Musings From The Oil Patch, November 11, 2013

• Safety Statistics Reporting Could Impact Offshore Regulation
• The Enigma Of China’s Economy And Its Energy Needs
• Will Slower Economic Growth Challenge U.S. Energy?
• First Time Since 2007 OPEC Raises Oil Demand Outlook
• Wrestling With The Natural Gas Production Bear

Musings From the Oil Patch
November 12, 2013

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 Department of Labor is considering creating a publicly available database of workplace safety information of large companies.  The head of the Occupational Safety and Health Administration (OSHA) and safety advocates argue that public information about injuries at the workplace will aid the government’s efforts at safety enforcement.  The proposal the government released last week calls for about 38,000 private companies – those with 250 employees or more – to provide a detailed quarterly report of all major injuries that occur at a worksite, including the cause of each injury.  OSHA plans to release the data with personal employee information redacted on its web site. 

Companies are already required to collect the safety information, to post it at their worksites and to provide injury rate summaries to government data surveyors when selected, but the statistics are not normally reported to OSHA.  At the present time, around 60,000 companies a year provide injury data that is stored on OSHA’s website, but that information is not complete.  The new proposal will expand the reporting requirement to about 440,000 companies that must report injury and illness information. 

Industry is fighting the government’s proposal because the data is subject to misuse/misinterpretation that could support agendas by groups that have nothing to do with safety and health.  On the other hand, regulators say they need the additional information to determine which industries and companies to target for investigations and improvements.  Some safety professionals and researchers are concerned that the additional reporting requirement might lead to under-reporting injury and illness data by companies in order to make them appear safer.  Will employees monitor their boss’ safety reporting accuracy?

We find it interesting that recent media articles reporting on accidents and deaths of foreign workers offshore could become another pressure point for the release of accident, injury and illness statistics.  In the past several years, there have been at least two accidents involving offshore platforms where four Filipino workers have died.  Investigations have pointed to a lack of communication between operators and contractors and even among contractors working offshore.  The 2011 extension of offshore regulation to service companies by the Bureau of Safety and Environmental Enforcement (BSEE) from its prior exclusive focus on operators/lessees has changed working relationships offshore.  Now that service companies are regulated, management has a responsibility to understand how their working relationship with their clients – the oil companies – has changed and how they must adjust to the new conditions.  One of the primary changes is that the service companies can no longer be indemnified by their clients, but rather everyone operates under “joint and several” liability, meaning each party must insure against not only its own accidents but also those that might be caused by other contractors or even the operator. 

The energy reporters at the Houston Chronicle have written several stories about the investigations into the safety incidents offshore.  The conclusion from these investigations can be summed up by comments from Brian Salerno, the head of BSEE.  He was quoted saying, “The connections between operators and contractors can probably be tightened up from a safety perspective.”  He also commented, "Our recent experience suggests that all offshore oil and gas operations … carry inherent risks."  But one issue that critics of safety conditions offshore point to is the current cap of $40,000 per incident per day in an environment where daily operating costs can run to several million dollars per day.  They question whether that cap is sufficiently high enough to draw the attention of managements.

In the new world of offshore regulation, especially for the heretofore unregulated service companies, the altered business relationships for working offshore means service company managements need to adjust their thinking and actions.  The pressure from OSHA officials seeking the release of safety data for industries and companies could further pressure the offshore oil and gas industry’s operations.  Welcome to the new world of offshore regulation!

In virtually every discussion about the future of global energy demand, the role of China is always highlighted.  The country has the world’s largest population and the fastest economic growth rate, especially among large economies.  As you are reading this article, China’s political leaders will have just concluded a major Party meeting that may set the stage for a significant shift in the trajectory of China’s economy, depending on the meeting’s outcome. 

The 3^rd Plenum of the 18^th Communist Party of China is scheduled to run between November 9^th and November 12^th.  A plenum is a meeting of the Communist Party Central Committee.  There are 205 full members of the Party with 167 alternates who were chosen at the 1st Plenum in November 2012.  Each Party lasts five years and with the exception of the first year, usually has one plenum per year.  The Politburo with 25 members meets more regularly than the full Party, while the Standing Committee of seven members meets even more frequently.  At the present time, Xi Jinping is the General Secretary of the Party.  He is also the head of State (President) and of the Military (Chairman of the Central Military Commission), meaning he is the embodiment of all official power in China. 

The historical pattern of Plenums is that the first one of a new Party introduces the new leadership for the country.  The second Plenum focuses on personnel matters and the structure of the Party.  The third Plenum is usually the first time the leadership has fully consolidated its power and can introduce its broader vision for the economic and political policies for the ensuing years. 

While we will only know how significant this 3^rd Plenum is once it is closed and the proclamations are released, China policy analysts are suggesting that it may rank with the significance of the 3^rd Plenum of the 11^th Communist Party in December 1978, held two years following the death of Chairman Mao, which ended the Cultural Revolution, led to the arrest of the Gang of Four and launched the “reform and opening” of China that put the country on its current economic trajectory.  These analysts also suggest that this Plenum could be as significant as the 3^rd Plenum of the 14^th Communist Party in November 1993 that endorsed the concept of the “socialist market economy” that set forth the theoretical foundation and provided the political cover for a more aggressive set of economic reforms. 

