usings rom the oil atch - energy musings · $30,786 reports the firm, down only 0.6% from a year...

MUSINGS FROM THE OIL PATCH January 21, 2014

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 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

Auto Sales Are Back But What About Electric Vehicles? The industry is predicting sales of slightly over 16 million vehicles this year Based on an analysis of green cars, including EVs, sold in the U.S. during 2013, the segment accounted for 662,821 units, up 20% from 2012

Weather in December caused auto sales in the U.S. to flatten despite a 4% increase in sales discounts according to TrueCar.com, a price tracker and auto research firm. The mix of higher vehicle prices translated into an average transaction price in December of $30,786 reports the firm, down only 0.6% from a year ago. Overall, last year the domestic auto industry sold 15.6 million vehicles, up 9.2% from 2012, and the highest sales rate since 2007. The industry is predicting sales of slightly over 16 million vehicles this year, but still below the heady sales years leading up to the 2008 financial crisis. Based on the media hype, the electric vehicle (EV) segment must be booming, too. We define EVs as cars that are exclusively battery-powered, meaning they need to be plugged in to be refueled (recharged). Based on an analysis of green cars, including EVs, sold in the U.S. during 2013, the segment accounted for 662,821 units, up 20% from 2012, according to green.autoblog.com. The estimated number of green cars sold included a fourth quarter estimate for Tesla Motors (TSLA-Nasdaq) based on an extrapolation of the company’s third quarter sales rate. Tesla doesn’t report monthly sales figures, only quarterly, and then only when it reports its quarterly financial results. That means Tesla’s fourth quarter sales volume is not likely to be released until sometime in February. Green.autoblog.com estimates that Tesla sold almost 21,000 Model S vehicles last year, although another web site, greencarreports.com, suggests that analysts expect domestic deliveries by Tesla to total about 18,000 units since the company has been exporting some of its luxury EVs to Europe. The American auto business has been helped by lower gasoline pump prices due to the glut of domestic crude oil as a result of the

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Producers see the move boosting wellhead profits and encouraging the industry to push for even greater output gains in the future If EVs gain greater market acceptance in the future, we would expect a corresponding positive impact on electricity consumption, and in turn on natural gas consumption Analysts point to the approximately 87% increase in unit sales from 2012 to 98,426 units

surge in shale oil output. That glut, partially due to the logistics of moving the increased oil production from the various shale basins around the country to the refining centers of the petroleum industry, has kept U.S. crude oil prices below world prices, and in turn contributed to reduced pump prices. A debate has emerged about whether the U.S. should junk its domestic crude oil export restriction that arose from the nation’s first oil crisis in the early 1970s. Based on forecasts by the Energy Information Administration (EIA) that U.S. oil production will climb by 18.5% or nearly 1.8 million barrels a day over the next two years, to 9.6 million barrels a day, there is a strong push by the petroleum industry to get the oil export ban lifted. Producers see the move boosting wellhead profits and encouraging the industry to push for even greater output gains in the future. Refiners, who benefit from buying lower-priced domestic oil, refining it into gasoline and diesel and selling it to high-priced European fuel markets, have been the prime beneficiary of the export restriction. The struggle over the oil export issue essentially pits 310 million Americans, who benefit from lower pump prices and reduced heating oil costs, against a few hundred oil company CEOs. The return to health of the domestic automobile industry is the result of a recovering economy and reduced fuel costs. We are interested, however, in the tangential issue of EVs and their potential impact on the consumption of natural gas. While you may be scratching your head over how EVs and natural gas are related, the growing fleet of battery-powered vehicles needs to be charged with electricity, increasingly being generated by electric plants fueled with the nation’s abundant natural gas supplies. Natural gas has gained a larger share of the power generation market over the past few years due to the surge in natural gas output that has severely depressed prices, thus making the fuel cheaper on a British thermal unit (BTU) basis than coal. The cost-competitiveness of coal and its access to power generation markets in this country is increasingly being restricted by government regulations limiting the release of greenhouse-gases. As cleaner-burning and cheaper natural gas has gained market share in the power market, electricity prices either have been restrained in their rate of increase, or have actually fallen. If EVs gain greater market acceptance in the future, we would expect a corresponding positive impact on electricity consumption, and in turn on natural gas consumption. The reviews of the EV market in 2013 have been positive. Analysts point to the approximately 87% increase in unit sales from 2012 to 98,426 units. That estimate includes 21,000 Tesla Model S vehicles. Among the EVs, two data points are of interest. Nissan’s (NSANY-OTC) Leaf saw its sales soar last year to 22,610 units from 9,819 the prior year. That gain was largely driven by the decision to cut the price, although the move of production from Japan to a plant in Tennessee also helped. On the other hand, General Motors (GM-


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With EVs outselling the early years of hybrids, they are judged to be doing well Despite experiencing a strong upswing in sales in 2012 and 2013 (projected), hybrid car sales have fallen well short of earlier projections

