117626_Musings 010411

MUSINGS FROM THE OIL PATCH January 4, 2011

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 Surprise Of 2011: Crude Oil Down And Natural Gas Up But in various places and ways the global liquid fuel supply is growing

Conventional wisdom calls for crude oil prices to average above the triple-digit barrier in 2011 and natural gas prices to continue its run in sub-$5/Mcf (thousand cubic feet) purgatory. What a surprise it would be if a year from now we looked back on 2011 as the year in which crude oil broke $100 a barrel but settled well below that level and that natural gas rallied to $6/Mcf and averaged above $5/Mcf. How could this possibly happen? Let’s take a look. Global crude oil inventories, while coming down due to tax planning and increased winter demand, remain high. OPEC spare output capacity is about 5.4 million barrels per day, well above the one million barrels a day it had fallen to when oil prices soared to $147/barrel at mid-year 2008. While there have been a number of new large oil discoveries, especially in deepwater off Brazil and West Africa, most of them will not come on stream to help boost the supply picture next year. But, in various places and ways the global liquid fuel supply is growing. For example, the Bakken shale formation in North Dakota is experiencing a drilling boom and due to significantly greater flows from these new wells, the state’s oil production has nearly doubled from 2008. Estimates are that North Dakota’s oil production could increase by another one-third, or an additional 100,000 barrels per day by the end of 2011. More importantly, the growth in gas shale drilling in the U.S. is leading to increases in both crude oil and natural gas liquids production along with surging volumes of natural gas. The increased volume of natural gas liquids, outside of the crude oil quotas of OPEC members, has also added to global fuel supplies. And the most recent OPEC development is the announcement that Iraqi oil production has reached 2.6 million barrels per day, a 20-year high, with growing exports. Iraqi exports may become an issue in 2011 for OPEC if global demand growth moderates.

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Oil price forecasters must look at more factors in more countries, most of which lack transparency compared to the U.S. and Europe The IEA is projecting oil demand growth of 1.2 million barrels per day in 2011, a growth rate consistent with the growth rate of the 1990s and 2000s The prospect of a decade of natural gas prices trading in the $4-$5/Mcf range strikes us as unreal

While supply is growing, the greater question for oil prices is the demand side of the equation. The bullish case for oil demand argues that America is no longer the driving force behind oil consumption growth as that mantle has been assumed by Asian developing economies. That means oil price forecasters must look at more factors in more countries, most of which lack transparency compared to the U.S. and Europe. Historically, oil demand growth in these developing economies has been spurred by price subsidies. The finances of many of these countries can no longer absorb those subsidies and we have seen and expect to see more countries cut or eliminate price subsidies. That means oil demand growth will become more dependent on economic growth, and energy usage will be subject to greater conservation than in the past. We still have a weak economic recovery underway in the United States and there are serious economic and financial questions in Europe. As long as these large energy consumers are languishing, it is hard to expect a repeat of the 2-plus million barrel per day demand growth this year, which reflected a snap-back from the recessionary years of 2008 and 2009. The IEA is projecting oil demand growth of 1.2 million barrels per day in 2011, a growth rate consistent with the growth rate of the 1990s and 2000s. A last consideration is what happens to the value of the U.S. dollar. If the new Congress addresses the government’s profligate spending and the country’s long-term entitlement issues, the value of the U.S. dollar could rally undercutting the global price of oil. The real surprise could come on the natural gas side where the Energy Information Administration (EIA) recently projected that prices will remain below $5/Mcf until either 2019 (Henry Hub price $5.04) or 2023 (wellhead price of $5.15/Mcf). While the natural gas industry has experienced boom and bust environments in the past, most of the pricing variability was due to regulatory changes impacting natural gas consumption. The prospect of a decade of natural gas prices trading in the $4-$5/Mcf range strikes us as unreal. Governmental and societal emphasis on using cleaner energy argues that natural gas will play a greater role in U.S. energy supply than it currently does. Even though we have huge deposits of natural gas, especially due to the successful exploitation of our shale gas formations, many of these deposits will need substantially higher prices to be economic. The rush to lease up the acreage covering these shale formations and to hold them by drilling wells and producing gas has contributed to the current gas oversupply situation. That will pass as the land grab mentality ebbs and rational economic analysis exerts greater control over producer spending. We may be seeing the first signs of that shift in producer mentality in the EIA’s latest release of its estimate of natural gas production taken from its Form 914 survey. After surging to a new record high for Lower 48 land gas production in September of 60.37 Bcf/d (billion cubic feet per day), the month’s production was subsequently


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October’s Gulf of Mexico production was almost 1.0 Bcf/d lower than a year ago The latest weekly rig count numbers from Baker Hughes show that since early September the number of drilling rigs targeting natural gas has declined by 50, or about 5%

Exhibit 1. Land Gas Production Shows First Decline In 2010

Source: EIA, PPHB revised down to 59.94 Bcf/d, still a new record. The initial production estimate for October is 59.79 Bcf/d, a sequential decline of 0.15 Bcf/d. Moreover, gas production from the Gulf of Mexico in October was flat with September at 5.95 Bcf/d versus 5.93 Bcf/d. October’s Gulf of Mexico production was almost 1.0 Bcf/d lower than a year ago (5.95 Bcf/d versus 6.94 Bcf/d) and on trend with the long-term decline in offshore gas production. Exhibit 2. Gulf Gas Production Remains In Down Trend

Source: EIA, PPHB While it remains too early to forecast a significant reduction in onshore natural gas production, we are witnessing a shift away from gas-oriented drilling. The chart below (Exhibit 3) shows the monthly average number of rigs drilling for natural gas through October but provides only a hint of the reduction in gas drilling. But if we look at the latest weekly rig count numbers from Baker Hughes (BHI-NYSE), we find that since early September the number of drilling rigs targeting natural gas has declined by 50, or about 5%.


