Musings from the Oil Patch – May 25, 2010

• Oil Price Decline Begins To Match September 2008 Drop
• Another Hurricane Forecast Calls For Bad 2010 Season
• On The Road Again: From Houston To Rhode Island
• Cape Cod and Rhode Island Wind Battles Continue
• Barron’s 500 Oil Company Financial Rankings Fall>
• Optimistic Auto Forecast Suggests Higher Oil Demand

Musings From the Oil Patch
May 25, 2010

Allen Brooks
Managing Director

Note: Musings from the Oil Patch reflects an eclectic collection of stories and analyses dealing with issues and developments within the energy industry that I feel have potentially significant implications for executives operating oilfield service companies.  The newsletter currently anticipates a semi-monthly publishing schedule, but periodically the event and news flow may dictate a more frequent schedule. As always, I welcome your comments and observations.   Allen Brooks

The stock market is in the midst of one of its worst monthly performances since the fall of 2009, and its fall is taking crude oil prices lower, too.  The market drop has been tied to the continuing sovereign debt crisis unfolding in Greece.  Investors are worried that Greece’s inability to address its financial problems through austerity measures and tax hikes will create further problems for other European Union members.  Without trying to explain all the permutations and combinations, the short story is that the economic pain experienced by Greece, and likely many other European countries, will curtail the Eurozone’s budding economic rebound.  With little or no economic growth, energy demand would suffer.

For the second month in a row, the International Energy Agency (IEA) has reduced its estimate for oil demand in 2010.  In both cases, the agency attributes the reduction to corrections in its historical demand data thus lowering the starting point for its forecast.  This explanation was cited as offsetting increased energy demand that should come from recent upward revisions in global economic growth projections by the International Monetary Fund (IMF).  What is important to focus on is that the revised IMF forecasts were made before the recent Greek financial crisis exploded. 

The robust global oil demand growth (+1.6 million barrels per day) the IEA foresees in 2010 is becoming almost totally dependent upon strong economic activity in Asia with a little help from a recovering U.S. economy.  The latest leading economic index for April 2010 reported by the Conference Board showed a -0.1% decline; a surprise given the expectation of a +0.2% gain.  After going straight up from March 2009 to March 2010, the decline in the April index might be worrisome.  The concern comes from the fact that the U.S. economy is slowly exiting a period of strong federal government stimulus – cash for clunkers, shovel-ready construction projects and new home purchase tax credits, for example.  Pending tax increases and smothering new regulatory rules are making it more difficult for companies to continue to invest in job creation.  The inventory rebuilding impact on consumption may be waning just as the impact of tax refunds and unemployment subsidies begin to run out.  Consumer access to credit is still severely limited and small business lending continues to lag.  All of these problems come at a time when state and local government spending is being crimped by falling real estate values and reduced tax collections.  Layoffs among teachers and state and local employees are growing and more municipalities are considering bankruptcy or receivership steps. 

Exhibit 1.  Leading Indicators Surprising Fall In April

Source:  the bonddad blog

As a result of the possible weakening of European and American economic activity and the resultant slowing in energy consumption growth, the case for rising global oil demand rests squarely on Asia.  Central to the Asian argument is the strength of China, although there are growing concerns that the Chinese government is working to slow its economy’s growth to avoid possible problems from emerging financial bubbles.  The long-term case for China’s energy demand growth stems from its growing middle class and its desire to enjoy the lifestyles of other middle classes around the world.  A part of that lifestyle argument is rising home and automobile ownership.  China has already become the world’s largest new car market, surpassing the United States.  Given its population, it is difficult to see that trend reversing anytime soon baring a major economic hiccup in China.

Exhibit 2.  China’s Growing Middle Class Power Energy

Source:  CLSA

Much has been made of the expanding Chinese middle class and its energy consumption.  In the past, when looking at world oil demand, the low per capita consumption in China (2.1 barrels per capita in 2008) is cited as a long-term driving force.  Several years ago we prepared an analysis based on assumptions of a growing middle class and that its members would have a significantly higher oil consumption rate than overall China.  We put the Chinese middle class on a pace of per capita consumption more like South Korea (16.4 barrels/capita) or Japan (13.7 barrels/capita), but not equal to the United States (22.6 barrels/capita).  The point of the analysis was that if the rising middle class adopted a lifestyle similar to other Asian economies, that increase alone in Chinese oil demand would eat up virtually all the then-known output gains from new oil fields scheduled to come into production over the next few years.  As the nearby chart of the impact of the rise in China’s per capita income demonstrates, the growth in the number of people earning $3,000 dollars and above nearly doubles the population we would classify as middle class.