NYSE) saw sales of its Chevy Volt EV model fall by 1.6% to 23,094 vehicles, barely ahead of the Leaf’s sales. While a positive year for EVs, there are numerous questions being asked about the segment’s long-term growth rate. At one point in 2012, there were many analysts arguing that the pace of EV sales was faster than that experienced by electric-hybrids during the early years of their existence in the market. With EVs outselling the early years of hybrids, they are judged to be doing well. Last fall, an analysis of this relationship pointed out the risks of using hybrid sales as a way to forecast the growth of EVs. In that analysis, researcher Brad Berman, writing on the web site plugincars.com, pointed to a graph he created in 2006 of all the forecasts for hybrid car sales beginning in 2003 and extending through 2005. Those forecasts projected hybrid car sales between 2006 and 2015. The forecasts called for hybrid car sales to range from 177,000 units in 2005 to as many as three million in 2015, with an even more optimistic forecast of 80% of the new car market that year. Mr. Berman plotted a curve through the range of forecasts to show the projection for hybrid car sales. In his updated chart (Exhibit 1), he has added red dots to show the actual volume of hybrid car sales since 2006. As can be observed, despite experiencing a strong upswing in sales in 2012 and 2013 (projected), hybrid car sales have fallen well short of earlier projections. Exhibit 1. Hybrid Forecasts Were Way Too Optimistic

Source: plugincars.com

Mr. Berman was positive about the fact that the industry sold 96,000 EVs in 2013 versus about 35,000 sold in 2002. He cautioned, however, that the industry should not expect that EVs will continue to outsell past hybrid records by three times given the differences in technology and other market factors. For example, for the first three


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“The first hybrids were introduced before green was in, when big SUVs still dominated U.S. roads” Hybrids still only account for about 4% annually of total car sales

years of hybrids, there were only two models – the first-generation Toyota Prius (TM-NYSE) and the original Honda Insight (HMC-NYSE). Mr. Berman pointed out that during that period, the marketing budget and media buzz for those cars was next to nothing, quite in contrast to the endless press coverage of the Chevy Volt, Nissan Leaf and Tesla, even well before the models were available. As Mr. Berman characterized it, “The first hybrids were introduced before green was in, when big SUVs still dominated U.S. roads.” The key to the hybrid sales explosion in 2004 was Toyota’s introduction of the much more accessible family-size liftback Prius and gasoline prices reaching the $2 a gallon level, the highest they had ever been. Mr. Berman noted that the financial crisis of 2008 and resulting recession devastated automobile sales in this country. It has taken five years for auto sales to recover, but only to 2007 levels. He wonders whether the growth rate for hybrids is about to resume its upward trajectory, or remain relatively flat. He notes that even after all the changes in the automobile market, hybrids still only account for about 4% annually of total car sales. That share reflects hybrids that need about the same refueling time as gasoline-powered vehicles, with EVs that require a much longer charging (refueling) time plus face a lack of public recharging stations. Exhibit 2. Missing The Mark Due To Financial Crisis

Source: Frost & Sullivan

We went looking for other forecasts for the EV market and found the Frost & Sullivan projection for 2008-2015 (Exhibit 2), and another one published late in 2012 by an investment management group and published in Barron’s magazine. The dramatic growth in the Frost & Sullivan forecast may be attributable to both optimism on the part of


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The Volt barely achieved two-thirds of that forecast The number of EVs sold last year represented 0.6% of the U.S. new-car market About two-thirds of the U.S. market is made up of cars costing less than $25,000

the forecasters and the forecast being prior to the 2008 financial crisis. The investment management group’s forecast called for U.S. deliveries in 2013 to reach 127,000 vehicles, some 130% above their estimate of 55,000 (closer to 53,000) units having been delivered in 2012. The money manager expected the sales jump to be driven by more models, lower price points and attractive lease offers, and a broader vehicle charging network. It went so far as to project the Chevy Volt to be the number one EV with sales in 2013 of 35,000. The Volt barely achieved two-thirds of that forecast. To better understand the dynamics within the EV market and how they might influence our view about natural gas volumes for the electricity market, we turned to an analysis by Matthew Klippenstein published on the greencarreports.com blog. Acknowledging that the number of EVs sold last year represented 0.6% of the U.S. new-car market, he wanted to piece together the relationships between vehicle price, type and market share in order to better understand the EV landscape. First, he looked up the entry-level sticker price for each of the 271 models listed in GoodCarBadCar.net’s tracking of auto sales (accounts for about 98% of all cars sold). He used the data as a proxy for the average selling price. This enabled him to estimate the U.S. auto market size by price points. Exhibit 3. Segmenting Auto Market By Price Points

Source: greencarreports.com

For EVs, he had to average the starting and ending manufacturer’s suggested retail price (MSRP) because of price reductions instituted during the year. He also subtracted the federal income-tax credit for each vehicle to get closer to what buyers would have actually paid. The result is that about two-thirds of the U.S. market is made up of cars costing less than $25,000. This conclusion is consistent with Navigant Research’s recent consumer survey that found that 71% of new-car buyers don’t want to spend more than $25,000 on their next vehicle.


