musings from the oil patch 010609… · 6/9/2001 · musings from the oil patch musings from the...

MUSINGS FROM THE OIL PATCH

MUSINGS FROM THE OIL PATCH January 6, 2009

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

Is There Any Light Amid The Gloom For 2009? Reading the 2008 year- end economic statistics along with various forecasts for 2009 certainly leave one mired in a gloomy mood

Reading the 2008 year- end economic statistics along with various forecasts for 2009 certainly leave one mired in a gloomy mood. The holiday period is generally a time of good cheer and optimistic expectations, but not this year. Even the prospect of a new U.S. government hasn’t done much to lift spirits depressed by the global financial crisis and the apparent inability to restart the economy. Part of the gloomy mood arises from the shock of how rapidly the credit crisis has impacted the global economy. Another aspect of the gloomy mood comes from the amazing fact that the rule for successful investing – diversification − provided no safe havens in 2008 for investors. Lastly, the deterioration of global economic growth prospects has left people feeling that there is little hope for marked improvement in 2009 and considerable risk the economy may be worse than 2008. With continued falling home prices and rising unemployment coupled with federal government and banking officials seemingly unable to figure out how to fix the economy and credit markets, it is easy to become depressed. Should we be? To answer that question we have decided to devote this entire Musings to an analysis of how we got to where we are, what scenarios might unfold in 2009 and how the energy and oilfield service sector might perform. The conventional wisdom is that economic growth globally will be weak in 2009. More importantly, it may remain weak in subsequent years – or at least remain at a growth rate well below historic rates and below optimal growth. This trend, if it occurs, means consumers will see their incomes grow, but at more modest rates than in recent years. This comes at a time when the economic excesses of recent years have put consumers, investors, businesses and governments

MUSINGS FROM THE OIL PATCH PAGE 2

JANUARY 6, 2009

The idea that housing prices always rose was destroyed in a matter of months, surprising homeowners, housing investors and speculators, mortgage providers and homebuilders What followed in 2006 has to be termed a bubble bursting!

in the position of having to acknowledge they spent too much, borrowed too much and saved too little. Americans, and many other citizens of the world, are being forced, almost overnight, to confront personal balance sheets that have been downsized or inverted with serious consequences for their current living standards and future security and retirement needs. The credit crisis emerged as a serious economic issue in 2007 when the housing market suddenly shifted from riding the up-escalator to falling into an elevator shaft. The idea that housing prices always rose was destroyed in a matter of months, surprising homeowners, housing investors and speculators, mortgage providers and homebuilders. It also surprised economists and government officials. As the chart on existing single-family home sales in the United States (Exhibit 1) shows the peak in housing sales actually came in early 2006. After retreating throughout most of that year, sales spiked in early 2007 but then collapsed as the fall in home prices wiped out recent home buyers’ equity and pushed many of them underwater considering the value of their homes and the balance of their mortgages. Exhibit 1. Home Sales Peaked in 2006; Collapsed In 2007-08

Source: Northern Trust The three year collapse in home prices, as reported by the National Association of Realtors (NAR), followed a spike in prices beginning in late 2004 and ending late in 2005. What followed in 2006 has to be termed a bubble bursting! Prices seemed to stabilize in early 2007 and actually rose somewhat from the 2006 price low. The rise evaporated when the subprime mortgage bubble burst and home foreclosures soared. That started the second leg of the house price collapse. What is most interesting in the NAR data is how stable the rate of increase in home prices had been between the mid 1980s and 2000. The rate of increase in house prices started to accelerate


JANUARY 6, 2009

Once the collapse began in 2006, the two indices fell in lockstep

in the early years of this decade culminating with the spike in 2005. Exhibit 2. Home Prices Collapsed Dramatically Since 2005

Source: Northern Trust As home prices soared and residential home flipping became “a game,” the media began to try to get a better handle on what was happening in the real estate market. Two economists – Karl Case and Robert Shiller – created an index measuring house prices in 10 large cities in the U.S. from 1988. In 2001 the economists expanded the list to include 10 additional cities. While there was some difference in the performance of the indices during the period of the rise in house prices (2002-2004), once the collapse began in 2006, the two indices fell in lockstep. Exhibit 3. Case/Shiller Best Measure of House Prices

Source: Agora Financial


JANUARY 6, 2009

Due to accounting requirements that mandated marking to market all similar assets whenever their value was established via a transaction, balance sheet integrity was questioned Soon all financial institutions began to doubt the trustworthiness of their counterparty balance sheets Since all industrial commodities have long investment cycles necessary for expanding capacity, higher prices became the rationing mechanism to deal with this growing demand

As the subprime home mortgage problem morphed from a housing issue to a credit market crisis, the financial institutions that held these mortgages quickly found them to be “toxic.” The value of these toxic assets eroded rapidly whenever it was possible to determine what they were truly worth. Therein lay the root of the current credit crisis. Financial institutions’ balance sheets were uncertain. Due to accounting requirements that mandated marking to market all similar assets whenever their value was established via a transaction, balance sheet integrity was questioned. As the value of these subprime mortgages plummeted, financial institutions were required to absorb the lost value stripping them of much of their regulatory capital. Financial institutions were ill-prepared for this development since they had been working for most of this decade in an environment of abnormally low interest rates that essentially mispriced financial risk and under lax governmental regulation allowed them to maintain highly leveraged balance sheets (25:1 to 35:1 ratios of liabilities to capital). The credit market woes spread slowly from subprime mortgages to other less-than-solid mortgages. The mortgage problems highlighted the various forms of derivative financial instruments that had been created to enable different classes of investors to benefit from various income streams and correspondingly different risk measures. All these problems further eroded financial institution capital positions. Soon all financial institutions began to doubt the trustworthiness of their counterparty balance sheets. As credit markets discovered that the subprime mortgage problems had spread from the United States to Europe and other countries, global credit markets began to seize up as the lubricant of trust evaporated. While the credit markets were in turmoil throughout 2008, commodity markets emerged as the new asset class darling for investors. They were targeted as a place for “hot money” investors (i.e., hedge funds) to play after investors embraced the orthodoxy of diversifying across all asset classes was the best way to maximize return while minimizing risk. This was the investment model promoted by the Yale and Harvard University endowment funds in 2005. As global economic growth appeared to accelerate, highlighted by the emergence of China and India as emerging economic powers due to their large populations and cheap labor, pressure grew on suppliers of raw materials, petroleum and agricultural crops to meet this increased demand. Since all industrial commodities have long investment cycles necessary for expanding capacity, higher prices became the rationing mechanism to deal with this growing demand. The growth in commodity investing was helped by a weakening U.S. dollar value. This made higher commodity prices less costly in many other countries compared to the United States. For investors, buying commodities was another way to protect portfolios against the declining value of the dollar. That hedging activity further pushed commodity prices up, especially crude oil.