According to research from CLSA, an Asian-focused investment research firm, by 2015, the number of Asians excluding Japanese, who will have disposable incomes of $3,000 or more, will rise from 570 million to 945 million, or slightly more than the total population of the United States.  China and India will account for nearly 85% of this rise.  CLSA sees the spending by this group rising from $2.9 trillion to $5.1 trillion with China, India and Indonesia accounting for 69%, 16% and 4%, respectively, of that increase.  CLSA points out that by 2014, 44% of China’s population will have incomes above $3,000, up 27% from 2009.  The sleeping dragons are beginning to awaken.

Exhibit 3.  Is Current Oil Price Correction Like 2008?

Source:  EIA, CME, PPHB

Despite this long-term economic and population argument, one cannot ignore the chart showing that the fall in crude oil futures prices since the beginning of April is beginning to match the pace of decline experienced in 2008 as the credit crisis exploded starting in September.  So far in May, crude oil futures have fallen 21%, a reflection of investor concerns about the weakening global economic outlook. 

As a financial vehicle, crude oil futures remain an important hedging tool against currency fluctuations and disparity in economic growth rates around the globe.  Thus the movement in crude oil futures prices may at times reflect other economic and financial forces than the underlying long-term global energy demand growth trends.  We are likely in an extended period when trading moves will seemingly overwhelm the long-term fundamentals of the energy business.  We urge people to continue to focus on the long-term if they want to be invested in the energy sector.

The latest forecaster to weigh in with his projection for the upcoming hurricane season that starts in a few days was Joe Bastardi, senior meteorologist and lead hurricane forecaster for AccuWeather.com.  According to Mr. Bastardi, this year will be “bad.”  He says, “This year has the chance to be an extreme season.”  By that he means 16-18 named storms with 15 of them in the western Atlantic or Gulf of Mexico and 6-7 hitting the U.S. coast.  He believes there will be five hurricanes with 2-3 reaching major hurricanes status, meaning a Category 3 or greater with at least sustained winds of 111 miles per hour. 

Exhibit 4.  Hurricane Ivan In 2004 In The Gulf of Mexico

Source:  AccuWeather.com

Mr. Bastardi says the storm season is setting up like past years such as 1964, 1968, 1988 and 2005.  In 1964, Hurricane Clio, a Category 2 storm landed in Southeast Florida near Miami and killed 217 people.  Hurricane Opal, a Category 3 storm came ashore near Pensacola, Florida in 1968, impacting 200 miles of coastline and causing $3 billion in damages.  In 1988, Hurricane Bonnie, a borderline Category 2/3 storm hit North Carolina near Wilmington causing $1 billion in damages.  And, of course, we are all familiar with 2005 when there were 27 named storms that included Hurricanes Katrina and Rita. 

This hurricane forecast is similar to others that have been released so far this spring.  In the case of the hurricane forecasting team of Phillip Klotzbach and William Gray of Colorado State University, their early April forecast is due to be updated June 1st and, based on its past predictive record, should be the most accurate of all their seasonal forecasts.  The National Oceanic and Atmospheric Administration (NOAA) is due to release its 2010 forecast on May 27th before the season kicks off five days later. 

All the weather forecasters see similar meteorological conditions influencing their forecasts.  The primary ones being warm sea surface temperatures in the hurricane development area of the Atlantic off the coast of Africa, a weakening El Niño, weaker shear winds in the Atlantic and a developing La Niña weather phenomenon.  Dr. Jeff Masters of Weather Underground reports that this region’s water temperatures in April were the warmest on record.  He points out that the past three hurricane seasons when water temperatures were the warmest were very active.  The past three peak water temperature years included 1969, 2005 and 1958 when the number of intense hurricanes were five, seven and five, respectively.  A neutral El Niño was experienced in both 2005 and 1958 while a weak one influenced the 1969 season.  The average storm record for these three years was 15 named storms, 11 hurricanes and six intense hurricanes, substantially above the long-term average.

A developing La Niña in the Pacific Ocean also could impact the 2010 hurricane season.  The last one experienced was in 2007 and it was moderate.  That hurricane season, however, experienced 15 tropical storms, six hurricanes and two intense hurricanes suggesting one should pay attention to this weather phenomenon.  The results of 2007 are consistent with the number of storms and hurricanes forecasted for 2010.

The AccuWeather.com forecast calls for a significant impact on the U.S. coast from the storms anticipated.  According to Mr. Bastardi, “I’m forecasting twice the normal impact on the U.S. coast.”  He has developed an “impact” score that combines a measurement of storm strength and the number of U.S. landfalls.  For 2010, Mr. Bastardi is projecting an impact score of 25, which is nearly double his 25-year average of 14.5. 