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Cutting the MSRP of the Chevy Volt from $40,000 to $35,000 roughly doubles the potential buyer pool from 6% to 11% of the market

Exhibit 4. EV Market Segmented By Price Points


Mr. Klippenstein points out that cutting the MSRP of the Chevy Volt from $40,000 to $35,000 roughly doubles the potential buyer pool from 6% to 11% of the market. The Federal income-tax credit further pushes the Volt’s price down into the high $20,000s exposing it to an even greater market potential. He also showed that Nissan’s Leaf, at $21,300 after the tax-credit, is now priced to cover three-quarters of U.S. car buyers. The point of his analysis was to focus on the market share of EVs based on price points. Exhibit 5. EV Market Price Points Ex-Trucks And SUVs


EVs are estimated to have about a 1.4% market share of the $25,000 price point, better than the 0.6% share of the entire fleet. Mr. Klippenstein argues that we should forget about the $20,000 price point since there are no EVs in that price range. He also is concerned about the impact of pickup trucks and SUVs, so he


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He calculates that EVs represent slightly more than 1% of the passenger-car market, almost 2% of the $20,000-plus market, and just about 3% of the $25,000-plus market The early release of the 2014 AEO calls for EVs to have about a 1% market share of new cars sold in 2040 This technology was introduced in an EV concept car – Amitron – built by tiny American Motors in 1967!

eliminated them from his analysis and found that the EV market share increased by one percentage point. Given that adjustment, he calculates that EVs represent slightly more than 1% of the passenger-car market, almost 2% of the $20,000-plus market, and just about 3% of the $25,000-plus market. He further determined that at the luxury level – cars costing $50,000 and up – Tesla has won more than 8% of the sales. And if you go to the $62,400-plus price point (after the federal tax-credit) Tesla has a 17% market share. Circling back to the impact EVs may have on the domestic energy market, we noted that last year the EIA made a significant change to its projections of the number of alternative fuel vehicles on the roads in its energy demand forecasts. The EIA disclosed its revision in the 2013 Annual Energy Outlook. At that time, the EIA cut its projected EV sales forecast for 2035 from 340,000 units to 119,000. Given that the industry sold over 98,000 units last year, one has to wonder whether the EIA will be revising its long-term forecast again. The early release of the 2014 AEO calls for EVs to have about a 1% market share of new cars sold in 2040, which suggests that the projection for sales volumes shown in Exhibit 6 hasn’t been materially adjusted. Exhibit 6. Sharply Lowered EV Sales Forecast

Source: IER

In the course of our EV market research, we discovered the answer to a question we had been wondering about for a while – when did the automobile industry first introduce regenerative braking? For those not familiar with hybrid vehicles, the batteries that power them at low speeds are recharged when the brakes are applied. The heat generated by the brake, rather than being allowed to vent to the air, is captured. The trapped heat drives the electric motor to run in reverse and recharge the battery. This technology was introduced in an EV concept car – Amitron – built by tiny American Motors in 1967! This 1,100-pound car was powered by a combination of nickel-cadmium and lithium-nickel-fluoride batteries. The former


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One can only wonder where our automobile technology might be today had American Motors, or the auto industry, pursued that EV concept car

provided quick power for acceleration while the latter provided maximum energy storage for sustained cruising. The combined battery gave the Amitron a sustained range of 150 miles at a speed of 50 miles per hour. Exhibit 7. The Amitron EV Concept Vehicle

Source: American Motors

Isn’t it astounding that what most American’s consider to be cutting-edge automobile technology today was actually introduced over 45 years ago? Interestingly, average new car fuel economy peaked that year at 14.8 miles per gallon (mpg). It then declined to 12.9 mpg by 1974 when the Arab oil embargo tripled U.S. oil prices and focused government policy-makers on improving the nation’s vehicle fuel-efficiency. The first CAFE standard was introduced in 1975 and established an average 18 mpg target for the 1978 U.S. new car fleet, targeted to rise to 27.5 mpg by 1985. One can only wonder where our automobile technology might be today had American Motors, or the auto industry, pursued the EV concept car. Maybe we would all be driving EVs today. For all the promise of EVs, we see them having little impact in the foreseeable future on electricity demand and in turn on natural gas consumption, unfortunately.