JANUARY 6, 2009

As economic growth continued to stoke the commodity markets, crude oil prices climbed, partially fed by analyst and commodity trader forecasts of ever higher prices Analyst oil price forecasts as of April 8th

The confluence of these forces drove markets. We entered 2008 with crude oil prices just below $100 a barrel, but barely into the year that barrier was passed. As economic growth continued to stoke the commodity markets, crude oil prices climbed, partially fed by analyst and commodity trader forecasts of ever higher prices. What was interesting, however, was that Wall Street analyst forecasts for crude oil early in 2008 were actually lagging well below current oil prices and the outlandish price predictions for future prices. It seemed that the business news shows and media could not get their fill of commodity prognosticators who dutifully produced ever more outlandish forecasts. The $100 a barrel forecast was quickly tossed aside by forecasts such as $150 by July and $300 a barrel within two years. With oil futures price rising steadily, along with gasoline pump prices, Congressional hearings attempted to delve into the forces behind the price rise. When senior oil company executives said they were doing everything they could to prevent oil prices from rising but were being overwhelmed by global economic growth, Congress shifted its attention to those trading in the commodities markets. Exhibit 4. Forecasts Initially Trailed The Market Then Changed

, 2008 Analyst oil price forecasts were raised sharply higher by the middle of 2Q2008

Source: Bespoke Investment Group


JANUARY 6, 2009

In July things began to change The first change was when the oil price failed to meet its latest outlandish price projection - $150 a barrel by July 4

To deflect the thrust of the Congressional hearings, a government study documenting the limited role of speculators and the pressure of fundamental market factors behind the rise in oil futures prices was issued. Oil prices continued to rise in the second quarter along with analysts’ forecasts for future prices. The analysts, executives and investors came to embrace the conventional wisdom – economic growth was behind the rise in commodity prices and demand would continue to rise despite the jump in commodity prices. And besides, even if the U.S., European and Japanese economies slowed due to high commodity prices, the growth in China and India would continue and become the driving force for higher commodity prices. This was how the concept of decoupling of developing economies energy demand from global economic weakness was born. But in July things began to change. The first change was when the oil price failed to meet its latest outlandish price projection - $150 a barrel by July 4

th The growing U.S. financial problems and their potential impact on global economic growth began to be recognized by the stock market

th

Global credit markets continued to worsen, but the U.S. housing and mortgage markets remained the focus of the media. The growing U.S. financial problems and their potential impact on global economic growth began to be recognized by the stock market. The stock market had dropped by 8.6% in the first quarter, which was influenced somewhat by the failure of the investment banking firm, Bear Stearns, but then the market only slipped an additional 3.2% over the second quarter. Given an 11.6% decline for the entire first half, it appeared 2008 would be a challenging year, but certainly not the “lost year” it became for investors. Exhibit 5. Stock Market Damage Really Happened In 4

. While that miss appeared innocuous, other fundamental economic trends began to suggest problems for commodities. U.S. driving patterns were changing and the media was beginning to pay attention. Mileage driven by Americans, something that had first turned down in October 2007, was now reported to be in its seventh consecutive month of decline. Gasoline volumes consumed started to fall and vacation traffic was off from last year. Commuter use of public transportation exploded.

th

500600700800900

100011001200130014001500 2008 S & P 500 Index

Quarter

Source: Yahoo Finance, PPHB


JANUARY 6, 2009

To the market’s low on November 20th

The damage for the stock market began to grow in the third quarter when the S&P 500 fell by 9.0% before plunging by 22.5% in the fourth quarter. The damage in the stock market was substantially worse than the overall quarterly declines suggest. To the market’s low on November 20

, the S&P 500 fell by 35.4% in the quarter 2008 was a year of halves The second half of 2008 was marked by the total collapse in the commodity markets and commodity-related stock sectors

th, the S&P 500 fell by 35.4% in the quarter. That put the overall stock market’s performance on track to be the second worst year in history. If the decline rate in the quarter had continued, 2008 might have ranked as the worst year since the Great Depression. The 20.0% recovery in the S&P 500 index from the market low came as the federal government and the Federal Reserve, in co-operation with various international monetary authorities and foreign governments, aggressively began to execute a financial and corporate bailout plan. Since that plan seems to change almost daily with market developments, there is a huge monetary stimulus underway that will be supplemented with a huge fiscal stimulus following the inauguration of President-elect Barack Obama. Exhibit 6. 2008 Was Third Worst Year in History

Source: Bespoke Investment Group 2008 ranks as the third worst stock market year in history – a decline of 37.6% for the S&P 500 and 36.0% for the Dow Jones Industrial Average. As pointed out above, 2008 was a year of halves. In the first half, the overall S&P 500 Index fell 11.6% but the energy sector turned in an 8.1% positive performance. The second half of 2008 was marked by the total collapse in the commodity markets and commodity-related stock sectors. Energy and materials, which were the only positive performing sectors in the first half, through Dec. 22 were the second and fifth worst-performing sectors, respectively. Defensive stock sectors – utilities, consumer staples and health care – were solid performers in the first half and even better ones in the second half.


