Investing in Energy

A Primer on the Economics of the Energy Industry

Gianna Bern

• Publisher: Bloomberg Press
• Year: 2011
• Print ISBN: 9781576603758
• eBook ISBN: 9781118128381
• Edition: 1
• Topic: Business
• Subtopic: Commodities
• Index: Business

An energy industry researcher and investment advisor provides a fresh perspective on the economics of energy

From major players in the energy industry, such as big oil, to the emerging cap-and-trade market, no other book offers a more complete overview of the energy industry, specifically its economic and financial intricacies, than Investing in Energy: A Primer on the Economics of the Energy Industry.

• Details how to value and invest in the four big energy sectors: oil, gas, power, and green
• Describes key financial considerations for the energy sectors, including credit metrics, the importance of liquidity, cash flow, and capital expenditures
• From Bloomberg, a leading provider of the most up-to-date business news and financial data

A comprehensive guide to the economics of the energy industry, Investing in Energy will prove an invaluable resource for traditional energy investors looking to expand into new areas, as well as for eco-investors looking to better understand how energy markets function.

Part I

Introduction and Financial Considerations

Chapter 1 Historical Perspectives

Financial Considerations

Chapter 2 Investment Opportunities in Energy

Chapter 3 Cash Flow and Liquidity at Various Crude Prices

Chapter 4 Capital Structure and Capital Markets

Chapter 5 The Quarterly Earnings Disconnect

CHAPTER 1

Historical Perspectives

The energy industry is undergoing unprecedented change as it reacts to new challenges in safety, regulation, exploration, and alternative-energy initiatives. One need only layer on the global political environment and the long-ranging repercussions of the 2010 Gulf of Mexico oil spill or the turmoil in the Middle East to realize that the energy sector is as complex as it has ever been. From this increasing complexity springs the need for this book. The following pages present a framework for understanding the basic elements of energy-industry economics. While not covering geology or refining from technical standpoints, this book provides a framework for analyzing the industry's basics and economics, and thereby helps prepare investors and other energy-industry professionals to more confidently venture forth into this vast and complex sector.

This book explores various opportunities available to investors in the energy arena and provides tools to better equip those new and not so new to investing in oil, gas, and alternatively generated energy. Time-tested analytic tools and investment criteria are utilized to provide the reader a better understanding of the economics behind the various energy sectors. Thoughtful and deliberate use of these analytic tools should enable deeper understandings of opportunities and more confident investment decisions. Also, long after the scent of fresh ink and paper have faded, we hope that this book will remain a trusted reference on many facets of commercial energy markets.

Chapter 1 explores some of the issues of the day in energy and places it in a historical context. We also review some of the key issues such as production and reserve growth for oil and gas producers. Cost structures continue to be a key consideration for alternative energy producers as project sponsors grapple with reducing electricity costs to become more competitive with that of fossil fuel producers. Next, we layer in the challenges in the regulatory environment that affect all energy producers. This chapter sets the foundation on which the next 21 chapters will build.

Oil and Gas Producers

A term that is used often in this book is integrated major (or major). This term refers to the industry business model of a large, vertically integrated oil and gas producer that has upstream, midstream, and downstream operations. Upstream refers to exploration and production, midstream consists of storage and transport, downstream refers to refining and retail operations. For integrated majors, the road ahead is one marked with significant challenges. In the wake of maturing basins, integrated majors are faced with stable to decreasing crude oil and natural gas production. The majors are also faced with the challenges associated with increasing crude oil and natural gas reserves in an environment where the preponderance of global reserves are controlled by national governments. The era of easy oil has indeed ended and the global oil industry is equally challenged by the development of new forms of alternative energies to meet future energy demand.

For national oil companies, the situation is different, but improving. National oil companies are challenged to extract hydrocarbons in an economical manner while supplying revenues to their governments. Therein lays the dichotomy and challenge. National oil companies are perennially faced with providing for the vast majority of their home country's economic resources. Many small national oil companies face a more precarious position of having to continually depend on high crude oil prices.

Are high crude oil prices a phenomenon of the past? While none of us has a crystal ball, the market consensus is that demand for crude and its refined products is going nowhere but up. Therefore, high crude oil prices have returned with a vengeance. How high is high? Over the near term, triple digit crude prices have returned but may not be sustainable over the longer term. The wild card is global economic recovery and returning crude oil demand from the 34-member Organization for Economic Co-operation and Development (OECD) countries. Currently, emerging market economies of China, India, Brazil, and Indonesia are contributing to the growth in crude and natural gas markets. Moreover, these emerging markets are stabilizing crude oil prices and preventing downward pricing pressure.

