By Allen Brooks,

Managing Director, PPHB

Expanding Offshore Regulation: Flying Below Radar Screen

We recently attended the 40th annual meeting of the National Ocean Industries Association (NOIA) in Washington, D.C., which was focused on the current state of the offshore industry along with a heavy emphasis on current economic and political trends, with the latter being of great interest for the attendees.  Attendees are always interested in the intersection between politics and regulation, which ultimately impacts the economic health of the domestic offshore oil and gas industry.  One of the panels dove into a topic – offshore regulation – that has not received much attention from the energy industry press or from offshore producing and service company managements.  

This is a topic that should be receiving greater attention and, in fact, some worry that how regulation is currently being conducted, may alter the historical working relationship between offshore service companies and their clients.

The past few years have been a watershed for the domestic offshore energy industry.  On April 20, 2010, when the Deepwater Horizon drilling rig, owned by Transocean Ltd. (RIG-NYSE) and working for BP p.l.c. (BP-NYSE), suffered a well blowout, caught fire and sank taking with it the lives of 11 offshore workers.  BP’s Macondo well blowout unleashed the largest oil spill in the history of the Gulf of Mexico and upended the workings of the entire offshore market.  

The offshore industry was engulfed in dealing with the well disaster while at the same time organizing a massive oil spill clean-up effort.  The U.S. government sprang into action, but often found that the laws and procedures for dealing with a situation such as Macondo were not clear and in some cases inadequate.  The Deepwater Horizon and Macondo disasters ignited a festering anti-oil industry feeling among the American populace and a large segment of the U.S. political establishment.

 If the oil industry wasn’t liked before Macondo, it was hated after!  Not only were lives lost in the accident, but the continued spewing of ugly black oil that washed up on the beaches of the Gulf Coast was witnessed not only from onshore, but could be seen 24/7 on TV and computer screens globally, courtesy of underwater cameras held in place there by remotely operated vehicles operated by offshore service companies.

The three primary players in the disaster – BP, Transocean and Halliburton (HAL-NYSE) – represented elements of the petroleum industry people and politicians disliked.  BP, a foreign oil company that had built its U.S. presence by buying up American oil companies, was run by British executives who seemed to be inept and more importantly, tone-deaf to the anger of Americans.

 Transocean, a leading offshore drilling contractor, had been one of the many oilfield service companies that abandoned the U.S. for lower-taxed jurisdictions around the world during the great wave of corporate inversions despite the criticism by Washington politicians.  Lastly, Halliburton, which had once been led by former Vice President Dick Chaney, a man hated by the Left and many Americans who opposed the Iraqi war, completed the trifecta.  

This was an industry trifecta that even the most ardent opponent of the oil industry couldn’t have dreamed up in a scenario of how an industry could self-destruct.  More importantly, this was a trifecta that was at war with each other over who was at fault in causing the disaster.  T

he Deepwater Horizon accident ushered in a new environment of critical review and new regulation for the offshore oil and gas industry.  Only weeks after embracing the idea of opening up parts of the U.S. East Coast for oil and gas development, the Obama administration was forced to reverse itself.  Not knowing what to do, and frankly not possessing any expertise in how to deal with the offshore industry, the Obama administration used the disaster as an opportunity to expand the federal government’s control over the industry.  

The long-standing problems at the Department of the Interior over its handling of Indian royalty income coupled with the sex, drug and payola scandals involving Minerals Management Service (MMS) inspectors just a few years earlier provided the impetus for a thorough examination into how the agency worked and whether it could be made to work better.  To work better, in this case, meant providing stricter regulation.

On May 19, 2010, Secretary of the Interior Ken Salazar signed Secretarial Order 3299 that established the Bureau of Ocean Energy Management (BOEM), the Bureau of Safety and Environmental Enforcement (BSEE) and the Office of Natural Resources Revenue (ONRR).  These three organizations were charged with carrying forward responsibilities that previously had been conducted by the MMS.  According to Secretary Salazar, the purpose of the reorganization was to address “conflicting missions” carried out by the current MMS that necessitated they be separated in order to eliminate the conflicts.  At the time of the announcement, Secretary Salazar said the reorganization is “not the first nor the last reform” of MMS, and subsequent actions support that statement.   

 Initially, the MMS was renamed the Bureau of Ocean Energy Management, Regulation and Enforcement (BOEMRE).  Michael Bromwich, formerly a partner and head of the internal investigations, compliance and monitoring practice with the law firm of Fried, Frank, Shriver & Jacobson LLP, and before that the Inspector General in the U.S. Department of Justice, was appointed the director of the agency.  In revising the regulation of the offshore oil and gas industry, Mr. Bromwich set in motion a policy that is quite radical based on the nearly 65-year history of regulation of offshore drilling in U.S. waters.  

The new policy was revealed in a speech Director Bromwich delivered at the 2011 Offshore Technology Conference in Houston.  In that speech, he said he wanted to announce two new major developments being initiated by his agency.  One dealt with how information about well permitting would be conducted in the future and the other dealt with regulations about entities that operate offshore.  It is this latter development that provides the substance of concern for oilfield service companies operating offshore.

Quoting from Director Bromwich’s prepared remarks we can see both the substance of the regulation, but just as importantly the inherent danger in how this regulation is being handled – what is and should be of great concern to offshore oilfield service company managements.  

Director Bromwich stated:  “Second, I have mentioned several times in recent weeks my interest in exercising regulatory authority over not only offshore operators but contractors as well. It has struck me as inappropriate to limit our authority to operators if in fact we had legal authority that reached more broadly to the activities of all entities involved in developing offshore leases. We have completed our review of the issue and have concluded that in fact we have broad legal authority over all activities relating to offshore leases, whether engaged in by lessees, operators, or contractors. We can exercise such authority as we deem appropriate. The reason for our historical practice that has focused solely on regulating operator was that it served to preserve clarity and the singular responsibility of the operator. I am convinced that we can fully preserve the principle of holding operators fully responsible -- and in most cases solely responsible -- without sacrificing the ability to pursue regulatory actions against contractors for serious violations of agency rules and regulations. We will be careful and measured in extending our regulatory authority to contractors.”  (Emphasis added.)

The current regulatory blanket that has been thrown over the offshore service industry hasn’t stirred much discussion or apparent concern among company managements, but the fact that the federal government has made this determination without citing any statutory authority should give pause. 
This policy was reiterated in a response to a question following a presentation to the NOIA meeting by James Watson the current director of BSEE.  Quite possibly company managements do not understand that they are now subject to regulation.  

It is possible they do not know because there haven’t been any actions by BSEE other than to issue “Incidents of Non-Compliance” (INC) to Halliburton and Transocean relating to the Deepwater Horizon accident.  Since those INCs were related to that disaster, other offshore service company managements may not appreciate their new regulatory status.  In a presentation dealing with this issue, attorneys Paul Smyth and Robert Thibault with Perkins Coie, LLP pointed out some of the problems with the way in which BSEE is conducting offshore service company regulation.  Besides there being no identified statutory authority for the regulation, there are no definitions of exactly who is covered, nor are there standards for performance set forth.  

As they pointed out, and even highlighted by Director Bromwich in his OTC speech, the historical regulatory process involves legal arrangements agreed to between Lessees (oil companies who hold the offshore lease) and the federal government.  Under that arrangement, the standards for performance are spelled out and the process allowing the government to bring a claim for non-compliance is set forth.   

In this case, the lack of authority and definition of performance standards can lead to revisionary interpretation of actions.  We all understand how perfect hindsight is.  Additionally, there is no process for dealing with the government’s claims and thus there are no limits as to the nature or source of a company’s possible exposure or to the extent of the government’s reach in extending its jurisdiction.  This regulatory situation is the equivalent of driving your car around a town with no speed or warning signs and then being subjected to the judgment and interpretation of rules by the traffic officer writing you a ticket.    

Messrs. Smyth and Thibault warned their audience that until either this regulatory scheme is rescinded by BSEE or overturned by the courts, the managements of offshore service companies should consider the potential impact this regulation could have on their businesses.  That means understanding the impact on operations, insurance coverage and even corporate governance, including regulatory filings for public companies.

 Companies should consider implementing, or at least reviewing, regulatory compliance programs.  Existing service contracts should be reviewed for clarity over risk-sharing and indemnification terms and even pricing arrangements.  Public companies also need to consider the adequacy of their business risk disclosure in their filings with the Securities and Exchange Commission.  

