Wednesday, September 26, 2007

Two Industries

In the first day of the John S. Herold Pacesetters Conference, most of which was focused on the exploration and production portion of the global oil and gas industry, I heard many interesting comments and themes, but I was struck by a contrast between the typical external picture of an industry beset by political and environmental challenges, and the companies on display here, which are working on real growth opportunities and generating real value for their shareholders and the economy as a whole. Anyone expecting this industry to fade quietly and get out of the way of emerging energy sources such as wind, solar and biofuels, is bound to be disappointed. Yet the industry would be equally wrong to ignore the future competition those new sources represent.

In some respects, this contrast arises from something one of yesterday’s panelists observed, that there isn’t one oil & gas industry, but really two. On the one hand, we see the eight or so world-scale companies that are household names across large portions of the globe, while on the other, a constellation of smaller companies that belie the stereotype of an industry that values financial engineering as much as the physical kind. While no one should be surprised to see such companies at an investment conference touting their companies’ stories, the underlying facts are impressive: these smaller companies are generating real production and reserves with the drill-bit-- rather than just buying each other--generating healthy profits along the way.

But as yesterday’s lunch speaker made clear, even the smaller companies don’t necessarily fly under the political radar. The CEO of Chesapeake Energy, one of the largest independent producers of natural gas in the US, shared a remarkable set of correspondence with the audience, in which the Governor of Connecticut accused his company of manipulating the gas market, to the detriment of consumers, by constraining production. She has asked for a Congressional investigation of this practice, and in the current environment she will probably get one.

You don’t have to take Mr. McClendon’s word concerning the inaccuracies contained in Ms. Rell’s allegations; they are easily discernable in the price and inventory storage data maintained by the Energy Information Agency of the Department of Energy. It certainly leaves open the question of how much due diligence the Governor’s office conducted before leveling these charges. More fundamentally, however, it’s not clear why any state government might think it appropriate to criticize a decision by a private company in another state to cut production that has become unprofitable because of falling prices. If natural gas producers can be taken to task for this, can ethanol producers faced with falling margins be far behind?

Finally, I heard some interesting thoughts about what the shape of the current futures markets for oil and natural gas is telling us. When you ignore the fluctuations at the front end of the market and focus on the further-out contracts, the pricing of low $70’s for crude oil and $8 for natural gas are in line with the prices implied by the incremental oil and LNG projects now under development. While that doesn’t preclude the possibility of a collapse back to $50 or $60 oil and $5 natural gas, it does suggest that such drops wouldn’t be permanent—unless producers are forced to produce flat out regardless of price.

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