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Citizen Gas & Oil Advisory Lobby

Douglas Grandt
(510) 432-1452

P.O. Box 6603


Lincoln, NE
68506-0603

5 September 2015
(Hand Delivered)
Senate Energy and Natural Resources Committee
304 Dirksen Senate Office Building
Washington, DC 20510
Attn: Chief of Staff
Re: Oil Refining - Considering future eventualities versus the myopia of the present (letter #22)
Dear Chief of Staff to the Energy and Natural Resources Committee,
This is a request for you to suggest Chairman Murkowski call one or more hearings as needed
of the Senate Energy and Natural Resources Committee taking testimony from CEOs of petroleum
corporations on how they will act in a scenario of continued global low-oil prices when the National
Interest might conflict with their fiduciary duty.
None of the twenty-two members of the Senate Energy and Natural Resources Committee (ENR) has
responded to my twenty-one letters, which I have sent from February 15 through July 23, 2015. My
letters explain what I believe should be considered a National Security energy issue and suggest
specific measures that ENR could take to avert economic catastrophe.
Now that ENR has completed its draft of two energy bills, it is almost too late to rectify the lack of
attention to the financial health of Americas national resource the petroleum industry in a
scenario of continued global low-oil prices. But you have an opportunity to act immediately.
The Energy Policy Modernization Act of 2015 and Offshore Production Energizing National
Security Act of 2015 have been assembled and amended without any apparent consideration for the
petroleum industrys financial stability under sustained low-oil-price scenarios. Yet, evidence
mounts daily showing that catastrophe is imminent, when petroleum corporations cannot meet their
debt obligations and petroleum production threatens to drop dramatically below near-term
consumption demands.
I believe taking sworn testimony from industry CEOs as to how they will weather the financial storm
would be responsible action by ENR. Lacking such investigation undermines ENR credibility and
the legitimacy of those bills from national interest and public interest perspectives.
The attached documents should pique your keen interest. You are well advised to initiate action.
Awaiting your response,

Douglas Grandt

Oil Industry Needs Half a Trillion Dollars to Endure Price Slump


August 27, 2015 | Luca Casiraghi and Rakteem Katakey

http://www.bloomberg.com/news/articles/2015-08-26/oil-industry-needs-to-find-half-atrillion-dollars-to-survive
At a time when the oil price is languishing at its lowest level in six years, producers need
to find half a trillion dollars to repay debt. Some might not make it.
The number of oil and gas company bonds with yields of 10 percent or more, a sign of
distress, tripled in the past year, leaving 168 firms in North America, Europe and Asia
holding this debt, data compiled by Bloomberg show. The ratio of net debt to earnings is
the highest in two decades.
If oil stays at about $40 a barrel, the shakeout could be profound, according to
Kimberley Wood, a partner for oil mergers and acquisitions at Norton Rose Fulbright
LLP in London. West Texas Intermediate crude was up 4.5 percent to $40.32 a barrel at
10:51 a.m. in London.

The look and shape of the oil industry would likely change over the next five to 10
years as companies emerge from this, Wood said. If oil prices stay at these levels, the
number of bankruptcies and distress deals will undoubtedly increase.
Debt repayments will increase for the rest of the decade, with $72 billion maturing this
year, about $85 billion in 2016 and $129 billion in 2017, according to BMI Research. A
total of about $550 billion in bonds and loans are due for repayment over the next five
years.
http://www.bloomberg.com/news/articles/2015-08-26/oil-industry-needs-to-find-half-a-trillion-dollars-to-survive

U.S. drillers account for 20 percent of the debt due in 2015, Chinese companies rank
second with 12 percent and U.K. producers represent 9 percent.

In the U.S., the number of bonds yielding greater than 10 percent has increased more
than fourfold to 80 over the past year, according to data compiled by Bloomberg.
Twenty`six European oil companies have bonds in that category, including Gulf
Keystone Petroleum Ltd. and EnQuest Plc.
Pressure Builds
Gulf Keystone can satisfy all its obligations to both its contractors and creditors after
authorities in Kurdistan, where the company operates, committed to making monthly
payments for crude exports from September, Chief Financial Officer Sami Zouari said in
an e`mail.
An EnQuest spokesman declined to comment.
Slumping crude prices are diminishing the value of oil reserves and reducing borrowing
power, even as pressure builds to find replacement fields.
Some earnings metrics are already breaching the lows of the 2008 financial crisis. The
profit margin for the 108` member MSCI World Energy Sector Index, which includes
Exxon Mobil Corp. and Chevron Corp., is the lowest since at least 1995, the earliest for
when data is available.
There are several credits which simply wont be able to refinance and extend maturities
and they may need to raise additional equity, said Eirik Rohmesmo, a credit analyst at
Clarksons Platou Securities AS in Oslo. The question is: would they be able to do that
with debt at these levels?
http://www.bloomberg.com/news/articles/2015-08-26/oil-industry-needs-to-find-half-a-trillion-dollars-to-survive

Credit Ratings
Some U.S. producers gained breathing space by leveraging their low`cost assets to
raise funds earlier this year and repay debt, Goldman Sachs Group Inc. wrote in a Aug.
6 report. This helped companies shore up their capital and reduce debt` servicing costs.
That may no longer be an option because energy companies have been the worst
performers in the past year among 10 industry groups in the MSCI World Index.

