Musings From the Oil Patch – October 17, 2006

• "Houston, We’ve Had A Problem" Do We Recognize It?
• Eni CEO Explains High World Oil Prices
• Seems Like Old Times Again – Look Out!
• Are Venture Capital Pros" Concerns True for Energy?
• For Energy Speculators: 2006 Hurricane Season a Bust
• The New Oil Sands Business Model?

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

“Houston, We’ve Had A Problem.”  Do We Recognize It?

 

Thirty-six years ago, Apollo 13 experienced an explosion on its way to the moon.  The crew used its ingenuity and training to adjust their course and safely return to earth.  In mid September we wrote about the critics of Peak Oil, Saudi Arabia and oil company executives, who need to sustain oil demand growth and choke off the development of alternative energy supplies to protect their livelihoods.  In that article we highlighted some of the information we gleaned from attending the Rice Alliance Clean Technology conference – in particular the tsunami of venture capital money targeting clean energy technologies.  Our article elicited an email from a long-time Musings reader who is convinced that failure to pay attention to alternative energy technologies may sabotage the City of Houston’s economy beginning sometime in the next 5-15 years.  Going over a cliff will be bad for citizens and their pocketbooks.

 

The email kicked off an exchange of views about the subject and what Houston should be considering.  At the moment, Houston is enjoying an energy boom driven by $70 per barrel oil.  We continue to meet with local energy executives who are convinced the world is facing a peak in global oil production, and not merely the easy-to-find and produce kind, i.e., cheap oil.  If so, one has to begin thinking about the long-term future of Houston’s hydrocarbon-based economy.  Alternative energy technologies are emerging.  Economic, social and investment conditions are feeding their development.  Will they become the 800-pound gorilla that ruins the Houston economy?  True, Houston has a more diversified economy than it had in the mid 1980’s, but it is not immune from challenges of emerging disruptive energy technologies – whatever they may be – that could undermine the future of the oil business. 

 

I thought I would highlight the key points in Douglas Leyendecker’s email to me about his view of the need for Houston to embark on a program to help develop disruptive energy technologies as a hedge for the city’s economic future.  Mr. Leyendecker is worried about the vulnerability of the long-term health of the Houston economy due to its possibly short-sighted view about the invincibility of the hydrocarbon-fuel dominated world we live and work in.  While many people would suggest Houston has a lot of time to prepare for the eventual changes coming to the hydrocarbon business, we only need to reflect on the rapidity with which the business collapsed in the 1980s and again in 1997-1999, to understand that being proactive could be insurance against having to react to the changes. 

 

Mr. Leyendecker’s concern focuses on two issues: Global warming and our Middle East problems.  He sees both as catalysts for the development of disruptive technologies that will significantly alter the hydrocarbon value proposition that underlies the Houston economy.  Mr. Leyendecker and I share many of these concerns, but I expect that the road from here to a repeat of the 1982-1992 Houston economic bust is not a straight line, and possibly not as quick.

 

Global warming, whether one believes the underlying science or not, has become a magnet for powerful and wealthy people seeking a cause for making the world a better place to live.  The momentum behind this cause has accelerated over the past several years, helped by a spate of weather-related phenomena such as last year’s off-the-charts hurricane season. 

 

While some might point to Al Gore’s movie, “An Inconvenient Truth,” as the catalyst for the global warming movement, we think the embracing of the issue by two powerful Republican politicians – Governor Arnold Schwarzenegger of California and Mayor Michael Bloomberg of New York City, might better represent the tipping point marking an acceleration in the drive to commercialize disruptive energy technologies.  Increasingly, more mainstream figures – politicians, businessmen and others – are embracing the need to attack and solve the global warming problem. 

 

In deed, The New York Times columnist Thomas Friedman recently wrote about the results of polling conducted by campaign advisor James Carville, the originator of the Clinton mantra, “It’s the economy, stupid,” and pollster Stan Greenberg that showed that energy independence has become the No. 1 national security issue.  When likely voters (this overcomes the bias of polling liberal greens) were asked to list the two most important national security priorities for the administration and next Congress, the number one response, with a 42% rating, was “reducing dependence on foreign oil.”  