JANUARY 6, 2009

Other forecasts call for 2009 to be another difficult year for investing as serious global economic weakness will continue

Exhibit 7. Energy and Materials Only Positive Sectors in 1H08

Source: Bespoke Investment Group Exhibit 8. Energy And Material Stock Prices Crushed in 2H08

Source: Bespoke Investment Group As the year drew to a close, investment fund managers and stock market pundits were all busy issuing forecasts, some of which suggest the best opportunities are in the stock market. Other forecasts call for 2009 to be another difficult year for investing as serious global economic weakness will continue, albeit with some improvement. The U. S. is one year into its officially designated recession so much of the debate about the stock market outlook focuses on whether this recession will be similar to those of the 1980s and 1990s or resemble the long period of economic woes that marked the Great Depression. The average length of a post-World War II recession is 16 months, suggesting that the U.S. economy is close to getting out of this recession. However, because the classic definition of two


JANUARY 6, 2009

What makes this recession more difficult to forecast is that we have a global credit crisis that has not been experienced in recent times Fourth quarter 2008 GDP may fall by 4%-6%

consecutive quarters of negative economic growth will not be met until the fourth quarter of 2008 is reported, the likelihood is that the 2008-2009 recession will last longer than modern recessions. What makes this recession more difficult to forecast is that we have a global credit crisis that has not been experienced in recent times. Usually we have had regional credit crisis at the time of recessions, but not a global one. It is this combination that is making forecasting the economic and financial future of economies much more challenging. Exhibit 9. Will This Recession Be Like 1980s or 1930s?

Source: Prieur du Plessis In the U.S. the economic statistics are dismal. They suggest that fourth quarter 2008 GDP may fall by 4%-6% and that first quarter 2009 will see only a slight improvement with an economic contraction of 3%-5%. Forecasters are expecting improvement in subsequent quarters. Exhibit 10. U.S. Leading Indicators At Record Low

Source: Prieur du Plessis


JANUARY 6, 2009

Exhibit 11. Consumer Spending Approaching 1991 Low

Source: Prieur du Plessis Exhibit 12. U.S. Losing Jobs At Rapid Rate

Source: Prieur du Plessis Exhibit 13. Unemployment’s Rise Will Cut Future Spending

Source: Prieur du Plessis


JANUARY 6, 2009

A recent Kiplinger Letter (Nov. 26, 2008) projects world growth slowing from 2.8% in 2008 to 1.0% in 2009, the official line marking a world recession

Exhibit 14. Manufacturing Approaching Recession Lows

Source: Agora Financial Exhibit 15. Low Savings Rate Reflects Financial Challenge

Source: Northern Trust Globally, the economic outlook is deteriorating rapidly as the financial fallout in the U. S., Europe and Japan are taking their toll on growth throughout the world. Every recent economic forecast for 2009 has been lower than its predecessor and we are approaching the line signaling a worldwide recession. A recent Kiplinger Letter (Nov. 26, 2008) projects world growth slowing from 2.8% in 2008 to 1.0% in 2009, the official line marking a world recession. After showing growth in 2008, each of the three regions of the OECD – the U. S., Europe and Japan – are projected to have negative


JANUARY 6, 2009

growth of about 1.0% in 2009. The genesis for the decline in economic activity is the spending and investment retrenchment in the mature economies. Exhibit 16. World Growth Forecast for 2009 Falling

Source: U.S. Global Investors The following charts show the collapse in various country industrial production and exports reflecting the growing global economic weakness. Exhibit 17. Korea Output Down

Source: WSJ


JANUARY 6, 2009

Exhibit 18. Japanese Exports Fall On Stronger Yen

Source: Bespoke Investment Group Exhibit 19. Brazil Shows Dramatic Weakness

Source: U.S. Global Investors Exhibit 20. India’s Economy Slowing

Source: The Economist


JANUARY 6, 2009

China’s contribution to the world’s economic growth has increased in every period since 1995-99 One estimate puts the shutdown of Chinese export manufacturing plants owned by Hong Kong-based companies at 10,000 out of 60,000

China A Key Growth Component The greatest surprise for economists and market analysts has been the speed with which economic activity in China has fallen. The country’s output slowdown has destroyed the concept of economic decoupling that argued that emerging economies were strong enough to grow in the face of a U.S. recession. In China’s case, the belief was its domestic consumption could sustain its growth and, importantly, its thirst for more crude oil and other natural resources. As the IMF has pointed out, China’s contribution to the world’s economic growth has increased in every period since 1995-99. Exhibit 21. China Is Key To Global Growth

Source: IMF Based on most forecasts, China’s growth is still closely tied to that of the United States. In November Chinese exports fell by a surprising 2.2% after seven years of double-digit growth. Industrial output growth slowed to 5.4% growth from 8.2% in October. At low growth rates (5% range) China’s manufacturing sector chokes up and starts to lose money. This partially explains why so many small export manufacturers have been shut down. One estimate puts the shutdown of Chinese export manufacturing plants owned by Hong Kong-based companies at 10,000 out of 60,000. Reports are that half of the rural immigrants previously imported to staff these plants are being forced to return to their villages because China does not have any social safety net for unemployed workers as exists in western countries. The loss of jobs has contributed to increased worker protests and in some cases violence as they want to be paid before they are forced to leave. This attitudinal issue increases the


JANUARY 6, 2009

China’s export growth measured in U. S. dollars fell in November from a rate in the 20% range to a negative 2.2% China cannot afford a weak U.S. dollar as the reserves are worth less and the country’s exports become more expensive for U.S. consumers

risk of serious internal civil disobedience problems developing for the Chinese government. People should remember that worker protests were a prelude to the student confrontation with the army/government in Tiananmen Square in 1989. The magnitude of China’s export problem is highlighted by the chart in Exhibit 20. It shows that while export growth measured in U. S. dollars fell in November from a rate in the 20% range to a negative 2.2%. If the country’s exports are measured in local currency and adjusted for inflation the decline was actually greater. Possibly more significant is that the local currency measurement shows that there had been a steady shrinking of the rate of growth of Chinese exports since 2004 with the pace of the decline accelerating in 2008. This points out that China possibly has more economic woes than realized from the outside. Exhibit 22. China’s Export Growth Shrank in 2007 and 2008

Source: The New York Times China’s foreign exchange reserves, the largest in the world, apparently fell in October for the first time in five years according to an official from the State Administration of Foreign Exchange. The problem is that China’s foreign exchange reserves are in U.S. dollars. Therefore, China cannot afford a weak U.S. dollar as the reserves are worth less and the country’s exports become more expensive for U.S. consumers. The challenge is that a stronger U.S. dollar will require higher interest rates that are counter to the Federal Reserve and U.S. Treasury efforts to stimulate the U.S. economy.