Exhibit 5.  Delaware Bay Provides Opportunity For Disaster

Source:  MAPQUEST

Mr. Bastardi’s particular “disaster scenario” would be a storm moving into Delaware Bay just south of Philadelphia with a storm surge of 10-15 feet at the same time rain-fed floodwaters are moving down the Delaware River.  This scenario would flood Philadelphia, a city of 1.4 million people with nearly a 60% minority population and a lower-than-average family income than the rest of Pennsylvania.  Philadelphia has only a 40-foot peak elevation and has a population density of 10,714 people per square mile. 

Exhibit 6.  Philadelphia Is Nestled Against Delaware River

Source:  www.distinctivehomesmainline.com

Could we see pictures of Philadelphia that resemble the images of New Orleans after the levies broke?  Could we see iconic city sights such as Independence Hall, Philadelphia’s famous town hall, the art museum where Rocky ran the steps while training for his fights, and even the statue of Ben Franklin sitting on a park bench all underwater?  That is not a pleasant thought, but it could happen and might reflect the complaisance that resides among people living in the mid-Atlantic and Northeast regions of the East Coast since it has been years since they were threatened by severe hurricanes.

Exhibit 7.  Iconic Philadelphia Sites At Risk

Source:  city-data.com

Just so that everyone is prepared, we have listed the hurricane names chosen for those tropical storms that develop in the western Atlantic basin or Gulf of Mexico this season.  We have trouble imagining some of these names going down in history as one of the worst hurricanes to ever hit the U.S., but possibly one or more of them will.

Exhibit 8.  2010 Hurricane Names

Source:  National Hurricane Center

A major question for the oil industry is what impact might an early season hurricane have on the efforts to clean up the oil spill off Louisiana and to drill a relief well?  If a storm develops that targets the location where two rigs are drilling relief wells, they would have to stop, secure the well sites and move to safer locations.  There would clearly be a delay in the drilling effort that would allow the existing blowout to continue to spew oil for additional days.  Given the sensitivity of the industry to another possible well problem, we suspect the order to shut down drilling and evacuate in front of the storm possibly would be issued earlier than normal.

As to the impact of a storm on the spill, there are conflicting views.  Certainly the storm with its high-powered winds and storm surge is likely to drive the spill closer to shore and possibly push it well inland.  On the other hand, there is a question whether the oil on the water’s surface might drain potential energy from the storm.  Some people believe a storm would have sufficient power and drive that it would skip over the oil slick.  The rough waters associated with a tropical storm can be helpful in breaking up the oil slick, making it easier for the ocean to absorb it.  The bottom line is that there are a lot of possible impacts on the Gulf clean-up that will only become clearer as a storm draws near.  It is difficult to envision a scenario in which the oil industry is made to look better, though.

All things considered, the 2010 hurricane season will be not only interesting but challenging.  If the forecasters prove correct, it could also be a long season with early and late storms, not a welcome scenario.

Our annual spring trip to Rhode Island demanded that we make it a quick drive.  Originally it was planned to be more leisurely following a week that saw me flying back and forth to Calgary twice to attend board meetings while participating in a client’s day-long planning session in Houston.  What turned the trip into a frantic drive was an invitation to my wife’s once-removed cousin’s wedding in Narragansett on Sunday afternoon. 

At mid-morning the Friday morning before, after packing the car and taking care of last minute business details, we hit the road.  One of the first amazing things we saw was a pickup truck pulling a gooseneck trailer loaded with old refrigerators heading for a highway exit.  Our guess was that these were refrigerators turned in for rebates on new refrigerator purchases under the Texas “cash for appliance clunkers” program, part of the federal government’s $300 million plan for state rebates to stimulate new energy-efficient appliance sales that was a part of the 2009 American Recovery and Reinvestment Act, aka the stimulus bill.  If the truck hadn’t been heading north, we might have assumed those refrigerators were heading south of the border just like most of the towed vehicles we often see on Texas highways. 

Exhibit 9.  Bogus Room Air Cleaner

Source:  GAO Report

After seeing the trailer-load of refrigerators, we immediately thought of the newspaper accounts about the federal government’s test of the Energy Star appliance rating system showing serious flaws.  The Energy Star program is a joint effort of the Department of Energy and the Environmental Protection Administration to promote more energy-efficient appliances.  A test of the system was performed by the Government Accountability Office (GAO).  It submitted 20 bogus products supposedly manufactured by four fictitious companies.  Each product applying for an Energy Star rating included made-up energy consumption test results and a certification application.  Of the 20 products, 15 were awarded Energy Star ratings, two were rejected (including one for a compact fluorescent light bulb!) and three products never received a response from the government.  Among the bogus products approved was a gas-powered alarm clock that was the described as the size of a small generator and powered by gasoline.  The other product approved for an Energy Star rating was a room air cleaner that was really a space heater with a feather duster taped to it. 