Credit`rating downgrades are putting additional strain on the ability of oil companies to
raise money cheaply. Standard & Poors cut the rating of Eni SpA, Italys biggest oil
company, in April, while Moodys Investors Service downgraded Tullow Oil Plcs debt in
March.
Spokesmen for Eni and Tullow declined to comment.
The biggest companies, with global portfolios that span oil fields to refineries, will
probably emerge largely intact from the slump, Norton Roses Wood said. Smaller
players, dependent on fewer assets, could have problems, she said.
Clearly, those companies with debt to pay will have one eye firmly on oil prices, said
Christopher Haines, a senior oil and gas analyst at BMI in London. With revenues
collapsing and debt soon to mature, a growing number of companies may find
themselves unable to meet repayment schedules.

http://www.bloomberg.com/news/articles/2015-08-26/oil-industry-needs-to-find-half-a-trillion-dollars-to-survive

Winter Is Coming For Upstream Oil And Gas


Companies In 2015, Part 1 - Exxon Mobil
Sep. 3, 2015 | David Addison
http://seekingalpha.com/article/3489266-winter-is-coming-for-upstream-oil-and-gascompanies-in-2015-part-1-exxon-mobil
Summary

Bargains among upstream companies stocks are difficult to come by; current
valuations discount much higher energy prices.

Stress-testing upstream assets for lower oil and natural gas prices indicates that
massive reserve quantity and balance sheet impairments may be due in 2015s
annual reports to shareholders.

Panic-induced selling following the disclosures of these impending impairments


could finally create some buying opportunities among higher quality assets.

Exxon Mobil, as a company, will be able to weather lower energy prices.

Exxon Mobils stock valuation, like most other upstream companies, is tied to
commodity prices.

"Winter is coming" for many upstream oil and gas companies. The precipitous 50% drop
in crude oil prices over the past year will likely force many oil and gas exploration and
production (E&P) companies to impair their upstream assets in this coming winter's 10K and 20-F annuals reports to shareholders. If one assumes that current energy prices
(i.e., $60/Bbl oil, $39/Boe NGL, and $18/Boe natural gas) are the "new normal",
bargains in upstream oil and gas stocks are scarce. However, once the market digests
the impending impairments and true impacts of lower prices, bargains may begin to
appear. Until that time, even seasoned investors who are tempted to "buy the dip" in the
stock prices of even the best upstream oil and gas companies should exercise restraint.
Accounting regulations compel companies with significant E&P operations to
periodically test the book values of upstream oil and gas assets for impairments.
Furthermore, the SEC compels publicly held companies with significant upstream
assets to disclose standardized measures of the discounted net present values (NPV)
for their oil & gas producing properties in annual reports to shareholders. The
standardized measure was intended to increase transparency, but it is able to sanity
check the capitalized costs of upstream assets.
In this first portion of the series, I stress test the balance sheet of the super-major,
Exxon Mobil (NYSE:XOM) to lower prices. Based on this analysis, it is fairly clear that
Exxon Mobil, as a company, can survive through the current commodity environment.
However, Exxon Mobil's attractiveness as an investment in the company's stock is
dubious. In order for the economic value of its net assets to match up with the
company's stock price, energy prices must quickly recover to $100/Bbl oil and $30/Boe
(~$5/Mcf) natural gas.
http://seekingalpha.com/article/3489266-winter-is-coming-for-upstream-oil-and-gas-companies-in-2015-part-1-exxon-mobil

Some Notes on Methodology


My core methodology for stress testing balance sheets is to estimate the economic
book values (EBV) of core assets. Estimating EBV simply involves creating an
economic balance sheet which converts certain accounting book values (ABV) to
estimates of their fair or intrinsic values and/or discounted net present values under
specific macro- and micro-economic conditions. If and when capitalized costs
significantly overstate the modeled intrinsic values of the upstream assets at current
commodity prices, one can assume that the economic values should be impaired. This
approach roughly mirrors common practices for impairment testing.
In this series, NPV analysis is applied to the upstream assets (i.e., oil and gas
producing properties) of various oil and gas exploration & production (E&P) companies.
Specifically, I estimate the NPV of a given company's oil & gas reserves using recent
commodity prices and the industry-standard 10% annualized discount rate which is
applied to future cash flows. When possible, I adjust the values of related upstream
items, especially when those values are both significant and tied to commodities prices.
I leave the values of Exploration & Evaluation (E&E) efforts, which can be either
extremely accretive or deleterious, to qualitative interpretation. The economic values of
downstream assets, when they are significant, are determined by a Nelson Complexity
analysis of their equivalent distillation capacities (see prior article on the fundamentals
of the refining business).
This methodology admittedly somewhat replicates reporting requirements. FASB
Accounting Standards Codification (ASC) 932 requires publicly traded E&P companies
to disclose a standardized measure of discounted future cash flows (i.e., SEC
Standardized Measure) in their annual 10-K or 20-F reports to the SEC. The SEC "Final
Rule" on the Modernization of Oil and Gas Reporting specifies that companies must use
the 12-month historical average of the beginning-of-month prices in determining reserve
quantities.
The standardized measure was originally intended to help interested parties see
through accounting distortions caused by the use of disparate accounting methods. It
can also sanity check capitalized costs of upstream assets and, to an extent, predict
impairments - this is especially true for companies which use the FC method.
Under the FC method, E&E efforts are fully capitalized to the balance sheet. Natural
resource companies reporting under the FC method perform annual "ceiling tests"
which set the maximum value at which capitalized costs can be carried. The first step of
a ceiling test estimates the intrinsic value of oil and gas production under recent
commodity prices - overwhelmingly, managements utilize discounted cash flow
analyses, vis--vis the standardized measure. If the book value is greater than this
estimate, the company impairs capitalized assets by the amount of the difference.
Under the SE method, only E&E efforts which result in the addition of reserves are
capitalized. Companies using the SE method are only required to impair assets when
the carrying amounts of oil and gas properties are deemed to be unrecoverable (on an
undiscounted basis).

