Musings from the Oil Patch – June 9, 2009

• Will Higher Oil Prices Drive Petroleum Industry Recovery?
• New Diet Attacks Cause of Global Warming
• Auto Emissions, Global Warming And New Car Economics
• CSU Hurricane Forecasters Lower Storm Projections
• GM Bankruptcy Signals New Era For Autos And Gasoline
• Commodities Soar – Green Shoots or Underlying Inflation?
• Environmentalists and Green Energy Meet In Conflict

Musings From the Oil Patch
June 9, 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

June crude oil futures traded above $70 a barrel last Friday before retreating to close at $68.44.  Part of the driving force behind the rise to $70 was a report issued by Goldman Sachs (GS-NYSE) that it was revising its oil price forecast for the end of 2009 to $85 a barrel from its prior $65 forecast.  Briefly, the Goldman Sachs’ higher price predictions are based on its belief that the world has entered into a four-part bull market for crude oil.  They view the current rise to $65 as reflecting the normalization of “pricing dislocations caused by the credit crisis” and its impact on oil demand.  They believe that most of the yearly oil demand decline anticipated has already occurred and that demand is stabilizing and should head higher in the future as the recession ends and economic growth resumes.  Their second phase is that OPEC’s production cuts coupled with stable and slowly rising oil demand will support higher prices as inventories contract and is the principle reason for their 2009 year-end price forecast hike. 

The third bull phase will see oil prices rising to $90 from the prior estimate of $70 a barrel in order to drive the resumption of investment in developing new oil resources.  Their final phase will take oil prices to $95 a barrel by the end of 2010 as energy scarcity becomes a greater consideration.  Longer term, Goldman Sachs suggests that oil demand in developed economies will need to shrink in order to support increasing consumption in the BRIC (Brazil, Russia, India and China) nations.  This is an interesting point because it suggests that oil demand in America, Europe and Japan will be less important for the globe’s petroleum industry in the future than the developing economies.

Exhibit 1.  Crude Oil Prices Are On The Rise

Source:  Bespoke Investment Group

That view was outlined in a recent report issued by the McKinsey Institute.  The report suggests, according to Frank Holmes of U.S. Global Investors, China will account for one-third of the world’s energy demand growth in the 2010-2020 period.  McKinsey, employing what it believes are conservative global gross domestic product (GDP) growth estimates, projects that China’s industrial sector will necessitate an incremental 28 quadrillion British thermal units (QBTUs) and its residential sector will need an additional 11.6 QBTUs.  One QBTU is equal to 172 million barrels of oil.

In 2006, according to the International Energy Agency (IEA), China consumed 75 QBTUs and over the next decade its consumption will rise by 52.4 QBTUs, or nearly 70%.  For the world, energy demand should rise by roughly 34% or 158.5 QBTUs compared to 2006’s estimated consumption of 472 QBTUs.  Within the world forecast, the United States should see a six QBTUs increase on 100 QBTUs of energy consumption in 2006.  Of major energy consumers, Japan will experience only a 0.4 QBTU increase in the next decade, less than a 2% increase as its steel (-0.1 QBTU) and light duty vehicle (-0.5 QBTU) businesses actually experience negative energy demand.  McKinsey does say that improved energy efficiency could alter its forecast of demand growth and therefore its projections for specific country and industry energy demand estimates.

These forecasts point out the challenge confronting executives in the petroleum industry.  Will the economic recovery that may or may not be underway but will be at some point in the near-future, be strong or weak?  Possibly the recovery will be somewhere in between.  In another article in this Musings we touch on the issue of the state of Americans’ love affair with the automobile.  Will we continue to build and buy new cars at the historic rates of the past, or will we need to settle for a significantly lower target?  What types of new housing will

Exhibit 2.  China Accounts For 1/3rd of Future Oil Demand

Source:  U.S. Global Investors, McKinsey Institute

Americans buy – slightly down-sized McMansions or the modest homes of the 1950s and 1960s?  The answers to these questions will determine how America’s energy demand will grow, and what fuels will be favored. 

The questions posed above are important and relate primarily to the United States, but they also impact the economic future of the rest of the world’s developed economies, especially those countries of Europe and Japan with aging populations.  Demographics are the engine of economic and energy demand that are often overlooked by forecasters.  Just how will China’s economy evolve as it confronts a rapidly aging population with few younger workers to support them due to the decades-long government policy mandating one-child families?

A bigger question is how will American consumers evolve as the credit crisis and economic recession end?  We can envision a future American economy that more resembles the 1950s than the 1960s or 1990s.  It is possibly that just as the 1950s set the stage for a robust 1960s, which produced the longest post-war economic expansion until the 1990s, a decade-long consumer retrenchment could set the stage for a robust economic era beginning in 2020.  On what basis might we assume this scenario? 