Lower Oil Price Outlook Hurts OFS Stock Outlook There has always been a strong correlation between crude oil prices and the OSX

We were quite intrigued to read a research note from an old friend and former competitor, Jim Wicklund of Credit Suisse (CS-NYSE), in which he and his research team used oil prices to forecast oilfield service stock prices. Because there has always been a strong correlation between crude oil prices and the Philadelphia Oil Service Stock Index (OSX), movement of one often moves the other.


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Their less optimistic oil price view is predicated on the assumption that global oil supplies will expand faster than demand grows, thus putting downward pressure on prices The increased production from Iran should come by year-end as a result of the recently negotiated deal over the country’s nuclear energy program The pattern of price reductions for WTI is similar to Brent, but the percentage declines are greater

The commodity analysts at Credit Suisse had just reduced the firm’s forecast for crude oil prices, both Brent and West Texas Intermediate, for 2014 and 2015. Mr. Wicklund used these newly lowered prices in his projection for the OSX, and the results were not pretty! Credit Suisse’s outlook for oil prices is not only lower than its prior forecast but also puts them below the consensus view by a meaningful amount. Their less optimistic oil price view is predicated on the assumption that global oil supplies will expand faster than demand grows, thus putting downward pressure on prices. Oil demand growth, according to Credit Suisse, will be stronger than the consensus view, but they see a significant difference in where that demand originates. They see more demand from OECD countries and less from non-OECD, meaning they believe the economic recovery emerging in developed economies will accelerate in 2014, while developing economies will struggle to sustain their recent growth rates. That view contrasts with the outlook of the International Energy Agency (IEA) that sees another year of lower developed economies’ oil demand and higher developing economies’ consumption. On the supply side, Credit Suisse sees more oil coming to the market from Libya and Iran, especially in the second half of 2014. In Libya, they see the internal strife calming and oil shipments stepping up. The increased production from Iran should come by year-end as a result of the recently negotiated deal over the country’s nuclear energy program. One assumption in Credit Suisse’s supply forecast is that Sudan’s oil flows will continue building, but literally three days following the publication of their forecast the civil war in Sudan shut down the country’s total oil output. The bottom line of the Credit Suisse forecast is that the global supply disruptions that have held oil prices up for the past two years will subside, thus allowing prices to fall in response to more oil seeking buyers. The new Credit Suisse forecast calls for Brent oil prices in 2014 and 2015 to be 7.5% and 2.5% lower, respectively, from their prior forecast. They see the 2014 price averaging $101.75 a barrel, while in 2015 they expect it to average $97.50 a barrel. Their 2016 and 2017 projected $95 a barrel prices remain unchanged, as is their long-term outlook of $90 a barrel. The pattern of price reductions for WTI is similar to Brent, but the percentage declines are greater. In 2014, the average price is projected to fall by 11.8% from its previous projection to $91.75 a barrel and decline a further 4.9% to $87.50 a barrel for 2015. Credit Suisse’s $85 a barrel forecasts for 2016 and 2017 are unchanged as is their long-term oil price projection of $80 a barrel.


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If the OSX closing price is projected by WTI prices, the index is likely to be 14% lower at year-end What we have learned in making forecasts during our extended career is that they will be wrong!

Exhibit 8. Brent Oil Price Forecast May Help Or Hurt Stocks

Source: Credit Suisse

The outlook for the OSX at the end of 2014, based on Credit Suisse’s Brent oil price forecast, is for the index to close 15% below where it finished 2013. Using a bullish Brent price outlook only lifts the OSX by 5% by the end of the year. If the OSX closing price is projected by WTI prices, the index is likely to be 14% lower at year-end, and even if a bullish price is assumed, the index will still be 4% lower than at year-end 2013. Exhibit 9. WTI Forecast Hurts Oilfield Service Stocks The Most

Source: Credit Suisse

Making commodity price forecasts at the start of the year is always dangerous, especially given the current geopolitical dynamics in the Middle East and Africa. Plugging those estimates into a mathematical model to predict stock prices is equally as precarious, but that is exactly what Wall Street and the media want – people to tell them exactly what is going to happen over the next 344 days. What we have learned in making forecasts during our extended career is that they will be wrong! We don’t know by how much or when, but we are comfortable in stating that they will be wrong. If per chance we were ever right with a forecast, we would attribute


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it to the “broken clock” phenomenon – the time will always be right twice a day.