http://seekingalpha.com/article/3489266-winter-is-coming-for-upstream-oil-and-gas-companies-in-2015-part-1-exxon-mobil

Irrespective of accounting method, companies may not reverse impairments once they
have taken effect, even if economic conditions improve.
Although natural resources accounting and reservoir management standards would
seem to improve corporate transparency, reported values may exist independently of
economic reality.
On the accounting end, if and when accounting convention significantly embellishes
economic reality, investors should notionally impair the asset even if management
chooses not to or is not compelled. Moreover, publicly traded companies are only
required to publish this information once annually - so when economic conditions
change, such as how energy prices have dropped in 2015, the company's latest
information may not reflect the current economic reality.
Moreover, there may be significant variability in how different reservoir managers
prepare standardized measures which severely limits their usefulness as a comparative
value metric. I wager that any petroleum engineer out there will corroborate that
reservoir management, from the financial perspective, is an art more than a science.
A 2014 S&P Capital IQ white paper, Drilling for Alpha in the Oil & Gas Industry, does not
support the idea that the standardized measure, as presented within company reports,
is a reliable tool for estimating future stock returns. The overwhelming problem,
however, is not the rationale behind the standardized measure, but rather
inconsistencies in its preparation.
To compensate for the information lag as well as for uncertainty and inconsistency in
managements' preparation of estimates, I utilize a uniform valuation methodology which
is accounting-methodology independent and which incorporates more recent
information on commodities prices. For simplicity, I assume constant commodities prices
($60/Bbl oil, $39/Boe NGL, and $18/Boe gas prices), adjusted for typical premiums/
discounts that different companies historically realize. A potential refinement in future
iterations would be to prepare NPV estimates using futures strip pricing (i.e., the term
structure of futures prices).
Although an "economic stress test" approach may seem foreign to some, this
methodology is actually very relevant to many types of investors since it removes
accounting distortions created by different accounting methods. Also, being premised on
estimating future cash flows, it give some insight into companies' abilities to sustain
dividends, buybacks, interest payments, and even operating costs. Furthermore, many
companies, especially independent producers, engage in debt covenants with lenders.
Lower cash flows and asset impairments can trigger breaches of these covenants which
can unleash a flurry of negative consequences... all of which can lead to massive
investor losses.
Some final notes regarding methodology:
The standardized measure, because it is based on proved (1P) reserves, may be
predisposed to underestimating the economic values of underlying oil and gas
assets. The SEC defines proved oil and gas reserves as those quantities of oil
and gas which are expected to be economically producible with "reasonable

http://seekingalpha.com/article/3489266-winter-is-coming-for-upstream-oil-and-gas-companies-in-2015-part-1-exxon-mobil

certainty". The Society of Petroleum Engineers' (SPE) Petroleum Resources


Management System (PRMS) guides that if deterministic methods are used to
measure reserve quantities, the SEC criteria (with some trivial differences in
wording) suffice. SPE further guides that if probabilistic methods are used,
proved reserves are those which are expected to be economically recovered with
at least 90% certainty. Although it would be preferable to model NPV using an
estimate of proved and probable (1P + 2P) reserves (i.e., those which are
expected to be economically recoverable under a most likely scenario), no US
regulatory body requires the disclosure of anything other than 1P reserves. Since
my estimate of economic value is also premised on 1P reserves, I also am likely
to understate the base case for economic value.
Industry analysts often use the terms standardized measure and PV-10 (i.e.,
present value, 10% discount rate) interchangeably. To avoid confusion, I refrain
from couching value in terms of PV-10 since its preparation is non-uniform and its
presentation non-standard.
The approach used in this series attempts to model out net asset values (NAV).
Especially in cases where investors lack full owners' rights (i.e., a call on residual
asset values), NAV-centric approaches may not be appropriate.
Exxon Mobil Overview
Exxon Mobil is the super-major. In 2014, the company's upstream segment produced
approximately 3,970 MBoe/d. Its downstream segment is capable of distilling about
5,248 MBbl/d of crude oil at a weighted average Nelson Complexity of 10.4. In 2014, its
refineries produced about 4,480 MBbl/d of refined products. Its chemical division, which
is reported separately, produced nearly 24 metric tons of ethylene, polyethylene,
polypropylene and paraxylene in 2014. In addition, the company markets its products
through 4,754 owned/leased and 15,463 distributor/reseller retail sites globally through
the Exxon, Esso and Mobil brands.
The Standardized Measure, Restated for Recent Prices
Table 1, below, contrasts Exxon Mobil's standardized measure of discounted cash flows
from oil and gas assets as presented in its 2014 10-K with an estimate of their value at
current commodity prices (i.e., $60/Bbl oil, $39/Boe NGL, and $18/Boe natural gas). I
take into account that Exxon Mobil typically realizes slightly lower than market prices on
oil but also receives significantly greater than market price for its natural gas. The drag
on realized oil prices can be attributed to the fact that the company also produces
significant quantities of bitumen and synthoil. Exxon Mobil receives an uplift on gas
prices due to the fact the international natural prices are typically much higher than they
are in the United States.