If we consider the historical pattern of U.S. Government debt as a percentage of gross domestic product (GDP) since 1929 to 2010, the post-World War II period provides an interesting template for the future.  During that period the older population felt lucky to be alive, having survived the 1930s and 1940s, and settled in to a time of saving, preservation of capital and lowered expectations as consumers.  During the Eisenhower years, real progress was made

Exhibit 3.  Government Debt Is Soaring As Percent of GDP

Source:  Annaly.com

in reducing the high relative public debt levels of the war years and in planting the seeds for a new kind of consumption-based economy.  Transistor radios, black-and-white and color televisions, new cars and new homes were all part of this new consumption economy.  But as the shift in the composition of spending was underway, the Kennedy administration relaxed tax codes to stimulate the economy’s growth, which set off a 106-month trough to peak expansion lasting from February 1961 to December 1969.  As the economy expanded the composition of private/public sector debt was rebalanced and the weighting of GDP was altered with consumers ultimately accounting for 70% of domestic growth and 20% of international growth.

Exhibit 4.  Soaring Debt Not Supported By Wealth and Income

Source:  San Francisco Federal Reserve Bank

Today, we are undertaking another significant structural change in which public sector debt will account for a greater share of total debt.  This shift has meant that it takes more debt to generate incremental dollars of U.S. national income.  In fact, recently the ratio was up to $5 of new debt needed for $1 of incremental national income.  The result of this shift is that the ratio of gross national debt to GDP will rise to 82.5% in 2010 from 55% about 20 years earlier.  Only Japan (177%) and Italy (117%) today have higher debt burdens. 

At the end of 2008, the average U.S. household debt to income ratio rose above 1.6.  The Eurozone is about half that ratio.  Aggregate U.S. public, corporate and consumer debt stood at $57 trillion or four times net income and is rising, largely driven by public debt.  Current income tax revenues of $2.6 trillion won’t support an additional $1.84 trillion in Federal debt.  U.S. public debt held by non-resident foreigners is about 115% of GDP. 

Exhibit 5.  U.S. On Japanese-style Deleveraging

Source:  San Francisco Federal Reserve Bank

The net result of all this is that consumer spending had to drop and the savings rate had to rise.  The issues are to what level; over what time period; and what will the impact be on consumption?  Most likely we will have a Japanese-style deleveraging in which the debt-to-income ratio is pushed down to 100% over the next 10 years.  In a typical debt dynamics model, if we assume that the nominal interest rate on existing debt is 7%; the future growth rate of nominal disposable income in 5%; 80% of savings generated are used to pay down debt; then the household savings rate would need to rise from 4% to 10% by 2018.  The impact of that savings increase would be to cut the consumption growth rate by three-quarters of one percent.  That calculation is based on a normal savings rate model, but if the calculation is off a declining savings rate such as experienced in recent years, the reduction in the consumption growth rate would be greater.  Real consumption growth rates remain negative and even in the last half of 2006 and in 2007, growth was in the 2%-3% range.  That rate would fall with a higher personal savings rate.

Exhibit 6.  Real Consumer Spending Fell In April

Source:  Northern Trust

Exhibit 7.  Savings Rates Are Rising As They Must

Source:  Annaly.com

The implication of this model for future U.S. economic growth is considerably less consumer spending.  That will mean fewer cars, houses, appliances, vacations, computers and other electronic gadgets, along with other things consumed in the U.S.  It also means that there will be a negative impact on manufacturing in many developing economies and reduced world trade.  Many industries being forced to retrench now may face years of highly competitive commercial markets.  For consumers, as the Rolling Stones put it, “You can’t always get what you want.”  Inventories will be kept low meaning delivery times for goods will expand.  Supplies of products will be limited, meaning re-orders may be non-existent.  Operating margins will be sustained by managing inventories.  Deflationary price discovery and distribution will dominate the economic landscape. 

This environment we are describing may resemble the post-Korean War period when interest rates were low, large drops in GDP occurred as the economy struggled to shift from its war-driven to a consumer-driven mode.  Inflation was generally low during this period except for some brief spikes due to demand/supply shocks.  The stock market may trade in a range for many years as occurred in that period and during the 1970s, but as we near the end of the static period, the market could rise dramatically.  The risk to this scenario is that the war underway between the public and private sectors results in the Federal government usurping larger and larger segments of the economy and turning the U.S. into a quasi-planned economy. 

