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Musings From the Oil Patch, June 19, 2012

Musings From the Oil Patch
June 19, 2012

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

Tom Fanning: “The Natural Gas Skeptic” Deserves A Hearing (Top)

A couple of Saturday’s ago, The Wall Street Journal’s Weekend Interview column was devoted to a discussion with Tom Fanning, the chairman and CEO of the Southern Company (SO-NYSE).  The title of the column was “The Natural Gas Skeptic,” but it wasn’t so much a discourse on skepticism about the universally endorsed view of the existence of a century of natural gas resources at historically low prices, as it was about the need for a balance in fuel supplies.  The discussion focused on utility company business models that actually create long-term risk for customers and shareholders due to their focus on fads and reckless actions designed to drive above-average short-term growth. 

The Southern Company is an electric utility with operations in four Southeast states - Alabama, Florida, Georgia and Mississippi - and power generation opportunities in six neighboring states.  The company’s service territory spans 120,000 square miles and is serviced by 12,222 megawatts of power generation capacity.  Southern Company has 33 hydroelectric generating stations, 34 power plants fueled by coal and natural gas, three nuclear facilities, 13 combined-cycle cogeneration plants, two solar farms and one landfall gas plant.  One could conclude this company has a conservative philosophy regarding its portfolio of fuel supplies.  Mr. Fanning explained, “Southern may not be exciting, but we’re dependable and we work like crazy to be dependable.”

In the interview, Mr. Fanning pointed out that his company is still building coal fired plants along with natural gas powered ones.  Southern Company is constructing the nation’s first nuclear power plant since the late 1970s and it is also building a waste biomass generating plant.  He characterized the company’s power diversity strategy as similar to investors diversifying a portfolio of stocks.  This

Exhibit 1.  Southern Area
Southern    Area
Source:  Southern Co.

philosophy was characterized by the interviewer as positioning Mr. Fanning as “one of the most trenchant critics of the transformative switch to gas from coal.”  Explaining his concern over totally embracing natural gas, Mr. Fanning says, “It just doubles down your risk into one segment that looks promising today but nobody can sit here and tell me that it’s going to be safe forever, safe in terms of economics and reliability.” 

The flip side of embracing natural gas is Mr. Fanning’s concern about the regulatory push to ban the burning of coal.  “It’s terribly unwise in my view to create a regulatory regime that bans one of the nation’s most plentiful resources.  We own 28% of the world’s coal reserves – we have a blessing of wealth.  It should be brought to bear here in America.  If not, due to regulatory policy, it will be burned for the benefit of the citizens of China or India or elsewhere.”  His views come even as Southern Company has reduced its dependency on coal from 70% in 2007 to 35% now, while natural gas-fueled power has increased from 16% to 47%.  The company’s divergent trends in energy use are reinforced by statistics showing that since 1990, power companies have opted for new coal-fired plants for only 6% of their new generation capacity while over the same period 77% of new capacity is being fueled by natural gas. 

Mr. Fanning is skeptical about the nation’s growing dependence on natural gas given the fuel’s historical price volatility and its potential consumption growth.  As he put it, “Nationwide, I think we’re going to be consuming over 50% more gas going forward than we currently do, or at least there’s a good potential for that.”  He acknowledges that increased production due to more wells and the use of hydraulic fracturing technology has contributed to increased supply and low gas prices.  But he offers, “Gas has traditionally been way more volatile certainly than coal and nuclear.  So you’re buying a more volatile product.  You’re creating a higher-Beta energy policy.”  (Beta is the measure of the volatility of the price of an asset in relation to the overall market.)  What Mr. Fanning is concerned about is that as coal, a low-Beta fuel, is eliminated from the market, power customers will be forced to rely on less productive and more expensive energy sources.  While that would appear to target renewables, Mr. Fanning says he is excited about renewables, but warns they are really a niche fuel.  He is also concerned about the political risk for natural gas supply from concerns about the wide-scale use of hydraulic fracturing. 

Looking to the future, Mr. Fanning sees natural gas prices normalizing globally, meaning America’s current low prices will disappear.  As a result, he sees the dividend our economy is getting now from low energy prices is something that will not last.  As a result, his strategy is best summed up in the following statement.  “Believe me. I think gas will be the dominant resource going forward.  But I am not willing to subject my customers to the risk of betting it all on gas.”  As a result, Mr. Fanning focuses much more on the risks in managing his business, and in particular the long-term risks.  He believes the vertically integrated, regulated utility model “should be the dominant solution” in the power industry.  What he worries about are those companies that are set up to focus on maximizing the next quarter’s returns at the expense of long-term profitability.  In his view, “Risk is as important as return.  And I think so often given the herd mentality we see in the markets, people forget that.”  Those are excellent thoughts to keep in mind as we contemplate the future of the natural gas industry.