JANUARY 6, 2009

The dilemma is that the U. S. is confronting the need to delever its citizens’ balance sheets, which is being accomplished by leveraging up the federal government’s balance sheet but with assets of questionable value The Federal Reserve, however, is more concerned at the present time with preventing deflation from developing in the U.S.

Higher U.S. interest rates mean slower economic growth and lower consumption of Chinese-made goods. Exhibit 23. China’s Manufacturing Reflects Weakness

Source: U.S. Global Investors So as 2008 ended, we find the United States struggling to restart its economy that will eventually help to provide growth to the rest of the world. This is very important for developing countries such as India and China. The dilemma is that the U.S. is confronting the need to delever its citizens’ balance sheets, which is being accomplished by leveraging up the federal government’s balance sheet but with assets of questionable value. For an economy that has depended upon consumers to fuel its growth, the future course for the U.S. means less spending and more savings are needed to repair family balance sheets and restore confidence. Given this need, the stimulus program being contemplated by the Obama administration will need to include tax cuts coupled with increased government spending. That means the federal government’s budget deficit will soar. To fund a growing deficit, the government is resorting to printing more dollars adding to the money supply. This additional money increases the risk of a sharp rise in inflationary pressures at some point down the road. The Federal Reserve, however, is more concerned at the present time with preventing deflation from developing in the U.S. – an environment where reduced demand causes suppliers to lower prices, which induces consumers to hold back spending because they anticipate further price reductions. As this cat-and-mouse game between consumers and suppliers is played out, the lower demand for goods causes suppliers to lay-off workers adding further downward pressure on consumer spending. A deflationary environment was a contributing factor to extending the downturn of 1929 into the Great Depression. It also marked a key characteristic of the Japanese experience in the 1990s.


JANUARY 6, 2009

The EIA’s 2009 global oil demand growth forecast fell from +1.55 million b/d to a decline of 450,000 b/d There have been estimates that the cutbacks in the chemical industry have alone accounted for a two-million b/d decline in global oil demand

As we turn the calendar into 2009, what can we expect from the energy business and the oilfield service sector, in particular? The key issue that needs to be analyzed is the health of the global crude oil and North America natural gas markets and what impact they have on producer cash flows. From that analysis we can attempt to determine how the producers will spend their funds and how those decisions impact of petroleum supply. From this analysis will unfold a view about how oilfield service companies’ earnings will fair and thus how their share prices are likely to perform. Let’s see if we can deal with these key issues. Crude Oil Demand Forecasts for the growth rate of crude oil demand in 2008 and 2009 steadily contracted as last year progressed. Using the forecasts of the U.S. Energy Information Administration (EIA) in their monthly Short-Term Energy Outlook (STEO) reports we see that their estimate for 2008 demand growth fell from an initial 1.61 million barrels per day (b/d) in January 2008 to a negative 50,000 b/d in December. Similarly the agency’s 2009 demand growth forecast fell from +1.55 million b/d to a decline of 450,000 b/d. A key component of their forecast was the rapidly falling petroleum demand in the United States. While gasoline demand has declined along with miles driven by Americans, a less visible demand contraction has come from the cutbacks by the petrochemical industry. Late last year leading chemical producers Dow Chemical (DOW-NYSE) and DuPont (DD-NYSE) announced plans to shutter a number of plants and to lay off workers. The fall in chemical demand is largely associated with the decline in new home construction and automobile sales. Chemical output is a large component of the products used to build cars and homes such as plastics, synthetic materials and glass. There have been estimates that the cutbacks in the chemical industry alone have accounted for a two-million b/d decline in global oil demand. This demand contraction may also explain part of the falloff in oil demand in the United States, especially during the second half of 2008. Exhibit 24. Falling 4Q08 Oil Demand In U.S.

Source: The Economist


JANUARY 6, 2009

The 1979-1983 fall in oil demand totaled 6.51 million b/d, or 10.1% of 1979’s consumption level at the time the decline began China’s oil demand in November fell by 3.9% and Paul Ting expects demand in December to be off more, down 4.5% to 7.4 million b/d

As the EIA pointed out in the press release announcing its December STEO forecast, the 2008 and 2009 predictions for negative global oil demand growth would mark the first time in over 25 years that the world experienced back-to-back yearly declines. In fact, one has to go back to the 1979 to 1983 period to find an extended period when global oil demand contracted. In that case, the four-year fall in demand totaled 6.51 million b/d, or 10.1% of 1979’s consumption level at the time the decline began. An important consideration is that it took fully 10 years for the world’s oil consumption to return to 1979’s level. There are a growing number of new oil demand forecasts that call for much greater volume declines in 2009 than predicted by the EIA. Because of their very negative outlook for global economic activity in 2009, some of these forecasters believe we might even see a further, albeit small, contraction in oil demand in 2010 before the economic recovery boosts overall consumption. The keys to whether the more pessimistic demand forecasts prove correct depends on just how deep the U.S. recession is and how great an impact it has on other economies around the world, especially China. There is little doubt that the European Union already has several large economies suffering severe economic problems and the ability of these countries to pull out of their economic malaise will depend upon their governments’ stimulus efforts, their ability to import low-cost labor to reduce their export prices and the value of the Euro versus the U.S. dollar. But China is probably the most troubling country to read. The country is known for having relatively opaque economic and financial statistical reporting systems. Therefore, many analysts distrust the government-issued numbers and instead spend time trying to piece together a more complete view of Chinese economic activity from a number of less visible economic and industry statistics. For example, independent oil analyst Paul Ting suggests based on his data and contacts with Asian refineries that China’s oil demand in November fell by 3.9%. He expects demand in December to be off more, down 4.5% to 7.4 million b/d. That pessimistic outlook is supported by the business sentiment index of Xinhua Finance/MNI. The index is based on a survey of executives at 152 companies in China. It showed that December’s sentiment was down for the third consecutive month to a record low of 35.2 from 39.9 in November. A reading of 50 is considered neutral. Oil Supply We fully expect a decline in full year demand for crude oil in 2009, but believe after very weak demand in the first half a recovery in the second half will commence. It is not out of the question for 2010 to show a very small demand decline as the strength of the economic recovery will take time to build steam. The recent CNBC poll of money managers says that the majority don’t expect positive GDP numbers until the third quarter of 2009. Another forecast we saw