In the run up to the Plenum, the leadership in China has held a series of meetings with media and analysts setting forth potential areas of economic and political reform.  The overall impression from these meetings, as reported in numerous economic and political analyses published in newspapers, magazines and online blogs is that the Party may introduce comprehensive and unprecedented economic and political reforms.  Some of those reforms could include changes in land ownership and transfer policies, broader financial reforms, changes to the household registration system giving rural residents greater rights and social protection, changes to the fiscal relationship between the central government and local administrations, more trade liberalization to increase openness, new policies designed to try to spur economic innovation, changes in the pricing of input factors that may weaken State-Owned Enterprises (SOEs), a reduction of administrative interference in the economy and a 5-year plan to combat corruption. 

Exhibit 1.  Areas Communist Party Focused On

Source:  WSJ

The overarching goal of the Plenum and this wide array of policy and regulatory changes will be to make the Party more efficient, responsible and accountable and to ensure single Party rule.  There will be a recognition, or admission, that it will take years to implement the changes and alter the economic, governmental and social relationships in China.  The reason for the long timeline to effect these changes is that it will take a while for the policies to flow from the central government down through the bureaucracy. 

At the end of the day, should all the above-listed changes be announced, the goal will be to transform the Chinese economic growth model in order to de-emphasize the growth rate of gross domestic product (GDP).  The impact of these policies may bolster the near- and medium-term economic prospects.  The more important consideration is that Xi Jinping will be focused on leading a great national rejuvenation of the country’s government and social structure.  That is important because, among longtime China analysts, no one believes the current economic structure and growth model is sustainable.  That is the reason why there have been so many predictions in recent years of an economic crisis in China.  So far, all these forecasts have proven incorrect, but like the boy who cried wolf, at some point that crisis could happen, and most likely it would happen when least expected.

Exhibit 2.  Long-term China GDP Growth Rates

Source:  tradingeconomics.com

Two recent analyses of the China situation, in light of the possible reforms, point out numerous problems within the economy and government.  Gideon Rachman of the Financial Times who attended one of the primary government presentations leading up the Plenum, captured the mood the Party leadership is trying to convey both within the country and outside to China’s major trading partners.  That mood is one of great confidence that the country can sustain rapid economic growth, defined as GDP growth of more than 7% per year for at least the next decade, without the need for further economic stimulus measures.  At the briefing, Li Keqiang, the prime minister, pledged to “deepen reform comprehensively” by promoting changes in the “fiscal, financial, pricing and enterprise fields.”  That pledge is being interpreted to mean possibly starting to privatize some of the SOEs.  Less optimistic observers hope that at least some of these SOEs will have their power reigned in, but that may prove difficult given the lobbying power those organizations possess and how difficult they are to control.  For example, the effort to alter the relationship between the central government and local administrations may prove daunting due to the Party’s leadership desiring to rein-in out-of-control borrowing by the local leaders while at the same time allowing them more room to experiment in how they govern and interact with the economy.  The two policies appear contradictory, but maybe they aren’t – we will only know over time whether the two objectives can be equally attained.

Mr. Rachman wrote that he left the meetings with doubts about the goals and the ability to achieve them without significant social, economic and political changes.  For example, he questions how an anti-corruption program can “truly succeed without a free press, rival political parties or truly independent institutions to act as a check on party officials.”  He also questions the commitment of the Chinese leaders to global peace given the rising tensions with Japan.  There is also a growing Chinese recognition that they need to develop a navy to ensure their trade routes, especially for the essential raw materials their economy increasingly requires to grow.  Finally, and maybe the one subject about the Chinese economy receiving the most negative press at the moment, is the growing environmental challenge.  More on this topic and its relationship to China’s energy markets later.

Another view of China’s economic challenges came in an op-ed written by Ruchir Sharma, the head of emerging markets at Morgan Stanley Investment Management (MS-NYSE) in The Wall Street Journal.  The first point he made was in reference to a 2007 cable revealed by WikiLeaks in 2010 quoting Li Keqiang acknowledging that official GDP numbers are “man-made.”  Li Keqiang also told the then-U.S. Ambassador Clark Randt that he watched more reliable numbers such as bank loans, rail cargoes and electricity consumption in order to determine the true health of the Chinese economy. 

Mr. Sharma pointed out in his analysis that with per capita income in China of about $7,000, the country had reached a similar stage of development when previous “miracle economies” of East Asia – Japan, Korea and Taiwan – began to experience a slowing in GDP growth rates from double-digit to mid-single digit rates.  He questioned how real the high economic growth rate is in China given the magnitude of new credit the government had pumped into it.  Mr. Sharma believes the vast majority of the credit has flowed into risky investments – real estate and speculative businesses – and not into manufacturing that offers more sustainable growth.  This latter point will be increasingly important if China is to build a more sustainable consumption-based economy. 