Another possible outcome from this public/private debt struggle is that the government decides to repudiate certain debt.  While this would appear to be a low probability given the government’s control over the money supply, there were several periods when American states repudiated their debt.  The first occurred in the 1840s following the panics of 1837 and 1839, largely related to the inflationary boom caused by the Second Bank of the United States.  As the deflationary period of the 1840s unfolded, nine of the 28 states repudiated some or all of their liabilities.  The next wave of repudiation happened in the South after its occupation by the North following the Civil War.  Eight southern states, under Democratic administrations, repudiated their debt during the 1870s and 1880s.  The final American debt-repudiation occurred after the Spanish-American War.  The U.S. repudiated the debt of Cuba after conquering the island as we claimed the debt was incurred by the Spanish government without the consent of the Cubans and was used to help finance oppression and therefore wasn’t legitimate. 

From the economic recovery scenario we have laid out, we can begin to build a model of what energy demand growth should look like and the implications for the petroleum industry.  We will tackle that in our next issue of Musings.

Details from an experimental program designed to alter the diet of dairy cows in Vermont has shown significant reduction in methane released by their belching and flatulence.  Since January, cows at 15 farms across Vermont have had their grain feed mix altered to include more plants like alfalfa and flaxseed instead of corn and soy. 

Alfalfa and flaxseed mimic the spring grasses the cows usually eat that are high in Omega-3 fatty acids, which may help the cow’s digestive tract operate smoothly.  Corn and soy have completely different types of fatty acid structures.

Cows have digestive bacteria in their stomachs that cause them to belch methane, the second-most-significant heat-trapping gas after carbon dioxide.  It also makes their breath smell sour.  Although methane is far less common in the atmosphere than carbon dioxide, methane contains 20 times the heat-trapping ability.  The average cow expels through burps and flatulence between 200 and 400 pounds of methane a year.  In a 2006 report, the United Nations identified livestock as one of the most serious near-term threats to the global climate.  Faced with the prospect of milk and beef production doubling over the next 30 years, the study concluded that the environmental impact of cows, including forest-clearing activity to increase pasture land, might be more dangerous to the Earth’s atmosphere than trucks and cars combined.

The good news from this condition is that American cows are much more productive – milk that is.  The average milk production per cow has more than quadrupled since the 1950s.  Fewer cows are needed per gallon of milk, so the total emissions of heat-trapping gas for the American dairy industry are relatively low per gallon compared with those in less developed countries.  Research conducted by the American dairy industry suggests it is responsible for only two percent of the nation’s emissions of heat-trapping gases. 

The Vermont cow experiment is being conducted with the help of Groupe DANONE, the French maker of Dannon yogurt, which purchased majority control of the American yogurt producer, Stonyfield Farm, which relies on organic farms for its milk supply.  The French company had been experimenting with altered diets and discovered that by putting more Omega-3 back into the cows’ food all year they could increase the milk yield.  They also found that the cows were more robust, their digestive tracts functioned better and they produced less methane.  The flaxseed used in the new diet needs to be heated to release the oil in the seed and yield the maximum benefit for the cows.  The heating is currently done in Canada where the flaxseed is purchased.  Stonyfield Farm says that if the volume of flaxseed consumed rises it will make economic sense to acquire a heating facility.  Even with a higher cost, Stonyfield Farm executives suggest that there are cost savings from the diet because the production of milk increases about 10% and the cows are healthier, live longer and produce milk for more years.

The fascination about breeding a better cow is currently the focus of the department of animal science at Colorado State University.  They are working on developing the “cow of the future” through genetics that will produce an animal that will belch less.  In the interim, changing the cows’ diet appears to be the most promising solution.  At one Vermont farm where milk cows eat the new diet,

Exhibit 8.  Less-Polluting Cows Romp On Vermont Farm

Source:  The New York Times, Cheryl Senter

methane output for the herd has declined by 18%, and the farmer says their breath smells sweeter. 

On May 19th, President Obama announced plans by his administration to boost vehicle fuel-efficiency standards along with reduced greenhouse gas emissions.  The plan, to be worked out through negotiations between the Environmental Protection Administration (EPA) and the Department of Transportation’s National Highway Traffic Safety Administration (NHTSA), is designed to boost overall vehicle fleet fuel-efficiency standards to 33.5 miles per gallon (mpg) by 2016, four years quicker than previously scheduled.  The new plan is partially to head-off possible litigation by a number of states, led by California, to impose tighter emission standards on vehicles sold in the respective states. 

In his prepared remarks at the press conference announcing these new rules, President Obama made the point that over the lifetimes of the vehicles sold in the next five years, the nation would save 1.8 billion barrels of oil, the equivalent of removing 58 million cars from the road for a year and equal to the combined amount of oil we buy from Saudi Arabia, Venezuela, Libya and Nigeria.  He also indicated that there would be a cost to implementing the program – estimated at $1,300 per vehicle.  These key points were reiterated in a letter by Secretary of Transportation, Ray LaHood, to the editors of The Wall Street Journal on May 29th in response to an earlier letter suggesting that the new rules would do little to improve GHG emissions and would increase the safety-risk by forcing Americans to buy only small cars that have proven more dangerous in collisions with larger vehicles. 