JANUARY 6, 2009

OPEC has claimed that oil prices – currently in the upper $40s a barrel – are well below their “fair value” estimated to be $75 by Saudi Arabian Oil Minister Ali Naimi In the early 1980s, Saudi Arabia was in a similar position as today with respect to bearing the brunt of a cartel production cut Some oil forecasters, on the other hand, say that OPEC’s past efforts to prop up oil prices have succeeded more often than not

suggests that economic growth will barely be 1% in the fourth quarter making it seem like the U.S. is still in a recession. In the meantime the challenge for crude oil producers is to rein in supply in order to boost oil prices. OPEC has claimed that oil prices – currently in the upper $40s a barrel – are well below their “fair value” estimated to be $75 by Saudi Arabian Oil Minister Ali Naimi. That fair value estimate is well below the estimated oil price required to fund the government budgets of several key OPEC producers such as Iran and Venezuela. During 2008, OPEC acted twice to reduce its production in an attempt to stem the fall in oil prices. In October the cartel agreed to pump 1.5 million fewer barrels each day from November 1st. As oil prices continued to fall, however, the OPEC oil ministers used a mid December meeting to agree to a further production cut of 2.2 million b/d effective January 1st. As Saudi Arabia remains the largest producer and the richest country within OPEC, the bulk of the production cut falls on its shoulders. So far it appears the kingdom is instituting its agreed production cuts, but one has to assume the government is watching closely the actions of other OPEC members. In the early 1980s, Saudi Arabia was in a similar position as today with respect to bearing the brunt of a cartel production cut. At that time oil demand was collapsing and Saudi Arabia watched its production volumes fall to unsustainably low levels for the viability of the kingdom as other OPEC producers who had previously agreed to cut their production cheated to offset their lost income due to falling prices and agreed production cuts. Saudi Arabia started out trying to defend the cartel’s $34 a barrel oil price target before abandoning it to instead defend a $27 price, but as demand fell faster than production cuts could shrink the oil over-supply, prices continued to drop. Once Saudi Arabia concluded its fellow cartel members were cheating and hurting its economy, the kingdom elected to teach them a lesson and flooded the market with crude oil, driving prices down to single-digit levels. At that point the financial pain convinced other OPEC members to finally cut their production setting the stage for an eventual recovery in global oil prices. It appears from various news reports and oil shipping tracking services that the key OPEC oil producers are reducing their production in line with their agreed upon quotas. The oil market is assessing OPEC’s compliance with these production targets. Most analysts assume compliance will not be total. Some oil forecasters, on the other hand, say that OPEC’s past efforts to prop up oil prices have succeeded more often than not. Since 1993, production cuts have led to higher prices in three-quarters of the cartel’s efforts to boost prices. Those times it did not work were when global economic activity slowed appreciably such as in 1997-8 during the Asian currency crisis and in 2000 after the dotcom bubble burst. In those periods, OPEC was chasing a downward spiraling demand.


JANUARY 6, 2009

Studying the demand and supply experience in the early 1980s may be of greater help in analyzing the immediate future of the oil market than any other period Money managers polled by CNBC suggesting that 2009’s third quarter will be the first quarter to show positive growth

We would suggest that studying the demand and supply experience in the early 1980s may be of greater help in analyzing the immediate future of the oil market than any other period. The economic recession at that time was caused partly by the jump in interest rates engineered by the U.S. Federal Reserve in an effort to choke off accelerating inflation. The world had just been hit by an oil supply shock in 1979 with the overthrow of the Shah of Iran’s government and the institution of a theocracy and their decision to stop exporting oil. As the new Iranian government shut down its oil exports, at the time a significant amount of the world’s supply, there was an oil price explosion. The 1980s oil demand falloff was also a function of the fallout from the 1973-4 oil embargo of the west and resulting price hike that caused a recession. In the U.S. the recession and oil price surge generated a strong energy conservation effort and a wave of energy-efficiency improvements for autos, homes and utilities. This conservation effort only began to significantly manifest itself at the end of the 1970s. Therefore the early 1980s demand decline reflects a broader based situation in which OPEC was chasing falling oil demand in an attempt to stabilize oil prices. That may be less of a case today. Exhibit 25. 1980s’ 4-Year Demand Fall Equaled 6.5 MMB/D

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Source: EIA, PPHB Until there is greater confidence in the timing of a recovery in oil demand, which will depend upon a recovery in economic activity, knowing whether OPEC can be successful in controlling oil markets is impossible to determine. With money managers polled by CNBC suggesting that 2009’s third quarter will be the first quarter to show positive growth, this marks a one quarter delay from their previous view. If more depressing economic data is released such as last Friday’s 28-year low for December’s ISM index of manufacturing activity, the recovery could be further delayed. On the other hand, one has to believe a wave of optimism will sweep this country with Barack Obama’s inauguration on January 20th.