Exhibit 3.  China Debt An Issue

Source:  WSJ

According to Mr. Sharma, China’s devotion to achieving a 7-7.5% annual economic growth rate is based on a rough estimate of what is needed to double GDP by the end of this decade.  But today, China needs four dollars of debt in order to generate one dollar of economic growth rather than the one dollar of debt needed five years ago to achieve the same target growth.  He suggests China’s leaders believe they need the high growth rate in order to generate sufficient jobs and minimize potential social unrest, but the statistics point to every percentage point of economic growth producing 1.6-1.7 million new jobs, up from 1.2 million ten years ago.  Therefore, even a 5% to 6% growth rate should create sufficient new jobs to meet labor force growth over the next decade.

The other problem Mr. Sharma identifies for China’s economy is its continued reliance on an unsustainable growth model.  China grew rapidly for three decades based on its huge pool of low-income workers that no longer exists, and employing them in manufacturing export industries that produce high productivity growth.  That model has reached limits similar to the pattern of growth of postwar Japan and Germany.  Both countries’ share of global exports peaked at 12% of their economies, which just happens to be the level of China’s exports for the past two years. 

Manufacturing represents 30% of China’s economy now, the same as Japan at its peak in 1970.  Chinese consumption is growing at 7% to 8% per year, the maximum rate any of the “miracle economies” achieved.  China’s investment is growing at 20% a year, much faster than consumption.  Thus, if consumption cannot grow faster and the current rate of investment remains high, then slower GDP growth will be the outcome.  This slower growth will be accompanied by greater bankruptcies due to speculative investments and under-performing businesses.  China’s housing market is already showing signs of speculation as home prices in major cities have risen by 17% so far this year. 

Complicating the Party’s pivot in managing China’s economy may be the environmental issue.  The issue is already impacting the future course of China’s energy policy.  Recent media reports about the magnitude of pollution in Harbin, an industrial city in northeastern China and home to 10 million people, created by the combination of cold weather, a lack of wind, coal-powered heating and farmers burning off post-harvest debris are highlighting the developing societal risks the country is facing.  A recent New York Times column by Thomas Friedman pointed to the pollution and raised several interesting but disturbing questions for the Chinese Party leadership as it begins the 3^rd Plenum.  Mr. Friedman discussed the pollution with Hal Harvey the CEO of Energy Innovation who is working with the Chinese government to try to bring its air quality under control.  Mr. Harvey asked, “What if China meets every criteria of economic success except one: You can’t live there.” 

Mr. Friedman quoted from information posted on the NASA Earth Observatory web site reporting that Harbin hospitals reported “a 30 percent increase in administrations related to respiratory problems and several Harbin pharmacies were sold out of pollution facemasks.”  The city reacted to the smog by closing schools, ordering buses off the road, shutting the airport, establishing check points to test tailpipe emissions of vehicles and sending police out into the countryside to order farmers to stop burning the cornstalks left in their fields after harvest.  With winter fast approaching, many Chinese cities in the northern regions of the country are concerned about turning on their coal-fired municipal heating systems.  Living with this pollution is becoming a serious challenge.

The great smog of Harbin resurrected memories of past great smogs elsewhere in the world such as the 1948 one that descended on the town of Donora, Pennsylvania for five days causing half the population to get sick.  The most famous event may be the Great Smog of December 1952 that hit England for five days and resulted in an estimated 4,000 deaths.  The combination of coal-burning furnaces and coal-powered businesses coupled with cold air created the yellowish smog that caused great distress.  The smog led to the enactment of the Clean Air legislation to restrict the use of coal.  But because replacing coal-fired furnaces, power plants and manufacturing operations took so long, other smogs developed such as the one in 1962 that contributed to 700 deaths.  On a personal note, my father was on a temporary assignment working at a manufacturing facility outside of London.  He and a co-worker were driving to their hotel one evening in the smog so they started following the taillights of a car ahead, even though the lights were all they could see.  The lights stopped, so my father stopped, also.  Next there was a tapping on his window and a man said to him: I don’t know where you are going but I’m parked in my garage.  It took the co-worker and the homeowner 15 minutes to guide my father back out of the driveway and onto the road.

Exhibit 4.  China Dams And Planned Dams

Source:  The Economist

The Chinese government is working hard to reduce pollution, but that means reducing its reliance on coal, which at the moment accounts for roughly 65% of the nation’s electric power generation capacity.  Over the years, China has worked to develop hydroelectric power including the one-and-a-half-mile-long Three Gorges Dam across the Yangtze River that is capable of generating 20,000 megawatts of hydropower, which is the world’s largest dam.  At the present time, the country is building 120 dams across the southern portion of the country and anticipates it will add 120,000 megawatts of power generation capacity by 2020.  Since the 1950s the Chinese have built some 22,000 dams more than 50 feet tall, roughly half the world’s current total.  Of the dams under construction, about 100 are in various stages of construction or planning on the Yangtze and its tributaries – the Yalong, Dadu, and Min.  Two dozen more will be built on the Lancang, called the Mekong in Southeast Asia, and still more on the last two of China’s free-flowing rivers – the Nu, called the Salween in Burma, and the Yarlung Tsangpo, known as the Brahmaputra in India and the Jamuna in Bangladesh.  All of these dams will not dramatically alter the fossil fuel dominance within the power sector. 