Consumer Reports magazine has repeatedly cited the Energy Star standards for being too lax and that their qualifying tests are out of date.  To prove the point, the magazine cited their tests of two French-door refrigerators with bottom freezers and through-the-door ice and water dispensers.  One of the Energy Star rated products tested was the Samsung RF267ABRS that supposedly uses only 540 kilowatt-hours (kWh) of power annually.  Consumer Reports found that based on its tests, which are both more stringent than the Energy Star ones and reflect a more realistic use of the product, the actual energy consumption was 890 kWh. 

They also tested LG’s model LMX25981, another French-door refrigerator, that Energy Star says only uses 547 kWh a year of electricity.  But as Consumer Reports points out, the Energy Star test is performed without the ice-maker being turned on.  When the real-life scenario is applied, this refrigerator’s power consumption more than doubled to 1,110 kWh.  So of what value is the Energy Star rating?  Consumer Reports says the standard for achieving the Energy Star rating should be limited to the top 25% of models in each product line rated.  Yet at the present time, 92% of dishwashers carry the Energy Star designation, while 67% of residential-use oil-fired oil burners and 60% of dehumidifiers qualify. 

So as we watched the load of refrigerators heading off the interstate, we wondered how many of those units weren’t being replaced by significantly more efficient ones.  We’ll never know, but it sure makes one question the value of government ratings, but then we believe most consumers have learned about the shortcomings of government ratings based on their experience with new car mileage ratings that are calculated on indoor treadmills – not a real live test!

Our drive this year was made in our new vehicle, which prompted us to notice how many other new cars were on the highway.  Based on what we observed, we now can substantiate the rebound in new

Exhibit 10.  Does He Know What That Rating Really Means?

Source:  tom.arthur/Flickr

vehicle sales.  This is especially important for the economy given that today’s vehicles sporting temporary license plates were not bought under the government’s cash for clunkers program.  Of course, given Toyota’s quality-problem-driven sales and GM’s incentive programs, it is not surprising to see more new cars on the road. 

Based on the truck traffic we encountered, we have to declare that the economy is on the mend.  Of course, we wonder what impact the working rules for over-the-road truck drivers is having on the number of trucks on the road we saw during the day.  We noticed that once the sun went down, the trucks disappeared only to be observed at rest stops, parked along highway on and off ramps or at truck stops.  The rules for truckers were tightened last year such that a long-haul driver can only drive for 11 hours a day and work for no more than 14 consecutive hours involving driving and non-driving tasks.  Between each work period, a driver must have 10 hours off.  Also, drivers can only work for a total of 60 hours in a week. 

So whether the additional trucks we saw during daylight hours truly reflected a commensurate increase in goods-hauling, we aren’t sure.  It was a little harder driving amongst all those trucks during the day, but at night it was pleasant not to be nearly run over by those behemoths racing to cover great distances in the dark. 

We noticed that at dinner time, our friendly Cracker Barrel restaurants were only partially full.  We couldn’t decide whether it was a sign of fewer people traveling or just fewer people eating out.  Many of the Cracker Barrels we frequent seem to have a substantial number of locals frequenting them, so there is a possibility that dining out is down in these areas.  The benefit we gained from the restaurant scene was reduced stopping time enabling us to cover more miles.  We can always count on McDonald’s for a quick-eating experience, but on this trip they all seemed to have crowds.  Does that reflect a downscale dining trend due to the economy? 

Finding a hotel room in Gadsden, Alabama Friday night proved not to be a problem as hotels seemed to be sprouting like mushrooms in the dark.  A nice, new Holiday Inn Express with a nice exercise room and an extensive free breakfast for $88 seemed quite a bargain.  We noticed the car parked next to ours in the parking lot had a Guam license plate, which suggests the owner was on his or her way to one of the military bases in the area, although we can’t prove that assumption.  But one thing we have learned about driving this route is that it doesn’t pay to plan on staying the night in Connecticut.  After finding three hotels in Danbury filled due to graduations and weddings, we soldiered on to our home in Rhode Island a few hours further.  This is the second time we have had trouble finding a hotel room in Connecticut in the early spring, so now we will stop either in Pennsylvania or New York and just drive further the next day. 