Weather Forecast Failures Create Energy Opportunities The pattern of the polar vortex determines how much cold air escapes from the Arctic and makes its way to the U.S. during the winter The cold air release sent a bitterly cold Jet Stream deep into the United States, dropping temperatures rapidly to mind numbing levels, which resulted in at least 17 deaths

Most Americans are now familiar with the polar vortex, a weather phenomenon in which the cold low-pressure area over the North Pole strengthens during the winter and weakens in the summer in response to changing temperature differentials between the equator and the poles. The pattern of the polar vortex determines how much cold air escapes from the Arctic and makes its way to the U.S. during the winter. The strengthening and weakening patterns of the polar vortex also help establish the seasonal configuration of the Jet Stream and the Gulf Stream. Often times, the strengthening is preceded by a lowering of the Jet Stream from northern Canada into the United States with an accompanying strengthening of the Gulf Stream, which in turn can produce a typical “Nor-Easter” winter storm. Exhibit 10. How Polar Vortex Impacts Jet Stream

Source: Wikipedia

The polar vortex is a high altitude low-pressure system that hovers over the Arctic in winter. When the polar vortex is strong, it acts like a spinning bowl balanced on the top of the North Pole, such as seen in the right-hand panel of Exhibit 11 on the next page. In early January, the polar vortex weakened and broke down that allowed fragments of cold air to slosh out of the bowl into mid-latitudes as shown in the left-hand panel of Exhibit 11. The cold air release sent a bitterly cold Jet Stream deep into the United States, dropping temperatures rapidly to mind numbing levels, which resulted in at least 17 deaths. A multitude of U.S. temperature records for January 7th were broken, although most of them did not break the all-time winter or January records. On that day, all 50 U.S. states recorded a temperature of 320 F or lower at some point during the 24 hours of that day. In Hawaii, the freezing mark was established at the top of Mauna Kea volcano, which often happens at that point


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Eleven U.S. cities set record low temperatures, including New York City where a 118-year record was broken Natural gas spot prices at the Henry Hub terminal jumped and have remained elevated

during winter months. Eleven U.S. cities set record low temperatures, including New York City where a 118-year record was broken when the temperature reached 40 F. After taking into account the wind chill, Chicago reached -310 F, while it was -160 F in New York City and -450 F in northern Minnesota along the Canada-U.S. border. Exhibit 11. How Polar Vortex Creates Extreme Cold

Source: climate.gov

The colder-than-normal December and the bitterly cold early January weather ramped up heating oil and natural gas demand, while causing gasoline demand to fall as Americans remained largely confined to their homes and not commuting to work and school. In response, natural gas spot prices at the Henry Hub terminal jumped and have remained elevated as consumption increased and expectations for additional cold weather this winter have supported the higher prices. Exhibit 12. Natural Gas Prices Respond To Cold Weather

Source: EIA, PPHB


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If natural gas storage volumes continue to be drawn down this winter at the same pace as last year, the gas market will be able to absorb substantially greater production in the spring and summer In the January weather chart, all of Canada is expected to experience cooler than normal temperatures

Last week, the Energy Information Administration (EIA) released its estimate of the amount of natural gas withdrawn from U.S. storage facilities in response to the polar vortex weather. The EIA estimated that 287 billion cubic feet (Bcf) of gas was withdrawn. That draw was considerably below the consensus forecast of 303 Bcf. The significance of the draw, even though lower than the optimists anticipated, is that it leaves the volume of gas in storage for the remainder of the winter heating season at 2,530 Bcf, 14.9% lower than the 5-year average volume for this week. Compared to last year at this time, the current storage volume is 20.7% lower. Both of these relative figures provide encouragement for bullish views about the trend in natural gas prices through the balance of the winter and potentially for the rest of 2014. If natural gas storage volumes continue to be drawn down this winter at the same pace as last year, the gas market will be able to absorb substantially greater production in the spring and summer in order to refill the storage caverns to be ready for the winter demand of 2014-15. Exhibit 13. Cold Temps Cause Gas Supply Drawdown

Source: EIA

The most intriguing development about the winter of 2013-14 is how the forecast for temperatures has changed. Originally, meteorologists anticipated this winter to be cooler than last year but generally in line with normal winter temperatures. Winter started with December’s weather seemingly cooler than expected, but the January polar vortex episode has significantly altered the seasonal outlook. We saw the impact of this temperature change reflected in the two winter forecast charts for Canada. In the December chart showing the anticipated temperature outlook for the next three months (Exhibit 14, next page), the forecast called for colder temperatures only in British Columbia, central Alberta and the northeast portion of the country. In the January weather chart (Exhibit 15, next page), all of Canada is expected to experience


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colder than normal temperatures. The polar vortex episode in early January has convinced people that this colder-than-normal outlook is probably correct, although U.S. government meteorologists don’t appear to subscribe to that view. Exhibit 14. Early Winter Outlook For Canada

Source: Macquarie Securities Group

Exhibit 15. Dramatic Shift In Canada Winter Temps Outlook

Source: Macquarie Securities Group


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A similar benign winter outlook for the United States was evident in the December commentary offered by the weather division of the NOAA December 2013 was the 21st coldest December in the 119-year record for the contiguous United States