http://seekingalpha.com/article/3489266-winter-is-coming-for-upstream-oil-and-gas-companies-in-2015-part-1-exxon-mobil

Table 1: Standardized Measure of Discounted Cash Flows from Oil and Gas
Assets, Exxon Mobil
(all values in millions, USD)

source(s): Exxon Mobil, 2014 10-k; Author's calculations


If energy prices hold constant, Exxon Mobil's the future value of expected revenues
from oil and gas producing properties are expected to decrease by about $500 billion
(33%) from 2014's estimates. However, the company could expect to save about $330
billion in combined operating expenses and income taxes. Despite these cost savings,
the expected net present value of discounted cash flows can be expected to decrease
by $95 billion (46%) from 2014 estimates.
Operating expense can be expected to decrease if low prices are here to stay. Lower
prices mean that: a) E&P companies will have to payout lower amounts to revenue/
royalty interests, and b) these companies will become more efficient and be able
negotiate better terms with service providers and vendors.
Furthermore, the Exxon Mobil's 2014 presentation of the standardized measure likely
overstates future income taxes. Actual income taxes are likely to be much lower due to
offsetting depreciation, amortization, and depletion expenses which can be charged
against net income.

http://seekingalpha.com/article/3489266-winter-is-coming-for-upstream-oil-and-gas-companies-in-2015-part-1-exxon-mobil

Since Exxon Mobil uses the SE method to capitalize reserve quantities, I do not believe
management will be compelled to impair proved reserve quantities or significantly
reduce future development expenses. Although many projects will have negative NPVs
at a 10% discount rate and at $60/Bbl crude oil (i.e., Alberta oil sands), simplifying
assumptions indicate the great majority of Exxon Mobil's proven undeveloped reserve
quantities still yield positive undiscounted cash flows even at $60/Bbl oil.
Exxon Mobil's lack of an expected impairment of reserve quantities is something of an
anomaly in relation to other E&P companies.
Economic Book Value Analysis
The following EBV analysis contrasts the accounting and economic book values of
Exxon Mobil's common stock using inputs from the restated standardized measure as
well as a few other key adjustments.
Table 2: EBV Analysis, Exxon Mobil
(all amounts are in millions USD, except as otherwise noted)

http://seekingalpha.com/article/3489266-winter-is-coming-for-upstream-oil-and-gas-companies-in-2015-part-1-exxon-mobil

source(s): Exxon Mobil, 2014 10-k; Author's calculations


The EBV analysis yields a $51 billion net impairment of Exxon Mobil's net property,
plant, and equipment. An upside revision of about $28 billion to downstream assets
offsets the $79 billion impairment to downstream assets (which notionally include those
held by the chemicals segment).
The upward adjustment of downstream assets reflects my belief that Exxon Mobil's
5,250 MBbl/d atmospheric crude distillation capacity (52,480 MBbl/d of equivalent
distillation capacity (EDC) at a weighted average Nelson Complexity of 10.4) at a longrun utilization rate of 85% warrants a significantly higher valuation than its 2014 book
value of $37.6 billion. Put into context with 2014's oil and gas production of 3968.5
MBoe/d, Exxon Mobil is every bit, if not more, a downstream enterprise as it is
upstream.
The fact that downstream assets are major beneficiaries of falling crude oil and natural
gas prices did not influence my upward adjustment of Exxon Mobil's downstream asset
values.
http://seekingalpha.com/article/3489266-winter-is-coming-for-upstream-oil-and-gas-companies-in-2015-part-1-exxon-mobil