All-in-all it was a rather uneventful drive.  There continues to be a lot of construction in Pennsylvania, but those annoying signs proclaiming the highway work was funded by the American Recovery and Reinvestment Act were gone.  It seems these specific highway projects were already approved under the regular highway spending authority before the stimulus bill was approved so they weren’t eligible for those special federal funds, so the state had to take down the signs.  Based on our drive through the area, we’d like to have the concession for orange cones and concrete barriers as they seem to go on for miles and miles.  Our feeling as we drove into recession-battered Rhode Island is that the nation has probably seen the worst of the downturn.  Early last week a headline in The Providence Journal proclaimed the Rhode Island recession over but that the recovery, especially for jobs, would be slow.  Our real concern for energy, however, is just how fast the rebound will be.

Massachusetts’ Cape Wind energy project moved a step closer to reality with two recent actions, but it still faces a daunting future in the courts.  At the same time, the future of the wind energy business in Rhode Island is bogged down in a legislative battle to circumvent the normal utility regulatory process in order to promote a politically expedient course of action.  Developments in both states suggest that the beauty of renewable energy projects may not be as universally accepted as thought once the cost/economics of these projects are understood by the public.

The Cape Wind victories include a final ruling from the Federal Aviation Administration (FAA) that the 440-foot tall wind turbines destined for Nantucket Sound do not pose a hazard to aviation in the region as long as they are properly marked and lighted at night.  The other positive development was the announcement that Cape Wind and National Grid (NGG-NYSE), the state’s principle utility, have agreed to a power purchase agreement (PPA) that sets the price of power generated by the wind farm at 20.7-cents per kilowatt-hour (kWh), which will escalate at 3.5% per year for each year of the 15-year contract life, but more on this contract’s details later.  It should be noted, however, that National Grid estimates the average power customer (500 kWh per month) will only see an increase of $1.59 in his monthly bill, or about a 2% monthly increase.

In Rhode Island, the rejection of National Grid’s PPA for power from the Deepwater Wind demonstration wind farm off the coast of Block Island sparked a sharp and swift reaction from the governor and legislators who have been championing the effort.  Wind power has been identified as having a bright future off the state’s coast due to the region’s favorable wind patterns.  The decision by the state’s Public Utility Commission (PUC) to reject the 24.4-cent per kWh price that was scheduled to escalate at 3.5% each year of the 20-year contract term as too expensive for Rhode Island electric consumers was seen as a major setback for the state’s economic recovery efforts.  Green energy was targeted as a “silver bullet” for the Rhode Island economy that continues to struggle with the recessionary effects of unemployment.  Legislators, with the backing of the governor, dreamed up a plan to create a super board made up of four heads of government departments that would review and could approve the Deepwater Wind/National Grid PPA, or any other renewable power contract, without seeking the approval of the PUC.  The legislation to create the board and provide it with the appropriate mandate has been introduced into the legislature, but has yet to be voted on as various amendments continue to be proposed. 

Rhode Island PUC Commissioner Mary E. Bray sent a letter to the House Committee on Environment and Natural Resources in reaction to the proposed legislation.  The primary case for approving the PPA, according to legislators, was that there would be a $200 million economic benefit for the state from the approval of the demonstration wind farm.  We are not sure whether this benefit also included the possible impact from the proposed larger wind farm to be built after establishing the economics and technical attributes of offshore wind farms with the demonstration project.  The legislators pointed to the PUC’s failure to consider the possible creation of a “green” manufacturing industry in the state and that it failed to follow state policy in support of renewable energy as additional reasons why circumventing the regulatory process was necessary.

In her 28-page letter, Commissioner Bray stated that the PUC found the $390 million in above-market electricity costs would only lead to the creation of 50 temporary jobs and six permanent ones.  In addition, the PPA would result in sizeable annual increases in power costs for the largest businesses in Rhode Island putting them at risk of extreme economic hardship that could lead to job reductions or abandoning the state entirely.  She said the commission “evaluated all of the evidence presented to it by the parties.”  She went on further to say, “Unless new studies have been performed or new binding commitments have been made since the commission issued its decision, it is unclear as to what evidence there is that the project will result in a net increase in jobs in Rhode Island or a net positive impact on the economic condition of the state that would justify such a large expenditure of ratepayer funds.” 

The members of the PUC are appointed by the governor and approved by the legislature and can only be removed for specific infractions.  Their mandate is to balance the financial needs of the utilities, the cost to consumers and to see that adequate power is available for the population.  In contrast, the four members of the newly proposed board hold appointed government positions and they can be removed by the governor at will, possibly compromising the independence of their decision-making power.  Only one of the four has to approve the contract.  Given this board’s structure and power, some legislators have begun to question whether circumventing the regulatory process for establishing electricity prices in the state is appropriate.  In testifying in favor of the new legislation, Governor Donald L. Carcieri said, “In fact, I believe it was the PUC that circumvented the clear public policy established by this body – the General Assembly.”  This attitude, based on our 13-year history with the state, is consistent with the political philosophy of governing in Rhode Island.  A recent survey of public attitudes toward wind power in Massachusetts shows little willingness by consumers to pay above-market prices for green energy.  We doubt Rhode Island’s citizens have dramatically different attitudes.