 

Once again, California may prove to be the locus of this tipping point.  Just as in popular music, dance, lifestyles and politics, Californians have been leaders in social, political and economic movements for decades.  Gov. Schwarzenegger has broken with President Bush over the need to move forward more aggressively on solving the global warming problem.  Just recently, Gov. Schwarzenegger and Mayor Bloomberg agreed to work together to reduce greenhouse gas emissions.  California is now the first state to have a law mandating a reduction in greenhouse gas emissions by 25% by 2020.  As Gov. Schwarzenegger stated it, clean energy is “the future of California, the nation and the world,” and it will produce new industries, jobs and strengthen the economy. 

 

Gov. Schwarzenegger’s statement may be a self-fulfilling prophecy.  The venture capital industry, ensconced in Silicon Valley in the San Francisco Bay area, recently discovered the hydrocarbon industry after the dot-com boom became the dot-com bust in 1999-2000.  These investors had raised billions of dollars at the top of the dot-com boom to help create new high tech companies with disruptive technologies, and they were looking desperately for new investment opportunities.  Some of the premiere Silicon Valley high tech venture capital investors have targeted the clean technology sector with its potential for creating disruptive technologies that could have mass market appeal for their next super successful investments.  Clean technology will be their new dot-com industry. 

 

In our September Musings article, we discussed the alternative and clean technology investment opportunities outlined by Rodrigo Prudencio of Nth Power LLC, in his presentation at the Rice Alliance conference.  He listed the following clean technology investment opportunities:

 

·         Transportation

Batteries not fuel cells; maybe drive-trains

·         Fuels

Bio-engineering

·         Energy Networks

Sensors, communications, data-management

·         Distributive Energy

Alternative utilities; solar focus

·         Materials and Nanotechnology

Key enablers that may be big winners

 

While this list probably does not contain every possible technology, the important thing to understand is that venture capitalists are experienced in seeking out, identifying and nurturing disruptive technologies that have the potential of creating meaningful new markets.  The key question is when their efforts in alternative energy technologies may begin to bear fruit.  Mr. Leyendecker believes that the 2010-2020 decade is when these disruptive technologies will alter the traditional hydrocarbon value proposition with potentially disastrous consequences for Houston. 

 

Mr. Leyendecker has been searching for a better moniker than “clean tech” as he believes that title does not adequately explain the nature of the challenge for the hydrocarbon industry.  For the time being, he believes “alternative energy technology” and/or “clean technology” should really be called “energy consumption conservation technologies.”  Mr. Leyendecker believes that these disruptive technologies are a ticket to reduced hydrocarbon demand that will lower commodity prices.  This ties to his second rationale for why alternative energy investing is here to stay.  Less demand and lower oil prices would reduce the income flowing to Islamic-centric Middle East governments who have become the world’s principal oil suppliers and who have targeted the United States and western civilization as their arch enemies and are trying to destroy them. 

 

We have become their enemy due to our hedonistic and social mores.  In Mr. Leyendecker’s view, the problem arises because these people suffer from low self-esteem that comes from not having had to have worked to acquire their wealth.  Theirs was an accident of location. God deposited much of the world’s oil resources under these Islamic radical countries.  As the Muslim population in these Middle East countries would put it – Allah willed it, so it must be just.  God is great!

 

Since the Muslim God gave them their wealth, he must be the best God in the world.  Yet with all that wealth, most of these countries have rampant poverty, underachieving societies and feeble economies.  In contrast to these Middle East Muslim economies, consider the dynamic society and vibrant economy of Israel – a desert rose among the thorns.  As former Israeli Prime Minister Golda Meir, the Russian-born, Milwaukee school teacher, put it, “Let me tell you something we Israelis have against Moses.  He took us 40 years through the desert in order to bring us to the one spot in the Middle East that has no oil!”  But look at the economy the absence of that oil has produced. 

 

More and more, people are beginning to embrace the view known as “the curse of commodities.”  The curse relates to the instant country wealth that comes from the raw materials buried there and not from the effort of citizens to create products or services that have value.  The curse creates a distorted view of the value of one’s creative efforts and acts to undercut the development of a stable, progressive and tolerant society.  A possible solution to the curse of commodities is to diminish a country’s income stream and wealth, and the way to do that in the Middle East is to reduce the demand for their oil.