In Sec. LaHood’s letter, he addressed the point made in the prior letter that American drivers would continue to use their older, dirtier vehicles because of the $1,300 cost added to the price of new cars manufactured to the new fuel-efficiency and GHG emissions standards.  Sec. LaHood put the number at $600 per vehicle for the cost of the new fuel-efficiency standards only, and said that a driver would recoup this additional investment over three years, and will then go on to save $2,800 over the remaining life of the vehicle by its improved gas mileage performance. 

Since these new standards were announced we have been scratching our head over the apparent low incremental cost and how the calculations for the fuel savings were prepared.  We were intrigued by another letter to the editor on June 3rd that purported to present a radically different set of vehicle economics as a result of these new environmental standards.  The letter’s author referred to a study presented to the NHTSA last June that showed a significantly higher cost to meet the new standards.  According to the 148-page study prepared by Sierra Research (who graciously provided a copy in response to our inquiry), the average automobile cost increase will be $3,778, which rises to $5,877 for light trucks – not the $600 suggested by Sec. LaHood.  The letter writer suggested that once the EPA completes its adjustment of the fuel-efficiency ratings, the vehicles won’t be getting 35 mpg, but more likely 20% less.

The letter writer also took on Sec. LaHood’s estimate of the economics of the fuel-savings for the new vehicle’s owner.  The writer suggested that if the vehicle went from 30 mpg to 40 mpg, the savings would not be $2,800.  He calculates the savings at 125 gallons of gasoline at 15,000 miles a year, or about $300 at $2.50 per gallon.  He estimates that the incremental financing cost for the additional vehicle cost at 6% per year would add $225 a year to the owner’s total vehicle cost.  Thus, the net savings for the owner would be $75 a year, or $225 over the three-year period when Sec. LaHood forecasts the incremental cost would be recovered.  This means the vehicle owner is still underwater by over $3,500.  Even after driving the vehicle for 150,000 miles, the owner is still upside down.  The letter writer suggests that the economics for SUV and light truck owners would be worse, which is not surprising since they have a much greater initial investment to recoup, even if their mileage savings were greater.

The letter writer further suggests that foreign car manufacturers will be more inclined to pay the proposed penalty of $60 per mpg for the difference between their vehicle’s mileage and the new mileage standard rather than inflate the vehicle’s cost to meet the new fuel standards.  He believes Americans will be more than willing to buy an imported car since it will be “a much better vehicle in terms of performance, utility, safety, comfort, handling and ride quality.” 

One has to wonder whether the Obama administration in working its deal with the United Autoworkers Union to support the Chrysler and GM bankruptcies is already thinking about how it can force Americans to buy the new, smaller, fuel-efficient vehicles it wants made here.  According to media reports, one of the terms of the sales agreement of GM’s European manufacturing operations (Opel), buyers would not be allowed to import any of these vehicles into the U.S. market and they are restricted from competing in China, another key part of the GM restructuring plan.  This is clearly an anticompetitive trade restriction and we will likely wind up in a struggle with some of our major trading partners over the practice.  The recent threat by China to initiate a steel anti-dumping trade case at the World Trade Organization against the United States is probably the first indication of how seriously our trading partners are going to fight for markets.  That is only logical in a world with projected sub-normal economic growth for an extended period.

So we urge investors to consider buying the stocks of companies that produce asphalt since there will probably need to be considerable acreage paved to park the small cars the Obama administration will direct GM and Chrysler to build but which the American public does not want to buy.  Mike Jackson, the CEO of AutoNation Inc. (AN-NYSE) recently made the point on CNBC’s Squawk Box when he said, “If gasoline is cheap, there’s going to be a huge disconnect.”  Failing to sell the cars will send the Administration back to the drawing boards for a new plan.  Higher gasoline taxes are a possibility, especially if the Congress embraces a value added tax (VAT) as the way to finance the growing deficit.  Americans, in our belief, should prepare to receive new car purchase coupons instead of Federal income tax refunds in the future as the solution to unsold GM and Chrysler cars.

As we suggested in our last Musings, the tropical storm forecasting team at the Colorado State University Department of Atmospheric Science has reduced its forecast for the number of tropical storms and hurricanes that can be expected this season.  One member of the forecasting team, Dr. William Gray, had been quoted as saying CSU was likely to reduce its forecast in light of the growing probability of a weak El Niño developing that would contribute to reduced likelihood for hurricane development due to its creation of greater wind shears in the Atlantic Basin.  Wind shear acts to cut off the upward development of the thunderstorm clouds that enable them to suck up more water and energy from the ocean surface thus increasing a storm’s power.  An additional factor in the reduced forecast is the continuing cooling of the surface waters in the tropical Atlantic region.  That cooling, tied to the global cooling that appears underway, also reduces the ability of tropical storms to form and to increase in strength.