The natural gas market is currently in a pricing downturn. However, if we look beyond natural gas prices, we see a natural gas sector poised for future growth. Currently, natural gas inventories remain at relatively high levels contributing to the downward pressure on pricing. Natural gas is quickly becoming the fuel of choice as consumers and industries seek to move to greener solutions. Natural gas is becoming the fuel of choice because it is the cleaner fuel.

Moreover, unconventional natural gas shales (described more fully in Chapter 8) in the United States are in an unprecedented boom. Producers are seeking to acquire acreage in the U.S. basins of the Marcellus, Bakken, Eagle Ford, Haynesville, and Barnett Shale unconventional natural gas shale plays. According to the U.S. Department of Energy, growth in the U.S. natural gas market has the propensity to increase proven U.S. natural gas reserves almost three-fold over the next decade as producers aggressively move to categorize unconventional shale gas deposits as proved reserves (see Chapter 6). At the same time, development of these unconventional natural gas shales will have a weakening effect on natural gas prices as new supply comes on-line. The U.S. Department of Energy and producers believe that demand for natural gas will continue to increase over the next decade because of its attractiveness as a clean-burning and attractively-priced fuel. While natural gas continues to grow in the United States, it is a much quieter story outside of the United States.

Production Perspectives

Integrated majors are looking beyond the once-prolific basins of the North Sea and Cantarell in the Gulf of Mexico, or shallower waters of the Gulf of Mexico. Today, the oil and gas industry is exploring in the Arctic Circle, off the west coast of Africa, and in the deep waters of the South Atlantic. The industry is exploring where the engineering and logistical challenges are significant. The engineering feats necessary to explore, develop, and transport fuels in −20°F (−29°C) are not insignificant.

This doesn't consider the costs associated with drilling in harsh environmental conditions. For novices to energy, exploration and production (E&P) represent the single biggest expense to oil and gas companies. Conversely, the E&P side of the business produces the largest portion of the revenues.

Today, most oil and gas production companies face significant production challenges. As basins mature, the integrated majors are not only left to explore in harsh environments but they are in the midst of stable to declining production profiles. Why is that? Independent oil companies do not own most of the oil and gas reserves on the planet. In most countries, governments own the mineral rights associated with oil or gas deposits. The oil and gas laws and regulations vary with each country.

Safety in Deepwater Drilling

Rig workers perform incredibly dangerous work, often in harsh working conditions. Included in the harsh environment is the practice of deepwater drilling. In April 2010, the Transocean-owned Deepwater Horizon platform exploded in the U.S. Gulf of Mexico killing 11 rig workers. Television news programs broadcast the challenges—reminiscent of NASA spacewalks and planetary rovers—of maneuvering heavy equipment in the 5,000 foot-deep waters of the Gulf of Mexico. The world watched as BP p.l.c. (BP) engineers finally capped and plugged the infamous runaway Macondo well in what became the worst oil spill in U.S. history.

The BP oil spill resulted in numerous countries reviewing safety standards and emergency response systems. There is no doubt that renewed or enhanced safety precautions, standards, and emergency response measures are necessary, particularly in deep water-drilling situations.

One of the oil and gas industry's responses to the BP spill was forming and implementing a collective effort to build a containment system to capture oil spilling in deepwater situations. An ExxonMobil-led consortium was formed to respond to such deep water-drilling emergencies. Consortium members, including Shell, Chevron, and Conoco Philips, each contributed US$250 million to form the joint-venture corporation. We believe that industry-led initiatives aimed at enhancing safety will continue to be put forth.

As authorities continue to sort through the details of this tragic accident, the industry and regulators must take steps to prevent these catastrophes, on behalf of employees, the environment, and regional economies. However, the collateral damage in the industry will be felt for years as sovereigns, municipalities, states, and provinces all over the globe assess deepwater drilling.

One of the most significant repercussions is that of increased regulation of deepwater drilling. Many sovereign nations are reassessing their current safety policies and those of the companies drilling in their waters. Included in this is a review of emergency response systems and the infrastructure necessary to manage a catastrophic drilling event.

Regulators around the globe also have tightened up the process of leasing and permitting new deepwater wells. The U.S. reaction to the oil spill has been to implement a moratorium, shutting down all new deepwater drilling projects. As of this writing, we still do not have an independent assessment of the accident. And while drilling officially reopened in the Gulf of Mexico, to date few drilling permits have been issued.