 

From Mr. Leyendecker’s viewpoint, Houston has a relatively short time  to benefit from the current high oil prices.  He believes that new disruptive technologies will emerge and marginalize our city’s source of wealth.  In his view, we may be a lot closer than we think to a re-run of the late 1980’s economic bust in Houston marked by abandoned homes, overgrown lawns and repetitive rounds of job-destroying layoffs that crushed our economy and society.  To protect against that re-run, Houston needs to launch an aggressive R&D effort to develop alternative energy technologies.  Unfortunately, we are way behind the venture capital investors situated along Route 128 outside Boston and those in the Bay area of California.  The bigger and more difficult question to answer is do we have citizens in Houston who can think outside the hydrocarbon energy box? 

 

Will Houston suffer as much as Mr. Leyendecker believes?  One could speculate that the major oil companies, who dominate the employment scene in Houston, have the cash to buy up and exploit whatever new disruptive technologies emerge in order to sustain their franchises.  Many of these companies will tell you that they are investing in alternative energies.  BP plc (BP-NYSE) touts in advertisements the idea that “BP” stands for “Beyond Petroleum.”  While that may be technically and politically correct, the company’s recent record of maintaining its petroleum-related assets in order to protect its employees and the environment does not measure up, diminishing the perception of BP as an “enlightened” company. 

 

Looking at the issue of disruptive technologies and hydrocarbon-based energy from a broader perspective, we are fascinated by the political battles waged over efforts to develop alternative energy projects, whether they are wind, solar or nuclear power sources.  The battle over expanding the ethanol business, at least the corn- or sugar-based fuels, likely will become more intense as people question ethanol’s net-energy balance, whether the program is really a sop to the farm lobby and the morality of using foodstuffs for energy when there are starving people in the world.

 

We believe that real disruptive energy technologies will come from somewhere or something we are not aware of today.  We always used to think that Star Trek’s mobility technology – “Beam Me Up, Scottie” – would prove the ultimate transportation system.  Unfortunately, it seems to only work on television.

 

In thinking about disruptive energy technologies, how they develop and how they alter the status quo, we looked at the role of the horse in America’s society and economy around the turn of the 19th Century.  This period marked the emergence of steam-powered energy sources and witnessed the rise of the automobile.  Most of us have little appreciation for the role the horse (and mule) played in the functioning of early American cities, and the social and economic problems they caused.  In 1900, there were estimated to have been between three million and three and a half million horses in American cities, compared with about 17 million living outside of cities.  Chicago had 83,330 horses, Detroit had 12,000 and Columbus had 5,000.  Thirty years earlier, New York had 1.7 million people, no electric street cars and an equine population of 150,000 to 175,000 horses and mules.  This huge animal population in the cities created a daily challenge for the citizens who struggled with the wastes and the associated diseases and other problems.

 

Sanitary experts in the early part of the twentieth century agreed that the normal city horse produced between 15 pounds and 30 pounds of manure a day, with the average being about 22 pounds, plus about a quart of urine.  Usually this waste was deposited along the route the workhorse traversed.  (According to one report, mules were used in some cities because they could be “potty” trained as opposed to horses.  Mules could be led to one location to defecate and another to urinate.)  The volume of daily waste generated in each city created the need to hire street cleaners and crosswalk sweepers.  In addition, it generated an opportunity to develop street cleaning machines.  Interestingly, the street cleaners were largely alien workers, which reminds us of today’s debate about illegal immigrants and their willingness to work the low-paying and unpleasant jobs ordinary American citizens shun.  

 

In Milwaukee in 1907, there was a human population of 350,000 and a horse population of 12,500, which meant 133 tons of manure a day was produced or a daily average of nearly three-quarters of a pound of manure for each resident.  Health officials in Rochester, New York calculated in 1900 that its 15,000 horses produced enough manure in a year to make a pile 175 feet high covering an acre of ground.  The greatest concern with the manure, however, was the breeding of flies that were thought to carry diseases such a typhoid that periodically ravaged cities.

 

An additional problem for the cities was the disposal of dead horses and mules.  Estimates were that the average streetcar horse had a life expectancy of two years.  It was not uncommon for drivers to be seen beating their overworked nags, which prompted Henry Bergh to found the American Society for the Prevention of Cruelty to Animals in 1866.  According to figures, New York City removed 15,000 dead horses from its streets in 1880, and as late as 1912, Chicago was removing upwards of 10,000 horse carcasses a year.  These carcasses also were breeding grounds for flies.  Other health problems came from the pulverizing of dried manure in the streets that blew around spreading diseases.  To avoid the problems of horse waste in the streets, besides street cleaners and crosswalk sweepers, architects in New York City designed homes with entrances at the second floor level (brownstones) that minimized the waste from entering the homes.