Highway Spending And Taxing Alternative-fuel Vehicles (Top)

As Congress’s summer recess draws near, the battle over national transportation spending grows increasingly partisan as the political parties spar over what should or should not be included in the legislation.  Should the proposed legislation provide a long-term solution to the decaying highway and transit infrastructure or merely be another short-term extension of the current spending authority?  The last time transportation legislation was overhauled was in 2005 when the Safe Accountable Flexible Efficient Transportation Equity Act (SAFETEA-Lu) was passed.  It was scheduled for renewal in 2009.  Given the 2008 financial crisis and resulting recession, politicians were reluctant to sign on to a permanent spending bill since increased highway funding was a part of President Barack Obama’s economic stimulus bill to deal with the recession.  Congress therefore embarked on a series of temporary highway spending extensions, now up to nine.  The last 90-day extension was signed into law by President Obama on March 30th, making June 30th the next deadline. 

The politics of highway spending are emotional since every politician benefits from it based on the spending formula in the law.  The challenge is that revenues to fund that spending come from gasoline, diesel and other transportation-related taxes and they are declining as motorists drive less, meaning less fuel and tires are purchased.  In recent years, the revenue shortfall for funding highway spending has been met by shifting money from the U.S. Treasury to the trust fund, and the amount of money transferred nearly doubled in FY2010 from the prior two years.  In past Musings, we have focused on the issue of the peaking and subsequent decline in vehicle miles traveled (VMT) and the trends’ implication for future economic activity, but it is having a big impact on highway funds. 

Exhibit 2.  Vehicle Miles Traveled In Secular Decline
Vehicle Miles Traveled In Secular Decline
Source:  Federal Highway Administration

Exhibit 2 shows the rolling 12-month total of VMT on all roads in America.  VMT peaked in 2007 immediately prior to the financial crisis and the onset of the recession.  Given its severity, it was not surprising VMT continued falling in subsequent years.  An uptick in VMT began in late 2009 and extended into early 2010 before resuming its decline.  The March upturn is being hailed as a sign Americans are feeling better about the economy, but the upturn came immediately prior to gasoline pump prices climbing sharply in response to higher oil prices due to geopolitical and Eurozone worries.  We do not know yet the impact high gasoline prices had on April’s and May’s VMT, but a review of historical data shows that when gasoline pump prices reached or exceeded $3.00 per gallon, driving declined.  The late 2009/2010 uptick in VMT came as gasoline prices fell below $3.  Based on history, we fully expect recent monthly VMT data to reflect a decline.

Exhibit 3.  High Gasoline Prices Send Driving Down
High Gasoline Prices Send Driving Down
Source:  EIA, FHWA, PPHB

While gasoline prices are the most visible cause of the VMT decline, America’s demographics also are working against future VMT increases.  As America’s population ages, fewer young drivers who traditionally have driven more than older adults will limit the prospect for any sustained increase in VMT.  We are a nation that now has a greater percentage of older residents than ever before, suggesting an extended moderating influence on the amount of VMT per person and collectively for the country.  At the same time, a number of younger people, those in their late teens to late 20s, have delayed obtaining their driver’s licenses and appear to be abandoning the historical “love-affair” with the automobile, which will further hurt overall VMT.

Another phenomenon impacting VMT is the growth of social media and its role in younger Americans’ socializing patterns.  Surveys have shown that young adults would rather communicate via social media than get in a car and drive to someone’s home.  Another electronic trend impacting driving is the growth of Internet commerce.  Many shoppers now buy goods on-line and have them delivered to their homes as opposed to driving to the shopping mall to purchase them.  While it is difficult to quantify the impact on VMT from social media and the Internet, it is clear these forces are impacting driving at the margin. 

Another consideration for VMT is the decline in the nation’s vehicle population that followed the outbreak of the global financial crisis.  According to the Department of Transportation’s Federal Highway Administration, the U.S. vehicle stock peaked at 256 million in 2008

Exhibit 4.  Drivers, VMT, Cars Down; MPG Up
Drivers, VMT, Cars Down; MPG Up
Source:  FHWA, PPHB

but has declined to 246 million by 2011.  The upturn in auto sales this year to a 14 million seasonally adjusted annual rate may translate into a vehicle population increase in 2012.  The lack of personal income growth over the past decade, difficult labor market conditions and more expensive vehicles, despite an improvement in automobile credit availability, may limit future new vehicle sales growth to a rate below that experienced prior to the financial crisis.  That means autos will provide less economic support in the future than during the past year and half. 