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What is missed, however, is the shift underway from drilling horizontal wells focused only on dry natural gas October’s gas production data represents only one data point

Exhibit 3. Gas Drilling Starting To Reflect Poor Economics

Source: Baker Hughes, EIA, PPHB If one only focuses on the number of drilling rigs drilling horizontal wells, there doesn’t appear to be much change. What is missed, however, is the shift underway from drilling horizontal wells focused only on dry natural gas and toward drilling horizontal oil wells and wells targeting high liquids volumes in the natural gas stream. Given the relative economics of drilling exclusively for dry natural gas versus crude oil and/or high liquids-content natural gas wells, we assume the current shift in focus will not reverse anytime soon. Exhibit 4. Horizontal Gas Drilling Decline Obscured

Source: Baker Hughes, EIA, PPHB Since we are not betting people, we are not providing odds on our oil and gas pricing surprise scenario happening. October’s gas production data represents only one data point. Some people worry about the estimate being revised upward when November’s data is released, but we would point out that in every month in 2010 so far, the revision of the initial monthly estimate has been down. One needs to go back to December 2009 to find an increase in the


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The trend in natural gas drilling activity this fall suggests a reversal is unlikely

monthly revision, and that was by only 0.01 Bcf/d and the prior two months saw revisions upward each month of about 0.20 Bcf/d . So while there may be a valid concern about the possibility of an upward revision, recent history suggests it would mean a reversal of the current trend. The trend in natural gas drilling activity this fall suggests a reversal is unlikely. That said, we suggest people should ponder our oil price surprise scenario as they contemplate energy business and investment decisions.

2011 Another Year Of Robust Industry Capital Spending The survey calls for a 10.8% increase in total global E&P spending to a record $490 billion 2010-2011 mark only the third time since 1970 that the annual spending increase is flat with the prior year

The annual Barclays Capital (BARC.L) survey of global exploration and production spending plans of oil and gas companies was recently released and its results signal a further healthy increase in expenditures, which should boost the revenues and earnings of oilfield service companies. The survey calls for a 10.8% increase in total global E&P spending to a record $490 billion, which follows on the estimated 10% increase in spending experienced in 2010. Growing optimism about a strengthening of the nascent economic recovery in the developed world, primarily the United States and Europe, combined with continuing rapid economic growth in developing economies underlies the strength in E&P spending. Exhibit 5. Capital Spending Tied To Oil Price Trend

Source: Citibank, Lehman, Barclays, PPHB The most interesting observation about the E&P spending survey results is that the period 2010-2011 mark only the third time since 1970 that the annual spending increase is flat with the prior year. The other two times were in 1977-1978 (20% both years) and 1993-1994 (4% and 3%). A characteristic of the two earlier periods is that each was marked by essentially flat crude oil prices. This time the industry is expecting crude oil prices to rise, but offset by weak natural gas prices. That could mean one of two conclusions – the spending increase either will be higher in 2011 than currently


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The most frequently cited price of crude oil that would trigger further increases in E&P budgets was $90 per barrel The difference seems only to be the question of when and for how long crude oil prices will remain at or above the century mark in 2011 The debate has centered on identifying the primary impetus behind the steady rise in crude oil prices throughout 2010 in the face of continued weak economic activity and high unemployment

forecasted or crude oil prices are headed lower. One outcome is positive for the industry while the other is negative. Food for thought! Oil and gas executives around the world continue to see healthy crude oil prices on the horizon. According to the survey, respondents expect the crude oil price (measured by the wellhead price for West Texas Intermediate) to average $77.32 per barrel in 2011, up from the $73.46 per barrel price indicated in the June 2010 survey and the $70.16 per barrel price in last December’s survey. In response to a survey question, the most frequently cited price of crude oil that would trigger further increases in E&P budgets was $90 per barrel – a barrier that has already been pierced. If we are to believe the forecasts of prominent commodity traders and the comments from several oil ministers attending the recent OPEC meeting, a $100 per barrel oil price cannot be ruled out for 2011. The difference seems only to be the question of when and for how long crude oil prices will remain at or above the century mark in 2011. Will $100 per barrel represent an average price for all of 2011, suggesting much higher prices at some point in the year as we are currently below the target, or will crude oil prices merely march slowly and steadily higher throughout the year to reach the target level, but resulting in a lower average price? Exhibit 6. 2011-2012 Crude Oil Futures Strip

Source: TickerTech.com The debate over the future direction of crude oil prices has raged for much of this year. The debate has centered on identifying the primary impetus behind the steady rise in crude oil prices throughout 2010 in the face of continued weak economic activity and high unemployment throughout the developed world and a well-supplied oil market. This supposed economic disconnect has led to a debate over whether the rising crude oil price has been driven by the declining value of the U.S. dollar in global currency markets, or whether the price rise reflects fears about future oil supplies being


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That the recent rise in crude oil prices had nothing to do with commodity speculators or U.S. Federal Reserve monetary policy but had everything to do with accelerating economic growth globally The strength of international spending dwarfs the 4.8% boost in Canadian E&P spending and is considerably stronger than the 8.1% increase in U.S. spending Weak natural gas prices are forcing many operators to forego drilling beyond the minimum activity levels needed to hold recently acquired leases

insufficient to meet future demand despite a continued above-ground oil supply surplus. At times, the debate has focused on the role of commodity speculators, a topic hotly debated in 2008 prior to the collapse of crude oil prices in the wake of the global financial crisis. Then again, speculators are always a convenient scapegoat whenever commodity price movements can’t be explained by conventional economic analysis. Last week in his column in The New York Times, Nobel prize-winner and Princeton University economics professor Paul Krugman wrote that the recent rise in crude oil prices had nothing to do with commodity speculators or U.S. Federal Reserve monetary policy but had everything to do with accelerating economic growth globally. Mr. Krugman surprisingly failed to mention any contribution from the cold and snowy weather in the Eastern and Southern portions of the U.S. and across Northern Europe. He also failed to point out that a partial explanation for the fall in crude oil and refined product inventories in the United States is the annual tax planning strategies of oil companies designed to minimize the amount of inventory they hold at year-end when local governments levy inventory taxes. Falling inventories are normally experienced in December unless there is an unusual circumstance such as anticipated supply disruptions expected early in the new year. Exhibit 7. Barclays 2011 E&P Spending Survey Results