 

The solution to the horse waste problem was not to put diapers on the animals, or figure out how to potty-train them, rather it was to find some other energy source to perform the work that created fewer, or at least more manageable, pollution problems.  The development of steam, electricity and gasoline power sources obviated the need for workhorses in cities.  The driver behind the acceptance of these alternative power sources was health concerns, although economics also played a role.  Sound familiar?  To understand these changes, we are extracting two paragraphs about the shift from the essay, The Centrality of the Horse to the Nineteenth-Century American City, written by Dr. Joel Tarr of Carnegie University and Dr. Clay McShane of Northeastern University, and published in The Making of Urban America, (Raymond Mohl, ed.), NY: SR Publishers, 1997.

 

“Horses did not disappear from cities overnight. Rather, they went function by function. It has already been noted that, while horse-powered machines persisted in manufacturing until about 1850, they were largely replaced by other energy sources in the following decade. The next use of urban horses to disappear was pulling streetcars. Their demise was very rapid, as between 1888 and 1892 almost every street railway in the U.S. was electrified. A few small companies kept horses for about another decade because they could not get permission to electrify, but they were a minor element in the industry. The rapidity of the change is explained primarily by the incredible technological advantage of electric traction in terms of speed in spite of its capital intensiveness. Another benefit was that the pollution from streetcars was reduced, and moved from a non-point mobile source (the horse) to a fixed point source, the coal-burning electrical generating plant. In addition, cities no longer had to worry about removing dead traction horses from their streets.

 

“The coming of the automobile dealt another large blow to the horse. Experimental motor cars had been around for a long time, but cities had always banned them. The crisis of the 1890s and early twentieth century, involving public health fears about pollution, traffic jams, and rising prices for both hay, oats, and urban land, made municipal governments and urban residents much more ready to switch to autos. A number of articles in popular magazines repeated the argument by a writer in Munsey’s Magazine that "the horse has become unprofitable. He is too costly to buy and too costly to keep." The process of substitution went faster in the U.S., than in Europe, because American incomes were higher, cars and fuel cost less, and distances were greater. Leisure drivers came first, since the early car was purely a luxury vehicle. (When Woodrow Wilson rode a carriage in his 1917 inaugural, the last president to do so, he marked the end of the horse as a status object.) By 1907, urban doctors and some members of footloose occupations (salespersons and construction engineers, for example) had adopted cars. Mechanized cabs became commonplace around the same date. In 1906, motor buses replaced horse-drawn omnibuses on Fifth Ave., New York City, likely the last omnibus service left. In 1912, New York, London, and Paris traffic counts all showed more cars than horses for the first time. The drop in Model T prices that followed after Henry Ford opened the first assembly line plant in 1913, led to the adoption of cars by commuters. Most cities experienced their first diurnal traffic jams throughout the central business district in 1914.”

The transition to the disruptive technology of mechanical power from the traditional and dominant horsepower had both positive and negative implications.  Traffic jams and polluted air were a couple of the negatives.  Vehicle-related deaths were another.  Offsetting these negatives were the positive health benefits of reduced diseases, cleaner clothes and better air quality.  For certain people, their livelihood was impacted negatively.  In 1880, New York and Brooklyn were served by 427 blacksmith shops, 249 carriage and wagon enterprises, 262 wheelwright shops and 290 establishments dealing in saddles and harnesses.  We do not know what became of these jobs.  However, we do know that numerous other jobs were created from the need to service the automobile and truck fleets and power plants that replaced horses.  

 In researching the transition from the horse to the motor vehicle, we were amused by observations of writers of the day about this trend.  One article we read quoted a writer in Lippincott’s Magazine who insisted that since “Americans are a horse-loving nation…the wide-spread adoption of the motor-driven vehicle in this country is open to serious doubt.”  Our amusement comes not from the quote missing the change, but rather from the similarity of much of the debate about the development of alternative fuels and their eventual role in meeting our energy needs.  “Never say never” is a sound motto to live by.  For the visionaries who will shape Houston’s future, thinking about the unconventional may be critical for a successful outcome.  We think they need to be working now and quickly if Houston is to avoid a repeat of the 1980s bust.