If energy prices do not recover, I estimate that the accounting basis of Exxon Mobil's net
assets will exceed their economic values (i.e., net value will not have been created).
Although this indicates that the company is dependent on external economic conditions
for long-term shareholder value creation, the fact that equity is expected to remain
significantly positive indicates that the company itself will be able to survive lower
energy prices for as long as its legacy reserve base keeps producing.
From an investment perspective, as of 1 September, the company's EBV is
approximately 60% lower than it current market price at current energy prices. In order
for the EBV and market value to balance each other out, energy prices need to return to
much higher levels (i.e., $100/Bbl WTI Crude and $5/Mcf Henry Hub Natural Gas).
Commentary
As a company, Exxon Mobil displays all the trappings of a survivor: its management
team has a long term focus, it has diversified and integrated operations, displays
conservative accountancy, is historically a low cost producer, has a long-lived reserves,
has been able to consistently replace its reserves, possesses a technological edge over
most competitors in finding and developing oil and gas properties, possesses immense
economies of scale, and has access to cheap capital (2014 cost of debt was around
1%; 2014 all-in cost of capital was around 3.5%).
In addition, I believe that the company's sophisticated downstream and chemicals
divisions hide the real strength of sensible vertical integration in the oil and gas
business: survivability. Relatively stable cash flows from downstream operations buffer
the hyper-cyclical economics of upstream operations. Furthermore, downstream
operations are typically beneficiaries of lower commodity prices since the prices of
refined products and consumer goods tend to be "sticky". When energy prices tank, as
they have, increased profits from downstream activities are expected to offset lower
profits from upstream activities. Exxon's downstream, in effect, hedges a significant
amount of its upstream commodity risk in addition to providing its own sources of cash.
Rational vertical integration helps explains how Exxon Mobil has been able to thrive
through multiple commodities cycles without significant hedges in place.
All in all, Exxon Mobil, as a company, will be fine.
However, as an investment, Exxon Mobil's story may not be as rosy. Even though
Exxon Mobil's underlying asset base is still able to produce significant cash and has
immense value, the stock price is too high if current commodity prices prevail. If crude
oil prices do not snap back to $100/Bbl, it will take some time for Exxon Mobil's
underlying net assets values to catch up with the market.
Moreover, even under a best case scenario, the stock has little potential for asymmetric
upside.
Unfortunately, the intrinsic value of Exxon Mobil's stock is tied to commodity prices
which are beyond even its control. If I really believe that oil prices are going to recover,
why would I make an investment that just barely breaks even in the event? Why
wouldn't I just go out and buy crude oil or natural gas futures contracts?

http://seekingalpha.com/article/3489266-winter-is-coming-for-upstream-oil-and-gas-companies-in-2015-part-1-exxon-mobil

However, Exxon Mobil's somewhat drab future at lower energy prices appears to
glimmer when compared to that of other integrated majors.
Winter is Coming
Initial results of stress-testing other companies' undeveloped reserves and sanctioned
development projects indicate that "winter is coming". A lot of expected future
production is not economic if current prices are to prevail. As a result, the values of
balance sheet and reserve quantity impairments disclosed in this winter's 10-K and 20-F
annual reports could be staggering.
Carbon Tracker Initiative's Oil & Gas Majors: Fact Sheets strongly corroborates my
position. The info paper utilizes Rystad's Energy UCube database (among the most
thorough of any upstream oil and gas project database) to analyze capital spending and
potential production in order to arrive at estimated "break-even" costs for associated
development projects. This break-even cost is the price of oil which is required for
economic rationalization (i.e., "sanction").
The paper concludes that 34% of oil majors' total planned capital expenditures require
oil prices of $95+/Bbl for economic sanction. The info paper was published in of August
2014, when oil prices were right around $95/Bbl. Even so, the paper claims that up to
22% of planned future spending on projects were candidates for deferral or outright
cancellation.
Forget for a moment that petroleum is a finite and depleting resource which society may
not be able to do without if 33% of anticipated future production would not work at
$95/Bbl, then how much does not work at $60/Bbl?
Clearly, the low oil price environment we are currently in is not sustainable.
However, prices could remain lower for longer. According to this nugget on EIA's
education portal:
"The volatility of oil prices is inherently tied to the low responsiveness or inelasticity of
supply and demand to price changes in the short term. Crude oil production capacity
and equipment that uses petroleum products as its main source of energy are relatively
fixed in the near term. It takes years to develop new supply sources or vary production,
and it is hard for consumers to switch to other fuels or to increase fuel efficiency in the
near term when prices rise. Under such conditions, a large price change can be
necessary to rebalance physical supply and demand."
In other words, prices will have to either a) remain low long enough drive excess
capacity out of the markets, or b) disincent production growth long enough to allow for
demand to catch up. Either scenario could take months or years because as long as
prices remain above lifting costs and associated non-income related taxes ($15-$30/Bbl
is typical, according to SA contributor Christopher Aublinger's research on production
costs), producers will keep on pumping. Moreover, lower prices may have actually
incented many producers to maintain and even increase production levels in order to
meet interest payments and stay in good financial standing with lenders.
Eventually, energy prices will recover. When producers are forced to reinvest to keep
production levels consistent with demand, the marginal producers will begin to feel the
http://seekingalpha.com/article/3489266-winter-is-coming-for-upstream-oil-and-gas-companies-in-2015-part-1-exxon-mobil

sting of replacing (i.e., finding and developing (F&D)) depleted reserves. After one
factors in F&D and non-core costs (i.e., G&A, R&D, interest, cost of equity, etcetera),
the marginal barrel of oil required to sate current demand could easily exceed $75-90/
Bbl.
Even if a rational price which balances long-term supply and demand does exist, it is
possible that oil prices could over-correct to the upside if/when under-investment affects
production. If production contracts too rapidly, global prices could respond very violently
to the upside. Even though much higher prices would seem a boon to oil and gas
producers, extreme price fluctuations doom the boom and bust commodities cycle to
repeat itself.
All of this speculation about commodity prices should be, of course, tangential to a
sound investment thesis. However, closer inspection reveals that investing in almost
any oil and gas producer is tantamount to speculating in commodities.
Concluding Remarks
When oil prices began to tank nearly 10 months ago, in October 2014, I devoted much
of my free time to learning the industry in order to capitalize on the panic that was sure
to ensue. I had originally envisioned buying cheap, over-looked upstream oil and gas
assets and then watching my net worth skyrocket. However, sanity checks revealed that
the oil and gas sector was already being very closely monitored by legions of analysts
who were already eagerly gobbling up any low-hanging fruit. It was also quickly clear
that the stock prices of most upstream companies were still being discounted for much
higher energy prices.
Even though my machinations of cruising around town in a brand-new Cadillac, adorned
in crocodile leather boots and a Stetson hat ( la J.R. Ewing of TV show Dallas), have
been temporarily foiled by reality, I do still cling to the idea that opportunities for
investing in upstream assets may present themselves.
Perhaps, the "winter is coming" thesis will play out, allowing patient investors to dive in
and scoop up some sweet deals. When asset write-downs that I am projecting become
public knowledge, the ensuing sell-off could result in more easily spotted bargains. Until
that time, I believe that potential investors in upstream oil and gas companies should
either move on to greener pastures or continue to face scouring the wasteland in search
of elusive value.