Exhibit 5.  China Power Depends On Coal

Source:  Stratfor

The dependence of China on coal is best demonstrated by the share of installed electricity generation capacity by fuel source.  It is shown equally as well by the chart in Exhibit 6 that shows the amount of electricity output fueled by coal. 

Exhibit 6.  Most Chinese Electricity Comes From Coal

Source:  phys.org

Even with the world’s largest wind and hydroelectric industries, the prospect for those renewable fuel sources to dramatically alter the mix of electricity production remains muted.  China is also hoping that it can develop its world-leading shale gas resources to help mitigate its coal dependency, but so far, after spending about $1.6 billion on drilling 130 shale gas wells, the economics of that endeavor have yet to be demonstrated.  While the average well cost is about $12 million, there are reports that some shale gas wells have cost upwards of $16 million, well above even the most expensive early shale gas wells drilled in the United States.  China’s target of producing 6.5 billion cubic meters (229.5 billion cubic feet) of gas by 2015 seems almost unattainable.  That volume would equate to an annual average flow rate of approximately 630 million cubic feet per day.  It would be dangerous to underestimate the ability of China to overcome the technical challenges of drilling shale gas wells, but the effort will remain expensive for the foreseeable future.  In the meantime, China’s dependence on coal will be significant as that fuel has accounted for the lion’s share of the country’s energy consumption since the turn of the century. 

Exhibit 7.  Coal’s Role Has Grown Dramatically

Source: phys.org

We will be anxious to read the media reports and analyst comments about the 3^rd Plenum session in China.  Reading and understanding the Party’s game plan will be only one aspect of assessing the future of China – its economy and its energy usage.  All of us will begin assessing how successful China may be in executing its new game plan, which will lead to a wide range of estimates for the economy’s growth and the rate of growth of energy consumption and which fuels will be the primary beneficiaries. 

A recent cover story in the investment newspaper Barron’s discussed the issue of future U.S. economic growth.  The author’s view is the nation is on a trajectory to slower than historical growth rates for decades in the future.  The article’s focus was on the challenges slower growth means for the federal government in its effort to deal with entitlement spending and government deficit problems that have become the focus of political battles and discourse in recent months in Washington.  The underlying factors driving this slowing economic growth involve demographic and labor productivity trends, but these factors also impact energy consumption. 

Since World War II, the average annual economic growth rate for America was more than 3.5% for most of that period despite periodic recessions and the inflation of the 1960s to early 1980s.  A recent report by economists with JPMorgan (JPM-NYSE) projects that the U.S. economy will grow at an average annual rate of just 1.75% over the next five years.  If our economy can only average that growth rate, it will be at great risk for falling into a recession due to minor economic and/or political shocks. 

Economic growth depends on both increases in the size of working-age populations and gains in their productivity, or output per worker hour.  More people producing more goods and services are what drive economic growth.  Weaker growth makes it harder for companies to grow and employ more people and that could contribute to increased social inequality and class struggles.  The latest Census Bureau forecasts for population growth show a much slower rate over the next three decades than it had projected in its prior forecast made in 2008.  The reasons for the slower growth are expectations of less net immigration into the United States and a lower-than-expected birth rate.  The reduced immigration rate is due to a weaker U.S. economy, relatively high unemployment and tighter security across the U.S.-Mexican border. 

Exhibit 8.  Baby Boomers Boost Aging Population

Source:  Census Bureau

According to the Barron’s article, “The U.S. working-age population (Americans from 18 to 64 years of age) is projected to grow only 0.36% during the current decade and then limp along at 0.18% from 2020 to 2030.  That is well below the 1.81% rate that prevailed during the 1970s when baby boomers and women were streaming into the workforce.”  They point out that what had been a demographic dividend in the past will now start to become a drag as baby boomers start to retire.  Quoting from the press release issued last December when the Census Bureau announced its most recent population projections and commented on why it was projecting slower growth over the next several decades, the agency said, “the population age 65 and older is expected to more than double between 2012 and 2060, from 43.1 million to 92.0 million.  The older population would represent just over one in five U.S. residents by the end of the period, up from one in seven today.”  The impact of the aging baby boomer generation is that entitlement spending will continue to increase, thus straining government budgets.