Many sovereign nations are pursuing deepwater drilling despite the risks. For many countries, deepwater drilling represents economic opportunity and badly needed revenues. By shutting down deepwater drilling, these countries would pay an unacceptable economic price. The best example of this is Brazil. There will be more on Brazil in Chapter 2, Investment Opportunities in Energy.

Importance of Reserves

One of the more significant challenges for an independent oil company (IOC) is growing its reserve base. In Chapter 6, we will review the industry standards for measuring and determining hydrocarbon reserves. Growing the reserve base becomes increasingly complex when one considers that virtually 80 percent of global reserves are owned by state-owned or national oil companies (NOCs). Therein lays the challenge. IOCs must work with NOCs to drill and extract hydrocarbons where sovereign nations own the mineral rights. Several Middle East NOCs are susceptible to geopolitical risk where oil or gas production may be potentially at risk. In 2011, Middle East turmoil in Libya and Egypt are excellent cases of production disruption and increased geopolitical risk. In Chapter 13, Bidding and Production Rights, we will review some the various oil and gas regulatory structures that exist.

In the oil and gas industry, reserves are often thought of as one of the key metrics. It is, in one regard, the end game. As previously mentioned, integrated majors have the traditional upstream (exploration and production) and downstream (refining and retailing) business model. Depending on the company, there also may be a midstream sector that includes pipeline, transportation, or storage operations. Midstream typically refers to business operations of refined fuels transport and storage. Within the industry, there are companies that are exclusively dedicated to the midstream segment of oil and gas operations.

Reserve growth is increasingly elusive. IOCs seek to work with NOCs, often in geographically challenging areas. Exploration for hydrocarbons is taking place in the deep waters of the South Atlantic and the frigid waters of Greenland and the Arctic Circle. In addition, IOCs are working with NOCs in geopolitically challenging areas around the world. One can easily imagine the challenges associated with working in Nigeria, Iraq, Venezuela, and the South China Sea.

In Chapter 2, we will explore the investment opportunities and challenges associated with countries such as Iraq, Australia, and Brazil. Each of these three countries presents a significant unique opportunity and set of challenges. Drilling opportunities in all three countries are highly sought after by the industry with companies from around the globe participating in the numerous oil and gas concessions that have been established.

Regulatory Environment

Spurred by the disastrous BP oil spill, many countries implemented deepwater drilling regulatory reviews. The explosion resulted in a six-month oil drilling moratorium in the U.S. portion of the Gulf of Mexico and lasting implications for the industry. What will be the ultimate effects?

Regulation has become one of the single biggest risks to the oil and gas industry. Certainly the U.S. oilfield service sector was adversely impacted as (according to U.S. government estimates) 35 drill rigs and thousands of workers were idled in the U.S. Gulf of Mexico. A small number of drill rigs left the Gulf of Mexico for the west coast of Africa and the South Atlantic. While many drill rig operators chose to stay and wait out the moratorium, the ensuing regulatory changes require producers to disclose their emergency response initiatives and safety plans. These are all very necessary, even critical, to both regulators and investors alike who need to assess possible risks.

Countries all over the globe are reevaluating drilling safety procedures and drilling operations. In addition, Australia and many European countries including Norway began initiatives aimed at reviewing new licenses for deepwater drilling. Norway, however, recently announced that it did not see any reason to impose a moratorium on deepwater drilling.

While many countries share in the concern for deepwater accidents, there are still others that are encouraging deepwater drilling. In addition, many of these countries see deepwater drilling as an economic opportunity and are not willing to unnecessarily curtail deepwater drilling. Brazil is a case in point, where deepwater drilling represents a significant economic boon to its oil and gas infrastructure and has become a decade-long initiative. Part of the Brazilian plan includes growth in its domestic drill rig and related oilfield service sector infrastructure.

Alternative Energy Forms

Alternative energy, in all of its forms, has a bright future. However, many energy analysts, including myself, conclude that the growth in alternative energy will not achieve the scale necessary to sig...

Table of contents

• Cover
• Series
• Title Page
• Copyright
• Dedication
• Preface
• Acknowledgments
• Part I: Introduction and Financial Considerations
• Part II: Crude Oil and Natural Gas
• Part III: The Power Sector
• Part IV: Green Energy
• Part V: Summary and Conclusion
• Appendix: Energy Equivalent Conversions
• Glossary
• About the Author
• Index