A similar benign winter outlook for the United States was evident in the December commentary offered by the weather division of the National Oceanic and Atmospheric Administration (NOAA) at the end of November. NOAA said that temperatures “may be a cold one for some in the Midwest, but relatively mild in other parts of the nation.” Its view is exemplified by the map in Exhibit 16 showing that NOAA anticipated that only the North Dakota/South Dakota/Montana region of the country would experience colder-than-normal temperatures for the 90-day period of December, January and February, with most of the rest of the country having an equal chance for normal winter temperatures and only a few areas seeing warmer-than-normal weather. Exhibit 16. Winter Temperature Outlook For 2014

Source: NOAA

The latest data from NOAA shows that December 2013 was the 21st coldest December in the 119-year record for the contiguous United States. The month was the coldest December since 2009 with an average temperature of 300 F, some 20 F below normal. One almost wonders whether the winter weather will produce a result similar to the collective missed forecast of meteorologists for the 2013 hurricane activity. By February, NOAA anticipates that nearly half of the country will be experiencing warmer-than-normal temperatures. The February


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What we find interesting is the expected deep-freeze potential for much of the United States during the last week of January

temperature pattern, as depicted in Exhibit 17, happens to coincide with the temperature pattern NOAA is projecting for the three-month period of February, March and April 2014. Exhibit 17. February 2014 U.S. Temperature Outlook

Source: NOAA

What we find interesting is the expected deep-freeze potential for much of the United States during the last week of January. If that occurs, we would expect January’s average temperatures to be colder than normal given the polar vortex episode and the generally cooler weather experienced across the southern half of the nation. Weather is fickle, however. Exhibit 18. Another Polar Vortex Coming?

Source: ImpactWeather


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There remains, however, a high level of skepticism about whether the gas industry will be able to break out of its low-price environment

The colder December, and likely colder-than-expected January, has done wonders for natural gas company CEOs’ and commodity traders’ optimism for gas prices. There remains, however, a high level of skepticism about whether the gas industry will be able to break out of its low-price environment, as virtually all energy-market forecasters still anticipate natural gas prices to languish below $5 per million Btu until around the end of the decade or early into the following decade. As natural gas production has continued to increase despite the low price and sharply reduced dry gas drilling activity, we wonder how fast it might ramp up if producers sense higher prices in the near-term following the bout of cold weather. We remain convinced the next permanent step up in gas prices will coincide with the start of liquefied natural gas (LNG) shipments from this country, which means around the year 2016.

Delaying Keystone While Creating Anti-fossil Fuel Legacy President Barack Obama signed a Presidential Memorandum establishing a Quadrennial Energy Review The committee is mandated to provide a report every subsequent four years to the then-president about other aspects of the nation’s energy system

On January 10th, President Barack Obama signed a Presidential Memorandum establishing a Quadrennial Energy Review. The White House hailed the action as a continuation of the President’s strategic energy and climate change initiative. This initiative began on March 30, 2011, when the President unveiled his Blueprint for a Secure Energy Future. He expanded on the initiative with his June 25, 2013, climate change speech at Georgetown University. The purpose of the new memorandum is to establish a high-level government body, composed of senior representatives from virtually every agency of the federal government that either does or might have an interest in energy policy, which is charged with examining all aspects of the nation’s energy industry infrastructure and presenting a report with recommendations on actions to improve the industry’s operations while considering water and climate issues. The Review will be headed by the President’s Science Advisor John Holdren and is charged with presenting its initial report by January 31, 2015. Mr. Holdren is known as one of the parties to the infamous bet over the ten-year trend in commodity prices back in the 1970s when he was an advocate of a Malthusian global economic and social crisis that required government intervention into population control. The committee is mandated to provide a report subsequently every four years to the then-president about other aspects of the nation’s energy system. It will be interesting to see what future reports will focus on, and how they will even determine what to examine. The initial Review has been given the following charge: “The initial focus for the Quadrennial Energy Review will be our Nation’s infrastructure for transporting, transmitting, and delivering energy. Our current infrastructure is increasingly challenged by transformations in energy supply, markets, and patterns of end use; issues of aging and capacity; impacts of climate change; and cyber and physical threats. Any vulnerability in this infrastructure may be


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His last principle thrust was to push research and development of clean energy sources “This plan begins with cutting carbon pollution by changing the way we use energy -- using less dirty energy, using more clean energy, wasting less energy throughout our economy” He went on to discuss how he wanted to mobilize the private equity industry to become involved in promoting and commercializing clean energy technologies