The growth in labor productivity is becoming a serious issue.  For the past three years, nonfarm productivity increased at only a 0.7% rate compared to the post-World War II average annual increase of 2.3%.  For the decade ending in 2005, the average annual productivity increase was 2.9% when the impact of the Internet and e-commerce boosted output per man-hour.  A troubling trend that is and will likely further contribute to the reduced growth in labor productivity has been the slowing in spending in private research and development.  That spending has fallen from an average of 4.7% a year between 1980 and 2000 to 2.8% per year for the past 10 years.  This slowdown in R&D spending was seized upon by Northwestern University economist Robert Gordon who has written a paper suggesting that the U.S. economy will be fortunate to reach average GDP growth of around 1.9% per year between 2012 and 2032.  He attributes the slowdown to the size of the U.S. population of 316 million or about eight times what it was in 1870 when the economy’s growth rate took off due to significant technological advances.  Whether Mr. Gordon has overstated his case is debatable, and clearly it is an area of contention advanced by technologists at other universities.  While the subject offers substantial room for debate, those who are naturally optimistic will always believe that America will solve its economic issues through the application of new technologies.  These critics have an innate belief in the ingenuity of people to figure out how to make economies grow, even if there are periods of sub-optimal growth.

Another key issue for economic growth is the aging of the population and the workforce participation rate.  The slower population growth rate forecast of the Census Bureau has caused Moody’s economist Mark Zandi to cut his estimate for the annualized percentage change in U.S. GDP for 2022 to 2032 from 2% to 1.8%.  The challenges for the U.S. economy are further hurt by the aging of the world’s population.  Japan’s retirement-age population has increased steadily and is projected to hit 26% of that nation’s total population by 2015 and exceed 29% by 2025, based on United Nations’ Population Division projections.  The aging of Japan has coincided with a barely growing economy since the 1990s.  Another economic powerhouse often pointed to is Hong Kong.  Its 65-or-older population segment is projected to make up 15% of the population in 2015, growing to about 22% in 2025.  Singapore retirees are projected to increase from 11% of the population in 2015 to 17% by 2025.  China, the current 800-pound gorilla in the world’s commodity markets, will see its 65-plus population segment expand from less than 10% of the population in 2015 to nearly 14% in 2025.  While that percentage increase in China’s population seems small, the sheer size of the country’s population (1.354 billion now and 1.39 billion in 2025) means the absolute number of aged people will be large.  For China, with its population peaking in 2030 and declining to 1.29 billion by 2050, its aged population will become a much greater drag on its economy.

Exhibit 9.  Global Growth Engine May Be Slowing

Source:  U.S. Global Investors

Europe has been experiencing the aging phenomenon for a while.  In Germany, the retirement-age segment is already above 20% and is forecasted to rise to 25% by 2025, and France is on a similar trajectory.  Even emerging European economies such as Poland are experiencing the same problem.  Poland’s 65-and-older population segment is expected to reach 15% of the country’s total population in 2015 and grow to 21% by 2025.  There is little doubt, judging by the economic struggles of Europe and Japan that aging populations are a drag on economic growth.

The significant issue for economic forecasting is the labor force participation rate.  In the United States, the Bureau of Labor Statistics computes the number by dividing all workers by the number of Americans over 16 years of age.  The labor force participation rate has been steadily falling for the past seven years from 66.2% in 2006 to 63.2% last August.  That decline cannot be totally attributed to layoffs during the Great Recession of 2007-2009 since we are well into the recovery period.  The decline also cannot be totally attributed to the retirement of the baby boomer generation since the leading edge of that segment only reached retirement age in 2011. 

Economist Gordon and the JPMorgan economists have pointed to the falling participation rates for various age groups important for economic growth.  For the prime 25-54 year old workers, their participation rate has dropped from 83% in the fourth quarter of 2006 to 81% in the third quarter of 2013.  The youth segment, aged 16-24, has seen its participation rate fall from 65% in 1988 to 46% in 2012.  On the other hand, females 20 and older saw their participation rate climb from 35% in 1968 to 58% in 2000, before dropping back to 55% in 2012. 

Exhibit 10.  Adjusted Participation Rate Higher Now

Note:  Dark line 55 and older; lighter line 25-54 years old; light line 16-24 years old

Source:  The New York Times

Floyd Norris of The New York Times recently examined the labor force participation rate and concluded that when adjusted for current demographics, the deterioration in the rate has not been as great as the regular data series shows.  We have presented the chart on the adjusted labor force participation rate and the change in the labor force participation ratio for more recent years.  That separate chart shows the participation ratios for three age segments – 55 and over (dark line); 25-54 (lighter line); and 16-24 (lightest line).  The actual labor force participation ratio compared to the ratio adjusted for current demographics shows that rather than being lower today than in the 1985, the ratio is higher.  The second set of charts shows the adjusted employment-to-population ratio has actually risen since the end of the Great Recession in contrast to the flat ratio shown in the actual data series.  While this analysis is interesting, it does not change the reality that the unemployment rate remains at 7.2% and the improvement in the rate over the past year has largely been the result of people leaving the work force rather than gaining jobs.  It is these realities that have limited improvement in median incomes that are critical for consumer consumption and energy demand.