http://seekingalpha.com/article/3489266-winter-is-coming-for-upstream-oil-and-gas-companies-in-2015-part-1-exxon-mobil

Deflationary Collapse Ahead?


August 26, 2015 by Gail Tverberg

http://www.zerohedge.com/news/2015-08-26/deflationary-collapse-ahead

Both the stock market and oil prices have been plunging. Is this just another cycle, or
is it something much worse? I think it is something much worse.
Back in January, I wrote a post called Oil and the Economy: Where are We Headed
in 2015-16? In it, I said that persistent very low prices could be a sign that we are
reaching limits of a finite world. In fact, the scenario that is playing out matches up
with what I expected to happen in my January post. In that post, I said
Needless to say, stagnating wages together with rapidly rising costs of oil production
leads to a mismatch between:

The amount consumers can afford for oil


The cost of oil, if oil price matches the cost of production

This mismatch between rising costs of oil production and stagnating wages is what has
been happening. The unaffordability problem can be hidden by a rising amount of debt
for a while (since adding cheap debt helps make unaffordable big items seem
affordable), but this scheme cannot go on forever.
Eventually, even at near zero interest rates, the amount of debt becomes too high,
relative to income. Governments become afraid of adding more debt. Young people find
student loans so burdensome that they put off buying homes and cars. The economic
pump that used to result from rising wages and rising debt slows, slowing the growth
of the world economy. With slow economic growth comes low demand for commodities
that are used to make homes, cars, factories, and other goods. This slow economic
growth is what brings the persistent trend toward low commodity prices experienced in
recent years.
A chart I showed in my January post was this one:

Figure 1. World Oil Supply (production including biofuels, natural gas liquids) and Brent
monthly average spot prices, based on EIA data.

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The price of oil dropped dramatically in the latter half of 2008, partly because of the
adverse impact high oil prices had on the economy, and partly because of a contraction
in debt amounts at that time. It was only when banks were bailed out and the United
States began its first round of Quantitative Easing (QE) to get longer term interest rates
down even further that energy prices began to rise. Furthermore, China ramped up its
debt in this time period, using its additional debt to build new homes, roads, and
factories. This also helped pump energy prices back up again.
The price of oil was trending slightly downward between 2011 and 2014, suggesting that
even then, prices were subject to an underlying downward trend. In mid-2014, there was
a big downdraft in prices, which coincided with the end of US QE3 and with slower
growth in debt in China. Prices rose for a time, but have recently dropped again, related
to slowing Chinese, and thus world, economic growth. In part, Chinas slowdown is
occurring because it has reached limits regarding how many homes, roads and factories
it needs.
I gave a list of likely changes to expect in my January post. These havent changed. I
wont repeat them all here. Instead, I will give an overview of what is going wrong and
offer some thoughts regarding why others are not pointing out this same problem.
Overview of What is Going Wrong
1

The big thing that is happening is that the world financial system is
likely to collapse. Back in 2008, the world financial system almost collapsed.
This time, our chances of avoiding collapse are very slim.

Without the financial system, pretty much nothing else works: the oil
extraction system, the electricity delivery system, the pension system, the ability
of the stock market to hold its value. The change we are encountering is similar to
losing the operating system on a computer, or unplugging a refrigerator from the
wall.

We dont know how fast things will unravel, but things are likely to be
quite different in as short a time as a year. World financial leaders are
likely to pull out the stops, trying to keep things together. A big part of our
problem is too much debt. This is hard to fix, because reducing debt reduces
demand and makes commodity prices fall further. With low prices, production of
commodities is likely to fall. For example, food production using fossil fuel inputs
is likely to greatly decline over time, as is oil, gas, and coal production.

The electricity system, as delivered by the grid, is likely to fail in


approximately the same timeframe as our oil-based system. Nothing
will fail overnight, but it seems highly unlikely that electricity will outlast oil by
more than a year or two. All systems are dependent on the financial system. If the
oil system cannot pay its workers and get replacement parts because of a collapse
in the financial system, the same is likely to be true of the electrical grid system.