Year-to-Year Companies($ in millions) 2011E 2010E % Change Surveyed

U.S. Spending 93,576 86,584 8.1% 210Canadian Spending 32,589 31,086 4.8% 126International Spending 363,345 324,099 12.1% 141Worldwide Spending 489,510 441,768 10.8% 402 Source: Barclays Capital, PPHB The Barclays survey shows that the 2011 E&P spending increase globally will be driven by a 12.1% expected international spending hike. The strength of international spending dwarfs the 4.8% boost in Canadian E&P spending and is considerably stronger than the 8.1% increase in U.S. spending. It is important to note, however, the nearly $40 billion increase in international spending expected in 2011 is considerably more than all of Canadian spending, and represents about 45% of total U.S. anticipated spending next year. In other words, the importance of what happens in international markets cannot be overemphasized. We know Canadian and U.S. E&P activity over the past several years has been driven primarily by drilling related to the exploding shale gas plays throughout the continent, although the emerging oil shales have also begun to impact drilling activity over the course of the past year. However, weak natural gas prices are forcing many operators to forego drilling beyond the minimum activity levels needed to hold recently acquired leases. Despite weak natural gas economics, North American E&P spending is up as operators are


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Current economics makes it difficult to make money on natural gas anywhere but in the Marcellus and possibly the Eagle Ford gas shales Another troubling consideration on the supply side is that producers have built, and continue to build, a backlog of drilled-yet-uncompleted wells that can be rapidly brought into production as gas prices rise The only true discipline is capital restraint We are reminded that the long-term is made up of many short-terms

finding many ways of securing capital to continue to play the “land grab” game. Operators, however, are actively switching their E&P focus to crude oil and liquids-rich natural gas drilling targets and away from dry natural gas prospects. Still, current economics makes it difficult to make money on natural gas anywhere but in the Marcellus and possibly the Eagle Ford gas shales. The problem with this liquids-rich drilling strategy shift is that it ignores the associated natural gas produced with the crude oil and natural gas liquids. So while the amount of natural gas produced per well may be lower than from dry gas wells, the volume has not yet been sufficiently lower to materially reduce the existing gas surplus, which would lead to higher natural gas prices. The current natural gas price outlook, as depicted by the forward curve of gas futures prices, suggests it will not be before 2013 that we see prices at or above $5 per thousand cubic feet (Mcf) on a sustained basis. That assumption rests on two considerations – first that gas production doesn’t fall off more rapidly than expected as drilling slows, and secondly that gas consumption doesn’t pick up materially along with the recovering economy. Another troubling consideration on the supply side is that producers have built, and continue to build, a backlog of drilled-yet-uncompleted wells that can be rapidly brought into production as gas prices rise (the question being the price level that triggers accelerated completion activity). Producers may also open the flow of wells that have been choked back in an effort to help reduce the gas surplus. We feel safe in predicting that whatever producers suggest they will do to counteract low gas prices will not happen as everyone will assume that conventional wisdom doesn’t apply to them. Therefore, producers will begin turning the valves and completing previously drilled wells before natural gas prices reach the threshold price everyone acknowledges is the trigger point for increased activity and production. The only true discipline is capital restraint, meaning that unless and until Wall Street is no longer willing to provide money for shale gas exploitation, producers will be hard-pressed to slow their activity despite acknowledging the poor economics associated with their decisions. We chuckle at the comments from natural gas E&P company executives, stock analysts and investors long natural gas-oriented stocks that the long-term outlook for natural gas is healthy. That may truly be the case, however, we are reminded that the long-term is made up of many short-terms, and if those are not healthy, then stringing together a number of bad periods before arriving at a good period seems to be a recipe for failure. We jokingly refer to it as “over the horizon forecasting.” By that we mean, things are going to be bad for as far as one can realistically see (to the horizon), but on the other side, everything is wonderful. This is usually a delusional forecasting model!


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It would seem there is a strong likelihood of an upward bias to E&P spending next year A significant number of companies would reduce their E&P spending if prices were to fall to $60 a barrel, and even more if they fell to $50

Exhibit 8. Natural Gas Futures Strip

Source: NYMEX, PPHB So what are the implications for producer actions relative to the Barclays E&P spending survey results? One question Barclays almost always asks is the willingness to increase or cut spending based on the changing level of commodity prices. What one gets is a central tendency for spending adjustments based on price sensitivities to higher or lower commodity prices. As we noted earlier, the budgets are being based on an average crude oil price for 2011 of $77.32 a barrel. Since February 2011 crude oil futures prices (as of December 27th) are nearly $91 a barrel and the average 12-month futures price curve is about $92.50, it would seem there is a strong likelihood of an upward bias to E&P spending next year. That is unless producers anticipate crude oil prices dropping next year due to economic, political or currency issues. With what we know about oil and gas company spending patterns, seldom are budgets increased during the first part of the year. Mid-year budget adjustments are generally the rule, so one should expect little additional spending until summer, at the earliest. What we found interesting in the producer responses to the questions about reducing spending based on lower crude oil and natural gas prices was just how wide the central tendencies were. As shown for crude oil, a significant number of companies would reduce their E&P spending if prices were to fall to $60 a barrel, and even more if they fell to $50. But what is often missed in a chart such as the one below (Exhibit 9) is the percentage of companies that would have cut their spending when crude oil prices fell to $70 a barrel or $65. Another way to look at the spending reduction vulnerability is to find the point at which the cumulative percentage reductions are equal to 50%. In the latest survey, we could expect meaningful reductions in industry E&P spending by the time crude oil prices had fallen to about $60 a barrel, or some $30 a barrel below the current futures