All of this is good advice, but the better solution would be for the government to follow the correct legal process and either establish authority for this regulation and its rules, or abandon the regulatory over-reach.  On the other hand, the offshore service industry needs to acknowledge its potential regulatory exposure and prepare to deal with it, or be willing to face the consequences should an issue develop.

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 and planning for the future.  The newsletter is published every two weeks, but periodically events and travel may alter that schedule. As always, I welcome your comments and observations.   Allen Brooks

PPHB 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.

By Allen Brooks, Managing Director, PPHB

Wishing MSM Understood Difference Of Product And Crude

The New York Times columnist Thomas Friedman wrote a column in late February about an email he received from energy economist Phil Verleger with the enticing title “Should the United States join OPEC?”  The email outlined some of Mr. Verleger’s thoughts about how the debate over who is responsible for high gasoline prices is missing the point about a significant shift in U.S. energy output that has once again made us a major oil producer and potentially an exporter.

We have not seen a copy of this email, but it appears evident from reading the column that Mr. Friedman, who professes to be a student of energy and the environment, doesn’t understand the difference between crude oil and refined petroleum products, a critical failing when making this argument.    

Mr. Friedman starts with a discussion about how successful the ethanol in gasoline mandate, coupled with the auto industry’s embracing higher fuel-efficiency requirements, has been in driving down gasoline demand.  As Mr. Friedman writes, “When this [the ethanol mandate] is combined with improved vehicle fuel economy — in July, the auto industry agreed to achieve fleet averages of more than 50 miles per gallon by 2025 — it will inevitably drive down demand for gasoline and create more surplus crude to export.”  Mr. Friedman would be smart to research that fuel-efficiency deal in order to understand the perversion of the rules to enable “green cars” to be counted multiple times toward the overall fleet fuel-efficiency rating.  With that gimmick the auto manufacturers, especially the Big Three in Detroit, will be able to sell more pickup trucks and big cars diluting the actual mile-per-gallon measure to about 44, some 12% less than the target.   

Mr. Friedman goes on to quote from Mr. Verleger’s email about how this surplus crude position can increase.  He wrote, “Add to that, says Verleger, ‘the increase in oil production from offshore fields and unconventional sources in America,’ and that exportable U.S. surplus could grow even bigger.”  Whoa!  It seems that neither Mr. Friedman nor Mr. Verleger understand the difference between crude oil and product.    It seems everything has been driven by the Energy Information Administration’s (EIA) report that the United States has become an exporter of petroleum products for the first time since 1949.  The chart from the EIA in Exhibit 10 shows the history of our petroleum product imports and exports and how in 2011 we achieved this net export position.

It has been achieved largely by the decline in our gasoline consumption, which over the past few years has allowed the U.S. to reduce gasoline imports from Europe.  The impact can be seen by the decline in imports that commenced in the mid-2000s.  At the same time, the U.S. increased its distillate exports in response to the colder winters and the need for more home heating oil and increased use of diesel fuel for vehicles that cannot be met from European refineries.   

 Exhibit 10.  U.S. Now A Refined Products Exporter  

Source:  EIA  

Mr. Friedman goes on to bring in the growth of natural gas production as a factor changing the domestic energy market.  He writes, “Then, add the recent discoveries of natural gas deposits all over America, which will allow us to substitute gas for coal at power plants and become a natural gas exporter as well. Put it all together, says Verleger, and you can see why America ‘will want to consider joining with other energy-exporting countries, like those in OPEC, to sustain high oil prices.  Such an effort would support domestic oil and gas production and give the U.S. a real competitive advantage over countries forced to pay high prices for imported energy — nations such as China, European Union members, and Japan.’”    

This point leads Mr. Friedman to quote from a Bloomberg News article that stated “’the U.S. is the closest it has been in almost 20 years to achieving energy self-sufficiency. ... Domestic oil output is the highest in eight years. The U.S. is producing so much natural gas that, where the government warned four years ago of a critical need to boost imports, it now may approve an export terminal.’  As a result, ‘the U.S. has reversed a two-decade-long decline in energy independence, increasing the proportion of demand met from domestic sources over the last six years to an estimated 81 percent through the first 10 months of 2011.’

This transformation could make the U.S. the world’s top energy producer by 2020, raise more tax revenue, free us from worrying about the Middle East, and, if we’re smart, build a bridge to a much cleaner energy future.”  The key for creating this energy nirvana is for environmentalists and the oil and gas industry to embrace safer ways to produce domestic energy.  Mr. Friedman is hopeful that President Obama can make this happen.  If we believe Mr. Friedman, then President Obama’s lobbying Democratic Senators to vote against an amendment that would have removed presidential approval of the Keystone pipeline permit was the correct thing to do since we can achieve this energy nirvana without any help from Canada.   

While Mr. Friedman’s scenario is interesting to contemplate, his failure to understand the difference between crude oil and refined petroleum products is a major flaw in the analysis.

Domestic crude oil production peaked in 1971, yet the United States was a net importer of refined product starting in the mid-1950s, meaning that despite the country being self-sufficient in crude oil supplies, it was not self-sufficient with refined product.  This meant that from the 1950s until the early 1970s, America lacked adequate capacity to refine all its oil into the necessary volumes of petroleum products – gasoline, diesel and jet fuel – needed by the economy.  One must remember that the post-World War II period marked the beginning of an economic boom in America that created our modern consumer economy.    

We understand that Mr. Friedman is admired and followed by many people – the same people who are now repeating this misleading fact that the United States is an oil exporter.  According to the EIA, for the week ending March 2nd, the U.S. imported 8.7 million barrels per day (bpd), a decline of 475,000 bpd from the prior week.  However, the EIA also pointed out that the latest four-week average of crude oil imports was 8.9 million bpd, up 766,000 bpd over the same four-week period in 2011.  Quoting from the EIA’s weekly report, “Total products supplied over the last four-week period have averaged 18.3 million barrels per day, down by 6.1 percent compared to the similar period last year.”  What this demand statistic means is that our crude oil imports represented 48.6% of total petroleum product demand.  That certainly doesn’t put the U.S. close to being a crude oil exporter.     

All of the twisted logic of Mr. Friedman’s column leads him to argue that the U.S. is on the cusp of becoming an energy exporter and thus the government should institute a policy that puts a floor under current high oil prices such that should they decline, consumers would have to pay the current high price with the difference being taxed and sent to the government.  It is amazing what government policies can come from misunderstanding the basics of an industry, but that has happened for almost the entire history of our country.  History, however, doesn’t excuse the failure of pundits such as Mr. Friedman from doing some basic research.  Unfortunately, we know this to be a failing of Mr. Friedman’s since he admonished his reader to ignore the scientific evidence (ice cores) about global warming when it didn’t fit with his preconceived ideas.  Our advice is: read Mr. Friedman’s columns with a ton of salt.

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 and planning for the future.  The newsletter is published every two weeks, but periodically events and travel may alter that schedule. As always, I welcome your comments and observations.   Allen Brooks

PPHB 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.

By Allen Brooks, Managing Director, PPHB

Wind Energy An Obama Favorite But Is It a Real Winner?

Every president works hard to achieve his agenda, but maybe none has worked as cynically as our current president.  Since coming to office, President Barack Obama has pushed a “green energy” agenda that is promoted by a large portion of the Washington establishment - from the Energy, Interior and Treasury Departments to the Environmental Protection Agency (EPA) and school lunches.  School lunches?  Why yes.  If you haven’t been paying attention, the war on obesity – a continually evolving definition – has been linked to the sins of fossil fuels that enabled people to move to the suburbs to escape the cramped and dirty conditions of the cities.  By doing so, however, those urban refugees became gasoline addicts.  Moving to the suburbs with their green lawns and trees forced people to commit to the automobile.  

That shiny new car is cited as the primary contributor to obesity among our youth due to depriving them of the opportunity to exercise by having to walk or ride bikes to school.  Furthermore, the automobile facilitated that great social invention – the drive-through.  It’s ok to drive through at the drug store or maybe even at a liquor store (we have).  The problem is that the biggest beneficiary of this invention has been the fast food industry – the purveyor of high caloric, salty and trans-fat loaded food, which lies as the root of all our health woes.    