JANUARY 6, 2009

2008 witnessed crude oil prices posting both a 52-week high and a 52-week low in a span of 165 calendar days Some forecasters are suggesting that oil prices could fall into the $20 a barrel range in 2009, but we chalk that talk up to people trying to attract media attention or crude oil traders talking to their book

Oil Prices Oil prices in 2008 experienced their most dramatic year since 1986 when the global price collapsed due to an internecine battle within OPEC. 2008 witnessed crude oil prices posting both a 52-week high and a 52-week low in a span of 165 calendar days. The collapse of crude oil prices in December was due to the filling of storage facilities at Cushing, Oklahoma where West Texas Intermediate (WTI) oil is traded, establishing the price commodity traders use to establish global oil prices. For oil prices to improve domestic demand must increase and refinery output will need to grow causing a draw on domestic oil inventories. Exhibit 26. Low Price To Average Gap 58%

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Sep

03, 1

984

Nov

03,

198

4Ja

n 03

, 198

5M

ar 0

3, 1

985

May

03,

198

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l 03,

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p 03

, 198

5N

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3, 1

985

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03, 1

986

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3, 1

986

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, 198

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3, 1

987

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l 03,

198

7Se

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, 198

7N

ov 0

3, 1

987

WTI Futures Oil Price 1984-1987

WTI Futures Price 200 per. Mov. Avg. (WTI Futures Price)

58%

Source: EIA, PPHB When crude oil futures prices bottomed out on Christmas Eve, the gap between the low price and a 200-day moving average of crude oil prices stood at 70%. That exceeded the gap that opened up during the 1986 oil price collapse. This wider gap in 2008 gives us confidence that we have probably seen the bottom for oil prices in this cycle. Some forecasters are suggesting that oil prices could fall into the $20 a barrel range in 2009, but we chalk that talk up to people trying to attract media attention or crude oil traders talking to their book (suggesting near-term price movements consistent with whether they are long or short crude oil). Baring a significant collapse in global oil demand or a lack of meaningful adherence by OPEC members to their agreed production cuts, we doubt oil prices fall into the $20s. If world oil demand shows any strength in 2009, oil prices are likely to firm up quickly. While commodity analysts are suggesting that the year-end move in crude oil prices above $46 indicates the market will attempt to test the $50 barrier. At that level


JANUARY 6, 2009

With the exception of the 1974-1986 and 2005-2008 periods, oil prices have been lodged in two periods of extended price ranges If, for sake of argument, that the next plateau will last for a equally shorter time span, then we are looking at the $50-$60 a barrel price range lasting for nine years

we might see a pullback in prices as traders take profits. If prices break through that barrier then we should see oil prices trade in the low $50s for some period of time. Exhibit 27. 2008 Price Gap Up To 70%

$0

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Jan

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003

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008

WTI Futures 2003-2008

WTI Futures Price 200 per. Mov. Avg. (WTI Futures Price)

70%

Source: EIA, PPHB We found a chart showing oil prices from 1947 priced in 2008 dollars. It shows that the fall in oil prices last year has brought the price to the top of the trading range that extended from 1986 to 2004. We find that both interesting and significant. If one examines the long-term price chart, with the exception of the 1974-1986 and 2005-2008 periods, oil prices have been lodged in two periods of extended price ranges. The first range was about $20 a barrel from 1947 to 1974, while the second was 1986-2004 when it averaged roughly in the upper $30s. The takeaway from this chart is that the cost of developing new oil resources have experienced a step-function increase only established after periods of extreme price volatility and very high prices. The market turmoil appears to alter consumer psychology towards higher oil prices by convincing consumers that it is the cost necessary in order to develop the new oil supplies the world needs. What we conclude is that following our 2008 period of oil market turmoil, crude oil prices should settle into a new trading range of $50-$60 a barrel. The unanswerable question is whether the length of time this new trading range exists will be shorter than the length of time of the last price plateau. We assume this will happen due to the lack of productivity of existing oil fields. The first plateau lasted for 27 years and the second for 18. If, for sake of argument, that the next plateau will last for a equally shorter time span, then we are looking at the $50-$60 a barrel price range lasting for nine years. It is interesting that this time frame would put us into the 2018 time frame for the next period of turmoil that just happens to coincide with many forecasts for the peak in oil production. (We won’t comment on that


JANUARY 6, 2009

The growth in domestic gas production has largely come as a result of the growing importance of these unconventional gas shale wells to total production Recent data shows that the number of rigs drilling in the U.S. targeting natural gas has fallen 16% from its peak and is declining at about 1.7% per week

Exhibit 28. Oil Prices At Top Of 1986-2004 Trading Range

Source: Whiskey & Gunpowder debate in this article.) While this may not appear to be the most scientific analysis, many times looking at the forest rather than the trees can prove more valuable. U.S. Natural Gas Market After years of falling domestic natural gas supply and a greater reliance on imports from Canada, the success of oil service industry technology in helping to unlock the resources contained in shales scattered across the country has enabled producers to grow supply. In the past year or so, domestic natural gas production has grown by about 8% due to the start-up of many wells in the gas shale plays. These reserves are usually accessed by using directional and/or horizontal drilling technology, and the flow rates of the wells are boosted by employing sophisticated and powerful formation fracs. When these wells come on there is usually a surge in production lasting for one to two years before the wells start a rapid decline to a low production level that continues for the balance of the life of the well. The growth in domestic gas production has largely come as a result of the growing importance of these unconventional gas shale wells to total production. Natural gas prices have been falling since spring when the growth of production coupled with a warmer than anticipated winter left the gas industry with substantial supplies in storage. The early cold weather this winter has helped to boost gas prices, but the key question is will the balance of the winter be sufficiently cold to draw substantial gas volumes from storage? A key to answering that question is the amount of new drilling activity, especially in the shales, and the number of high volume gas wells coming on production. Recent data shows that the number of rigs drilling in the U.S. targeting natural gas has fallen 16% from its peak and is declining at about 1.7% per week. More important, rigs drilling for unconventional gas reserves are also declining, however, the decline rate is about one-third to one-half that of the entire rig fleet. Because of the high cost of these unconventional wells and the speed within which


