
The Massachusetts plan will have no impact on the Cape Wind project offshore Nantucket Island that will involve the construction of 130 wind turbines at a cost of over $1 billion. That project is located in federal waters so other than permits for the transit of the power transmission cables, the approval has been in the hands of the federal government, which is now in the final stages of review.
Offshore Rhode Island, the state has selected Deepwater Wind Rhode Island to build two offshore wind farms. The state has a number of attractive locations for offshore wind projects, albeit they are considerably more expensive that onshore wind projects.
Exhibit 20. Rhode Island Best Wind Is Way Offshore
Source: U.S. Dept. of Energy
Deepwater Wind Rhode Island, is a company founded by investors headed by FirstWind, a major developer of onshore wind projects in the United States, DE Shaw & Co., a private equity investment firm heavily involved in renewable energy projects and Ospraie Management, an asset management firm focusing on alternative energy projects.
The facilitating legislation underlying the Rhode Island offshore wind power business was Gov. Carcieri’s move to get the state to agree that 20% of local power consumption should come from renewable sources – solar and wind – and the power should be produced within the state. This effort initially had a mandate that 5 megawatts of power come from solar projects, but the area is not the most solar-friendly location. Some studies suggest that solar power is considerably more expensive than current power sources while wind power is only modestly more expensive. From the prior utility legislation to the bill signed into law last week, the solar power purchase mandate was reduced to three megawatts from the earlier five megawatts.
After the decision to award the Rhode Island franchise for the wind farms to Deepwater Wind, the problem became how to secure financing for their construction. Without the legislation mandating National Grid purchase a portion of the output, it would have been virtually impossible in today’s credit markets to secure the necessary funds. While the National Grid purchase will be only a small portion of the wind farms’ output, the security of the contract provides lenders what they need to provide the construction funds. Under the power purchase legislation, National Grid will be able to charge a three percent fee on top of the cost of the power. That is in contrast to the current electric power pricing structure in which National Grid only passes on power costs to its customers.
Deepwater Wind is planning to build two wind farms – one of 5-8 turbines in state waters producing approximately 20 megawatts of power and another with 100 turbines producing 385 megawatts of power in federal waters some 15 miles off Block Island. The smaller wind farm is to be in operation by 2011 and the larger one between 2013 and 2014. The cost of these two wind farms will be in excess of $1.5 billion.
One aspect of the Deepwater Wind project for Block Island residents is that they will be able to tap into both Deepwater Wind’s and National Grid’s power supply. When the wind is blowing, they will get their power from Deepwater Wind and went it doesn’t blow they will have power shipped from shore by National Grid. Additionally, the power transmission cable will contain fiber-optic cable bringing Internet, phone and cable service to the residents. The key, however, is that Block Island residents will see their power cost drop from the current 39-cents per kilowatt hour, which is more than two and a half times the rate onshore.
Another Rhode Island benefit from the Deepwater Wind agreement is that the company has agreed to lease 117 acres in the Quonset Business Park to build turbine manufacturing and turbine assembly facilities that are required to employ 800 workers. While much will be made of these green-jobs, the reality is that Rhode Island’s economy is in such dire straits that any new employment will be welcomed with open arms. Deepwater Wind has another project in the approval process offshore Delaware and has been discussing other possible offshore projects along the East Coast, all of which would be supported by the Quonset facilities.
When the Massachusetts draft wind power plan was announced last week, we enjoyed reading the comments on the Boston Globe web site reporting the news. The comments, as one would expect, ranged from intelligent and factual discussions of the issue to idiotic comments. For example, one comment began by citing that wind power is 2.5-times and solar power is 40-times the cost of merely plugging into the grid. Huh? Where does this guy think the power comes from, regardless of its cost? Other comments took on the Kennedy family that has been opposed to the Cape Wind project. Another reader suggested that wind turbines shouldn’t be located as close to shore as a third of a mile. He was happy with at least one-mile. Isn’t it interesting that people are willing to accept wind turbines that will last for 20-30 years, yet they can’t tolerate an offshore drilling rig for maybe six-months to maybe a couple of years but then totally disappears. One reader suggested the wind turbines will provide the subject for a new song – junkyards on the horizon.
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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.