The last factor to consider about the future of the American automobile market is increased penetration by electric vehicles (EV) and alternative fuel vehicles such as those powered by natural gas and ethanol.  While these vehicle types have barely dented the American fleet, as their presence increases, the volume of gasoline and diesel fuel consumed will fall, putting additional pressure on the Highway Trust Fund’s income. 

Exhibit 5.  Highway Trust Fund Bankrupt?
Highway Trust Fund Bankrupt
Source:  FHWA

Since the late 1950s to 2000, the Highway Trust Fund generally was able to fund highway construction and maintenance from its taxes on gasoline, diesel and tire sales.  Following the 2000 and 2008 recessions, highway spending was increased to the point it outstripped fuel tax revenues.  As a result, the trust fund was stressed and the federal government stepped in with contributions from general tax revenues.  In fiscal 2008 (starting September 2007) the federal government moved $8.0 billion into the Highway Trust Fund.  The fund was further bolstered in FY2009 by $7.0 billion and in FY2010 by $14.7 billion. 

The Highway Trust Fund is funded by an 18.4-cents-per gallon federal tax on gasoline and a 24.4-cents-per gallon tax on diesel fuel.  The federal fuel tax was instituted in 1932 at one penny per gallon and has been increased steadily over time.  The last hike in the federal tax rate occurred in 1993 and since the tax is not indexed for inflation, revenue growth is dependent almost entirely on fuel consumption, which is a combination of VMT and vehicle fuel-efficiency.  In fiscal 2011, the Highway Trust Fund collected $30.1 billion, which was $1.2 billion lower than the amount collected in 2008 when fuel consumption was greater.  As the American auto fleet becomes populated with more fuel-efficient vehicles and the country’s demographics contribute to a reduction in the number of licensed drivers and they drive fewer miles, revenues flowing into the Highway Trust Fund will steadily decline in the future.  In order to continue supporting highway construction and maintenance, at least at the current level, the federal government will have to continue injecting money into the fund, unless they raise fuel taxes or develop another way to tax vehicle highway use. 

In January, the non-partisan Congressional Budget Office (CBO) issued a forecast projecting a dire outlook for the Highway Trust Fund.  It projects the highway spending portion of the fund will not be able to meet its obligations sometime during 2012 and the transit portion will be exhausted in 2014.  To reach its conclusion, the CBO assumed 2012’s highway and transit spending levels will increase only by the rate of inflation.  On the revenue side, however, the forecast assumed the following: “Although the number of miles that people drive is projected to increase as the economy grows, CBO expects the effect of that increase on fuel use to be largely offset by improvements in the fuel economy of vehicles, mainly because of increases in the government’s fuel economy standards.”  At the time of the CBO forecast, gasoline prices were modest and there was less concern about prices reaching the level at which VMT has been negatively impacted in the past.  Additionally, at the time of the forecast, the U.S. economic recovery appeared to be accelerating with projections that unemployment would fall increasing the number of workers driving to work.  Six months later, those assumptions are questionable.

Most of the issues would appear to have short-term influences on the health of the Highway Trust Fund.  Long-term, the demographic and fuel-efficiency trends will put continuing downward pressure on the volume of fuel consumed.  An issue that has received little attention is the impact on the highway fund from more EVs and alternative fuel vehicles on the road.  These vehicles pay no fuel taxes.  Is this a serious issue?  It could be, especially given the deteriorating condition of our highways, bridges and transit systems. 

Exhibit 6.  Nation’s Bridges In Bad Shape
Nation’s Bridges In Bad Shape
Source:  FHWA

While the number of bridges structurally deficient has declined over the past 20 years, the number of functionally obsolete bridges has remained fairly constant.  (Exhibit 6.)  The question not answered by the data is whether the cost to repair the remaining bridges will be substantially greater than those already repaired.  When we look at the condition of highways, the situation doesn’t look quite as bad except for two states: California and New York having a significant amount of poor roads.  (Exhibit 7.) 