 

Eni CEO Explains High World Oil Prices

 

In the October 7 New York Times, there was a brief interview with Paolo Scaroni, the chief executive of Eni SpA (E-NYSE), the international oil company headquartered in Italy.  We thought his answer to the reporter’s question about high oil prices was both clear and insightful, but important it should be read as a message to American citizens. 

 

“Q. Some people believe high oil prices are here to stay.  Do you share that view?

 

“A. First of all prices are not very high.  Sixty dollars a barrel is not very high.  If they were high, the American consumer in particular would behave differently.  As long as each American consumer burns 26 barrels of oil per year against 12 for Europeans, this means that the prices are not high.  High means that people start to say that I can use my energy better.  Today, a barrel of oil is worth half a barrel of Coca-Cola.  So you should put things into perspective.  It has been clear to everybody that the Western world can live with oil above $30, $40, $50, $60, $70 a barrel and economies expand, inflation is low, and consumers continue to drive S.U.V.’s and air-conditioners are so high in American restaurants that you have to put on a coat otherwise you get sick.”

 

Seems Like Old Times Again – Look Out!

 

Anyone who has been in or around the energy business for very long has to feel more comfortable given current events.  Why?  Because OPEC is reacting to the recent fall in oil prices with its customary approach, i.e., talking up a cut in its production.  It is hard to believe that this situation happened only two years ago.  At that time, OPEC’s announcement of a prospective cut in its production was greeted by crude oil traders with a rally that jumped oil prices 15% higher.  This time, however, the talk has produced very little material price appreciation.  Are other considerations at work?

 

 

Do investors and analysts remember the last time we experienced OPEC producing flat-out as oil demand fell?  It was in late 1997.  In the summer of that year, Thailand‘s currency, the Bhatt, imploded in value taking down the country’s economy and eventually a number of neighboring economies.  Most of the Asian countries had weak financial reserves and their economies were tied together by their currencies.  With the economic contraction throughout the region and the collapse of the value of many of the local currencies, crude oil and refined product inventories became very expensive assets to maintain, so they too were dumped, making the fall in oil demand appear worse than it actually was. 

 

The imbalance between oil supply and demand had been exacerbated further by the recently stepped-up OPEC production that was attempting to cool off the rise in crude oil prices driven by global demand growth – primarily due to Asian consumption.  If you don’t remember what happened, here’s a brief refresher. 

 

As the world’s economy recovered from the early 1990s recession, oil demand was growing.  It increased 1.9% in 1994 and 1.7% in 1995, but projections by the International Energy Agency (IEA) called for demand to grow by 2.4% in 1996 and 2.7% in 1997.  Crude oil prices that had traded in the upper teens for all of 1993 through 1995 jumped into the low $20s, averaging slightly over $22 for all of 1996.  By December of 1996, crude oil was trading over $25 per barrel.  Oil prices moderated some in the first half of 1997 and then fell below $20 during the summer before strengthening in the fall to yield an average oil price for 1997 of slightly over $20. 

 

In December 1997, the IEA was projecting demand growth of 2.8% for the year, following on 1996’s 2.4% growth, and further growth in 1998 of 2.5%.  The December IEA monthly talked about an additional 500,000 to 1.1 million b/d of OPEC production coming into the market.  They also hinted at the first signs of concern about demand weakness.  Between November and December of 1997 crude oil prices dropped almost $2 per barrel.  In January 1998, they dropped another $1.50 per barrel, bringing them to an average for the month of $16.72.  For the rest of 1997, crude oil prices weakened every month until hitting bottom in December at $11.35. 

 

The December 1998 IEA monthly began with the headline: What Happened To Demand?  The previous forecast for a 1.85 million b/d demand growth in 1998 had been pared to only 500,000 b/d.  With revenue plummeting, OPEC members, lead by Venezuelan President Hugo Chavez, began a dance with non-OPEC producers (Russia, Great Britain and Norway) in an attempt to secure an agreement to cut production to stop the hemorrhaging.  That agreement was put in place in March and the rally began.  By December 1999, crude oil prices were back over $26 per barrel.   Little did we know that the agreement would mark the beginning of an extended bull market in commodities that only ended its long-term upward trajectory this summer. 