The significance of the below-average storm-year forecast is best seen by looking at the three detailed forecasts issued by CSU for the 2009 season along with the storm activity record since 2003.  If the new CSU forecast proves out, then 2009 would be about the lowest storm-year activity in the recent past and comparable to the 2006 season. 

Exhibit 9.  CSU Forecast Calls For Calm Hurricane Season

Source:  Colorado State University, PPHB

The new CSU forecast is also consistent with the May tropical storm forecast probabilities issued by the U.S. Government’s National Oceanic and Atmospheric Administration (NOAA).  We have shown in the exhibit below a table with the two latest CSU forecasts and the NOAA forecast.  NOAA characterized their forecast as reflecting a below-normal season, while CSU used a below-average assessment for its latest forecast.  These reduced forecasts, if they prove accurate, should be welcomed by the offshore oil and gas industry in the Gulf of Mexico as they suggest less disruption of drilling and production activities this summer and fall.

Exhibit 10.  Hurricane Forecasts Are All Consistent

Source:  Colorado State University, NOAA, PPHB

Maybe the more significant aspect of the new CSU forecast is its estimates for the probability of tropical storms making landfall on either the U.S. coastline or in the Caribbean region.  The latest forecast calls for a 48% probability of a storm making landfall somewhere along the entire U.S. coastline compared to the average for the last century of 52%.  The breakdown of landfalls along the U.S. coast is: 28% (31% for the last century) for landfall along the East Coast and the Florida peninsula and 28% (30%) for the Gulf Coast from the Florida Panhandle to Brownsville, Texas.  The CSU team is estimating the probability of a storm making landfall somewhere in the Caribbean region at 39% compared to the 42% historical average.

In summing up the conditions for hurricane formation, the CSU team contends that the driving force for tropical storms and hurricanes is the multi-decadal trend in the Atlantic Basin that has been the dominant force since 1995.  The CSU forecasters suggest that based on history, it is not unusual to see below-active years within the trend, but they expect the active pattern to remain in control of hurricane formation for the next 10-15 years.

The decision by General Motors to enter a pre-planned bankruptcy, following a path forged by Chrysler, marks the beginning of a new era for the domestic auto industry.  The bankruptcy, under the direction of the Obama administration’s auto task force, is designed to produce a slimmed-down automaker.  The “new” GM will be a much smaller company and more focused on making smaller, more fuel-efficient and environmentally-friendly vehicles – those being mandated by the Obama administration.  But making smaller cars may not be the issue, selling them may be the real challenge. 

The new GM has been relieved of its former legacy health, pension and interest costs and, with a new wage agreement with The International Union, United Automobile, Aerospace and Agricultural Implement Workers of America, better known as the United Auto Workers (UAW), should soon become profitable. There are serious doubts, however, whether American taxpayers who have injected some $50 billion in cash into the new GM and $12.5 billion into its financing arm, GMAC, will ever earn a realistic profit on this investment. 

An analysis in the May 29th business section of The New York Times did some back of the envelope calculations to point out the herculean task confronting the new GM management.  The authors, Anthony Currie and Rob Cox, suggested that GM would need to have a total equity value after the bankruptcy of $69 billion or more assuming bondholders exercise their warrants.  They then go on to point out that GM’s market capitalization reached $60 billion in 2000 when the automaker was enjoying huge profits from selling high-margin SUVs and light trucks as gasoline prices were at historically low levels.  In addition, GM was getting a third of its $21 billion in earnings before interest, taxes, depreciation and amortization (EBITDA), a measure of cash flow, from its auto financing company, GMAC.  A problem is that the new GM will only own a small piece of the financing company, so expecting as large a cash flow contribution is unrealistic.

The analysis concluded that for taxpayers to be made whole (get their investment back) the new GM would need to have an enterprise value of $95 billion based on the $69 billion in equity value and $26 billion in debt.  (The debt total was actually reduced prior to the bankruptcy filing to $17 billion, which would reduce the enterprise value target to $86 billion.)  Based on a market valuation of five times enterprise value, this implies that the new GM needs to earn $19 billion in EBITDA ($17.2 billion adjusted), or nearly as much as the old GM earned in 2000.

The authors suggest that to achieve these results, the new GM would need to generate $150 billion in sales or nearly 50% more than forecast for the company this year.  In addition, it would need to earn a 14% operating cash flow margin, equal to the best operating margin highly-profitable Toyota (TM-NYSE) has earned.  On the adjusted EBITDA estimate needed to support the reduced enterprise value calculation, the operating margin percentage required would also be lower.  Are these scenarios possible?  Yes.  Are they likely?  Highly questionable.