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It appears there is considerable room for a downside move in crude oil prices before the industry significantly reigns in spending

Exhibit 9. Oil Price Level For Capex Cut

Source: Barclays Capital, PPHB price. Another measure is to look at the 25% cumulative reduction percentage, which is somewhere between $70 and $65 a barrel. The point of this chart (Exhibit 10) is to show that it appears there is considerable room for a downside move in crude oil prices before the industry significantly reigns in spending. This should provide some comfort for oilfield service companies who are being pressured to add capacity to their businesses. Often times the maximum amount of pressure for capacity additions occurs at peaks in activity and just prior to industry activity downturns. The timing of capacity additions can make or break industry pricing and in turn, oilfield service company financial returns. Exhibit 10. Capex Cut 50% Point Level

Source: Barclays Capital, PPHB Another way of visualizing this relationship is to look at the longer term record of industry price assumptions when planning their budgets and then examining the actual average price for that particular year and the percentage increase in E&P spending plans. Following the recession of 2002, there was a small increase in E&P


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With crude oil prices today moving higher amid expectations for further increases, it is not surprising that E&P spending is rising at a moderate pace The greatest percentage of budget cuts will come when natural gas prices fall under $4.00/Mcf

spending that reflected the general assumption of a relatively flat future crude oil pricing trend. As actual prices started rising faster than companies’ expectations, spending increases also grew. Interestingly, the increase peaked in 2006 and the rate of increase in 2007 was less than half the prior year gain. Spending growth declined again in 2008, especially when the financial crisis hit. The impact of the 2008 credit crisis and the impact on the economy and the lack of industry access to capital markets translated into cut in E&P spending in 2009. With crude oil prices today moving higher amid expectations for further increases, it is not surprising that E&P spending is rising at a moderate pace. Exhibit 11. Capex Vs. Oil Price History

Source: Lehman, Barclays Capital, PPHB When we examine spending and its sensitivity to lower natural gas prices, we see a similar pattern as displayed for natural gas prices. Interestingly, the greatest percentage of budget cuts will come when natural gas prices fall under $4.00/Mcf. There are also large percentage cuts anticipated when gas prices fall by another $0.50 to $3.50/Mcf, and then again by an additional $0.50/Mcf drop. Exhibit 12. Natural Gas Price For Capex Cut

Source: Barclays Capital, PPHB


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Somewhere between $3.50 and $3.75/Mcf is the point at which 50% of the producers suggest they would cut their budgets The blanket nature of gas shale formations means that acreage acquired in the basins is highly prospective – the issue is just how economic the acreage may be 2011 marks only the third time since 2000 that cash flow was ranked at the most important determinant for E&P spending

Due to the large percentage reduction at the $4.00/Mcf point, what we find is that somewhere between $3.50 and $3.75/Mcf is the point at which 50% of the producers suggest they would cut their budgets. Because current futures prices for natural gas are slightly over $4.00/Mcf, it would appear that E&P spending on natural gas projects would be vulnerable to reductions now and that they will only get worse if prices fall by another $0.25/Mcf. Is it any wonder producers are looking for E&P natural gas projects that involve substantial volumes of liquids that enhance the price realizations they receive from their production? Exhibit 13. Natural Gas 50% Price Cut Level

Source: Barclays Capital, PPHB Once again, when we look at capital spending versus budgeted and actual natural gas prices over the past decade, they seem to match quite well until we get to 2010 and the estimate for 2011. While we know the spending increase is not just for natural gas, the projected increase given the outlook for gas prices suggests other considerations are behind spending decisions such as the need to drill and complete wells in order to protect the investment already made in prospective gas shale acreage. The blanket nature of gas shale formations means that acreage acquired in the basins is highly prospective – the issue is just how economic the acreage may be. And that often will not be known until wells are drilled and production histories established. There were two other answers to survey questions we found quite interesting. One had to do with the key determinants for E&P spending and the other with the most important technologies. Each of these questions and their responses suggest interesting industry trends that should be important, especially for investors. With respect to the first question, 2011 marks only the third time since 2000 that cash flow was ranked at the most important determinant for E&P spending. The other times were in 2000 when it was tied with natural gas prices, and in 2005.


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The concern today about cash flows may signal a greater concern about spending due to weak natural gas pricing that is spreading globally

Exhibit 14. Natural Gas Capex and Price History

Source: Lehman, Barclays Capital, PPHB The concern about cash flow in 2000 was easy to understand as the global economic boom was slowing due to the 1997-1999 currency-driven financial crises in Asia. Additionally, the stock market was overheating due to the dot.com craze and Y2K concerns. Given these concerns, producers were worried about how strong their cash flows might be. The interesting fact is that 2000 marked a year with significant increases in both crude oil and natural gas prices after nearly 15 years of commodity prices trading in a relatively narrow range. The concern in 2005 is a little more difficult to fathom as we were in the midst of what became a strong upswing in commodity prices. The concern about cash flows may have been the result of a relatively long history of relatively stable commodity prices so it is likely that producers were concerned about the sustainability of the forces driving crude oil and natural gas prices higher. Exhibit 15. E&P Spending Determinants

Source: Barclays Capital, PPHB The concern today about cash flows may signal a greater concern about spending due to weak natural gas pricing that is spreading globally. It may also reflect producer concerns at the time of budget preparations for the potential of a double-dip recession that would undercut energy demand and likely commodity prices. As the double-dip fears have faded from the forefront of economic forecasting, the caution reflects either weak natural gas prices or concerns about the lack of adequate oilfield service industry capacity and the pricing power that is being transferred to those companies, which will be used and will squeeze producer profit margins.