Exhibit 11.  Adjusted Employment Data Shows Improvement

Note:  Dark line 55 and older; lighter line 25-54 years old; light line 16-24 years old

Source:  The New York Times

At the end of the day, the importance of the demographic trends and whether the future growth of the population is faster or slower than previously projected is that energy demand is a direct function of the number of people and their lifestyle.  Until very recently, the driver for global oil demand has been consumption and economic growth in the developed economies of the world (usually the OECD members).  That role is transitioning to the non-OECD countries of the world, with particular attention focused on China and India, and secondarily on other Asian countries.  As mentioned above, many of these countries are projected to have significant increases in their aged to young populations suggesting drags on their economic growth rates.  Slowing growth rates should mean less energy demanded.  When we also factor in the push via mandates and incentives to minimize the use of fossil fuels and to increase the use of renewable fuels, along with the elimination of fuel subsidies, it would appear that oil demand growth will remain moderate, and probably at about the historical growth rate of one million barrels a day, which has been the average for the last 23 years despite periods of faster and slower growth as shown in Exhibit 12. 

Exhibit 12.  Long-term Oil Demand Growth Fairly Stable

Source:  IEA, PPHB

While a number of economists believe the U.S. economy can return to its historical growth path of 3.2% annual growth, the evidence suggests that demographic considerations and public policy actions are dictating a lower rate for the foreseeable future for the United States.  We believe some of these same trends are impacting economies around the world.  Slowing economic growth will mean slower energy demand growth.  The push to restrict the use of fossil fuels will, at the margin, slow oil use.  None of these trends, however, reduce the pressure on energy companies to find and develop new oil and gas reserves as the world continues to confront the depletion of existing reserves that if left unchecked would produce supply shortages.  We do not believe a slower economic growth rate means that the oil and gas industry will not remain a vital and vibrant force in global economic activity.

For the first time since 2007, OPEC raised its long-term forecast for crude oil demand after reassessing its view of Chinese car ownership.  On the other hand, the other two leading energy forecasters – the International Energy Agency (IEA) and the Energy Information Administration (EIA) – long-term oil demand forecasts have been repeatedly reduced in recent years largely due to improved energy efficiency, especially in the transportation sector, a theme they continue to point to as to why the pace of global oil demand isn’t increasing.  It would seem these views are in contrast to OPEC’s conclusion.

OPEC forecasts there will be an additional 380 million vehicles on the roads in China over the next 22 years.  Those additional vehicles represent 161% of the peak U.S. vehicle fleet of 236 million light duty vehicles established in 2007.  Since then, the U.S. fleet has shrunk despite healthy annual vehicle sales in recent years.  Based on the increase in the number of Chinese cars, ownership would rise about tenfold to 320 vehicles per 1,000 people by 2035.  The significance of the vehicle penetration increase is shown in Exhibit 13, which displays car penetration rates for 2009 for a number of countries.  The chart shows that the United States, home to the American love affair with the automobile, is only fourth in the world in penetration rates as measured by the number of cars per capita.  China ranked extremely low in that measure.  However, with the U.S. falling out of love with its automobiles and China falling in love, by 2035 both country’s car penetration rates could be similar, or possibly China might exceed the U.S. rate.

Exhibit 13.  Car Penetration In Select Countries

Source:  Carnegie Endowment

Another aspect of the latest OPEC forecast is its skeptical view of North American shale oil.  The report argues that well economics could rapidly deteriorate as the best prospects have now been drilled.  The report states: “Constraints could come from the resource base, while improvements in drilling efficiencies and fracking operations could plateau.”  OPEC also does not foresee any shale oil output outside of North America during its 22-year forecast period. 

Exhibit 14 shows OPEC’s view of the growth in tight oil output and an optimistic view of how much additional oil might be developed if we assume higher recovery rates from shale reservoirs.  Based on data in a table in the report, OPEC is assuming additional tight oil in North America of 280,000 barrels a day (b/d) by 2015 increasing by 1.21 million b/d in 2020.  By 2035, OPEC projects 2.68 million b/d of additional tight oil.  In the optimistic case, as shown in the chart,

Exhibit 14.  OPEC Not Optimistic On Tight Oil Output

Source:  OPEC

OPEC assumes there should be roughly an additional two million b/d of tight oil by the end of the forecast period.  These two forecasts suggest we may be rapidly approaching a peak in tight oil’s contribution to North American oil supplies with a subsequent decline to about the level we are producing today by 2035.  The upside supply scenario suggests the peak in tight oil output won’t occur until the 2020s and that the subsequent decline will be slower than in the Reference Case, only falling by about 900,000 b/d over the following 15 years.  These forecasts contrast with the bullish projections of Citicorp’s commodity group that foresees the U.S. alone adding between 700,000 b/d to 800,000 b/d of shale oil each year through the end of this decade, or 4.9-5.6 million b/d of incremental output.  Their forecast calls for potentially more new tight oil output than OPEC projects for its peak estimate for all tight oil production in North America in its Reference Case.  The difference in outlooks may reflect the different perspectives of the forecasters, but following one or the other estimate may lead to entirely different economic outcomes. 