Under the new business model for the domestic automobile industry evolving in response to the Obama administration’s fuel-efficiency and tailpipe emission rules, small cars seem destined to be the near-term solution given the short time before the standards need to be met.  We have seen estimates that current small cars selling for $17,000 to $20,000 will see their prices rise to $25,000 to $30,000 in order to provide the necessary profit margins to offset the profits lost from selling larger and historically more profitable SUVs, large sedans and light trucks.  We don’t know whether these suggested higher future prices include the estimated cost to meet the new fuel and emissions standards, if not, then we could be looking at even larger prices.

Exhibit 11.  Have American’s Fallen Out Of Love With Cars?

Source:  The New York Times

The unanswered question for both the auto industry and the petroleum industry remains: Is the American love affair with the automobile ending?  The financial crisis coupled with the energy crisis has certainly altered American driving patterns.  We found that once gasoline pump prices first went above $2.50 a gallon, the 12-month cumulative vehicle miles driven stopped rising and as gasoline prices went higher miles started falling.  The mileage decline has been aided by the deteriorating economic downturn.  While we have seen an easing in the pace of the decline in miles driven with lower gasoline pump prices earlier this year, pump prices are beginning to climb in concert with higher crude oil prices.  Unfortunately the statistics on vehicle miles driven lag by about two months, so the chart in the exhibit below shows only the March data and we know that current gasoline pump prices are now at $2.60 a gallon not the $2.05 shown for April.

Exhibit 12.  Miles Driven Falling With Higher Gas Prices

Source:  DOT, Federal Highway Administration, PPHB

Analysts are counting on the aging of the American vehicle fleet to drive future sales.  There is little doubt that more vehicles will be sold in the future than in recent months.  With profitability having to change, meaning higher vehicle prices, people may rethink their vehicle purchasing decisions.  Better built vehicles can support a meaningfully older domestic fleet. 

Lifestyle changes may be the most significant factor impacting the automobile industry and in turn the petroleum industry.  More fuel-efficient vehicles mean fewer gallons of fuel sold unless miles driven climb and/or the total domestic vehicle fleet grows meaningfully.  An increase in vehicles manufactured (and presumably sold) will be welcome news for the U.S. economy and the natural gas industry in particular that has been hard hit by the auto and housing downturns.  Unfortunately, we are not sure that new vehicle sales in the future will be sustained at a rate assuring profitability for the auto industry.

The recent stock market rise has been keyed by the dramatic rise in materials and energy company stock prices in response to soaring commodity prices.  In May, the Reuters-Jefferies Commodity Research Bureau (CRB) index of 19 commodities futures prices had the largest monthly increase since 1974 – 35 years ago!  That historical period was marked by accelerating inflation following the Arab oil embargo and the quadrupling of oil prices from $3 per barrel to $12, the misallocation of domestic economic resources due to wage and price controls introduced by the Nixon administration and fear about the value of the U.S. dollar given the growing pool of international petro-dollars due to the global oil price hike. 

The question overhanging the investment community today is why we have experienced this explosion in commodity prices.  The global economy remains mired in a recession that has crippled world trade and left the world’s manufacturing plants and workers idle, so shouldn’t commodity prices – the raw materials of economic activity – be tame? 

Exhibit 13.  Dramatic May For CRB Index

Source:  Agora Financial

The 12.3% rise in the CRB index during May was led by crude oil that increased almost 30%, the best monthly gain since March 1999 when oil prices jumped 36% following the agreement between key OPEC producers and Russia to cut production and end the petroleum industry depression resulting from the Asian currency-induced recession of 1997-1999.  Copper, a high profile industrial commodity, saw prices rise nearly 9% during May while lead prices increased 13%.  The second largest commodity price jump was experienced by silver, which was up 27%, the largest monthly gain in 22 years or since the Hunt brothers went broke after failing to corner the silver market in the late 1970s. 

If one examines the chart of historic performance of a select group of commodities since 2000, it is evident that so far in 2009 the strength has been concentrated in industrial commodities.  Copper and lead have been the leaders so far this year with silver and crude oil next.  Maybe the more interesting measure is that only three of the 14 commodities tracked have shown negative price changes so far this year.  Those commodities include aluminum, coal and natural gas.  Natural gas has been the victim of weak demand and surging supplies in the U.S. while the coal industry has been hit by lower electricity demand, weaker industrial consumption and fears about carbon regulations in the U.S. making it a less desirable fuel for the future.  Aluminum is the one industrial commodity most hurt by the economic contraction, especially given the cutbacks in the aerospace and automobile industries.