 

 

So will we have a repeat of 2004 or 1997?  The answer to that question will determine whether oil prices are headed higher in the near-term or long-term.  If it is the long-term scenario, then we are likely to have a period of rough sledding ahead for energy markets and energy stocks.  In an attempt to answer that question, we looked at the global oil production picture and how it has changed between 1997 and August 2006.  Global supply had increased by 11.44 million b/d, with OPEC, including its NGLs, accounting for over 4 million b/d of that total.  Within OPEC, all producers are up except Venezuela and Indonesia, which combined for a loss of 1.15 million b/d of production.  Other big gainers included the FSU with over a 5-million b/d increase, Asia with a 1.17 million b/d gain, led by China being up by 540,000 b/d, Latin America with a 1.08 million b/d increase, virtually all of it coming from Brazil, and a 1.35 million b/d boost from Africa due to gains from Angola and others offsetting declines for Gabon and Egypt. 

 

Exhibit 1.  Global Oil Supply Change by Region

Source: IEA; PPBH

 

On the losing side of the equation, North America is down due to falling U.S. production more than offsetting gains from Mexico and Canada.  Both of those countries are beginning to show signs of production declines.  Europe was down as both the UK and Norway are experiencing falling production.  Given these results and current production trends within a number of the countries that accounted for the gains, it is hard to see a repeat of 1997.  The one caveat is demand.  A simultaneous recession in the United States, Europe and China could still create a severe short-term oil supply/demand imbalance.

 

Are Venture Capital Pros’ Concerns True for Energy?

 

Sevin Rosen Funds, one of the oldest and most successful technology venture capital firms, is returning money raised from clients due to its perception that investment opportunities are not attractive.  The firm was in the process of raising money for its Fund X when it decided to abort the process.  The firm wrote a letter to its prospective investors who had ponied up commitments of between $250 million and $300 million.  The firm wrote, “The venture environment has changed so that overall returns for the entire industry are way too low and even the upper quartile returns have dropped to insufficient levels.”

 

The problem, according to partners of Sevin Rosen who spoke to the media and financial press, is that too much money has gone to venture capital firms who are providing financing to too many companies in every conceivable sector of the industry.  Too much capital is one problem, but the lack of attractive exit opportunities is potentially as severe.  Sevin Rosen believes that the dearth of initial public offerings (IPOs) plus a current market for technology company acquisitions at valuations it considers too low will limit the fund’s ability to deliver the kind of returns that venture investors have come to expect.  At the end of 2005, venture capitalists had a combined $261 billion under management.  That is more money than at any time in the history of the industry. 

 

Exhibit 2.  Sevin Rosen’s Concern About Inadequate Returns

Source: NYT

 

Sevin Rosen’s decision, and the rationale behind it, presents an interesting backdrop for the current surge in energy private equity investing.  Their decision is based not on where the market for IPOs and acquisitions are now, but where the Sevin Rosen partners think it will be five to seven years from now, the typical life of a venture fund.  While the partners believe the markets are unlikely to change, other venture capitalists think differently.  The big question is whether Sevin Rosen’s view is limited only to venture capital investing, as there has been a substantial volume of funds flowing into private equity funds, too. 

 

Last spring we heard a partner from the private equity firm HM Capital Partners LLC discuss the change at his organization in light of the challenges for generating superior investment returns for their investors.  His thesis was very similar to Sevin Rosen’s, but probably reflected a little more emphasis on the impact of current valuations (too high), due to so much new private equity money, that was limiting upside profit potential.  He said that this changed environment was one reason why founder Tom Hicks was retiring from the firm.  Private equity investors utilize the same exit strategies as venture capital investors, so if Sevin Rosen’s view about current and future financial markets reflecting weak valuations proves true for all industry sectors, then energy private equity investors should be concerned. 

 

Since the spring run-up in energy stock prices, the market for energy-related IPOs has been extremely weak, resulting in a number of offerings being cancelled or delayed.  One energy-related IPO underway is for Paradigm Ltd., a seismic-software and data processing company, which underwriters are attempting to market as a technology company.  The problem with this strategy is that Paradigm’s customers are all energy companies, and there aren’t too many customers.  That would seem to make it difficult to call it a technology company rather than an oil service company.