We were not surprised that the nation experienced another monthly increase in Lower 48 natural gas production.  The Energy Information Administration (EIA) reported that total U.S. Lower 48 gross natural gas withdrawals, as determined from the agency’s Form 914 survey of producers and state oil and gas regulatory agencies, increased by 0.18 billion cubic feet a day (Bcf/d) of gas for August compared to the revised July production estimate.  As is often the case with the national statistics, there were substantial differences among individual state and region producing trends within the overall national statistics.  Nationally, total gas volumes declined, driven by a 4.5% fall in Alaskan production, or an output drop of 0.35 Bcf/d. 

Lower 48 gas production rose by 0.3%, or a hike in monthly output of 0.22 Bcf/d.  The Gulf of Mexico region experienced a significant production decline of 5.6%, or an output reduction of 0.20 Bcf/d.  On the positive side of the ledger, Texas gas output rose by 0.14 Bcf/d, or a 0.6% increase while the big winner was the Other States category, which saw its production climb by 0.64 Bcf/d, or a 2.4% increase.  The Other States category, as we have written, largely represents the Marcellus region in Pennsylvania.  We don’t know for sure, but fully believe that the rise in output from the Utica formation in Ohio has also been a meaningful contributor to the significant monthly increase in the Other States category. 

The EIA’s monthly release includes two charts – one showing the production performance of the total natural gas output for the United States along with the volume produced from the Lower 48 States while the other chart shows production volumes from the leading gas producing states.  The latter chart (see Exhibit 15 below) highlights the dramatic increase in gas production from the Other States since the fall of 2009.  The Other States volume is largely influenced by the Marcellus production of Pennsylvania and in recent months the start of production from the Utica formation in Ohio.  The liquids-rich producing areas of these two formations are the targets of most of the drilling today, and while they do not produce dry gas, the oil and gas-liquids wells being targeted produce large volumes of associated natural gas.  More gas in this region is not completely unwelcomed in Pennsylvania and Ohio as these states are close to a major gas-consuming region of the country and sufficiently close to enable exporting surplus natural gas to Eastern Canada. 

Exhibit 15.  Marcellus The Driver Of Production Rise

Source:  EIA

The August increase in natural gas production was not a surprise for those who have been reading the Musings.  When the July gas volumes were reported by the EIA, we presented a chart comparing natural gas production against drilling rigs and horizontal drilling rigs targeting natural gas.  Due to the EIA’s reporting schedule, their production report is always two months late.  As we were using the weekly drilling rig data from Baker Hughes (BHI-NYSE), we can see oilfield activity during those two months when the gas output data is not available.  The chart we showed in that earlier Musings has been updated and is in Exhibit 16.  At the time we published the chart, we commented that the subsequent upturn in the gas rigs and horizontal gas rigs suggested that natural gas volumes would continue to rise.  For the first of those two months – August – we now have the data confirming our expectation.  If you examine Exhibit 16 closely, you will see that the overall gas rig count increased in the second month while the horizontal gas rig count was essentially flat (down one rig).  Based on that pattern, we should expect another increase in natural gas output for September. 

Exhibit 16.  Rising Rig Means Gas Output Headed Up

Source:  EIA, Baker Hughes, PPHB

While we do not know the exact production volumes from the Marcellus and Utica formations because those figures are obscured in the Other States totals, we thought it would be interesting to examine what information we received about these regions from the new well count data series issued by Baker Hughes and the well productivity data recently produced by the EIA.  The summary Baker Hughes well count data table shows that the number of wells drilled in the third quarter compared to the second quarter declined by 14 wells (562 wells versus 576 wells).  Compared to a year ago, the current quarter’s well count was higher by 119 wells, or nearly 27%.  The Utica formation data followed a similar pattern of a modest decline in wells drilled between the second and third quarters – six fewer – but a slightly greater than 19% increase in the wells drilled in the current quarter compared to a year ago.  The conclusion to be drawn from the Baker Hughes data is that wells drilled in the Marcellus have declined slightly during recent months. 

The rig count data for these two basins shows an interesting pattern that raises questions.  In the Marcellus formation, for the third quarter there were 83 rigs working as compared to 79 in the prior quarter.  Compared to the third quarter of 2012, there were ten additional rigs, or 93 total rigs, working in the region.  The Utica formation had two additional rigs working in the third quarter versus the second quarter (36 vs. 34), and 14 more rigs working than in 2012’s third quarter.  What becomes interesting is to look at the wells drilled per rig by basin.  In the Marcellus, there has been slightly more than half of a well per rig per quarter decline between the second and third quarters (6.77 vs. 7.33 wells per rig per quarter).  However, compared to the same quarter a year ago, there was a two well increase (4.77 vs. 6.77 wells per rig per quarter).  While the Utica formation demonstrated a similar pattern in drilling performance as the Marcellus for the two most recent quarters, the big difference was the comparison with the year-ago drilling efficiency.  The recent performance was 3.11 wells per rig in the third quarter compared to 3.48 wells per rig in the second quarter.  But in the third quarter of 2012, the industry was drilling 4.23 wells per rig per quarter.  Why has the drilling industry become significantly more productive in the Marcellus but 26.5% less efficient in the Utica formation?  The data on wells drilled and rigs operated for the entire data series is displayed in Exhibit 17. 