Exhibit 14.  Industrial Commodities Leading The Rally

Source:  LME, MarketWatch, The Wall Street Journal, PPHB

The strength of commodity markets has been attributed to the “green shoots” of economic recovery sprouting around the globe.  People have cited the continuing strength of manufacturing data for China as support of the economic recovery scenario.  The Chinese Purchasing Managers Index has risen for the past three months.  In addition, there have been several positive early economic statistics in the United States, but the key support for the “green shoots” theory has come from antidotal observations by financial and corporate executives suggesting that the pace of the global economic decline has slowed and may actually be forming a bottom.  For Wall Street, these signs breed conviction that the next move in economic activity is up, and that stocks will be the primary beneficiary.  That could prove wrong, but it is the conventional wisdom, which is driving both commodity prices and stock prices higher.

The economically sensitive Baltic Dry Index (BDI) that measures prices charged for ships engaged in world cargo trade also has been recovering this year from its second half of 2008 collapse.  The index surprisingly rose every day during May.  In fact, the BDI rose for 23 straight sessions before falling last Wednesday for a brief respite.  Since its low on December 5th, the BDI has climbed a staggering 517%.  In 2008, however, the index fell 94% from its May peak.  To return to that previous peak, the index still needs to rise by another 188%.  Global factors attributed to driving the BDI rise are increased iron ore demand in China in response to its economic stimulus program, harbor congestion in China and a shortage of ships in the Atlantic Basin.  What is quite interesting about the performance of the BDI is its close correlation to the changes in the Chinese PMI. 

Exhibit 15.  BDI Follows China PMI Export Orders Higher

Source:  Plexus Asset Management

The BDI has also shown a remarkable parallel performance to the Economist Metals Index.  This would suggest that the recovery of both the BDI and industrial commodities is signifying the early signs of the resumption of global economic activity.  It may still be premature to ascribe these actions as confirmation of the start of a robust economic recovery, something the bulls on Wall Street would like to see happen. 

Many economic and financial problems still exist to inhibit a robust pace of economic recovery.  The 345,000 job losses for May reported last Friday was considerably better than expected, but it extends the monthly job losses to 17 months, equal to the string of monthly job losses experienced in the 1981-1982 recession.  The unemployment rate for May climbed 0.5% to 9.4%, higher than the forecasted 9.2% rate.  Economists expect the unemployment rate to continue to rise probably into 2010 and exceed 10%. 

Exhibit 16.  BDI Tracking The Economist Metals Index

Source:  Plexus Asset Management

Until job losses cease, it will be hard for the economy to experience a robust recovery.  An additional problem for the pace of the recovery was the worker productivity data reported by the U.S. Labor Department on Thursday.  It showed productivity improving in the face of the economy’s slowdown.  That pattern is atypical of what normally occurs during a recession.  The government reported nonfarm business productivity rose at a 1.6% annual rate in the first quarter, double the initial estimate, and compared with a 0.6% decline in the fourth quarter.  In contrast, during the recession of 1981-1982, labor productivity fell as much as 5%.  The implication is that manufacturers can generate output with fewer hours worked, or fewer workers.  When the economy recovers, the productivity gains could be significant in the early stages of the recovery delaying the need to hire additional workers thus prolonging the consumer pain from the economic downturn.  Since consumers account for 70% of economic spending and are being counted on by the Obama administration to help drive the economic recovery, this data is not a positive for a strong recovery.  That possibly means a weaker energy demand increase, also.

Another factor driving commodity prices higher is investor fear that the value of the U.S. dollar is being debased by the federal government’s spending splurge and its need to print money to finance the economic stimulus program.  The U.S. dollar index has recently hit a new low this year of 79, taking it back to levels experienced at the end of last year.  That drop has contributed to the rise in the value of many foreign currencies such as the British pound and the Canadian dollar.  It also drives foreigners to buy commodities that become cheaper in U.S. dollars and afford some inflation protection. 

The impact of the fall in the value of dollar from early 2007 through to its trough in the summer of 2008 can be seen in the upward move

Exhibit 17.  U.S. Dollar Sinking To Lows

Source:  Agora Financial

of the CRB index during that period.  The fall in the dollar’s value so far in 2009 has to be partially responsible for the strengthening of the CRB, which merely reflects what is happening to the underlying commodity prices.  Some observers have pointed out that the most recent dollar slide started when Chrysler filed for Chapter 11 protection.  At that point, many investors, both here and abroad began to recognize the structural changes underway in the U.S. economy driven by the Obama administration’s willingness to become deeply involved in its functioning.  Economic involvement of this scale by the government has not been seen in the U.S. since the 1930s and its possible ramifications continue to haunt investors. 