Exhibit 7.  Condition Of America’s Highway
Condition Of America’s Highway
Source:  FHWA

How much of a funding problem for the Highway Trust Fund might EVs and alternative vehicles create?  Currently, EVs are struggling to make an impact on the nation’s vehicle population as their cost, range limits and performance make them less desirable options for American car customers.  Sales for the two leading EVs have been spotty so far this year.  Strong EV sales in March were followed by weak sales in April.  The new Toyota (TM-NYSE) plug-in Prius has experienced positive market reception since it began selling at the end of February.  The results of recent sales and their outlook for the full year are shown in Exhibit 8.  One conclusion from the sales data is that President Obama’s goal of one million EVs on America’s roads in 2015 is unattainable despite Energy Secretary Stephen Chu’s claim at the Detroit Auto Show earlier this year that EV battery costs would drop by 70% by 2015 from $12,000 to $3,500. 

Exhibit 8.  American Electric Vehicle Sales
American Electric Vehicle Sales
Note: * February - April
Source:  Ward’s Automotive, PPHB

Lately, as natural gas prices have collapsed, consumers and businesses have begun focusing on vehicles powered by this environmentally-friendly and now cheap fuel.  Many analysts wonder why the U.S. has failed to embrace natural gas vehicles (NGV) unlike other countries in the world. 

Exhibit 9.  EV Penetration By Global Regions
EV    Penetration By Global Regions
Source:  NGV Global

NGVs have been of interest to drivers in Latin America and Europe since the early 1990s, but in recent years their acceptance has soared in the Asia/Pacific region.  Both North America and Africa show almost no interest in NGVs.  The primary drawbacks to increased use of NGVs has been the absence of vehicle choices, the cost of converting traditionally-powered vehicles and the lack of refueling infrastructure, creating range anxiety.  All of these barriers are being lowered so the pace of NGV sales should pick up, with the primary push now coming in the medium- and heavy-duty truck markets.  Based on information from Pike Research, there are 120,000 NGVs among America’s 246 million unit fleet.  Sales of NGVs grew 30% in 2007 and by 25% every year since.  Last year, 40% of all trash-hauling trucks sold in the U.S. were powered by natural gas and that figure is projected to grow to 50% this year.  Despite these growth rates, Pike Research estimates NGVs in North America will still barely make a dent in the global fleet by 2016.

Exhibit 10.  NGV Market Outlook Thru 2016
NGV Market Outlook Thru 2016
Source:  Pike Research

What is the market potential for EVs and NGVs?  To estimate the penetration of these alternative fuel vehicles, we took the estimated sales for light-duty NGVs in 2012 according to Pike Research and grew them at 25% per year to 2019.  For medium- and heavy-duty trucks, we increased sales at 10% per year, consistent with Pike’s growth projection.  Adding these new vehicles to the current 120,000 NGV fleet gives us a projected total of 476,000 NGVs in 2019.

We estimated future EVs sales from the industry’s projected 2012 sales target of 40,000 vehicles based on current sales rates.  We increased annual sales at 50% per year through 2019.  As a check on our projection, we estimate 202,000 EVs will be sold in 2016, which compares favorably to auto consultant LMC Automotive’s estimate of 95,000 units.  Over 2012-2019, we estimate 1.968 million EVs will be sold.  Adding the 17,000 EVs sold since they were introduced in 2010, the EV population will total 1.985 million units by 2019.  By adding all the EVs and NGVs together, in 2019, alternative fuel vehicles will represent 2.46 million units.  If we assume that between now and 2019, the total U.S. vehicle population remains unchanged, alternative fuel vehicles will represent 1% of the total vehicle fleet. 

We would suggest that the challenge for the Highway Trust Fund will come less from alternative fuel vehicles that are contributing no tax revenues, even if we double our estimate of their share of the future fleet, but rather from more fuel-efficient internal combustion engines, and the potential of shrinking VMT.  The highway fund’s challenge will be eased if alternative fuel vehicles pay into the fund, but little thought has been devoted to how to tax them.  NGVs present less of a challenge since their fuel consumption can be easily converted to gasoline-gallon-equivalents (that is how NGV’s fuel-cost advantage is calculated) in order for a federal fuel-tax to be assessed.  EVs present a greater challenge since electricity is sold on an entirely different basis than fossil fuels.  Adding a tax to the electricity to charge a battery in an EV will further complicate the economic argument for buying them.  Large tax subsidies are being provided to help offset the expense of EVs, but it doesn’t seem to be helping. 