Exhibit 17.  Well And Rig Data Point To Efficiency Gains

Source:  Baker Hughes, PPHB

The other new data series we explored was the drilling productivity measure the EIA has introduced.  The new data is being presented to help analysts better understand what is driving the growth of unconventional oil and gas production when the drilling rig count would suggest output should be rising at a slower rate.  We wrote about the introduction by the EIA of this new data series in the last Musings, and we suggested there needed to be several clarifications to the data in order to better understand the data’s ability to explain the inconsistency between the production and drilling rig measures. 

In the last Musings we presented the chart in Exhibit 18 showing all the data presented for the Marcellus formation that attempts to better explain the underlying production trends.  The chart shows the total volume of natural gas being produced in the basin along with the decline in legacy well volumes.  Remember, shale gas wells start with huge initial production but then experience 60% to 80% declines by the end of the first year, and then decline at slower rates in subsequent years until a low but steady production level is established.  The chart also shows the number of drilling rigs and the amount of initial well production associated with those rigs. 

Exhibit 18.  How The Marcellus Region Is Performing

Source:  EIA, PPHB

To better understand the relationship between gas production per rig and the rig count in the Marcellus, we have constructed the chart in Exhibit 19 on page 23.  If we examine the Marcellus basin drilling rig and production-per-rig dynamics we find interesting patterns.  From the start of 2007 through the spring of 2009, there was a relatively stable drilling rig count and slowly increasing natural gas output per rig.  In the spring of 2009, the drilling rig count began climbing at a sharp rate, reflecting the recognition that shale gas output in the basin could be profitable.  As the rig count shot up, the volume of gas production-per-rig began climbing at a faster rate.  At the end of 2011, the Marcellus drilling rig count peaked and began a sharp decline, but gas production-per-rig continued to climb, and surprisingly at a faster pace than the previous two years.  Right at the point when the drilling rig count bottomed and began to recover, the growth in gas production-per-rig shifted to a pace more similar to the pace experienced during 2009-2011.  After a short period of increased drilling activity, the rig count turned down, but the growth rate of natural gas-per-rig didn’t slow.  In fact, now that the basin’s rig activity has begun to increase, unless there is a decline in the volume of natural gas added per drilling rig, we should expect overall gas production to grow faster in the future than it has been growing in recent years.  The one potential offset would be if the growing number of legacy wells begins to experience sharply lower gas output.  What we are describing is the treadmill effect – the need to drill more wells with higher initial production rates in order to offset the rapidly declining production from legacy wells. 

Exhibit 19.  Rising Rig Count Points To Higher Output

Source:  EIA, Baker Hughes, PPHB

Based on the model developed by the EIA from the historical data from 2007 through September 2013, the agency says that one drilling rig will add 5,820 thousand cubic feet per day (Mcf/d) of gas in October, which will grow to 5,920 Mcf/d in November, or an increase of 160 Mcf/d from each rig.  Since we do not know whether the EIA’s volume forecast reflects all gas produced, including any gas volumes re-injected or flared, or a net gas withdrawal estimate, we are not completely sure how significant their estimate truly is.  Without that understanding, it is difficult to discern what was happening when gas production per drilling rig started growing faster than the rig count.  Is it possible that there was a backlog of previously drilled but uncompleted wells that were brought into production and distorted the analysis?  Or is the increased production attributable to drilling a “sweet spot” in the formation?  Quite possibly the faster production increase is the adoption of new completion techniques and/or the use of more fracture stages that contribute to greater volumes from a well.  Again, we have no information about the model the EIA is employing to forecast the future production, which is important even if the agency is only projecting volume contributions for the next two months. 

There is little doubt but that the continued rise in gas output over the past few years despite the decline in the number of drilling rigs targeting gas prospects is causing consternation among analysts and even energy policy makers.  The latest gas production information reported by the EIA is for August.  From the week ending August 16th through the week ending November 1st, the total U.S. drilling rig count has fallen by 49 rigs or 2.8%.  The number of drilling rigs targeting oil prospects has fallen by 21 rigs, or 1.5% while the gas drilling rigs are down by 28 rigs, or an amazing 7.2%.  Maybe in the next couple of months we will find that gas output begins dropping following the recent gas rig decline.  Possible offsets to the unfolding scenario are for crude oil drilling with associated natural gas production or liquids-rich gas plays to hold up better than drilling that targets dry natural gas, or improved completion techniques boosting well output, and better well targeting of more productive areas of the formation.  What we know at the moment is that neither of the new data series – the EIA’s drilling productivity nor the Baker Hughes’ well count – adequately explains the current relationship between drilling activity and gas production.  More information and analysis is needed.

Contact PPHB:
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Houston, Texas 77056
Main Tel:    (713) 621-8100
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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.