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From 2000 through 2006 when seismic was considered the most important technology, the oil and gas industry was extremely concerned about the difficulty in developing more prospects and losing access to prospective acreage around the world Unless the U.S. offshore regulatory process improves or crude oil and natural gas prices strengthen further from current levels, it is likely that U.S. spending may not reach the planned levels suggested by the survey results

Exhibit 16. Important Technologies Trends

Source: Barclays Capital, PPHB In the case of the most important technologies, fracturing/stimulation was ranked first in the 2011 survey. This means that fracturing/stimulation has been considered the most important technology in four of the past five annual surveys. All the other surveys back to 2000 picked 3-D and 4-D seismic as the most important technology. From 2000 through 2006 when seismic was considered the most important technology, the oil and gas industry was extremely concerned about the difficulty in developing more prospects and losing access to prospective acreage around the world. As gas shales emerged as the industry’s new “silver bullet,” the key for E&P success was no longer finding the shales, but rather figuring how to maximize the flow rates from them at the least cost. Fracturing/stimulation technology, coupled with horizontal drilling, which has been around for a long time, have been key to the successful commercialization of gas shale extraction and that success seems to have blossomed beginning in the 2005-2006 period. Thus, producers identifying fracturing/stimulation as the most important technology beginning in 2007 therefore should not be a surprise. The idea that seismic was the most important technology in 2008 probably has more to do with the introduction of several of the new wireless recording systems that are revolutionizing the seismic data gathering business at that time. While those wireless recording systems represent significant improvement in that sector’s technology, the importance of the contribution of fracturing/stimulation for improving the economics of gas shale developments should continue to make it the most important E&P industry technology for the next several years. After reading the results of the Barclays E&P spending survey for 2011, one is left with the impression that the industry wants to step up its activity. Uncertainty over Gulf of Mexico deepwater permitting and its effect on drilling and development activity in 2011, coupled with continued low natural gas prices will impact the amount of money available and spent. As a result, unless the U.S. offshore regulatory process improves or crude oil and natural gas prices strengthen further from current levels, it is likely that U.S. spending may not reach the planned levels suggested by the survey results. Even with these challenges, which should only impact a few industry subsectors, 2011 should be another year with higher industry activity as international spending will carry the day.


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A Simmons’ Bet Matt Would Have Likely Doubled Down On Mr. Tierney called Mr. Simmons to discuss a bet that the price of crude oil in 2010 would average $200 a barrel in 2005 dollars In the 1970s, Dr. Simon found that his optimism about the future didn’t generate as much attention as the doomsday forecasters The bet was that if, at the end of ten years, the value of this portfolio had increased Dr. Simon would pay Dr. Ehrlich the difference and vice-versa

Our late friend, Matt Simmons, made the news last week with a story about a bet over crude oil prices he made some five years ago and that his estate is paying off. The New York Times columnist John Tierney wrote a column titled “Economic Optimism? Yes, I’ll Take That Bet.” The column was prompted by the fact a bet he made in 2005 was due to be settled on January 1, 2011. Mr. Tierney read in an August 2005 article in The New York Times Magazine titled “The Breaking Point” that detailed the global challenge of meeting rising oil demand that would only be met with crude oil at $200 a barrel according to Mr. Simmons. Mr. Tierney called Mr. Simmons to discuss a bet that the price of crude oil in 2010 would average $200 a barrel in 2005 dollars. The call produced a $5,000 wager over that $200 a barrel prediction. Mr. Tierney labels himself as “a Cornucopian optimist” and he wanted to challenge the Malthusian view of Mr. Simmons and others in the peak oil camp. Mr. Tierney claims his bet was only following a rule he learned from a mentor and a friend, the University of Maryland economist Dr. Julian Simon. Dr. Simon had discovered that optimism didn’t make for elaborate cover stories or splashy front-page headlines. In the 1970s, Dr. Simon found that his optimism about the future didn’t generate as much attention as the doomsday forecasters such as Dr. Paul Ehrlich, a Stanford University biologist and the author of the 1968 book, The Population Bomb, that offered a doomsday outlook for the world due to rapid population growth and an inability to feed the people. He wrote, "The battle to feed humanity is over. In the 1970s, the world will undergo famines. Hundreds of millions of people are going to starve to death in spite of any crash programs embarked upon now. Population control is the only answer." In his 1974 book, The End of Affluence

, he upped the death toll to a billion or more that would die by the mid 1980s. He predicted that by 1985 the world would enter a genuine era of scarcity. While Dr. Ehrlich was correct about population growth (it increased by 50% between 1968 and 1993), he was wrong about starvation as food output more than doubled over that time period.

The classic confrontation over the planet’s physical limitations versus the power of human ingenuity was the 1980 bet between Dr. Ehrlich and Dr. Simon. Dr. Simon suggested that if the world was about to enter an era of scarcity as suggested by Dr. Ehrlich, then commodity prices would certainly rise. However, if he was wrong, then prices would fall. In October 1980, Dr. Ehrlich purchased $1,000 worth of five metals ($200 each) – tin, tungsten, copper, nickel and chrome. The bet was that if, at the end of ten years, the value of this portfolio had increased Dr. Simon would pay Dr. Ehrlich the difference and vice-versa. Ten years later, Dr. Ehrlich sent a check for $576 to Dr. Simon as all five metals had declined in price.