While the obesity/fossil fuel link is a relatively new development, Mr. Obama’s love for green energy and distain for fossil fuels is long-standing.  In his recent State of the Union address, the President shocked his supporters by seemingly embracing fossil fuels as he announced he was calling for exploiting more than 75% of the nation’s offshore oil and gas resources.  He went on to extol the virtues of shale gas, and even claimed that the breakthrough technologies responsible for its success had been developed by government R & D.  The President’s green-energy supports fear his pivot on energy.  They noticed that Mr. Obama delivered his State of the Union speech without once mentioning climate change.

While Mr. Obama’s environmental supporters were downbeat following the State of the Union speech, a few weeks later they were heartened when he presented his budget calling for large spending increases for the Energy and Interior Departments and the EPA in furtherance of the green agenda.  Included in the proposed spending increase spending was $310 million for the SunShot Initiative, designed to make solar electricity cost-competitive with traditional energy, without subsidies, by 2020 and $95 million for wind energy technologies.  Mr. Obama is again pushing the extension of the wind energy Production Tax Credit (PTC) and an extension of the Treasury Cash Grant Program (Section 1603 of the American Recovery and Reinvestment Act) that expired in 2011.  Under the PTC, wind power developers receive a tax credit of 2.2-cents per kilowatt-hour of electricity produced during the first ten years of operation.  

A 50 megawatt wind farm operating at an average capacity utilization of 30% would generate 131,000,000 kilowatt-hours of electricity per year.  The wind farm’s owner would receive a PTC of $2,891,000 per year, or $28,910,000 over 10 years.  Section 1603, however, allowed wind turbine owners to take a cash grant equal to 30% of a project’s capital costs up front ($100-120 million project cost, 30% = $30-36 million) that came directly from the U.S. Treasury – whether or not the turbine ever produced any electricity.  This tax credit removes the performance risk for the developer and allows marginally economic projects to get built even if all the capital from private investment sources is not present.  There is no expectation of having to repay any of his tax credit money back.  Because the money is taken up front rather than annually, there is no incentive for developers to keep up the costly maintenance, so the turbines can eventually be abandoned.

The Interior Department recently came out with its environmental assessment giving its blessings for development of wind energy projects offshore New Jersey, Maryland, Delaware and Virginia.

This approval should make it easier for companies to secure offshore leases, although site specific environmental approvals would still be needed.  The bigger hurdles for offshore wind are costs and financing, along with technical challenges.  The Interior Department, at the direction of the Obama administration, developed the National Offshore Wind Strategy, which has a goal of installing 10,000 megawatts of wind generating capacity by 2020 and 54,000 megawatts by 2030.

Those scenarios include development in both federal and state offshore areas, including along the Atlantic, Pacific and Gulf coasts as well as in the Great Lakes and Hawaiian waters.    

The great attraction for the Atlantic coast is that its shelf area is large so that turbines can be placed far enough offshore so as to not be an eyesore for residents, but close enough to not present significant technological challenges for the industry to install and maintain them.  For the offshore market that can be a significant issue, which suggests that the first offshore wind farms will likely be along the East Coast.  It may have been the administration’s announcement of its environmental assessment that prompted the release by North Carolina Governor Bev Perdue of the final report of the Governor’s Scientific Advisory Panel on Offshore Energy.  

The panel’s work spanned two years and involved not only meetings and working sessions for the members and its staff but also three public meetings seeking input from the state’s citizens. The panel concluded, “This panel’s work is an essential step in assessing the impact of offshore-energy development in North Carolina.  But taking the next steps to develop offshore energy will require a united effort to assess the impacts on North Carolina’s economy, communities and natural resources, to promote economic development of offshore energy that boosts North Carolina’s economy and to establish North Carolina as a leader in offshore-energy development.”

The panel found that North Carolina has the largest offshore wind resource on the east coast.  “The offshore-wind industry may offer significant opportunities for renewable energy generation and for economic development and job creation.”  This conclusion was based on the state’s extensive coastline and its offshore wind resources.  As shown in Exhibit 5, the potential sites for offshore wind development are fairly close to the coast and importantly to interconnections with the power grid.   

Shortly after reading about the North Carolina report and examining its conclusions, we learned about a new study published in the National Academy of Sciences magazine, which was prepared by researchers from Carnegie Mellon University suggesting that hurricanes could destroy a significant number of offshore wind turbines if they are located along the Atlantic and Gulf coasts.

The authors focused on the likelihood that a hurricane could topple turbines in waters where projects are under consideration or development.  This becomes an important research consideration because of the frequency of hurricanes that target areas where the government believes it is appropriate to place wind turbines.  It is also important because 20 offshore wind farms have been proposed for the U.S. coastline.

The chart of the tracks of hurricanes recorded from 1851 to 2007 shows three “hot” spots around the globe – the Atlantic and Gulf coasts of the U.S., the Pacific coast of Mexico, and Southeast Asia.  It is important to note that for about a third of the time period identifying hurricanes was not always possible, regardless if accurate records of the storm paths were kept.  It is possible there were many more storms than recorded in the past because they did not intersect with population centers or ships at sea.  

Regardless of missed storms, there is little doubt that the planned location of U.S. offshore wind farms makes them targets of future hurricanes.  The flip side of the analysis is that where the number of offshore wind farms is growing - around England and off the coast of Northern Europe – there are no hurricanes.  There are sometimes violent storms, but they tend to be rarer than hurricanes and not as severe.  

The Carnegie Mellon study examined the potential damage for a 50-turbine wind farm off the coasts of four states: North Carolina, New Jersey, Massachusetts and Texas.  The authors fed historical data about hurricane occurrence and intensity into a probabilistic model.  They simulated potential damage to the turbine towers over several 20-year periods and then took an average of their results.  The towers were based on those currently in use to support 5 megawatt offshore turbines.    

According to the researchers’ model, Category 3 or greater hurricanes (those with wind speeds of 50 miles per hour or more) could buckle up to 46% of the traditional turbine towers. Hurricanes of that severity are not rare in the United States.  According to weather records, every state in the Gulf Coast and nine of the 14 states on the Atlantic Coast were struck by a Category 3 or greater hurricane between 1856 and 2008.    

The riskiest of the four locations investigated, with a possibility of a 60% chance that at least one tower would buckle in a 20-year period and a 30% probability that more than half the towers would be destroyed, was off Galveston County, Texas.  The second riskiest location was Dare Country, North Carolina where there is also a 60% probability of one tower being destroyed, but only a 9% chance that more than half of the turbine towers would be destroyed.  

Wind farms off Atlantic County, New Jersey and Dukes County, Massachusetts were considered less risky.  What’s the solution to protect against this potential storm damage?  First would be to build in less risky areas.  The mid-Atlantic and New England regions are less exposed because they experience fewer and less intense hurricanes.  The second strategy would be to build smarter turbines.  

That means turbines that can always point into the hurricane-force winds, which reduces the potential for them to buckle, rather than being hit broadside.  The problem is that keeping a turbine pointed into the wind during a hurricane is complicated.  Wind speeds vary and they change direction in a matter of a minute or two.  Turbines would need strong motors to be able to turn quickly enough to cope with the changing winds.  They also would need to be able to sense the wind direction.  Lastly, many of the turbines run on grid power, which is often lost during hurricanes, so they would need battery backup adding both capital and maintenance costs to the project. 

The study produced a chart showing the risk of a Category 3-4-5 hurricane making landfall along the U.S. Atlantic and Gulf coasts.  As shown in Exhibit, the risk is greatest along most of the Gulf Coast, the tip of Florida and the Outer Banks of North Carolina.  Two of these three locations are where companies or politicians would like to see offshore wind farms located. 

Since the governor of North Carolina has trumpeted the offshore wind potential of her state, we thought it would be interesting to examine the number and path of major hurricanes that have landed on the state’s coastline.  If they build offshore wind farms we certainly hope the future weather resembles the pattern of the 1966-2010 years rather than the earlier 45-year span.                      Source: Klotzbach and Gray, CSU

N.C. Is Risky If Storms Follow 1921-65   

Source:  Klotzbach and Gray, CSU

If it weren’t for those pesky details of hurricanes, utilization and cost, offshore wind power would seem like a winner even with coastal residents hating the visual pollution.  But as we watch the President extol the virtues of his green energy agenda, we are starting to believe we are Dorothy with her three companions starting down the yellow brick road in the Land of Oz.  In this case, we are accompanied by President Obama (the virtualist), Sec. Chu (the theorist) and Administrator Jackson (the restrictionist).  What

we are afraid of is that when we get to the Emerald City, Oz will be just as disappointing as in the movie.