 

Energy-oriented private equity firms, who are scrambling to invest their huge sums of money in private companies should consider whether Sevin Rosen’s and HM Capital’s views have any merit.  If they do, then private company valuations will likely plateau or decline.  The valuation changes are needed in order to open up the prospective return potential for private equity investors.  Lower valuations for private equity investors could open up opportunities for strategic buyers to become more active in the merger and acquisition market for private companies.  That could set the stage for a wave of industry consolidation that might wind up paralleling a similar consolidation phase in the producer sector.  If that happens, the face of the oil and gas and oilfield service industries would be altered dramatically. 

 

For Energy Speculators: 2006 Hurricane Season a Bust

 

The Colorado State University Department of Atmospheric Science hurricane forecasting team has recently cut its forecast for storms this hurricane season due to the development of El Niño conditions in the Pacific Ocean.  Through the end of September, this year’s hurricane season has been about an average year.  August experienced substantially below average storm activity while September had above-average activity.  U.S. landfall by tropical storms has been well below average.  No hurricanes have made landfall so far this year.  According to the statistics, 83% of the Net Tropical Cyclone (NTC) activity this year had occurred through the end of September.  In an average year, 80% of the seasonal average NTC of 100 occurs by the end of September.

 

When the 2006 tropical storm forecasting season began last December, the Colorado State University unit, along with virtually every other forecaster, predicted another severe hurricane season, although not as severe as 2005 when the U.S. experienced a record, 27 named storms.  The warming temperatures in the Atlantic Ocean and the absence of El Niño conditions were encouraging for the formation of tropical storms.  The consensus view for this hurricane season also called for early season hurricanes to target the Gulf of Mexico with later storms heading for the East Coast. 

 

When one looks at a map showing the paths of the named tropical storms so far this year, it almost seems as though the U.S. mainland was about a quarter-turn to the left of the main track of the storms.  The impact of this misplacement was to diminish the number of days that tropical storm conditions impacted the United States coast.  Importantly, the energy industry escaped the hurricane season without any material disruption, other than having to shut-in operations in the eastern portion of the Gulf of Mexico for a few days.

 

Exhibit 3.  2006 Hurricanes Were Largely Irrelevant

Source: Weatherunderground.com

 

The expectation of a severe tropical storm/hurricane season this year was marked by an initial forecast in December 2005 for 17 named storms including nine hurricanes, of which five would be intense (Category 3 or better).  That initial forecast was maintained until early in the hurricane season as weather conditions were consistent with the expectations on which the forecast was based.  When Tropical Storm Alberto formed in early June, the forecasters were feeling comfortable with their forecasts and concerns about the impact on the U.S. economy.  The fact that it was more than a month later before the next tropical storm formed, forecasters began to encounter problems with their forecasting models as tropical storm development was inhibited by increased shear wind conditions that eroded the strength of thunderstorms before they could spin up into hurricanes.  Climatologists began to notice that Pacific Ocean surface temperatures had begun to climb suggesting the formation of an El Niño. 

 

 

Exhibit 4.  El Niño Formation Undercut Hurricane Forecast

Source: Colorado State Univ.; PPHB

 

As El Niño conditions strengthened, the expected severity of the hurricane season diminished.  At the start of August, Colorado State University lowered by two its forecast for tropical storms and hurricanes.  That forecast was further reduced at the start of September by another two storms.  Intense hurricanes, after being reduced by two earlier, was only lowered by one this time, bringing the total for the season to two from the initial forecasts of five. 

 

The Colorado State University forecasters have developed a new forecasting model that is designed to predict storm activity for each individual month of the hurricane season.  They point out that there are often monthly periods within both active and inactive Atlantic basin hurricane seasons that do not conform to the trend for the overall season.  They cite as examples, 1961 when an active year produced no storm activity in August; 1995 had 19 named storms, but only one named storm developed during the 30-day period during the peak of the hurricane season between August 29 and September 27.  In contrast, the inactive season of 1941 had only six named storms compared to the average of 9.3 storms, but four of them developed during September.  In the inactive 1968 hurricane season, three of the eight named storms formed in June, which has a long-term average of 0.5 storms. 

 

Based on the new forecasting model and historical patterns, Colorado State University now expects only two more named storms this season with one becoming a hurricane, but not an intense one.  As this hurricane season exits with a whimper, attention will turn to the impact of El Niño conditions on this winter’s weather.  Equally important will be on the assumptions forecasters make for the continuation of El Niño conditions on their hurricane forecasts for next year.  We will get our first peek at their thinking in early December.