exacerbated by the increasing interdependencies of energy systems with water, telecommunications, transportation, and emergency response systems. The first Quadrennial Energy Review Report will serve as a roadmap to help address these challenges.” President Obama’s energy blueprint set forth three goals – develop and secure America’s energy supplies; provide consumers with choices to reduce costs and save energy; and innovate our way to a clean energy future. It was with this March 2011 report that President Obama began his campaign to demonstrate how much his administration had done to boost domestic oil production while at the same time reforming safety and environmental standards for oil and gas following the Deepwater Horizon accident the prior year. He also hyped the administration’s efforts to reduce gasoline consumption by mandating higher average vehicle fuel-efficiency. Besides autos, President Obama was also pushing a plan to leverage the private sector’s efforts with federal money to improving the energy efficiency of homes and buildings. His last principle thrust was to push research and development of clean energy sources. In the Blueprint document, the following statement was made regarding the administration’s aspiration for achieving new breakthroughs in clean energy such as “a battery that will take a car 300 miles on a single charge or a way to turn sunlight into fuel like gasoline...” The administration went on cite how it was investing “in a host of clean energy programs and ultimately supported thousands of projects across the country targeted at the demonstration of clean energy projects in every state.” Last summer, the President went to Georgetown University in the heat of the day and outside in the sun to speak about the need to mobilize the nation to tackle the climate change challenge. The staging of this speech was reminiscent of the Congressional hearing in the mid-1990s orchestrated by Vice President Al Gore and NASA scientist James Hansen to promote the issue of global warming by turning up the heat starting the night before to transform the hearing room into a “sweat box” to dramatize the issue. The climate speech was essentially a retelling of the Blueprint’s goals. As President Obama said, “This plan begins with cutting carbon pollution by changing the way we use energy -- using less dirty energy, using more clean energy, wasting less energy throughout our economy.” There was great interest in promoting renewable fuel usage, not only here in America but abroad as well. President Obama stated, “So to help more countries transitioning to cleaner sources of energy and to help them do it faster, we're going to partner with our private sector to apply private sector technological know-how in countries that transition to natural gas. We’ve mobilized billions of dollars in private capital for clean energy projects around the world.” He went on to discuss how he wanted to mobilize the private equity industry to become involved in promoting and commercializing clean energy technologies.


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“Today, I'm calling for an end of public financing for new coal plants overseas -- (applause) -- unless they deploy carbon-capture technologies, or there's no other viable way for the poorest countries to generate electricity.” He will point to the Review as the reason he cannot make a decision The EIA is projecting another one million barrels a day of oil shale output this year and 750,000 barrels a day more in 2015

As an aside, in reading the June 2013 speech, we found out where Health and Human Services Secretary Kathleen Sebelius came up with her exemption allowing those whose health insurance plans were cancelled and found health plans on the healthcare.gov web site to be too expensive to buy replacement health policies even though they would not be compliant with the Affordable Care Act requirements. In the speech, the President said, “Today, I'm calling for an end of public financing for new coal plants overseas -- (applause) -- unless they deploy carbon-capture technologies, or there's no other viable way for the poorest countries to generate electricity.” With the Quadrennial Energy Review being told to target the nation’s energy infrastructure, we were struck with the potential this decision might have on the President’s upcoming decision to either approve or reject the permit to construct the Keystone XL pipeline border crossing. We may be overly cynical but we can see the decision (once it runs the gauntlet of administrative challenges over the integrity of the environmental consulting firm that prepared the Environmental Impact Statement okaying the pipeline, and the scope and adequacy of the study) being dodged by President Obama by this action. He will point to the Review as the reason he cannot make a decision, and that he won’t be able to make it until the Review report is completed in January 2015. It is clear to us that President Obama is seeking to avoid making a decision about Keystone in hopes that time and the shale revolution will eliminate the need for the pipeline. With more shale oil output, the energy debate may shift to questioning why we need all the Canadian oil sands bitumen when we have more domestic oil output than we can use. Think about how much new oil production there is in this country since TransCanada (TRP-NYSE) filed its initial application for Keystone in September 2008 – nearly an additional three million barrels a day! The Energy Information Administration is projecting another one million barrels a day of oil shale output this year and 750,000 barrels a day more in 2015. In the meantime, we continue to add more rail tank cars to haul shale oil around the country to refineries. Never underestimate a politician’s desire to help solve a problem, but first he needs to study it to death before he can act. The administration hasn’t finished studying Keystone to death yet, but the new Quadrennial Energy Review should just about do it.

The Dividend Vs. Share Buyback Debate Continues GM announced it was instituting its first quarterly dividend payment since June 2008

Last week, General Motors (GM-NYSE) announced it was instituting its first quarterly dividend payment since June 2008 when it eliminated its dividend in an attempt to conserve cash during the financial crisis and economic downturn that eventually led to the firm’s bankruptcy and bail-out by the federal government. The $0.30