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 and planning for the future.  The newsletter is published every two weeks, but periodically events and travel may alter that schedule. As always, I welcome your comments and observations.   Allen Brooks

By Allen Brooks, Managing Director, PPHB

Can’t People Find A New Way To Regulate O&G Industry?

On January 18th, Representative Denis Kucinich (D-Ohio), along with five liberal Democrats in the House of Representatives, introduced a bill that displays not only a lack of understanding about the basics of business, but also champions some of the most failed government economic policies of the past 40 years.  

The bill, H.R. 3784, otherwise known as the “Gas Price Spike Act of 2012,” would, as its preamble sets forth: “…amend the Internal Revenue Code of 1986 to impose a windfall profit tax on oil and natural gas (and products thereof) and to allow an income tax credit for purchases of fuel-efficient passenger vehicles, and to allow grants for mass transit.”  For this group of politicians, profits are as dirty as the crude oil they are derived from.  While the preamble sets forth the premise of regulating energy industry profitability, the proposed mechanisms in the bill demonstrate the worst of a social engineering mandate.    

The premise of the bill is the mantra that fossil fuels are bad and the “excess” profits they produce should be confiscated by the government and handed over to the buyers of politically-correct, fuel-efficient vehicles and the operators of mass transit systems.  What’s worse about the policy is that not all fuel-efficient vehicles would benefit, only those assembled in this country by union labor.    

So just what are “excess” profits, or for that matter “reasonable” profits?  To answer those questions, we would have to await the determination by the Reasonable Profits Board, which would be a three-member board appointed by the president for three-year terms.  (Sounds like Rep. Nancy Pelosi and Obamacare.)  Once they figure out what is an acceptable profit for the oil and gas industry, the law would levy an excise tax of 50% of the excess profits between 100% and 102% of that reasonable profit measure.  For excess profits between 102% and 105%, the excise tax would be 75%, and anything above 105% would be taxed at 100%.    

One of the requirements to serve on this board is that you don’t work in the industry.  We would hope, however, that the members would at least understand business and the respective measures of profitability.  That might stand in contrast with many of President Obama’s economic and cabinet appointees.  What should be the test of “reasonable” profits?  Should it be the absolute dollars?  Or maybe it should be the company’s profit margin percentage.  There is also a case to be made that profitability should be measured based on return on equity.  Whichever measure is used, there will be problems in determining what’s reasonable, since reasonableness should be based on the capital needs of the industry.   

Exxon Mobil Corp. (XOM-NYSE) generated a 9.1% profit margin last year, but that was over two percentage points below the margin of Chevron (CVX-NYSE).  More importantly, while those oil company profit margins exceeded those of GM (GM-NYSE) and Ford (F-NYSE) at 6.6% and 5.1%, respectively, Apple (AAPL-NYSE) had a 25.8% margin, Microsoft’s (MSFT-NYSE) was 32.6%, and Google’s (GOOG-NYSE) was 25.7%.  So why should oil companies be punished given their low profit margins?  Just because ExxonMobil earned $41.1 billion last year and Chevron $26.9 billion, admittedly very large numbers, they were nowhere near as profitable as some of our high tech powerhouses.  If you look at return on equity, Apple (45.6%) and Microsoft (41.7%) were way more profitable than ExxonMobil (26.8%) or Chevron (11.4%).    

We know, we’ll devise a new “Buffett rule.”  Berkshire Hathaway (BRK.B-NYSE) for the twelve months ended September 30, 2011, earned $11.6 billion in net income.  The problem is that its profit margin was only 8.2%, only besting the beaten up auto companies.  On a return on equity measure, Berkshire Hathaway only mustered a 7.6% performance, coming in last among all these companies.  No Buffett rule here.  Even GM had a 26.2% performance through September, but then again it had all its debt stripped away by the Obama administration’s restructuring (we won’t use the term bankruptcy).  A recent article in The Wall Street Journal pointed out how GM hopes to report profits of $8 billion for 2011, a nice recovery, but then again the article pointed out that the company is not paying any taxes as a result of its bailout.  (Above figures from Yahoo Finance.)

What gets lost in this populist assault on the oil and gas industry is its size and capital-intensive nature.  Last year, ExxonMobil generated $453 billion in revenues while its major U.S. competitor, Chevron, earned $236 billion.  These numbers compare to Apple’s $127 billion, Microsoft’s $72 billion and Google’s $38 billion.  The two auto companies – GM and Ford – were similar in size to Apple at $149 billion and $134 billion, respectively, but more importantly, they are comparable to Berkshire Hathaway’s $142 billion in revenue.  Because the oil companies are so large, their profit numbers are going to be large even with modest profit margins.  To punish them due to their absolute size would be akin to requiring all National Basketball Association players over 6-feet 10-inches tall to have to wear 10-pound ankle weights during games to counter their height and ability to jump.    

Assuming there are excess profits to tax, where would the funds go?  First, they would go to buyers of fuel-efficient passenger vehicles.  Buyers would get a $3,000 tax credit for a vehicle with a fuel-efficiency rating within 10% of the most fuel-efficient vehicle.  Buy a car with a rating within 5% of the most fuel-efficient and you would get $4,500.  But if you buy a car that gets at least 65 miles per gallon, you get a $6,000 tax credit.  This latter category would  include all the electric vehicles, some hybrids and a select number of very small cars, many of which have been arbitrarily assigned very high mileage ratings.    

The most interesting point in this section of the legislation is the definition of what is a Qualified Passenger Vehicle.  While that classification includes measures such as having been purchased after the effective date of the legislation, being first used by the owner and only for personal and not business use, the car has to be American-made.  Moreover, as subparagraph B of the section states, a qualified car is one “which is assembled in the United States by individuals employed under a collective bargaining agreement.”  Assuming you want this tax credit, your vehicle shopping list will be limited to models from Chrysler, Dodge, Jeep, Ford (F-NYSE) and General Motors (GM-NYSE).  You also could choose from Mazda Motors’s (MZDAF.PK) Mazda 6 and Tribute models and Mitsubishi’s Eclipse.  Otherwise, you’re out of luck.    

Any left over money collected can be given out by the Secretary of Transportation to operators of mass transit systems to help them reduce fares during gas price spikes.  Mass transit means rail and bus systems, but the grants are made on a fiscal year basis and remain in effect until funds are expended.  Nowhere in this bill is there a definition of a gas price spike – so we guess it has already happened.  Without a definition, we wonder what happens if oil and gas prices decline?    The Lima News in Lima, Ohio editorialized that Rep. Kucinich’s bill would do little but guarantee the return of gasoline lines such as the nation experienced in the 1970s.  

Those lines came partly as a result of the shocks to the petroleum system from the quadrupling of crude oil prices following the Arab oil embargo after the Six Day War in 1973, and the Iranian Revolution and capture of American hostages in 1978.  The reactions to these events prompted politicians to become involved in directing how the flow of oil and gasoline moved in this country and controlling product prices to protect consumers.  That meddling in the business produced little more than long lines of cars at gasoline stations and restrictions on the amount one could purchase on a visit.    

The reason for the gasoline lines was that the government relied on population statistics to allocate gasoline volumes.  As these statistics were notoriously late, and especially before the widespread use of computers, gasoline volumes were always allocated based on historical population measures that were out of date.  The only question was just how out of date they were.  The statistics failed to capture the mass population migration from the Rust Belt states to the jobs Mecca of the oil producing states.  

As a result, states like Ohio and Michigan had areas swimming in gasoline and no lines while Dallas, Houston and Tulsa, to name a few oil-centric cities, had horrendous gasoline lines and rationing.  The experiments ofregulating the industry proved that bureaucrats didn’t have the ability to anticipate demand changes and their regulations masked the price signals that appropriate allocate petroleum products.    

A different situation occurred in the 1980s after the Iranian Revolution when President Jimmy Carter signed into law the Crude Oil Windfall Profits Tax Act.  That law imposed a 70% excise tax on the amount of an oil sale price exceeding $12.81 per barrel.  According to the Congressional Research Service, domestic oil output declined by 3%-6% and oil imports rose by 8%-16%.  Due to the recession’s impact on the economy, oil demand fell, bringing oil prices down and causing the tax to generate very little revenue.    