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The Malthusian view was originally designed to counter a popular view in Europe about the limitless potential for improving society While this expert group lost their bet, it didn’t seem to hurt their professional reputations

The view of the limits to population growth due to famine and disease has been around since 1798 when the Rev. Thomas Robert Malthus postulated this view in the first edition of his book, An Essay on the Principle of Population

. The Malthusian view was originally designed to counter a popular view in Europe about the limitless potential for improving society. This pessimistic view of the long-term future of society was expanded over the years to include limits on the physical output of the planet – food, minerals and energy – that would restrict the number of people who could reside on Earth and what would happen to their standards of living.

Mr. Tierney’s article was written primarily to herald the unsung heroes of optimism. We are not sure, however, whether he intended to make the subtle point we found fascinating when he discussed Dr. Ehrlich’s 1980 bet. At the time of the bet, Dr. Ehrlich formed a consortium with two colleagues at Stanford University – John Holdren and John Harte, who were supposed to be experts in natural resources, according to Mr. Tierney. While this expert group lost their bet, it didn’t seem to hurt their professional reputations. As Mr. Tierney pointed out, both Dr. Ehrlich and Dr. Holdren were awarded MacArthur “genius awards,” something Dr. Simon never won. In addition, Dr. Holdren went on to lead the American Association for the Advancement of Science, and today serves as President Obama’s science advisor. Does anyone find it interesting that the Administration’s key strategy advisor on science, which has to include energy, is philosophically a Malthusian and has been proven wrong about those views throughout his career? Does this help explain the Obama administration’s devotion to “green” energies such as wind, solar and biofuels?

Will China Prevent $5 A Gallon Gasoline Here? Many people are questioning Mr. Hofmeister’s analysis given the current surplus of global crude oil production

Recent television news show visits by John Hofmeister, former president of the U.S. subsidiary of Royal Dutch Shell (RDS.A-NYSE), have led to a wave of media stories about his projections that gasoline prices will hit $5 a gallon before very long. Mr. Hofmeister suggests that due to rapid crude oil demand growth coming from developing economies such as China and India, world oil prices will rise and send gasoline pump prices skyrocketing in the United States. Many people are questioning Mr. Hofmeister’s analysis given the current surplus of global crude oil production, the large gasoline refining capacity surplus in the United States and the damage to the economy caused by high oil prices needed for $5 a gallon gasoline prices. As Mr. Hofmeister was talking, the Chinese government was acting to cool its auto market and its economy overall. By raising interest rates on Christmas Day, the Chinese government hopes to cool off its economy. In the capital city of Beijing, the metropolitan government instituted measures to restrict the number of cars that


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There also will be restrictions against non-Beijing licensed cars entering the city during rush hours By separating residential from commercial sectors, the government has increased the length of citizens’ commutes and the need to drive to work and shopping The government now believes that restoring the 10% rate will help cool the economy and ease carbon emission problems

can be sold in the city next year. This action, designed to help reduce traffic congestion, is accompanied by other steps such as increasing parking fees in the city while reducing them outside, building more roads, restricting the number and use of government vehicles, and incentivizing citizens to use mass transit. There also will be restrictions against non-Beijing licensed cars entering the city during rush hours. The decision to limit the issuance of license plates to 240,000 next year, or about a third of the number of cars estimated to have been sold this year, however, was a greater reduction than anticipated and sparked a surge in car sales before the rules were scheduled to go into effect. China’s other major city, Shanghai, began auctioning license plates in 1994, along with restricting non-Shanghai cars from using city roads during rush hours. According to Chinese media reports, the license fees in Shanghai are now averaging about $6,000 per car. The media also reports that since the city instituted the license restriction measure, traffic that once crawled now moves much better and, in fact, better than it moves in Beijing. Of course, the greatest criticism of Beijing traffic comes from its poor urban planning. By separating residential from commercial sectors, the government has increased the length of citizens’ commutes and the need to drive to work and shopping. Poor planning was further impacted by low parking rates charged in commercial areas that promote the purchase and use of cars over mass transit. Maybe the government’s actions will help ease some of the city’s traffic congestion, which saw a “commuter pain” report issued by IBM (IBM-NYSE) earlier this year ranking Beijing’s traffic equal with Mexico City for the most onerous traffic among 20 major world cities surveyed. Less than a week after the Beijing announcement, the Chinese government confirmed rumors that it would end the special sales tax break for small cars that had been in effect for all of 2010. The tax rate will return to its original 10% rate that existed prior to 2009. The rate was lowered in January 2009 to 5% following the global financial crisis in an attempt to stimulate economic activity. The rate was raised to 7.5% in January 2010. The government now believes that restoring the 10% rate will help cool the economy and ease carbon emission problems. The government has maintained its historic 40% tax rate for large, fuel-inefficient vehicles throughout the economic downturn. What remains unknown is whether the government will end its cash subsidy for buyers of certain fuel-efficient vehicles with 1.6-liter or smaller engines. The conclusion of auto industry analysts is that these Chinese government actions will cut the rate of auto sales growth to 8%-10% from the 34% projected for 2010 and the 25%-a-year average for the past decade. The 2010 growth rate may be higher as the government’s steps pull new car sales forward from 2011. The potentially greater problem for the auto industry may be a shift in


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Even in certain rural provinces governments are moving to restrict the number of cars sold If the market slows dramatically, it is likely the government will act to favor domestic manufacturers over the joint venture companies

emphasis to smaller cities and rural areas where the focus tends to be on smaller and cheaper cars. But even in certain rural provinces governments are moving to restrict the number of cars sold. The Wall Street Journal wrote that based on state media reports, “the wealthy eastern provinces of Jiangsu and Zhejiang are also considering measures to tighten car use, such as requiring residents to secure a parking space before being allowed to buy a car.” Exhibit 17. Could Auto Companies Be Squeezed?