Our economy is a self-organized networked system that continuously


dissipates energy, known in physics as a dissipative structure. Other
examples of dissipative structures include all plants and animals (including
humans) and hurricanes. All of these grow from small beginnings, gradually

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plateau in size, and eventually collapse and die. We know of a huge number of
prior civilizations that have collapsed. This appears to have happened when
the return on human labor has fallen too low. This is much like the after-tax
wages of non-elite workers falling too low. Wages reflect not only the workers
own energy (gained from eating food), but any supplemental energy used, such as
from draft animals, wind-powered boats, or electricity. Falling median wages,
especially of young people, are one of the indications that our economy is headed
toward collapse, just like the other economies.
6

The reason that collapse happens quickly has to do with debt and
derivatives. Our networked economy requires debt in order to extract fossil
fuels from the ground and to create renewable energy sources, for several
reasons: (a) Producers dont have to save up as much money in advance, (b)
Middle-men making products that use energy products (such cars and
refrigerators) can finance their factories, so they dont have to save up as much,
(c) Consumers can afford to buy big-ticket items like homes and cars, with the
use of plans that allow monthly payments, so they dont have to save up as much,
and (d) Most importantly, debt helps raise the price of commodities of all
sorts (including oil and electricity), because it allows more customers to afford
products that use them. The problem as the economy slows, and as we add more
and more debt, is that eventually debt collapses. This happens because the
economy fails to grow enough to allow the economy to generate sufficient goods
and services to keep the system goingthat is, pay adequate wages, even to nonelite workers; pay growing government and corporate overhead; and repay debt
with interest, all at the same time. Figure 2 is an illustration of the problem with
the debt component.

Figure 2. Repaying loans is easy in a growing economy, but much more dicult
in a shrinking economy.

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Where Did Modeling of Energy and the Economy Go Wrong?


1

Todays general level of understanding about how the economy


works, and energys relationship to the economy, is dismally
low. Economics has generally denied that energy has more than a very indirect
relationship to the economy. Since 1800, world population has grown from 1
billion to more than 7 billion, thanks to the use of fossil fuels for increased food
production and medicines, among other things. Yet environmentalists often
believe that the world economy can somehow continue as today, without fossil
fuels. There is a possibility that with a financial crash, we will need to start over,
with new local economies based on the use of local resources. In such a scenario,
it is doubtful that we can maintain a world population of even 1 billion.

Economics modeling is based on observations of how the economy


worked when we were far from limits of a finite world. The indications
from this modeling are not at all generalizable to the situation when we are
reaching limits of a finite world. The expectation of economists, based on past
situations, is that prices will rise when there is scarcity. This expectation is
completely wrong when the basic problem is lack of adequate wages for non-elite
workers. When the problem is a lack of wages, workers find it impossible to
purchase high-priced goods like homes, cars, and refrigerators. All of these
products are created using commodities, so a lack of adequate wages tends to
feed back through the system as low commodity prices. This is exactly the
opposite of what standard economic models predict.

M. King Hubberts peak oil analysis provided a best-case scenario


that was clearly unrealistic, but it was taken literally by his followers.
One of Hubberts sources of optimism was to assume that another energy
product, such as nuclear, would arise in huge quantity, prior to the time when a
decline in fossil fuels would become a problem.

Figure 3. Figure from Hubberts 1956 paper, Nuclear Energy and the Fossil Fuels.

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The way nuclear energy operates in Figure 2 seems to me to be pretty much


equivalent to the output of a perpetual motion machine, adding an endless
amount of cheap energy that can be substituted for fossil fuels. A related source
of optimism has to do with the shape of a curve that is created by the sum of
curves of a given type. There is no reason to expect that the total curve will be of
the same shape as the underlying curves, unless a perfect substitute (that is,
having low price, unlimited quantity, and the ability to work directly in current
devices) is available for what is being modeledhere fossil fuels. When the
amount of extraction is determined by price, and price can quickly swing from
high to low, there is good reason to believe that the shape of the sum curve will be
quite pointed, rather than rounded. For example we know that a square wave can
be approximated using the sum of sine functions, using Fourier Series (Figure 4).

Figure 4. Sum of sine waves converging to a square wave. Source: Wolfram


Mathworld.
4

The world economy operates on energy flows in a given year, even


though most analysts today are accustomed to thinking on a
discounted cash flow basis. You and I eat food that was grown very recently.
A model of food potentially available in the future is interesting, but it doesnt
satisfy our need for food when we are hungry. Similarly, our vehicles run on oil
that has recently been extracted; our electrical system operates on electricity that
has been produced, essentially simultaneously. The very close relationship in
time between production and consumption of energy products is in sharp
contrast to the way the financial system works. It makes promises, such as the
availability of bank deposits, the amounts of pension payments, and the
continuing value of corporate stocks, far out into the future. When these
promises are made, there is no check made that goods and services will actually
be available to repay these promises. We end up with a system that has promised
very many more goods and services in the future than the real world will actually
be able to produce. A break is inevitable; it looks like the break will be happening
in the near future.

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Changes in the financial system have huge potential to disrupt the


operation of the energy flow system. Demand in a given year comes from a
combination of (wages and other income streams in a given year) plus the
(change in debt in a given year). Historically, the (change in debt) has been
positive. This has helped raise commodity prices. As soon as we start getting large
defaults on debt, the (change in debt) component turns negative, and tends to
bring down the price of commodities. (Note Point 6 in the previous section.)
Once this happens, it is virtually impossible to keep prices up high enough to
extract oil, coal and natural gas. This is a major reason why the system tends to
crash.