With this bill, Rep. Kucinich and his band of followers have committed the folly of planning to repeat history because they haven’t taken the time to know their history.  As a result, they will prove Albert Einstein’s definition of insanity correct – repeating the same thing over and over and expecting a different result.  We are not sure which is the worse criticism - the claim of insanity or of ignorance?  These politicians clearly don’t understand anything about business, only about politics, and for that Americans will suffer.

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 and planning for the future.  The newsletter is published every two weeks, but periodically events and travel may alter that schedule. As always, I welcome your comments and observations.   Allen Brooks

By Allen Brooks    

Managing Director

Parks Paton Hoepfl & Brown 

What’s The Outlook For Energy Stocks?

Just like oil and gas prices, energy equities have been highly volatile in recent months.  Of course, one could say the same thing about the overall stock market, interest rates and the value of currencies.  Everything seems to be keyed to whatever the early morning headlines say about the latest developments in Europe – collapse of the euro; riots in response to austerity plans; another sovereign debt crisis; or euphoria over agreements among warring countries to bail out a sinking economy.  Long-term investment strategy is caught up in anticipating the overnight headlines – about a 12-hour cycle!

In the latest Big Money Poll taken in late September by Barron’s magazine and published at the beginning of November, 52% of surveyed portfolio managers were bullish or very bullish compared to only 17% who were bearish or very bearish. 

The bullish percentage was down from last spring’s poll that showed 59.5% of portfolio managers were bullish.  Sentiment, however, remains quite positive as 90% of the portfolio managers said they would be net buyers of stocks over the next 6-12 months.

On the economy, only 12% felt there would be a double dip recession with more than three times the number saying it was “unlikely.”  Overwhelmingly they believe that the U.S. economy will be mired in slow growth (1-2% per year) for an extended period of time. 

Only 15% of the portfolio managers think the economy can grow at 2.5% or better, which just happened to coincide with the first estimate by the federal government for third quarter’s gross domestic production growth.  (Within that growth estimate are mixed signals about the health of the economy and where it may be heading, however.)

It was very interesting that 56% of the managers believe growth stocks will outperform value stocks.  At the same time, 68% of them said that the best performing stocks would be large cap stocks while only 15% believe small caps will lead the parade.  That seems to be somewhat of a conflict since growth is usually associated with smaller companies while large caps tend to be more value oriented and slower growing.

With this outlook, it was quite interesting to see the latest Top 100 Best Small Companies list as compiled by Forbes magazine.  Among this group of companies, there were three oilfield service companies and one E&P company.  It is important to understand that this list was compiled on the basis of past performance and not future prospects. 

To qualify, a company had to have been publicly traded for at least a year, generate revenue between $5 million and $1 billion and have a share price higher than $5.  The rankings were based on earnings growth, sales growth and return on equity for the past 12 months and over the last five years.  The final qualifying statistic was the relative share performance versus the company’s peer group.  The significance of making this list, as Forbes points out, is that last year’s members outperformed the Russell 2000 small-company index by an average of 10 percentage points.

The three oilfield service companies included at number 18, offshore driller Atwood Oceanics, Inc. (ATW-NYSE) with sales of $628 million.  In the number 75 slot was the world’s largest manufacturer of ceramic proppants used in fracturing oil and gas formations, Carbo Ceramics Inc. (CRR-NYSE) with sales of $539 million.  The number 88 company was Chart Industries Inc. (GTLS-OTC), a manufacturer of products for purifying, distributing and storing liquid natural gas, with sales of $662 million.  The only E&P company to make the list at number 71 was GeoResources, Inc. (GEOI-OTC) with sales of $112 million and player in the two hottest American oil shale formations – the Bakken and the Eagle Ford.

So what about the outlook for energy stocks?  In light of the continuing economic weakness and financial turmoil, prospects for commodity prices and E&P spending in 2012 are not robust.  In was interesting, however, that in the Barron’s poll, of the ten industry sectors, 12% of portfolio managers picked energy to be the best performing sector over the next 6-12 months. 

That percentage put energy as the number two industry sector.  In the worst performing ranking, only 5% of managers listed energy, helping it finish in the top half of all sectors and tied for second place.  In other words, investment pros don’t seem bothered by a questionable economic and industry outlook next year.  Maybe that reflects the belief that in a slow-growth economy energy demand will continue to hold up reasonably well, supporting oil and gas prices at levels where companies can make money and, more importantly, continue to spend money to develop new resources.

With the Dow Jones index up about 5% over the past 12 months (through November 1) and the Standard & Poor’s 500 index up 3%, energy stocks have either held their own (OSX +3%) or outperformed (EPX +7%; XOI +10% and XNG +17%).  The latter group of commodity-oriented sector indices have probably benefitted from the strong performance of their dividend paying members.  Investors have struggled for the past few years to find investments providing higher income than that available in debt markets, and as

a result have turned to energy companies and master limited trusts.  Portfolio managers are well aware that investors will continue to seek out high-yield securities and energy stocks are high on that list, which may continue to drive performance over the next year.  If commodity prices crater in response to a weak economy or another credit crisis, energy company earnings will suffer and so will their payouts, in the mean time investors chasing yield will keep energy stocks in the race.

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 and planning for the future.  The newsletter is published every two weeks, but periodically events and travel may alter that schedule. As always, I welcome your comments and observations.   Allen Brooks  

By Allen Brooks, Managing Director

Parks Paton Hoepfl & Brown

Admiral Allen (Ret.) Has Family Chat With Offshore Execs

The National Ocean Industries Association (NOIA) fall meeting was held the week before last.  The breakfast speaker on the final morning was Coast Guard Admiral Thad Allen (Ret.), the National Incident Commander for the Macondo oil spill and the principal federal officer dealing with the government’s response to Hurricanes Katrina and Rita.  He also was in charge of the Coast Guard’s response to the 9-11 attacks, which included organizing the evacuation of an estimated 300,000 citizens from lower Manhattan following the collapse of the twin towers and the 7 World Trade Center building.

Admiral Allen requested from the audience permission for his talk to be “among family,” which we interpreted to be an “off the record” discussion.  Therefore, we cannot quote from his talk or give many details.  However, we can report on some of his themes and pointers he offered the offshore industry executives in attendance in order to help them manage any future offshore disaster or accident.

The last time Admiral Allen spoke to this group was at NOIA’s 2009 spring meeting in Washington, D.C.  As he strode into the meeting room for his talk, he had a cell phone glued to his ear, which he put away as he walked to the podium.  Transocean’s Deepwater Horizon rig had exploded the night before and was listing and burning creating a serious pollution and safety situation for the Coast Guard.  As he hung up his phone, Admiral Allen informed us he had been talking with Secretary of Homeland Security Janet Napolitano as they were coordinating arrangements for a White House briefing on the incident scheduled for later that day.  With a month of duty remaining before his retirement, little did Admiral Allen know that he shortly would become the most important government figure in the oil spill and clean-up effort.

President Obama recognized (or it was pointed out) Admiral Allen’s leadership talent and named him the National Incident Commander.  While that position conferred important legal powers on Admiral Allen, including becoming the chief government briefer to the media about the oil spill and response efforts, it forced him to embark on one of the steepest learning curves imaginable and put him in the middle of what rapidly became a highly politicized event.

Admiral Allen admitted he had no idea what a blowout preventer was until he showed up on the doorstep of Cameron International (CAM-NYSE) seeking to be educated.  As he quickly discovered, the government had no knowledge or capability to deal with the well blowout, yet politicians at all levels and the general public were clamoring for solutions to the blowout and spill.  Politicization of the spill response was one of Admiral Allen’s themes.

As he explained, the laws governing oil spills are clear about the obligations of the responsible party.  Unfortunately, there were some gray areas within the laws governing oil pollution that had not been clarified following their revision following the Exxon Valdez oil tanker spill in Alaska in 1989, even though Admiral Allen had pointed out the need for them to be addressed during a meeting with the then-incoming Homeland Security Secretary in late 2008.  As he regaled the audience with the details of the challenges of capping the well, his over-arching theme was the disruption and frustration created by the need for politicians to be seen as actively representing their constituents.  These needs often created agendas in conflict with the technical challenges of stopping the spill and the logistics of the cleanup effort, but maybe more importantly they took time and energy away from the task of managing the response.

During the spill, we always felt that the response effort resulted in the active parties being improperly deployed.  For example, it seemed to us that the oil industry, led by BP (BP-NYSE), should have been in control of the effort to stop the spill while the government should have been handling the logistics of the clean-up effort.  That would have been, in our mind, the proper use of the respective parties’ expertise.  Dividing the responsibilities in that manor would not have relieved the responsible party, in this case BP, from having to pay for the cost of the cleanup, but it would have probably made the effort more focused, coordinated and possibly quicker.  After Admiral Allen’s talk, we had a better understanding of why things happened the way they did.