JANUARY 6, 2009

What we found was that the 2000s upturn had not boosted the rig count as high as occurred in the late 1970s

Exhibit 29. Recent Gas Production Growth Caps Gas Prices

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55,00057,00059,00061,00063,00065,00067,00069,00071,00073,00075,000

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Nat Gas Production Price per MCF

Source: EIA, PPHB commodity prices and economic activity declined and the escalation of capital market problems for producers, the current pace of the rig decline may be just the beginning and is about to increase. That conclusion, and any cut in gas supply growth, must wait time. Domestic Rig Count About a month ago we prepared an analysis of the rig count decline underway. We compared this decline against the rig count trajectory experienced in the 1973-1983 period, the last major boom period for the U.S. energy business. We chose that historic period because economic, credit market and energy industry characteristics then more closely matched those we are experiencing now. What we found was that the 2000s upturn had not boosted the rig count as high as occurred in the late 1970s. This was a function of a change in the types of wells drilled, the greater cost of these new wells and the price of equipment and services are significantly higher. Exhibit 30. Rig Count Forecast Calls For 1,000 Rig Drop

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US Rig Count Index 1970s v. 2000s

1970s 2000s Forecast

Source: Baker Hughes, PPHB


JANUARY 6, 2009

From the recent peak in domestic rig activity, the drilling industry could lose up to 1,000 rigs The actual rig count has declined faster than suggested by the historical pace The oilfield service stocks in the 2000s did not rise as much as they did in the 1970s period and they have declined faster and to a lower level

To see what might happen to the rig count in the future, we applied the decline pattern of 1979-1983 to the current rig count. It showed that that from the recent peak in domestic rig activity, the drilling industry could lose up to 1,000 rigs. Since the rig count had already declined by 165 rigs from the peak of around 2000 rigs when we prepared our study, we concluded that an estimate of a possible 800-rig decline made by Nabors Industries (NBR-NYSE) might prove fairly close to reality. We updated the analysis to see how the rig decline during December compared to our prior analysis. What we found was the actual rig count has declined faster than suggested by the historical pace. Today, we are down 140 rigs more than forecast by the historical pace. Does this mean that we may have a greater rig count decline? We don’t think so; rather, we suspect that the industry is merely reducing its activity at a faster pace. Exhibit 31. Rig Count Dropping Faster Than Forecast

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Source: PPHB Oilfield Service Stock Prices There is an interesting parallel between the decline in the current rig count and the drop in the stock price of the oilfield service component of the S&P 500 index. It, too, has dropped at a faster pace than suggested by the correction in the early 1980s. We just updated a chart that came from our analysis of the 2008 industry slowdown and the early 1980s downturn (see Exhibit 32). After others had time to study the chart, we were asked how different the patterns would appear if the data for the two periods under study were indexed (see Exhibit 33). The conclusion that comes from the updated indexed chart is that the oilfield service stocks in the 2000s did not rise as much as they did in the 1970s period and they have declined faster and to a lower level than during the 1980s correction.


JANUARY 6, 2009

We are not sure exactly how long we may have to wait for that upturn, but we suspect it will be a while

Exhibit 32. Current Correction Faster And Deeper

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Source: Global Financial, PPHB Exhibit 33. Indexed Stock Prices Show Same Trend

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Energy Then and Now Indexed

1970s 2000s

Source: Global Financial, PPHB In our mind, the question about the stocks is whether they have gone lower relative to their low during the 1980s correction and reached that low point sooner suggesting they may have established their low for this cycle and now it is only a matter of time before stock prices go higher. Of course, we are not sure exactly how long we may have to wait for that upturn, but we suspect it will be a while. Energy Stock Prices and the Stock Market Turning to the energy stocks, and especially the oilfield service stocks, it seems to us there are two critical questions. First is, if the stocks have actually bottomed as we believe then when and why might they go up in price? The second question, partially related to the price question, is what should be the proper valuation for the stocks in the future?


JANUARY 6, 2009

In early November a number of Wall Street oilfield service analysts began recommending the stocks In the first stock peak in the 1970s, the high prices were achieved with large P/E ratios on relatively small earnings but in the last peak the stocks had substantially greater earnings but lower P/E ratios It seems that the business environment we have stumbled into and are trying to get out of has more similarities to the late 1970s and early 1980s than any other period in the post-World War II era

Dealing with the second question first. In early November a number of Wall Street oilfield service analysts began recommending the stocks. Their rationale was that the stocks were cheap based on various valuation approaches such as relative price to earnings multiples or stock prices to book values. We were somewhat surprised about the recommendations, not because we thought their idea was wrong, but more because the current economic and financial environment is one few people have experienced and there are factors that make this market downturn different from those in the 1990s and 2000s. This is particularly true for most of the oilfield service analysts. Their analysis involved taking the most recent past – 1993 through now – as the period to establish historic valuation measures. We have learned over the years of researching this sector beginning in 1971 that two things happen in major cycles for the industry. Early in the cycle, the stocks have very high P/E valuations because early investors anticipate the sharp rise in earnings that will occur as utilization of equipment and people rises. These investors believe, and usually it proves correct, that the earnings leverage exceeds any estimate by Wall Street analysts. Late in the cycle, however, just as companies’ earnings growth rates are exploding, stock prices do not rise commensurately, and may even start slipping, as investors begin to discount the continuation of these earnings growth rates. In the 1970s cycle, the oilfield service stocks were the best performing market sector for the decade. The stocks experienced two price peaks during the decade. In the first stock peak, the high prices were achieved with large P/E ratios on relatively small earnings but in the last peak the stocks had substantially greater earnings but lower P/E ratios. Part of the early cycle peak valuation may have been tied to the market phenomenon of the Nifty Fifty. That was 50 companies that were perceived by investors as having the greatest growth potential that would not be challenged in any economic environment. As a result, these 50 stocks were accorded extremely high P/E ratios because the belief was there was no price too expensive for buying these stocks. Two of the 50 were oilfield service stocks – Halliburton (HAL-NYSE) and Schlumberger (SLB-NYSE). In the 2000s cycle as it matured, the stocks, which sported higher forward P/E ratios on small earnings early on, saw those multiples fall as their earnings grew. This phenomenon is highlighted by the chart in Exhibit 34. One of the issues with oilfield service company valuations is how the overall stock market is going to be valued in the future. The introduction of a global credit crisis to the worldwide recession is unique in modern times. Outside of the Great Depression, we have only experienced regional credit crises such as the Asian currency crisis in 1997-1998 in modern times. It seems that the business environment we have stumbled into and are trying to get out of has more similarities to the late 1970s and early 1980s than any other period in the post-World War II era. Many people are concerned that today’s economic and financial conditions are more like those that created and prolonged the Great Depression. That comparison,