Now that Cape Wind has a PPA with National Grid for 50% of its power, it can move forward to seek approval from Massachusetts regulators and begin negotiations for project financing.  The latter development will be significant as it will require Cape Wind to develop firm cost estimates for the project.  Estimates had ranged around $1 billion, but in recent weeks various media reports have suggested a number at least twice as much as the previous figure and the latest information seems to confirm the higher estimate.  We are not sure whether the details of the PPA give us much insight into the project’s cost.  How quickly Cape Wind arranges financing may depend on how rapidly the various court cases move forward or are dismissed.

At this point, a number of environmental groups have filed lawsuits against the federal Fish and Wildlife Service and the Minerals Management Service (MMS) over violations of the Endangered Species Act.  The Alliance to Protect Nantucket Sound and Duke’s County/Martha’s Vineyard Fisheries Association have filed suit against the MMS for violations of the Outer Continental Shelf Lands Act.  The Wampanoag tribe has indicated it is readying lawsuits over violations of tribal rights, the national Environmental Policy Act, the Migratory Bird Treaty Act, the Rivers and Harbors Act, the Clean Water Act and the Outer Continental Shelf Lands Act.  Legal experts have suggested that the best opportunity for success among all this litigation lies with the Endangered Species Act that has the most teeth and legal recourses.  As these lawsuits have just been filed, or not yet filed with respect to the Wampanoag tribe, the timing of their resolution is uncertain.

Exhibit 11.  Consumers Struggle To Accept Electricity Price

Source:  Cape Cod Today

The PPA between Cape Wind and National Grid calls for a 20.7-cent price in 2013 when the project is expected to begin operation.  The total price consists of 12.5-cents for power, 6.7-cents for a Renewable Energy Certificate (REC) and 1.5-cents for hedging.  While the argument has been made about the PPA price being more than twice the cost of wholesale price for power from natural gas sources in the region, the fuel that currently generates 41% of the state’s electricity, the actual energy component is only about 50% greater. 

Many people may not be familiar with a REC.  It is a piece of paper that represents one megawatt-hour of renewable electricity delivered to the grid and the environmental benefits of displacing an equivalent amount of dirty electricity.  This is because the electrons associated with green energy and dirty energy are no different, so a utility buying green power has no way of knowing if they actually get green power.  The REC insures that the utility can represent to the regulators that it has complied with its green power mandates.  The REC is essentially a “green” premium paid to renewable generators to help them compete with lower-cost but dirty power.  So to actually compare the true cost of renewable power, the REC value should be added to the actual cost of the power, which in the case of the Cape Wind PPA results in a 19.2-cent price, or more than twice the current alternative cost of power. 

RECs are registered pieces of paper and are tradable.  They are registered so that they cannot be re-circulated after the power is produced.  However, these certificates enable power companies to meet their renewable mandates without actually having to buy green energy.  According to reports, the deal between Cape Wind and National Grid allows the latter to nearly meet its entire mandatory renewable fuel requirement under Massachusetts’ portfolio standard.  That mandate will be at 5% when Cape Wind begins operation and this agreement represents 3% of National Grid’s power purchases. 

We wondered how the negotiated REC price compared to the market.  In New Jersey, there is an exchange for the sale of REC’s associated with solar energy projects (SREC).  As of March, the average price for an SREC was $568.66 per MWh.  That would translate into a 5.7-cent per kWh price, which would compare to the negotiated 6.7-cent price.  The negotiated price, however, is for purchases in 2013.  Over the period July 2008 through September 2009, there were 77,810 SRECs issued and 115,188 traded in New Jersey.  During that period, the price of a SREC ranged from $308.08 to $544.85 per MWh.  As the market for SRECs has grown, the price has increased.  We are not sure whether the increase reflects greater investor and/or power company interest in the market, or merely reflects the rising cost of solar energy.  When we looked at the data for each March since 2006, we found the average SREC price per MWh climbed each year from $201.97 to $208.65, then to $231.00 and $466.85, finally reaching $568.66 last March. 