One of the key lessons Admiral Allen preached to the executives was the powerful role of the social media and why it is important for companies, whenever there is a problem, to get involved in the discussion immediately.  As he pointed out, the discussion will begin with or without the company being involved and in a position to disseminate correct information and dispel rumors and false information that would otherwise come to dominate the story.  He quoted Winston Churchill’s famous line that “A lie gets halfway around the world before the truth has a chance to get its pants on.”  Admiral Allen’s message is critically important for companies dealing with accidents or false rumors, but most companies are not masters of the process – something that really needs to be established beforehand.

Following his presentation, Admiral Allen was reminded by a questioner about his last presentation to NOIA.  The questioner wondered what it would take for Admiral Allen to be willing to go back to the White House, but the idea behind the question was for him to become the resident as opposed to being a visitor.  The comment drew a warm round of applause as this audience recognized there was a real leader in the room.

The “Great Crew Change” Carries Potential Risks For Industry

Over a decade ago, petroleum industry human resource officials began focusing on the demographics of the industry and their companies.  What they saw was a rapidly aging work force that created numerous challenges for companies, not the least of which was how were they going to obtain the necessary technical staff they felt they needed to manage their long-term growth.  The demographic challenge became known as the “Great Crew Change” because it fit with the practice of the industry to have groups of workers (crews) switch off with others workers after the first group had worked a certain number of hours in the day or weeks in the month.

For most of the early years of this century’s first decade, the great crew change impact was focused on the lack of students enrolling in petroleum-related scientific disciplines leading to positions such as geologists, geophysicists and petroleum engineers.  According to data from industry consultant IHS, the peak age for oil and gas technical personnel was 43 in 2000, which rose rapidly to 50 in 2006.  Projections show the peak age will reach 60 in 2012.

The bad news for the industry was summarized in a study produced by Schlumberger Business Consulting (SLB-NYSE) showing that by 2014, only 17,000 new petro-technical professionals would enter the workforce while 22,000 would be retiring, or a net shrinkage of 5,000 skilled workers.  IHS projected that half the petroleum industry is likely to retire within the next 10 years placing a significant strain on the ability of the industry to continue to grow as it has in recent years.  The Schlumberger study also found that due to the industry’s growth – both domestically and internationally – the recruitment target for technical staff in 2011 was 15% greater than the levels anticipated in 2009, further pressuring company capabilities and escalating wages and overall compensation in response to the pressure to hire staff.

A 2007 study on industry hiring prepared by executive recruiting firm Boyden in conjunction with the University of Houston’s C.T. Bauer School of Business pointed out that between 1982 when the industry’s last great boom ended and 2000, according to the American Petroleum Institute, some half a million jobs were lost in the petroleum industry.  At the time of the study, the authors put the average age of management and technical personnel in the petroleum industry at between 48 and 50.

In the middle of the decade, professors at Duke University conducted a study to determine whether the United States was actually falling behind the rest of the world in producing technically-trained youths that would imperil the nation’s global lead in this area.  What the study concluded was that for every one million citizens, the United States was producing 750 technically-trained specialists compared to 500 for China and 200 for India.  Those figures would seem to belie the idea that the U.S. was losing its edge in highly technical industries such as the petroleum industry.

The recent National Petroleum Council (NPC) study on the resource potential of North America had a section on macroeconomics and the energy business.  One subject addressed in that section was the energy industry’s labor force challenges.  It was also a subject touched on in a presentation we attended about the NPC study presented by one of the study’s leaders.  The charts in the NPC study of the age distribution of various scientific disciplines important for the operation of the petroleum industry showed the challenges confronting the industry by a rapidly aging employee population.

One chart showed the age distribution of the members of the Society of Petroleum Explorationists (SPE) in 1997 compared to 2010.  The chart showed how the peak age of the group has increased from about 42 years old to about 52 years.  According to the figures, approximately 52% of SPE members are in the baby-boomer generation or older compared to only 38% for the general U.S. population.  The energy industry has an old labor force!

A significant percentage of petroleum engineers and geologists working in the industry are within 10 years of retirement.  An analysis of the age distribution of the various technical disciplines important to the oil and gas industry shows that 61% of the members of the American Association of Petroleum Geologists (AAPG) and 69% of the members of the Society of Exploration Geophysicists (SEG) are 45 years old or older.  In contrast, the average age of hydrologists (water scientists), a hot new academic discipline given the growing attention being paid to our water supply problems, shows a much younger peak age, somewhere in the 31-40 age category as new scientists have been attracted to the perceived long-term growth prospects for the industry.

Within the government sector, 72% of geologists and 75% of petroleum engineers are 45 years or older.  Moreover, given the recent restructuring of the former Minerals Management Service, the resulting new agencies are actively recruiting technical talent.  While the federal government has been actively recruiting on college campuses, the petroleum industry’s needs have driven starting salaries and annual bonus opportunities to levels making it difficult for the government to compete.  As a result, these new agencies are beginning to recruit retired petroleum industry technical staff hoping that lower salaries are less of a concern for scientists probably already collecting private industry pensions.  If this recruitment effort proves successful, it is likely that the percentage of government technical employees 45 years or older will rise significantly.  For the government, the great crew change is underway and maybe accelerating.

An annual study of enrollment in petroleum engineering studies is conducted by Dr. Lloyd Heinze at Texas Tech University.  It shows that enrollment peaked in 1983 and then declined rapidly along with the fortunes of the petroleum industry.  Enrollment remained relatively low throughout the 1990s and early 2000s before starting to climb after 2005.  But as pointed out by the NPC leader in his presentation, it is probably “too little, too late.”

That too little, too late outlook is shown in the chart above that projects the geoscientist workforce compared to three different outlooks for their demand.  The chart clearly shows a growing gap between trained workers and the number of workers needed in the future.  A problem in trying to correct this situation is the lack of university staff to educate the new scientists.  This shortage reflects a shifting of university staff to scientific fields that do not lead to developing the target set of skills needed by the oil and gas industry.  Correcting this staffing problem is an even greater hurdle than attracting new students to the scientific disciplines.

The troubling aspect of this great crew change is the potential cost to the industry.  J. Ford Brett, managing director of PetroSkills, spelled out the potential cost in a magazine article.  He suggested that if demographics result in about 20% of industry personnel having less than five years of experience, companies should expect about a 20% reduction in performance.  In 2006, he pointed out, the E&P industry spent $170 billion, meaning that the lack of training could cost the industry about $35 billion.

We also wonder about the sea change underway in the C-suite of energy companies.  As a result of past industry down-cycles, layers of younger managers and technical staff were let go in cost reduction efforts.  Those workers were never replaced leaving significant voids in the age spread of employees.  Today, the industry is actively pushing younger and somewhat less experienced employees into positions of leadership within companies.  Without the opportunity to have made small managerial or technical mistakes in their earlier jobs, we wonder whether the industry is setting itself up for larger failures as these younger managers gain “on the job” education.  We hope this will not be the case, but increasingly we are hearing from older industry professionals, especially those nearing retirement, who believe there is a strong possibility of this scenario unfolding.

We have also heard of energy companies hiring technical consultants to comb through their internal scientific information to help their staffs identify what information is already known by the organization, although maybe not known by the individuals.  This is a recognition that company managers really don’t know what they know or what they don’t know, because they just don’t know what information exists within their four walls.  The consultants are often brought in because they have older employees who can identify the information the younger workers don’t know.  This is a potentially scary situation that needs to be monitored closely.  The executive leadership change is a risk that many retiring managers and board members must be aware of and point out to the newly promoted individuals.  Managing risk is the primary responsibility of managers and directors, and the impact of the great crew change is rapidly becoming a critical risk for companies and the industry.

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 and planning for the future.  The newsletter is published every two weeks, but periodically events and travel may alter that schedule. As always, I welcome your comments and observations.   Allen Brooks

By Allen Brooks, Managing Director

Parks Paton Hoepfl & Brown

New Auto Efficiency Standards Arrive As Oil Prices Collapse

Literally days before Standard & Poor’s downgraded the United States’ credit rating, the Obama administration negotiated a deal with the automobile industry to boost the corporate average fuel economy (CAFE) standards for 2017-2025 from 35.5 miles per gallon (mpg) to 54.5 mpg.  Under the standard in place until 2016, which had been increased in May 2009 by President Obama from the prior legislated standard enacted under the Bush administration, the automobile industry is supposed to achieve a fleet average of 35.5 mpg.