JANUARY 6, 2009

From a top down/macro basis, the S&P 500 index’s earnings should be about $42, while a bottoms up/stock-by-stock basis puts the estimate closer to $70 If we focus on the period since 1955 to now, there appear to be three distinct valuation ranges – 1955-1970; 1970-1995; and 1995-2008

Exhibit 34. P/E Ratios For Oil Service Companies Have Fallen

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Major Manufacturers Major ServiceUS Well Service US Land Drillers

Source: PPHB we believe, is not valid because today we have a Federal Reserve and a federal government that are capable of, and are actively, taking steps to stimulate an economic recovery that did not exist in the 1930s. Additionally, we have had decades to study the causes and government policy mistakes that hindered a recovery from the excesses that produced the 1929 stock market crash and subsequent economic calamity. A big question about the appropriate stock market valuation level is whether the P/E ratios that have prevailed in recent years will be representative of future valuations or whether future valuations will resemble those that existed in the 1970s. Many stock market analysts suggest that today’s stock market is “cheap” when they look at the P/E ratio for the broad market and compare it to recent years. The problem is there is a wide disparity about what the earnings estimates for the broad market indices are going to be. From a top down/macro basis, the S&P 500 index’s earnings should be about $42, while a bottoms up/stock-by-stock basis puts the estimate closer to $70. By using these two estimates one calculates a widely divergent P/E ratio for the index. The problem is compounded by the pace at which future earnings estimates are being reduced. In Robert Shiller’s book Irrational Exuberance, he calculated the P/E ratio of the stock market since 1881 based on a ten-year averaging of trailing earnings to the stock price. Valuations have risen and fallen at various times during the period. If we focus on the period since 1955 to now, there appear to be three distinct valuation ranges – 1955-1970; 1970-1995; and 1995-2008. In the first period trailing P/E ratios were generally in the 6-10 times range, while in the second they were more like 3-5 times and then 10-16 times in the most recent period. The last 13 years have been marked by extremely low interest rates, investor worship of anything with “high” earnings growth and a general mispricing of risk. If we are looking at the possibility of higher interest rates and higher inflation in the foreseeable future, we should experience a stock


JANUARY 6, 2009

We believe oil prices will probably trade in the $50-$60 a barrel range this year with excursions outside the range

Exhibit 35. 2009 Earnings Estimates Are Falling

Source: Bespoke Investment Group market environment more similar to 1970-1995 than that of the last 13 years. That suggests we will see much lower P/E ratios in the future than in recent years. Exhibit 36. P/E Ratios Have Varied Widely Over Time

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Source: Robert J. Shiller Our Conclusion In conclusion, we believe oil prices will probably trade in the $50-$60 a barrel range this year with excursions outside the range. We found it interesting that the recent CNBC money manager poll found no one believing that oil prices can average above $75 a barrel in 2009 while on the other end of the spectrum, only 2% believe prices will be under $30. Some 56% of respondents think prices will average between $50 and $75 a barrel, so we fall in that group. We are also cognizant that the event not expected often occurs.


JANUARY 6, 2009

We believe the rig count will drop about 500-600 additional rigs from where we ended 2008 Since the OSX index hit its intraday low on December 5th the stocks climbed even while oil prices fell further Either time or a sharp, sustainable upturn in oil and gas prices will be the catalyst It is our belief that the geology is the key factor that is different this time

We believe the rig count will drop about 500-600 additional rigs from where we ended 2008. That drop will result from the sharp cutback in petroleum industry capital spending due to uncertainty about the future levels of crude oil and natural gas prices, global petroleum demand, the role of alternative energy, producer access to capital markets and the energy regulatory environment. In addition, producers will seize upon the current market turmoil to reduce expenditures as leverage to beat back oilfield service company price increases achieved over the past several years. As a result, earnings estimates for oilfield service companies are still too high. With all that negativity, one would expect that the oilfield service stocks should be heading lower, but we believe the opposite. We find it significant that since the OSX index hit its intraday low on December 5th the stocks climbed even while oil prices fell further. Exhibit 37. The OSX Has Gone Up Even With Lower Oil Prices

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OSX WTI Futures Price

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Source: Yahoo Finance, EIA, PPHB In recent days the OSX has climbed higher in concert with rising oil prices. Most likely the stocks are locked in a trading range that for the OSX is probably 110 to 140. Wall Street earnings estimates for the companies need to be reduced, but those earnings estimate cuts will probably have little impact on the share prices as stock prices already anticipate reduced estimates. What’s missing at the moment for oilfield service stocks is the catalyst to drive a breakout from this trading range. Either time or a sharp, sustainable upturn in oil and gas prices will be the catalyst. It is our belief that the geology is the key factor that is different this time. The production depletion rate, which appears to be climbing, will be our long-term earnings and stock price driver. While it is hard to imagine now, just like last year at this time, 2009 is likely to be another surprising year!


JANUARY 6, 2009

Contact PPHB: 1900 St. James Place, Suite 125 Houston, Texas 77056 Main Tel: (713) 621-8100 Main Fax: (713) 621-8166 www.pphb.com Parks Paton Hoepfl & Brown is an independent investment banking firm providing financial advisory services, including merger and acquisition and capital raising assistance, exclusively to clients in the energy service industry.

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