As more details of the Cape Wind PPA become public now that the 159-page agreement has been filed with the Massachusetts PUC, the importance of the federal renewable energy tax incentives has become clearer.  These federal tax credits have finite lives that could see them ended before Cape Wind begins operation.  One tax credit is an investment tax credit, which enables a wind farm developer to accelerate its depreciation by writing off its investment over five years rather than 20 years.  The other credit is for producing renewable energy and worth 1.8-cents per kWh.  According to Cape Wind, these two tax credits are worth about $600 million that would help offset the estimated $2 billion plus cost of the wind farm.  If the largest tax credit, the investment tax credit, is ended, Massachusetts ratepayers would have to come up with an additional $20 million in payments in the first year.  Under the terms of the PPA, to compensate Cape Wind for the possible ending of the investment tax credit, the electricity power price would rise to 22.8-cents per kWh (+10% over the currently negotiated rate).  If both tax credits ended, the power price would climb to 23.5-cents per kWh, which would be more than two and a half times the cost of alternative power. 

Besides the Cape Wind power cost, New England ISO, the manager of the distribution and transmission network in the region, believes the system needs upgrading to handle greater renewable power and additional power volumes to the tune of $10 billion over the next 20 years.  The cost of the region’s power grid upgrade will have to be borne by both National Grid ratepayers along with other energy consumers in the region.  The cost impact on ratepayers has not yet been estimated, but as more renewable energy supplies enter the power pool, the system will need additional investment.

When the public learns about these new power costs, the results of a recent University of Massachusetts survey will carry even greater weight.  The survey found that Massachusetts consumers would not pay more for electricity produced by wind turbines.  Much of the previous support for Cape Wind was generated based on the assumption that wind power would lower consumer power bills, not raise them.  After the price associated with the PPA was announced, the survey showed that 80% of respondents were opposed to the project.  How do you think they will feel when confronted with the potential for an electricity price 15% higher than already proposed?  As Massachusetts and Rhode Island are demonstrating, green energy is nice as long as it’s not in my backyard and doesn’t raise consumer power bills.

The that fact oil and gas company and oilfield service company financial performance rankings in the Barron’s 500 company survey fell last year should be of little surprise to energy investors.  What may be a surprise, however, was how far they fell.  As the financial newspaper pointed out in its accompanying article on the survey results, the top companies “earned their spurs the old-fashioned way – by working to generate solid sales growth and healthy returns on investment even amid the worst recession since the Great Depression.”  Unfortunately, with the collapse in energy demand and global oil prices in the second half of 2008 and the subsequent drop in natural gas prices later in 2009, revenues for the industry collapsed.  More importantly, cash flow for the companies was chopped significantly, and for the oilfield service companies it meant substantially less work that translated into lower equipment utilization, weak pricing power and greater overhead to be absorbed.  So while some companies successfully overcame the recessionary effect on their businesses, energy companies, in most cases, were not among those successful few.

The latest Barron’s 500 survey marks the newspaper’s 12th edition.  The newspaper commissioned HOLT, a unit of Credit Suisse (CS-NYSE), to prepare the rankings.  HOLT uses three equally weighted measures to grade and rank the largest U.S. and Canadian companies that trade on U.S. stock exchanges.  The companies’ size is based on its sales in the latest fiscal year.  HOLT calculates the median return on investment based on cash flow for the past three years using a proprietary cash-flow-return-on-investment metric (CFROI).  The metric removes the effects of inflation and adjusts for accounting distortions. HOLT also calculates each company’s CFROI for the fiscal year compared to the three-year average and the company’s sales growth in the latest fiscal year, adjusted for any divestitures.  Using these three measures, HOLT grades each company and awards them a letter grade based on quintiles of performance.  From the A through F rankings, each company is awarded a total grade-point average with 4.0 being the maximum value attainable.  Ties in the GPA rankings are broken on the basis of the latest CFROI compared to the three-year average.

The rankings of the companies in each sector are contained in the adjacent table.  The most interesting point to note about the companies is their ranking in 2010 compared to 2009.  With the exception of FMC Technologies that was not ranked in 2009, only one company, McDermott International, rated a higher ranking this year than last.  Many of the declines were very significant including National Oilwell Varco that dropped 150 points from the number two position last year.  In general, the oilfield service companies performed much better than the E&P companies, both those in the U.S. and Canada, and the international oil companies.  Only Halliburton, among the oilfield service companies, fell into the bottom 20% of all companies ranked.  On the other hand, only Suncor among all the oil and gas companies avoided falling into that bottom quintile.