In late April, German-owned power company, RWE (RWEOY-PK), plans to build a new nuclear power plant at Kirksanton in Cumbria in northwest England were revealed at a local county council forum meeting.  The surprise in the revelation was that the plant would be located at a site where one of Britain’s oldest wind farms sits.  The Haverigg wind farm was commissioned in 1992 and is believed to be one of only two of its type in the UK, i.e., partially owned by a co-operative of local residents.  The wind farm was created through financing from a group of pioneering ethical investors and was subsequently expanded to a total of eight turbines after £6 million ($9.6 million) of additional investment was raised.  The Haverigg wind farm is reportedly one of the most efficient in the UK with a 35% “capacity factor” compared with an average of 30% for most other wind farms.

The site was one of 11 locations around England and Wales that have been nominated by the British government for possible nuclear power plants.  The sitting determinations were completed May 15th and the next step in any development was still awaited.  RWE admitted that letters it was required to send to the wind farm’s owners prior to the announcement of the site’s selection were not received before the plan was revealed at the council meeting. 

Exhibit 18.  Haverigg Wind Farm

Source:  Arnold Price, copyright with permission to use

A representative of RWE said that the proposed new nuclear plant site does involve an overlap with the wind farm that might require the movement of some turbines.  Possibly the entire site will need to be displaced.  They said there would be negotiations with local representatives of the community and the management of the wind farm before any work on the nuclear plant’s plans would progress.  The RWE representative went on to say, “Its worth pointing out that we could build up to 3,600 megawatts of low to free CO2 power compared to the 3.5MW or so of wind power that we might replace.  And it’s not a case of wind or nuclear.  We ourselves are spending over £1 billion on wind.”  RWE currently operates 20 wind farms throughout Europe.

The Guardian newspaper in the UK wrote about this development and provided a table comparing the performance and cost of the two power sources.  We have reproduced part of the table, ignoring the list of local fans and opponents of the respective plants.  What we cannot tell from the table is whether the economics of wind power are based on its capacity ratio and/or the cost of maintaining backup power sources to supply electricity when the wind doesn’t blow.  These are variables that have made wind power, seemingly one of the most economical fuels, less competitive against fossil fuels. 

Exhibit 19.  Wind Power Often Trumped By Nuclear Economics

Source:  Guardian, PPHB

An equally strange confrontation between an environmentalist and environmentally-friendly legislation was experienced in the past couple of weeks in New York State.  In a revenue-generating step, New York announced plans to add a deposit requirement for new classes of beverage bottles – bottled water, tea and energy drinks.  The bill was modified to only be applicable to bottled-water.  As passed, the bill required further negotiations over details by legislators, which were completed before Gov. David Paterson (Dem) signed it into law. 

The bill’s sponsors were elated after having fought nine years for an improved bottle-law only to find that a leading local environmentalist had joined with Nestle Corp. (Nestle-BSE) to take legal action to prevent the law from being implemented.  It has been delayed by a federal judge.  The environmentalist was Robert F. Kennedy, Jr. who also happens to own a boutique plastic-bottled-water company, Keeper Springs, which he says donates all its profits to the protection of rivers and public water supplies.

Mr. Kennedy wrote an op-ed for The New York Times on May 28th in which he argued that the bottle-deposit law would reduce the volume of trash in curbside recycling bins and would decrease the profitability of those endeavors.  He also argued that the deposit law would make zero-calorie water more expensive relative to sugary drinks such as tea, sports and juice drinks that contribute to obesity in children and other health problems.  He viewed the price impact on bottled-water as a significant problem for lower- and moderate-income families.

Having shocked the environmentalists who had pushed for the bill’s passage and after having published his op-ed, Mr. Kennedy called one of the leading supporters of the legislation.  The details of the call were reported by Wendy Williams, a Cape Cod science writer and one of the primary reporters of the Cape Wind wind farm battle of the past few years.  Ms. Williams said that the supporter reported that in Mr. Kennedy’s explanation for why he attacked the law he said, “All children have a right to drink spring water.”  The bill’s supporter responded that New York City’s water had a terrific reputation, to which Mr. Kennedy replied that he wouldn’t let his children drink it because it had too many contaminants.  While an extremely elitist view, Mr. Kennedy raised an even more troubling point when he explained he had “made a commitment to Nestle.”  He did not elaborate, but the statement that raises the question of exactly what the commitment is – to support them in their efforts to get the bill overturned or some commercial venture. 

Much of Mr. Kennedy’s op-ed dealt with the impact the bottle deposit law would have on reducing the amount of curbside trash for recycling and therefore the profitability of these recycling ventures.  Ms. Williams compared the hypocrisy in Mr. Kennedy’s position with his efforts to keep wind turbines from being placed in Nantucket Sound near his family’s summer homes.  Increasingly, it appears that high-profile environmentalists are finding it difficult to adjust their personal lifestyles to those they promote and help mandate for others.

Contact PPHB:

1900 St. James Place, Suite 125

Houston, Texas 77056

Main Tel:    (713) 621-8100

Main Fax:   (713) 621-8166

www.pphb.com

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