A big problem in taxing both EVs and NGVs is that their owners often will be using residential re-fueling systems, meaning they are tapping into the same energy supply that powers their homes, and for which there is an entirely different tax structure.  Since utilities that supply homes with electricity and natural gas cannot distinguish when the power is used for vehicles rather than homes, how could they administer two tax structures?  What is the appropriate way to tax these vehicles to contribute revenues to the highway fund?  Maybe we need to revamp how the government raises revenues from the transportation fleet in order to build new highways and maintain existing ones?  Are we headed to a highway use tax structure such as has been tested in Oregon or used in traffic congestion reduction efforts in cities such as London? 

Many of us benefit from the electronic highway signs telling us how long it takes to go from point A to point B.  We were surprised to learn that this information is based on reading vehicle GPS or passenger cell phone signals.  These electronic systems can track exactly where vehicles drive, and thereby can be used to determine how many miles a vehicle drives on a state’s highways.  The data can then be used to charge vehicle owners a per-mile-tax rather than a per-gallon-tax to fund highway spending, but this technology raises privacy issues that governments are wrestling with.  In the trucking industry, this technology is used to replace the daily paper/computer reports drivers now fill out showing the truck’s odometer readings and hourly information that enable their employers to file reports with fuel and tire companies who then send the appropriate tax revenues to the respective states.  Philosophically, it is easier for the public to justify mandatory filing rules and electronic measurements for businesses, but Americans traditionally have prided themselves on our voluntary compliance with income taxes.  Governments, strapped for income, already are wrestling with how to tap the “lost” tax revenue of the “underground economy” where transactions are conducted in cash or bartered and the transaction’s value is not reported to the government taxing authorities.  An even bigger issue is emerging for states due to lost sales by stores to Internet transactions with enterprises having no physical presence in the state.  The sales tax is not imposed on these Internet transactions and most buyers ignore their moral obligation to report and pay the tax.  We are now starting to see agreements between large Internet merchants and states to help resolve this issue.

We expect the upcoming extension of the Highway Trust Fund, whenever it occurs, will include additional transfers from the federal government to help the fund meet its obligations.  In the same vein, we expect an increased government focus on raising the fuel tax and possibly on how to extend it to those non-taxed transportation fuels (natural gas and electricity) that will grow in importance for our future transportation fuel mix.  This issue will be contentious due to its privacy concerns, but the politics of highway spending dictate more money needs to flow into the fund. 

Natural Gas Futures Price Action Reflects Volatility Of Market (Top)

Last Thursday morning at 10:30 am EDT, the federal government released its estimate of the amount of natural gas in storage in this country as of the end of the prior week (June 8, 2012).  The government said there was 2,944 billion cubic feet (Bcf) of gas in storage, an increase of 67 Bcf from the storage total reported for the prior week.  Natural gas storage volumes now are up nearly 32% from the 2,236 Bcf of gas in storage a year ago.  Significantly, the latest storage total is 29% above the five-year average of 2007-2011 of 2,278 Bcf.  The greater storage volume relative to recent years is the primary reason natural gas prices are so low and showing little hope of significantly improving anytime soon.

Exhibit 11.  Gas Storage Relative Surplus Shrinking
Gas Storage Relative Surplus Shrinking
Source:  ISI Group LLC

What caught our attention with the gas market that day was when the government’s estimate was released how natural gas futures jumped immediately by nearly 10% and then continued climbing throughout the day to close 14.2% higher than Wednesday at $2.495.  The initial explanation for the price jump was that the 67 Bcf weekly gas storage increase was below the anticipated figure by gas analysts of 75 Bcf.  Moreover, last week’s increase was below the 88 Bcf five-year average weekly storage injections at this time of the year.  Articles commenting on the gas futures market quoted analysts claiming that fuel-switching by electricity generators remained strongly in favor of natural gas and that electricity demand remained high, which is shown clearly in Exhibit 12.  Analysts cited covering of short positions by commodity traders who were betting that natural gas prices would continue to decline, but who now believe that the low for the year for gas prices was established in April.  These traders represent those notorious speculators President Barack Obama chastises for driving oil and gas prices to unrealistically high levels just to make money at the expense of the American consumer.  We wonder how much money these gas traders lost on their natural gas short positions given the magnitude of the price move that day.

Exhibit 12.  Gas Share Of Generation Growing
Gas Share Of Generation Growing
Source:  EIA

The Energy Information Administration (EIA) recently lowered its peak gas storage estimate to 4,015 Bcf from its prior estimate of 4,096 Bcf.  Consistent with that reduction, the EIA also raised its Henry Hub price expectation for 2012 to $2.55 per thousand cubic feet (Mcf) of gas from its earlier estimate of $2.45.  The EIA is forecasting gas prices to average $3.23 in 2013, a nearly 27% increase over this year’s upwardly revised price.  Some of us are even more optimistic suggesting natural gas prices could hit $4/Mcf by the end of the year, which admittedly will be during the winter demand period.