This year’s CAFE standard calls for an average of roughly 25 mpg.  Under the standard that was legislated during the Bush years, the rise was anticipated to go from 25.3 mpg in 2012 to 30.0 mpg in 2016.  On announcing the increase in the current standard, President Obama declared, “The status quo is no longer acceptable.”  Wasn’t that the truth!  Here we are barely two years later and we are witnessing a bold move to nearly double vehicle fuel efficiency in just over a dozen years.

The new 54.5 mpg standard by 2025 will be achieved by getting autos to average 62 mpg and light trucks 44 mpg.  The newly agreed-to standard is actually about two mpg below what the Obama administration had initially proposed, which the auto industry had pushed back on.  Even the auto workers union was concerned about the higher standard as they saw it as a potential job killer if the industry couldn’t meet the new stricter regulations with domestic vehicles.  As the government and the industry negotiated, the Obama administration gave up some of its goal in return for assurances that the auto industry could meet the new higher standard by introducing new technologies.

The more one learns about the deal, however, the more it appears it may have been a repeat of the Obama health care legislation.  As you may remember, then House Speaker Nancy Pelosi (D-CA) told her members that “you have to vote for the bill to find out what’s in it.”  Isn’t it wonderful when substantive legislation impacting a large segment of the economy and our future choices of automobiles and light trucks isn’t known until after the legislation is enacted?

On the other hand, as we are learning, many of the details in this legislation were negotiated by Ron Bloom, the former car czar and current Assistant to the President for Manufacturing Policy, and the various car companies on a one-by-one basis.  The details suggest this negotiation may have been much like a modern-day version of Bob Barker’s Let’s Make A Deal television show.

The newly negotiated CAFE standards have lots of deals – credits – to help the auto makers meet the tougher standards by acting in ways the White House wants them to act.  Behind the deals are the Obama administration’s twin goals of cutting carbon dioxide (CO2) emissions from vehicles and getting one million electric vehicles on the nation’s highways by 2015.   The problem is that the latter goal is probably unrealistic given a lack of battery charging infrastructure and the expense of electric vehicles (EV).  The former goal is driven by a belief in climate change science that is proving highly suspect and will create upheavals in our economy that will produce both known and unknown costs.

By Allen Brooks, Managing Director

Park Paton Hoepfl & Brown

A recent issue of Forbes magazine carried an article by three business school professors who have studied the world’s most innovative companies for the past eight years, which is the subject of their book, The Innovator’s DNA.  The professors’ efforts were directed to trying to identify those companies that are consistently innovative and to determine the particular skills that set their managers apart from the rest of the corporate world.

The five skills of disruptive innovators that were identified by this effort were summarized in the article and we quote them below.

“• Questioning allows innovators to challenge the status quo and consider new possibilities;

• Observing helps innovators detect small details – in the activities of customers, suppliers and other companies – that suggest new ways of doing things;

• Networking permits innovators to gain radically different perspectives from individuals with diverse backgrounds;

• Experimenting prompts innovators to relentlessly try out new experiences, take things apart and test new ideas;

• Associated thinking – drawing connections among questions, problems or ideas from unrelated fields – is triggered by questioning, observing, networking and experimenting and is the catalyst for creative ideas.”

What the professors observed is that there is a significant stock market premium assigned to companies identified as the most innovative companies.  The professors worked with the people at HOLT, a subsidiary of Credit Suisse (CS-NYSE) to identify and measure this premium.  The innovation premium is the value investors assign to a company’s stock market valuation that reflects their belief that the company will launch new offerings and enter new markets that will generate even bigger income streams in the future.

The innovation premium is calculated by projecting a company’s income (cash flows in this case) from its existing businesses, plus anticipated growth from those businesses, and looks to the net present value (NPV) of those cash flows.  Then the NPV is compared to the company’s current market capitalization.  Companies that have a current market capitalization greater than the NPV of its cash flows have an innovation premium built in to its valuation.  The professors were quick to point out that this valuation method does not correlate with substantial investor returns, so just because a company is one of the best innovators doesn’t mean that Wall Street necessarily agrees.

The professors go on to point out that their method of determining the innovation premium contrasts with conventional reports that draw on surveys of corporate managers asking them to name the companies they consider to be the most innovative.  The rating method adopted by the professors relies on investors who buy and sell stocks to identify those companies they expect to be innovative today and tomorrow.  Within that context, it was interesting to see that the oilfield service industry accounted for six of the top 100 companies.

Included in the group of leading innovative oilfield service companies are the two largest companies in the industry – Schlumberger and Halliburton – and two of the leading drilling equipment companies – FMC Technologies and Cameron International.  The remaining two companies among this cadre were foreign companies – China Oilfield Services and Tenaris SA.

The first two companies are not surprising since they possess probably the broadest range of drilling and completion products and services and they are known for their R&D efforts to develop new oilfield products.  The second pair of companies represents the preeminent developers of new drilling hardware for use both on- and offshore, but they are best known for their offshore equipment.  The last companies on the list are somewhat surprising since Tenaris’ tubular business is known more as a commodity business than for new technology.  China Oilfield Services is also a surprising selection since it provides a range of services offshore China, but they are not particularly innovative.  We suspect these latter two companies may be more beneficiaries of investment funds trying to participate in the China and European energy markets through these foreign-based companies than rewarding them for their innovative DNA.

Since companies had to have a market capitalization of $10 billion or greater to be included in the analysis, many of the more dynamic and innovative companies in the oilfield service industry were excluded because they were too small.  Despite their exclusion, it is possible to utilize the five key characteristics identified by the professors to look for future innovative winning companies.

Please go to www.pphb.com for full details.

PPHB 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.

Allen Brooks, Managing Director

Park Paton Hoepfl & Brown 

Gas Shale Debate Creates Strange Producer Economic Analysis

As we wrote in our last Musings, the debate over gas shale well profitability not only has gone mainstream, but it has quickly degenerated into character assassination yielding little of value from the discussion.  As distressing as that is, we believe there is plenty of room for a fair debate over gas shale data, facts and their interpretation without stooping to personal attacks.  We were somewhat surprised by the lack of credible intellectual arguments put forth recently by Dr.Terry Engelder a professor of geosciences at Pennsylvania State University.   

Dr. Engelder heads a team at Penn State that developed the initial estimates of the massive Marcellus shale formation covering areas of Pennsylvania, New York, Ohio and West Virginia.  It is one of the hottest gas shale plays in the country due to its extent and belief in its gas resource potential, but also because of its proximity to the huge, gas-hungry East Coast market.  As the Marcellus underlies areas of large population concentration, it has become the battleground over the use of hydraulic fracturing to unlock the trapped gas.  

Environmental and anti-fossil fuel lobbies have teamed up to attack gas shale development as being unsafe for citizens.    The primary attack against gas shale development is that hydraulic fracturing can damage drinking water sources, although there are no documented cases of it happening.  There are cases of poor well drilling practices having allowed produced gas to seep into nearby water wells, but this is not due to fracturing.  The obtuse argument made by some industry critics is that if it didn‘t use hydraulic fracturing then wells wouldn‘t produce so the opportunity for gas to seep into water wells wouldn‘t exist.  That‘s all well and good, but it doesn‘t help our energy supply picture.  

Under the Obama administration‘s convoluted thinking that requires everyone to buy health insurance policies to spread health costs, they should be making landowners drill wells to keep natural gas prices down.    On the issue of water well poisoning, Dr. Engelder is on record demonstrating that hydraulic fracturing is not the cause of well problems in Pennsylvania.  But Dr. Engelder has less credibility when he weighs in on the issue of gas shale well economics.  In an article for The Houston Chronicle by Jennifer Dlouhy based on a conference call with Dr. Engelder sponsored by the American Petroleum Institute, he is quoted saying, "There‘s a disconnect between industry and their particular statements about what this business is — and it really is a long-term investment — and Berman‘s view that it has to pay off in a relatively short period of time."    