 

The New Oil Sands Business Model?

 

On October 5, ConocoPhillips (COP-NYSE) and EnCana Corp. (ECA-NYSE) announced the creation of two new partnerships designed to facilitate the accelerated development of oil sands resources in northern Canada.  The idea of the partnerships – one for the upstream and another for the downstream – is to expand the opportunities for leveraging increased oil sands production by expanding and upgrading each partner’s facilities that should produce superior financial returns with less risk.  EnCana will be marrying its strong acreage and production position in the Alberta oil sands regions with ConocoPhillips’ strategically located U.S. refineries.

 

The upstream partnership, headquartered in Calgary, will consist of EnCana’s Foster Creek and Christina Lake projects located on the eastern flank of the oil sands region.  The projects are estimated to contain more than 6.5 million barrels of recoverable bitumen.  The partnership plans to boost this production from the current 50,000 barrels per day (b/d) rate to 400,000 b/d by 2015.  The plan is to transport and sell the bitumen at major Alberta trading hubs.  EnCana will be the operator and managing partner of this venture and each company will hold a 50% interest in the partnership, which plans to invest $5.4 billion by 2015.

 

The downstream partnership, headquartered in Houston, will consist of ConocoPhillips’ Wood River (Roxana, Illinois) and Borger (Borger, Texas) refineries.  These refineries will be revamped and expanded for processing heavy oil from approximately 60,000 b/d to 550,000 b/d by 2015.  The bitumen handling capacity of the refineries will be expanded from 30,000 b/d to 275,000 b/d.  Total throughput at the two facilities is expected to increase from the current 450,000 b/d to 600,000 b/d over the same time period.  The partnership may expand heavy oil processing capacity further, either at the refineries or in Alberta.  ConocoPhillips will be the operator and managing partner.  Each company will own a 50% interest in the partnership, although ConocoPhillips will hold a disproportionate economic interest in the Borger refinery for two years: 85% in 2007, and 65% in 2008.  The partners will purchase and transport all the feedstock for the refineries and sell the refined product.  The partners are planning to invest $5.3 billion in the expansions and upgrades.

 

Several weeks ago, Murray Edwards, vice-chairman of Canadian Natural Resources Ltd. (CNQ-TSX), speaking to a Canadian business group, discussed the challenges to developing Alberta’s oil sands resources and the impact these challenges were having on profitability.  The lack of adequately trained skilled labor and sufficient infrastructure in the Fort McMurray region of Alberta has created severe cost inflation in the construction of new oil sands facilities.  As a result, some of the newly planned projects are falling behind schedule.  Total (TOT-NYSE), which bought into the oil sands region a year ago and had expected to see initial production in 2010, recently announced that the production is now targeted to commence operations in 2013.

 

Mr. Edwards questioned the impact of cost inflation on project economics and production goals.  “Given the current challenges we face…it is going to be difficult for the Canadian sector to deliver the forecast growth in oil sands volumes over the next 15 years,” said Mr. Edwards in his speech.  “Costs are accelerating to the point where you have to start wondering if projects are still economic.”  According to Mr. Edwards, in the past five years, the price to build a

 

project has doubled.  That trend seems to be intact, given Shell Canada Ltd.’s (SHC-TSX) declaration in July that a planned expansion of its existing oil sands project could cost C$12.8 billion, up 50% from an estimate made just one year ago.

 

With this partnership deal, ConocoPhillips secures a future stream of heavy oil feedstock for two of its refineries, sufficient to justify investment in upgrading their processing capacity.  It also has the potential to expand that capacity further if the oil sands output is expanded.  At the same time, EnCana gains access to refining assets that would have been prohibitively expensive to acquire on its own, and that provide security for its investment in expanding the production from its two oil sands projects.  This looks like a win-win situation for both companies, assuming oil prices stay sufficiently high to justify the mining costs for extracting the bitumen resource.  At the same time, as we wrote last issue, expansion of the pipeline capacity for moving bitumen from northern Alberta to the U.S. is moving forward, which is another key factor in the development of this North American market.  We wonder if there will be more deals like the ConocoPhillips-EnCana venture.

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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.