Exhibit 13.  2012 Natural Gas Prices
2012 Natural Gas Prices
Source:  EIA, PPHB

In Exhibit 13, we charted the daily price of natural gas futures for 2012 to date.  The red circle shows the price move experienced last Thursday to demonstrate how dramatic that increase was relative to the path of gas prices this year.  The chart also highlights how significant the gas price decline has been in response to the absence of normal heating demand last winter and continued growth in domestic gas production.  As we wrote in our last Musings, we are starting to see a decline in gas production, but no one is clear how much of the decline is due to normal well production declines coupled with lower dry gas drilling and voluntary cutbacks by producers.  We mention this last point because we found it interesting that it was never cited by any of the analysts discussing the market dynamics of Thursday.  The message is that commodity traders often react to simplistic analyses of complicated markets.  The prime market driver remains the emotional reaction to a difference between a market headline and trader expectations. 

Rio 20 Opens Tomorrow – Will It Be A Repeat of 1992? (Top)

Tomorrow is a momentous day in the climate change/global warming/environmental/climate skeptic world.  Rio 20, the shorthand name for the United Nations Conference on Sustainable Development, opens in Rio de Janeiro, 20 years after it was last there.  Twenty years ago, the meeting was known as the United Nations Conference on Environment and Development, and became the first Earth Summit.  The approach of that first global environmental summit was to build on the views of the 1972 doomsday book, The Limits To Growth, published by the Club of Rome.  The book’s premise was the planet was on a ruinous course due to overpopulation, poisoning of our land and water from overuse of fertilizers and health protecting chemicals, and increasing air and water pollution due to growing consumption of fossil fuels.  From that meeting came the United Nations Framework Convention on Climate Change that set in motion the dialogue among nations that led to the 1995 Kyoto Protocol agreement in which industrialized countries agreed to reduce their greenhouse emissions by between six and eight percent from 1990 levels and for those reductions to be achieved between 2008 and 2012.  President Bill Clinton signed the Kyoto Protocol, but because a treaty requires the affirmative vote of two-thirds of the U.S. Senate to be binding, he elected not to send it to Congress given the opposition from not only Republicans but also a number of influential Democrats.  President Clinton suggested the treaty should be presented to Congress in 2001 following the 2000 election.  We assume he anticipated that Vice President Al Gore would be his successor so the treaty would get due consideration.  Florida and the Supreme Court upended that scenario.

Rio 20 will have a Clinton-flair to it as Secretary of State Hillary Clinton will be attending representing the United States.  We doubt President Barack Obama will be attending as he did when the conference was held in Copenhagen.  You may remember he flew there to try to broker a climate agreement and at one point actually burst in on a meeting organized by other countries.  While the President may not be in Rio, his ideas about how to treat fossil fuels compared to green energy will be represented.  The conference agenda lists three objectives for the meeting: 1) Securing renewed political commitment to sustainable development; 2) Assessing the progress and implementation gaps in meeting already agreed commitments; and 3) Addressing new and emerging challenges. 

According to a story on Times 24/7, the web site of The Washington Times, the agenda for the Rio conference calls for the nations to agree to the creation of a tax on fossil fuels in order to fund clean energy development in less developed economies.  The copy of the agenda was obtained by the Center for a Constructive Tomorrow, a group skeptical of the UN’s position on global warming.  It says, “We recognize that subsidies for non-renewable energy development should be eliminated and replaced with a global tax on the production of energy from non-renewable energy sources.”  The agenda goes on to state, “The income of this tax should be allocated to renewable energy development.”  The tax rate will be between 0.015 and .020 percent of a nation’s gross domestic product to fund development assistance for least developed countries. 

The British Broadcasting Company reports that the proposed tax would help pay for the Green Climate Fund “which will eventually gather and disburse finance accounting to $100 billion (£64 billion) per year to help poor countries develop cleanly and adapt to climate impacts.”  This program is similar to one proposed by President Obama in a letter to Congress last year regarding ending subsidies for oil and gas and using the money to finance the development of green energy.  You may remember that idea didn’t go very far.  Therefore, we wonder how President Obama will deal with the UN’s tax proposal, which has been estimated will cost each American family $1,325 per year? 