Source: Econbrowser One does wonder whether the decision to reinstate the higher sales tax on small, fuel-efficient cars marks a shift in the government’s strategy toward its auto industry. Long-term projections assuming the continuation of the lower sales tax rate showed that by 2015 the Chinese auto manufacturing industry would move into an oversupplied situation. Even though Beijing accounts for only about 5% of the Chinese auto market, its move may be followed by more cities. Since the Chinese auto industry is made up of domestic producers and many joint ventures between western auto companies and local producers. If the market slows dramatically, it is likely the government will act to favor domestic manufacturers over the joint venture companies. One outcome of the spreading of Beijing’s restrictive policies could be a reduction in auto sales necessitating a reduction in manufacturing and an earlier date for industry overcapacity. That scenario might cause auto manufacturers, especially the joint venture companies, to step up export sales. That, in turn, could lead to overcapacity on a global scale and reduced profit margins for auto manufacturers. We doubt any of these potential negatives are built into stock market valuations and energy industry expectations. Fewer cars manufactured means less oil and gas sold in the future.

East Coast Blizzard And Snowy Europe = Climate Change?

The weekend before Christmas northern Europe was hit by a


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Possibly the bigger discussion underway is how we can be in the grip of such cold and wintery weather yet have the National Oceanic and Atmospheric Administration claiming 2010 may be the warmest year on record A negative NAO in winter creates a blocking force over the northern latitudes, which prevents the normally mild westerly winds reaching Europe from the relatively warm ocean waters That concern is predicated on the supposition that global warming may have changed the atmospheric circulation that increases the risk of cold winters in Northern Europe

significant winter storm and extremely cold weather that disrupted holiday travel plans for millions as major airports were shut for days in some cases, and highways and train tracks were blocked. As Europe was recovering, the U.S. East Coast was blanketed by a winter blizzard dumping double-digit snowfalls on many localities on Christmas weekend. The Christmas Blizzard of 2010, as the storm is being referred to by some, shut down the major airports in the New York area and shut down Amtrak train service between New York City and Boston. Earlier, the storm had hit Atlanta, Georgia and the southern tier states. While Washington, D.C. escaped the snow, further north New Jersey was slammed as well as states further up the coast. As this article is being written, Florida is in the grips of a deep freeze that has commodity markets all in a tizzy over the potential impact of the cold weather on that state’s citrus crop and indirectly on food inflation in this country. Possibly the bigger discussion underway is how we can be in the grip of such cold and wintery weather yet have the National Oceanic and Atmospheric Administration (NOAA) claiming 2010 may be the warmest year on record. The explanation may lie in an item that was part of an article in the Financial Times discussing the European winter storm. The article pointed out that the extremely early winter cold striking Northern Europe could be due to a climate phenomenon called the North Atlantic Oscillation (NAO). The NAO is a measure of the difference in sea-level pressure between the Icelandic Low and the Azores High. The NAO is in what is called its negative phase. That is when atmospheric pressure is unusually high over the Arctic yet low further south. A negative NAO in winter creates a blocking force over the northern latitudes, which prevents the normally mild westerly winds reaching Europe from the relatively warm ocean waters. Instead, cold air blows from the Arctic region. NOAA has determined that the strongly negative NAO experienced last winter has returned. The NAO index during November 2010 was the second lowest since 1950. This strongly negative index seems to have continued through December. Through the first two-thirds of December, average temperatures in the UK have been the lowest for 100 years. The question is whether the strong NAO currently in place (it has been in this negative phase for 15 months now, the longest period on record) is just a random climatic event or is linked somehow with climate change. That concern is predicated on the supposition that global warming may have changed the atmospheric circulation that increases the risk of cold winters in Northern Europe. If this is true, then the statement by a Gatwick Airport spokesperson about their rethinking the need to invest in more snow removal and de-icing equipment could prove prescient. “This is not a one-in-20-years event. It’s going to be more frequent than that as the past few weeks have shown.”


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New York City has had four of its top-ten snowfalls in the past decade The latest snowfall brought Philadelphia’s 2010 snowfall for the calendar year to 67.3”, breaking the mark for snowiest year ever

Exhibit 18. Shifting Polar Vortex Creates Severe Winter

Source: NOAA The blizzard of 2010 that socked the New York area left the region reeling as there were problems with snow removal in New York City and reopening the airports and moving the passengers stranded by the thousands of flights canceled. According to weather reports, the storm dumped 20.0” of snow on New York City’s Central Park, making it the sixth largest snowstorm for the city in recorded history and the second top-ten snowstorm this year. According to the records, New York City has had four of its top-ten snowfalls in the past decade - #7, 19.8” Feb. 16-17, 2003; #6, 20.0” Dec. 26-27, 2010; #4, 20.8” Feb. 25-26, 2010; and #1, 26.9” Feb. 11-12, 2006. Newark, New Jersey’s 24.2” snowfall was one that city’s top-ten snowstorms of all-time and the 20.1” that fell on Atlantic City, NJ was that city’s second largest snowfall in history. Atlantic City’s three biggest snowstorms have all occurred in the past ten years. Philadelphia, Pennsylvania picked up 12.4”, the city’s fourth one-foot or greater snowstorm in just over a year. That is an amazing string given that the city has had just 24 such snowfalls since 1884. The latest snowfall brought Philadelphia’s 2010 snowfall for the calendar year to 67.3”, breaking the mark for snowiest year ever. The previous record was 57.0” in 1978. So is there a pattern developing? And does that pattern have anything to do with global warming? Several climatologists researched snow storms in a 2006 report. The map below (Exhibit 19) shows the annual average number of snowstorms with a 6-inch or greater accumulation from the years 1901-2001. A value of 0.1 means an average of one 6-inch plus snowstorm every ten years. While there are a large number of these 6-plus inch snowstorms in the mountains of the West, there also has been a marked rise in their number in the Northeast during the past ten years. This raises