Researchers are expected to follow in the steps of researchers before


them, rather than starting from a basic understudying of the whole
problem. Trying to understand the whole problem, rather than simply trying to
look at a small segment of a problem is difficult, especially if a researcher is
expected to churn out a large number of peer reviewed academic articles each
year. Unfortunately, there is a huge amount of research that might have seemed
correct when it was written, but which is really wrong, if viewed through a
broader lens. Churning out a high volume of articles based on past research tends
to simply repeat past errors. This problem is hard to correct, because the field of
energy and the economy cuts across many areas of study. It is hard for anyone to
understand the full picture.

In the area of energy and the economy, it is very tempting to tell


people what they want to hear. If a researcher doesnt understand how the
system of energy and the economy works, and needs to guess, the guesses that
are most likely to be favorably received when it comes time for publication are the
ones that say, All is well. Innovation will save the day. Or, Substitution will
save the day. This tends to bias research toward saying, All is well. The
availability of financial grants on topics that appear hopeful adds to this effect.

Energy Returned on Energy Investment (EROEI) analysis doesnt


really get to the point of todays problems. Many people have high hopes
for EROEI analysis, and indeed, it does make some progress in figuring out what
is happening. But it misses many important points. One of them is that there are
many different kinds of EROEI. The kind that matters, in terms of keeping the
economy from collapsing, is the return on human labor. This type of EROEI is
equivalent to after-tax wages of non-elite workers. This kind of return tends to
drop too low if the total quantity of energy being used to leverage human labor
is too low. We would expect a drop to occur in the quantity of energy used, if
energy prices are too high, or if the quantity of energy products available is
restricted.

Instead of looking at wages of workers, most EROEI analyses consider


returns on fossil fuel energysomething that is at least part of the
puzzle, but is far from the whole picture. Returns on fossil fuel energy can
be done either on a cash flow (energy flow) basis or on a model basis, similar to
discounted cash flow. The two are not at all equivalent. What the economy needs
is cash flow energy now, not modeled energy production in the future. Cash flow
analyses probably need to be performed on an industry-wide basis; direct and

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indirect inputs in a given calendar year would be compared with energy outputs
in the same calendar year. Man-made renewables will tend to do badly in such
analyses, because considerable energy is used in making them, but the energy
provided is primarily modeled future energy production, assuming that the
current economy can continue to operate as todaysomething that seems
increasingly unlikely.
10 If we are headed for a near term sharp break in the economy, there is
no point in trying to add man-made renewables to the electric grid.
The whole point of adding man-made renewables is to try to keep what we have
today longer. But if the system is collapsing, the whole plan is futile. We end up
extracting more coal and oil today, in order to add wind or solar PV to what will
soon become a useless grid electric system. The grid system will not last long,
because we cannot pay workers and we cannot maintain the grid without a
financial system. So if we add man-made renewables, most of what we get is their
short-term disadvantages, with few of their hoped-for long-term advantages.
Conclusion
The analysis that comes closest to the situation we are reaching today is the 1972
analysis of limits of a finite world, published in the book The Limits to Growth by
Donella Meadows and others. It models what can be expected to happen, if population
and resource extraction grow as expected, gradually tapering off as diminishing returns
are encountered. The base model seems to indicate that a collapse will happen about
now.

Figure 5. Base scenario from 1972 Limits to Growth, printed using todays graphics by
Charles Hall and John Day in Revisiting Limits to Growth After Peak Oil http://
www.esf.edu/efb/hall/2009-05Hall0327.pdf

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The shape of the downturn is not likely to be correct in Figure 5. One reason is that the
model was put together based on physical quantities of goods and people, without
considering the role the financial system, particularly debt, plays. I expect that debt
would tend to make collapse quicker. Also, the modelers had no experience with
interactions in a contracting world economy, so had no idea regarding what adjustments
to make. The authors have even said that the shapes of the curves, after the initial
downturn, cannot be relied on. So we end up with something like Figure 6, as about all
that we can rely on.

Figure 6. Figure 5, truncated shortly after industrial output per capita (grey) and food
per capita turns down, since modeled amounts are unreliable after that date.

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If we are indeed facing the downturn forecast by Limits to Growth modeling, we are
facing a predicament that doesnt have a real solution. We can make the best of what we
have today, and we can try to strengthen bonds with family and friends. We can try to
diversify our financial resources, so if one bank encounters problems early on, it wont
be a huge problem. We can perhaps keep a little food and water on hand, to tide us over
a temporary shortage. We can study our religious beliefs for guidance.
Some people believe that it is possible for groups of survivalists to continue, given
adequate preparation. This may or may not be true. The only kind of renewables that we
can truly count on for the long term are those used by our forefathers, such as wood,
draft animals, and wind-driven boats. Anyone who decides to use todays technology,
such as solar panels and a pump adapted for use with solar panels, needs to plan for the
day when that technology fails. At that point, hard decisions will need to be made
regarding how the group will live without the technology.
We cant say that no one warned us about the predicament we are facing. Instead, we
chose not to listen. Public officials gave a further push in this direction, by channeling
research funds toward distant theoretically solvable problems, instead of understanding
the true nature of what we are up against. Too many people took what Hubbert said
literally, without understanding that what he offered was a best-case scenario, if we
could find something equivalent to a perpetual motion machine to help us out of our
predicament.

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