Danger Ahead: Reserve Confusion And Faulty Conclusion (Top)

The latest annual statistic study of the energy business issued by BP (BP-NYSE) was released last week.  It highlighted how supply disruptions boosted oil prices, but free markets were able to handle the shortages.  At the same time, long-term energy demand trends remain in place.  This is the 61st edition of the highly regarded report, not just for its scope and insight into energy trends, but also for its lengthy and consistent energy data series enabling analysts like us to examine historical industry trends seeking insights into the future of all energy fuels.  No sooner had the BP report been issued, but we saw an energy stock market newsletter use data from the report to make its case about the potential for peak oil.  The title to their research note was “This Chart Destroys the Idea of Peak Oil.”  The newsletter went on to opine, “Here is a graph that we believe cast serious doubt on peak oil theory — the idea that we are imminently in danger of exhausting the world's hydrocarbon supply.” 

Exhibit 14.  Growing Global Crude Oil Reserves
Growing Global Crude Oil Reserves
Source:  BP, Capital and Energy

After making the claim that the chart in Exhibit 14, which shows consistent growth in the amount of the world’s proved crude oil reserves, demonstrates the world is not in danger of running out of oil supply, contrary to peak oil claims, the newsletter editor acknowledges that BP has a more nuanced view of the data.  According to BP, "The world is not structurally short of hydrocarbon resources – as our data on proved reserves confirms year after year – but long lead times and various forms of access constraints in some regions continue to create challenges for the ability of supply to meet demand growth at reasonable prices."  In essence, this is the nub of the peak oil debate – is it a peak in productive capacity or the exhaustion of total available reserves?  An issue in trying to answer this question is defining crude oil reserves. 

The term reserves can be very nebulous.  The volume of oil in a reservoir, including both producible and non-producible oil, is called “oil in place.”  Because reservoir characteristics vary and production technology may be limited, only a portion of the oil in place will be produced.  It is this portion of the reservoir’s oil that can be considered as reserves.  Even then, there are further challenges for defining the volume of reserves because they need to be technically-producible as well as economically-producible, meaning that existing technology and prices makes the effort to produce the reserves profitable.  The portion of total reserves that meets these definitions are then divided into proved developed (producing) versus proved un-developed, i.e., not producing currently but can be with time and investment.  The value of E&P companies is primarily the estimated net worth of all the proved developed reserves with a discounted value for the proved undeveloped reserves.  The discounted value is a function of what it will cost the oil company to bring these reserves into production and how long it may take.  It is important to keep in mind that the determination of the amount of reserves in a field is tied to the physical characteristics of the reservoir, the state of extraction technology and the price of the oil produced.  Technology improvements and higher oil prices over time will have a meaningful impact on the volume of reserves determined to be proved.

Exhibit 15.  Higher Oil Prices Increases Oil Reserves
Higher Oil Prices Increases Oil Reserves
Source:  BP, PPHB

The traditional issue in any debate about non-renewable resources is confusion between total resources available and proved reserves.  We have witnessed this confusion in discussions about the volume of shale resources in this country.  We worry that politicians and energy professionals are convinced that all these shale resources are, will be and will remain forever, profitable.  It is this belief that enables analysts to take the gas shale potential estimates from organizations such as the Potential Gas Committee, divide them by current gas consumption rates and thus conclude that the nation has 90-100 years of gas supply, thereby supporting unbridled growth in the nation’s use of gas.  This “Don’t worry, be happy!” philosophy carries the potential for the nation’s energy strategy and energy investments to be misguided.  Given all the variables involved in estimating gas resources, we’re more comfortable worrying!

New York State Fracturing Plan Emerges – Battle To Come (Top)

The New York Times wrote last week about a plan being developed by the administration of Governor Andrew Cuomo of New York to allow horizontal drilling and hydraulic fracturing in portions of five struggling counties along the Pennsylvania border referred to as the Southern Tier.  Importantly, the areas to be opened would be communities that have expressed support for these technologies.  The plan being developed by the New York State Department of Environmental Conservation targets the deepest areas of the Marcellus Shale formation in the western part of the state.  Activity would be prohibited in areas such as near aquifers and nationally designated historic districts along with the Catskill Park.  There are thoughts that the plan’s details were leaked to The New York Times as a trial balloon to assess the reaction from anti-shale groups. 