Mr. Arthur Berman, a consulting geologist and long-standing critic of gas shale economics, has repeatedly stated in presentations that his clients demand relatively short payback periods.  So when he evaluates gas shale prospects for his clients, usually independent oil and gas companies, he has to take into account the time required to pay out the wells‘ investment, which is a function of the wells‘ production and their cost to drill and complete, along with the present value of that money.  If a similar cost well requires twice as long to pay out as another well, the longer payout well will generate a lower rate of return.  For producers who prize higher returns, they value E&P projects with faster paybacks.   

An article in FirstBreak, published by the European Association of Geoscientists & Engineers (EAGE), written by Rudd Weijermars, a professor in the department of geotechnology at Delft University of Technology, and Steve Watson, a professor at the Ashridge Business School, discussed the impact of technology deployment and rolling investment decisions for improving the performance of unconventional field development projects.  In the article, the professors discussed the differences in economic decisions when developing conventional versus unconventional resources.  We quote the two key paragraphs below.  "In conventional gas projects, significant upfront investments are made to tap into the whole of the interconnected gas reservoir at once, applying a tailor-made and optimized field development strategy.  The present value of conventional gas fields is continually maximized by applying a rigorous value assurance review (VAR) system, using pre-determined decision gate-stages as part of the company‘s auditable records.  As a result of the established VAR process, cash flows of traditional or conventional gas projects invariably perform adequately and deliver high IRRs.  In contrast, field development plans for unconventional gas operators are highly susceptible to economic pressures.    

The traditional VAR process does not provide a guarantee for profitable unconventional gas operations.  A fundamental handicap for unconventional gas development projects is that optimized well development and maximization of net present value are marred by much higher subsurface uncertainty.  There is no gas interconnectivity between wells in unconventional reservoirs and the lack of gas communication means appraisal well data give very limited information over the rest of the acreage under leasehold or licensed.  High variations in reservoir quality cannot be excluded by initial appraisal wells.  Sweet spots only emerge gradually and after considerable expenditure has been made while the drilling of new wells advances to cover the acreage acquired.  The initial risk in new unconventional gas plays is therefore very large.

Opting out also remains a hard decision throughout the field‘s development as that would mean deferred losses are moved closer to recognition.    At the heart of the argument is the difference in investment time horizons and the gas production curves of the wells that generate the returns producers count on when beginning projects.  In the exhibits nearby, we show the plots of the two different well types – conventional and unconventional.  From looking at the unconventional gas chart, the projected gas curve resembles a tight gas or coalbed gas well rather than a gas shale well, but the analysis is similar.  An interesting side note is the amount of taxes paid by producers in a conventional well versus an unconventional well, which would seem to be important for federal, state and local governments desperate for revenues.

By Allen Brooks, Managing Director, 

Park Paton Hoepfl & Brown

Politics Of Oil Rises To A New Level With Oil Release

On June 23rd, the International Energy Agency (IEA) called an emergency press conference to announce that its 28 member countries, in a coordinated action, will release 60 million barrels of crude oil from their respective strategic reserves during the month of July. 

Under the arrangement, the U.S. will release 30 million barrels while the remaining 27 countries collectively will offer up an equal amount.  The volume of crude to be put onto the market equates to 2 million barrels per day (b/d), or about 2% of global demand.  The action is being done in response to the “emergency” situation that has developed as a result of the loss of the 1.4 million b/d of oil exports from Libya due to the civil war underway in the country and the 300-400,000 b/d lost from Yemen due to its recent civil disturbances.

The immediate reaction to the announcement was roughly a $4 per barrel drop in crude oil futures prices from the mid-$90s a barrel to the low-$90s.  When the announcement was made that an emergency press conference was being called, analysts, investors and energy economists began scratching their heads trying to figure out what exactly was going on.  

The most popular explanation was that the IEA decision reflected a decision by governments to counter faltering global economies due to high oil prices and the inability of global monetary authorities to boost economic activity through other stimulus steps.  

This was an especially popular conclusion given that U.S. Federal Reserve Chairman Ben Bernanke had told reporters in a press conference the prior afternoon that the Federal Reserve had no idea why the economy was slowing and that the agency would sit tight and not implement another “quantitative easing” program.  Instead, he said that stimulus actions needed to come from the fiscal authorities, e.g., governments.

The questionable emergency is becoming more questionable daily as analysts examine the past experience with coordinated oil releases and they look deeper into the current oil supply/demand balances.  In the United States, current crude oil inventories, excluding the oil stored in the Strategic Petroleum Reserve (SPR), are at the highest level they have been since 1980.  The high level of inventories is largely a function of increased U.S. oil production, the growth in oil imports from Canada, principally due to its expanded oil sands output, and infrastructure limitations that restrict the movement of this inventory from the midcontinent region to the refineries located along the Gulf Coast.

Exhibit 1  Oil Supplies Are Healthy    

Source: IEA

In the IEA’s May oil report, which was based on data through March, total oil stocks in the OECD countries had declined into the mid-point of the 2006-2010 range.  The IEA’s estimated outlook for 2011, based on the continuation of the output cut from Libya and rising demand consistent with a global economic recovery, projects a steady decline in oil stocks through the balance of the year.  

According to the chart, in June total stocks would fall below the bottom of the recent past range of inventories suggesting that global oil prices would rise to ration the oil supply.  With the additional output cut from Yemen, the projected inventory decline could accelerate, however, as the global economic recovery is fading rapidly there would be an offsetting reduction in energy demand.

Exhibit 2.  Global Oil Stocks Falling Absent Libya

Source: IEA

While the total OECD oil stock inventory appears to be reasonably comfortable as of March, the story within two of the three primary markets – the U.S. and Europe – is significantly different.  As mentioned above, U.S. inventories are the highest they have been since 1980.  In Europe, however, inventories are at five year lows.  The lack of Libyan and Yemeni oil output, coupled with falling production in the North Sea, is putting increased upward pressure on petroleum product prices in Europe, which are already very high.

Exhibit 3.  Europe Oil Inventories At Lows And Falling  

Source:  IEA

While the IEA’s outlook may be behind its push for the release of oil stocks, another important consideration is that the lost Libyan oil supply is light in quality and therefore extremely important for the refineries in Europe.  Those refineries are configured to refine the lighter oil and cannot use the heavier, sour crude oil Saudi Arabia has said it will add to the global supply to help offset the lost Libyan output.  This is a reason why the IEA’s coordinated oil release will be primarily light, sweet crudes that can be refined by European and U.S. refineries that should boost the supply of gasoline and diesel, which will help reduce those product prices.

Exhibit 4.  U.S. Divided Into Oil Districts For Control   

Source: EIA

It is this particular crude oil supply release in the U.S. that is creating more questions about the impact it will have on oil and product prices beyond the very immediate term.  The U.S. established a system of monitoring oil supplies during World War II.  Due to the history of where oil was discovered in quantity and thus became the center of the domestic industry, refineries were located nearby.  This has put the U.S. refining center in the Gulf Coast states that comprise PADD 3.  This region is also where the U.S. SPR is located so any oil released will be targeted at buyers operating refineries there.  According to Platts, more than 50% of the nation’s refining capacity is located in PADD 3.

Exhibit 5.  Half U.S. Refining Capacity In Gulf Coast  

Source:  Platts, EIA

When we examine the EIA’s data on crude oil stocks in PADD 3, however, we find that inventories are nearly at a recent high suggesting the refineries are not desperate for additional oil supply.  This may mean that when the EIA seeks bids for the released oil, there may not be many takers.  

The last time there was a release from the SPR following Hurricane Katrina when many of the Gulf Coast refineries were put out of service and then could not secure domestic oil supply due to the damage to offshore pipelines and producing facilities, only 37% of the estimated volume was taken.  That could happen in this situation, also.  Since the released oil has to be replaced by the buyers, we are essentially borrowing supply that will then boost demand in the future.  

The decision buyers will need to make is what price they have to pay for the oil, what profit margin they can make from refining and selling it, and what price they will be able to buy the replacement oil.  As this is written, oil futures are just a couple of pennies under $92 a barrel.

They have subsequently jumped back up to the mid $90s.  If we assume that later this summer oil prices move above $95, will the incremental cost to replace the SPR oil be offset by profits from refining and marketing the output?  We are now hearing that some SPR oil buyers may merely store the oil on tankers parked in U.S. ports for  redelivery later when the futures trades the buyers have entered into are settled.  All that has happened is that some oil traders are locking in profits and not helping the market.

Exhibit 6.  Gulf Coast Oil Supply Very Healthy      

Source:  EIA