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The analysis pointed out that forecasters are calling for the slowest rate of forward dividend payout growth (+8.7%) since the third quarter of 2010 On the basis of dividend payouts from reported earnings, energy outperformed three other sectors – technology, financials and consumer discretionary

per share quarterly payment ($1.20 annualized rate) gave the GM shares a 3% dividend yield based on the share price at the time of the announcement. GM’s action adds an additional company to the 417 members of the Standard & Poor’s 500 Index already paying dividends as of mid-December 2013, or 84% of the total. The payout will again provide fodder for the debate among investment professionals, business school academics and corporate executives over whether it is better to return cash to shareholders via dividends or through share repurchases. In a mid-December review of trends in the S&P 500 index, the analysis pointed out that forecasters are calling for the slowest rate of forward dividend payout growth (+8.7%) since the third quarter of 2010. That forecast contrasts with the trailing twelve month dividend per share growth for the index of 13.1% year over year. An additional interesting point was that this is the first time since late 2009 that non-dividend paying S&P 500 stocks have outperformed dividend paying stocks over an 18-month time period since late 2009. Exhibit 19. Tracking S&P 500 Dividend 20-Year Record

Source: FactSet

The analysis also looked at dividend trends within the various sectors of the S&P 500 index. We noted that Energy was the third worst sector when measured by the percentage of companies increasing their dividends last fall. It was also interesting to compare the energy sector’s dividend payout ratio based on both trailing twelve-month reported earnings and operating cash flow. In both cases, the sector’s payouts are below the aggregate ratios for the index. On the basis of dividend payouts from reported earnings, energy outperformed three other sectors – technology, financials and consumer discretionary. However, when measured against the payout ratio calculated from operating cash flows, energy only outperformed financials. It would appear the energy business has lagged much of corporate America with respect to its dividend payouts, which may explain why more energy companies are now talking about either instituting dividend


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The industry needs to improve its shareholder relations by providing a larger current return to shareholders Academic research has questioned this strategy as it often seems that the inflated earnings are not rewarded with a stable valuation

Exhibit 20. Energy Sector Has Poor Record On Dividends

Source: FactSet

payout policies or taking steps to boost existing payouts. These steps are being taken in recognition that the industry needs to improve its shareholder relations by providing a larger current return to shareholders rather than promising higher share prices and resulting capital gain opportunities in the future. Exhibit 21. Energy Trails Index Median Payout Ratios

Source: FactSet

The strategy for returning capital to shareholders by using surplus cash to repurchase shares is based on the belief that by reducing the number of shares outstanding, per share earnings results will increase. As long as the company’s stock market valuation parameters do not change, the higher earnings per share should push share prices higher, offering positive investment returns for those shareholders who do not sell their shares. Academic research has questioned this strategy as it often seems that the inflated earnings are not rewarded with a stable valuation. Academics have also shown that companies tend to repurchase shares during periods when they are doing well operationally and financially, meaning they are generating excess cash, but this is often when the share price is at its highest point, meaning that companies are often overpaying for their shares.


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Growth in earnings per share is often a measure used to judge the performance of CEOs and to financially reward a company’s management team We understand that increased share repurchases are, and will remain, a fact of corporate life

Exhibit 22. Buybacks Are Outspending Dividend Payments

Source: Standard & Poor’s, PPHB

It is interesting to consider what the companies in the S&P 500 index have done on a quarterly basis over 2001-2013. Until the economic boom times that kicked off in 2004, dividend payouts exceeded buybacks. That changed as the good times rolled during 2004-2007. The financial crisis of 2008 and 2009 recession took a toll on share buybacks and dividend payments, too. Once the economy began to recover and corporate America started building substantial cash balances from conservative spending and increased operating leverage, stock repurchase funds started flowing at a faster rate than dividends. Given economic uncertainty, managers saw share repurchases, especially of share prices depressed by investor uncertainty, as the easiest way to return excess cash to shareholders. Other reasons given for increasing share repurchases were to increase financial leverage that often boosts financial returns and to offset option grants to executives. A reason seldom mentioned, but potentially a strong driver for share buyback programs, is the impact reduced share counts have on a company’s per-share earnings. Growth in earnings per share is often a measure used to judge the performance of CEOs and to financially reward a company’s management team. Some shareholder groups have criticized buybacks because they use shareholder money to boost the performance of management who in turn receive larger bonuses and other compensation at the future expense of a company’s financial performance. While we personally prefer dividends, and steadily rising ones, as a more effective declaration of management performance, we understand that increased share repurchases are, and will remain, a fact of corporate life. We doubt the argument over which method to return excess cash to shareholders is “best” will be resolved anytime soon. We believe energy companies will be more sensitive to the need to provide better returns to their shareholders. If share prices


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Expect shareholders to demand greater cash returns

continue to climb, even if they trail the performance of the overall market, shareholders will be happy for management teams to return cash via either dividends or buybacks. If stock market conditions change or the industry suffers an economic setback, expect shareholders to demand greater cash returns, and maybe the seldom-mentioned alternative to dividends and buybacks - selling the company!

Contact PPHB: 1900 St. James Place, Suite 125 Houston, Texas 77056 Main Tel: (713) 621-8100 Main Fax: (713) 621-8166 www.pphb.com

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.

usings rom the oil atch - energy musings · $30,786 reports the firm, down only 0.6% from a year...

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