Exhibit 16.  New York State Proposed Fracking Areas
New York State Proposed Fracking Areas
Source:  The New York Times, PPHB

The plan envisions requiring drillers to maintain a 1,000-foot buffer between ground water sources and the top of the shale formation, in an attempt to ease residents’ concerns about possible water pollution.  There are other location (setback) restrictions that might reduce the number of well locations, but could increase the number of wells and their length from the drilling pad locations allowed.  These setback restrictions are being cited by some leaseholders as a problem because if a single drilling pad cannot be located within a single 640-acre section due to setback rules that property might not be drilled costing the landowner income.  Possibly, these inaccessible areas might be able to be reached by extended horizontal wells, but that will add further to the cost of these wells.  We have seen estimates that the restrictions in the proposed Cuomo plan could eliminate drilling on about 60% of the leases held in New York State.

Exhibit 17.  NY Fracking Zone Next To PA Gas
NY Fracking Zone Next To PA Gas
Source:  EIA

As seen in Exhibit 17, drilling in Pennsylvania has stretched from the southwest corner of the state, which tends to have more oil and liquids-rich gas, to the northeast portion of the state that tends to be “dry” gas oriented.  It is this dry gas region that lies just south of the area of New York State that may be available for shale development if the suggested plan is approved.  This plan has been developed in response to the state’s restriction on shale drilling in mandated until adequate study of how gas shale could be developed and potential risks mitigated.  The temporary ban on shale drilling in New York State was initiated in 2008.  Since then about 25 communities have banned the use of hydraulic fracturing while another 75 have put in place moratoria on the technology until additional rules and safeguards were enacted.  One restriction the state has put in place is a restriction on drilling and fracturing in the watershed areas for New York City and Syracuse.  After an extended prohibition period, the start of drilling may be drawing near.  We expect plenty of fireworks over the rumored proposal when it is finally presented.  Unfortunately, the claims and counterclaims by proponents and opponents to gas shale development will obscure the fact that this resource can be developed in an environmentally-friendly and safe manner for the benefit not only of residents of New York, but for all power customers throughout the New York, New England and Middle Atlantic regions of the country. 

Rhode Island Should Wish It Had Oil And Gas Resources (Top)

The Rhode Island state legislature finished its annual session last week.  Reading and listening to the news, we harkened back to that old Texas expression that you hold onto your wallet when the legislature is in session in Austin.  That seems to be an apt expression for the Rhode Island legislature meeting on Smith Hill in Providence.  Taxes are going up in Rhode Island, but the politicians continue to bank on questionable revenue assumptions, in particular banking on growth in gaming revenues.  An article in The Providence Journal focused on a chart showcased by a Rhode Island state senator during the budget debate showing where the state’s revenues came from.  His chart attempted to point out how dependent Rhode Island is on revenues from slot machines and a gambling casino.  This gaming dependence is dangerous as neighboring Massachusetts is moving forward to approve six new casino sites, four of which will ring Rhode Island.

Exhibit 18.  Rhode Island Dependence On Gaming
Rhode Island Dependence On Gaming
Source:  RISC

Rhode Island currently depends on gaming revenues for nearly 11% of its budget.  This dependency has grown over time.  In fact, gaming revenues have more than doubled over the past 10 years, and are up 50% over the past four years.  The danger is if the Massachusetts casinos are built, Rhode Island’s gross gaming revenue could be cut in half over the next four years (Exhibit 19) forcing the politicians to look for new revenue sources elsewhere. 

Exhibit 19.  Massachusetts Could Ruin RI
Massachusetts Could Ruin RI
Source:  RISC

Unfortunately, Rhode Island was not endowed with fossil fuels to exploit.  A March article in The Columbus Dispatch focused on the role of oil and gas taxes in easing the tax burden for Ohio’s citizens during a debate about revising the state’s oil and gas taxes. 

Exhibit 20.  Selected State Oil And Gas Income
Selected State Oil And Gas Income
Source:  The Columbus Dispatch

It is interesting how different states have used the revenues from their oil and gas severance taxes to fund their governments.  Surprisingly, Texas was not on that list, which is because its oil and gas income amounted to only $2.6 billion last year, or 6.6% of the state’s $39 billion in tax revenues.  In a 2011 study of America’s top states for business prepared by CNBC, ten factors were considered: cost of doing business; workforce; quality of life; economy; transportation and infrastructure; technology and innovation; education; business friendliness; access to capital; and cost of living.  The top state economically was North Dakota with Rhode Island ranked 42nd.  Texas came in at 14th place.  In the overall state rankings, Virginia was first, with Texas in second place.  Rhode Island brought up the rear in 50th place.  I doubt all the offshore wind farms the state may build will ever replace the 11% of Rhode Island’s tax revenues coming from gaming.  They probably will never contribute even 6.6% of the state’s spending.  Oh for an oil or gas well or two.



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

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