Exhibit 12.  Barron’s 500 Survey of Energy Company Results

Source:  Barron’s; PPHB

About the only conclusion one can draw from this performance is that when oil and gas prices collapse as they did in 2009, it is impossible for energy companies to perform financially anywhere close to the levels they did during a high commodity price era.  That is not an indictment of either the companies or their managements, but is more a statement about industry cyclicality.  We suspect, but cannot prove, that if oil and gas prices had stayed steady or changed only slightly between 2010 and 2009, the financial performance of the companies would have been better.  As a result of the financial crisis, there would not have been the dramatic turnaround in performance demonstrated by financial institutions – going from nearly bankrupt to outstanding earnings growth.  Thus the competitive situation for energy companies would have been improved.

We have contended for the past several years that the key to future energy demand in the U.S. will depend on a stronger housing market and higher new auto sales.  A recent forecast by analysts at A.T. Kearney, a market research firm, says that the recovery in the domestic auto market will be stronger than almost everyone else believes.  Between 1999 and 2007, new auto sales consistently were above 16 million units per year.  Auto sales dropped in 2008 to 13.2 million units and further declined to 10.4 million units in 2009 as the recession extracted a significant toll on consumer incomes and the financial market turmoil limited access to credit. 

As we know, the domestic auto industry was decimated during the 2007-2009 recession by the rapid and dramatic fall in new car sales and the escalation in autoworker health care costs.  As a result, the industry witnessed the bankruptcy/take-over of General Motors and Chrysler.  Ford Motor (F-NYSE) barely avoided failing but has been able to remain independent and increasingly more profitable as a result of operational changes forced on the business by economic and market pressures. 

Daniel Cheng, A.T. Kearney partner, points out that the average age of all light vehicles in the United States was 9.8 years at the end of 2009 and will rise to 10.1 years by 2011.  Mr. Cheng believes that 9.2 million units of pent-up demand from the recession and credit market problems will be coming into the market starting next year.  As he pointed out, “We know cars last longer, but they don’t last forever.”  A.T. Kearney believes that American consumers delayed purchasing 19.6 million units between 2007 and 2010.  With the prospects of no double-dip recession and easier credit, much of this demand should come back into the market over the next several years.  As a result, Mr. Cheng is projecting that new car sales in 2010 will be at an 11.7 million unit seasonally adjusted rate.  That estimate is within the range of an optimistic forecast of 12.3 million vehicles and a pessimistic projection of only 11.4 million units.  For 2011, Mr. Cheng believes the industry will sell 14.4 million units with a possible upside of 15 million.  In 2012, the auto industry is expected to sell 16.1 million vehicles – the first time sales will be above 16 million in five years.  The single point sales estimate falls within a range of 12.9 million and 16.8 million units.  That seems like a pretty wide range.

The A.T. Kearney forecast is the most optimistic projection of new car sales that has been published.  It is more optimistic than the forecasts made by auto manufacturers and gets to the 16 million new car sales’ threshold quicker than all other forecasts.  Mr. Cheng suggests that “If you look at the 1980s and the recovery from the low point then, the steepness of the return is much like our forecast.”  While we often find historical performance a good measure of how business cycles might perform in the future, the change in American demographics, credit market conditions and lifestyles may alter that recovery pace.  Recent statistics point out that today there are four million fewer cars in the country than there were at the end of 2008.  As there continues to be more vehicles than licensed drivers, one has to question whether Americans will replace older vehicles at a one-for-one rate.  Additionally, the teenager sector of our population is shrinking and a lower percentage of them are getting driver’s licenses than in the past.  That trend will also limit car buying.

One of the more interesting developments in the auto business is the change in the manufacturing processes and how that may reshape the industry.  Building cars on global platforms is a force that will reshape the industry.  Projections are that by 2015, 38% of the world’s cars will be manufactured on top-selling platforms, up from 13% today and 10% in 2000.  This trend will push auto company mergers and alliances such as we are seeing.  The impact of manufacturing one million cars on the same platform can save $700 per vehicle compared to a platform that only produces 400,000 units annually.  At the present time, eight automakers have 12 platforms on which at least one million vehicles are made annually.  By 2015, there should be 10 companies with 20 platforms producing at least one million units a year.  Today, the leading world class auto manufacturing platform is Toyota’s (TM-NYSE) Camry at 2.8 million units annually.  That is followed by Hyundai’s (HYMTF.PK) Elantra and then two Nissan-Renault (NISA.F – RNL.F) platforms – the Clio and the Sentra.  If this forecast is right, before long we will see cars with the same body-shape but a different name all over the world.

We don’t doubt that the American automobile industry will sell more cars this year and in the next several.  However, we seriously question how quickly the industry will get to 16 million annual car sales on any sustained basis.  That was a pace associated with the last economic boom, which was propped up by cheap credit and rising home equity values.  Getting back to 16 million car sales in the next few years would suggest another boom-like economy, and that we have a very difficult time accepting.

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