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A 2006 study found that for the contiguous U.S. between 1900-2001, some 61%-80% of all heavy snowstorms of 6-plus inches occurred during winters with above normal temperatures Based on this study, one could conclude that if the climate continues to warm, we should expect an increase in the number and intensity of snowstorms over the next few decades

the question of whether the rise is due to random chance or a change in the climate. Exhibit 19. Heavy Snowstorms Increasing In Northeast

Source: WunderBlog.com According to Dr. Jeff Master’s WunderBlog, a study done of the top ten heaviest snowstorms on record for each of 121 major U.S. cities showed no upward or downward trend in these very heaviest snowstorms during the period 1948-2001. Dr. Masters wondered whether if this study were updated to include the last decade’s data whether the conclusion would change. He went on to say that bigger snowstorms are not an indication that global warming is not occurring. He reminded his readers that there is an old adage, “It’s too cold to snow,” which has some truth to it. There is research showing that the average climate in the U.S. is colder than optimal to support the heaviest snowstorms. A 2006 study found that for the contiguous U.S. between 1900-2001, some 61%-80% of all heavy snowstorms of 6-plus inches occurred during winters with above normal temperatures. The authors of the study also found that 61%-85% of all heavy snowstorms of 6-plus inches occurred during winters that were wetter than average. The authors conclude, “a future with wetter and warmer winters, which is one outcome expected (National Assessment Synthesis Team 2001), will bring more heavy snowstorms of 6-plus inches than in 1901-2000.” The authors also found that over the U.S. as a whole, there had been a slight but significant increase in heavy snowstorms of 6-plus inches than in 1901-2000. Based on this study, one could conclude that if the climate continues to warm, we should expect an increase in the number and intensity of snowstorms over the next few decades, or until the climate grows so warm that we pass the point where winter temperatures are at the optimum for heavy snow events.


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The CSU forecast team believes that the primary driver for tropical storm formation is the Thermohaline Circulation (THC) that is a large scale Atlantic Ocean circulation pattern driven by changes in salinity and temperature The relationship between the strength of the THC and storm activity is very consistent over 1949-2010

What is interesting about the NAO is that it is also the climate phenomenon responsible for Atlantic basin hurricane activity. As we wrote in our last Musings when discussing the early tropical storm forecast for 2011 made by Colorado State University (CSU), the question is always asked whether the high number of tropical storms is due to global warming and especially its impact on sea surface temperatures. Dr. William Gray has devoted most of his research time over the past few years to assessing the role of global warming and increased tropical storm activity. So far he has found no causal relationship. The CSU forecast team believes that the primary driver for tropical storm formation is the Thermohaline Circulation (THC) that is a large scale Atlantic Ocean circulation pattern driven by changes in salinity and temperature. The THC is often related to the Atlantic Multi-Decadal Oscillation (AMO). When the THC is stronger than normal usually the AMO is in its warm or positive phase. Likewise when the THC is weaker than normal the AMO is in its cool or negative phase. The AMO is also known as the ANO. What Dr. Gray has found is that CO2 levels are not correlated with the THC or sea-surface temperatures. As a result, the strength of the THC (or AMO) is the principal driver for tropical storm activity and major hurricane activity in particular. The relationship between the strength of the THC and storm activity is very consistent over 1949-2010. In its simplest form, the THC/AMO is the driving force for storm activity and it is a variable trend that potentially has long-term cycles. These natural variations may also explain other climate phenomenon such as winter snows. Exhibit 20. Number Of Hurricanes Determined By THC Strength

Source: Colorado State University What we know about climate patterns such as THC and AMO is that they are cyclical and their live span can vary considerably. The chart of changes in sea surface temperatures over 1878-2006 demonstrates these points quite well. (Exhibit 21.) A paper titled “Hot Arctic-Cold Continents: Hemispheric Impacts of Arctic Change” presented by Dr. Jim Overland of NOAA’s Pacific Marine Environmental Laboratory at the annual meeting of the American Geophysical Union in December focused on the recent reversal of the Polar Vortex and how high pressure replaced low


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This altered pattern brought record snowstorms to Europe and the East Coast along with the coldest temperatures in 25 years, while also delivering the warmest winter on record to Canada and much of the Arctic What is becoming clearer every day is that developing simple explanations of the Earth’s climate is much more difficult than global warming proponents anticipated

Exhibit 21. Cyclical Sea Temperatures Reflect THC

Source: Colorado State University pressure over the Arctic. Normally the Arctic is dominated by low pressure in winter and a Polar Vortex of counter-clockwise circulating winds develops surrounding the North Pole. During the winter of 2009-2010, high pressure replaced low pressure over the Arctic, and the Polar Vortex weakened and even reversed at times, with a clockwise flow of air replacing the usual counter-clockwise flow. This unusual flow pattern allowed cold air to spill southwards into the Eastern U.S. and Northern Europe and be replaced by warm air moving poleward. This altered pattern brought record snowstorms to Europe and the East Coast along with the coldest temperatures in 25 years, while also delivering the warmest winter on record to Canada and much of the Arctic. This Polar Vortex reversal has happened only four times in the past 160 years – 1969, 1963, 1936 and 1881. What we noticed is that 1963 was within the first strong THC period and 1969, while not within the strong THC period was in the interim period before the start of the THC weak period. (Exhibit 20.) Could there be a relationship or explanation? It is impossible to know whether or not the Northeast United States and Northern Europe are in for years of heavy snowstorms and cold weather. We suppose that these causal relations between global warming and heavy snowstorms will continue to be made in the media and supported by climatic research. What is becoming clearer every day is that developing simple explanations of the Earth’s climate is much more difficult than global warming proponents anticipated. On the other hand, their claims need to be examined to see whether there are elements of relationships that need to be understood so the world can have a better climate in the future.


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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.

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