RJ EnergyGroup, Monday, January 29, 2007 8:32 AM
Daily Update
Energy Market: Crude oil prices are trading lower this morning due to a report that Saudi Arabia may be content to maintain oil prices around $50. It is rumored that last week the Saudi's vetoed an OPEC emergency meeting to help prop up prices. According to Saudi energy officials, prices around $50 per barrel are not too high to hurt the global economy and not too low to hurt their own economy. Last year's record oil prices meant that the growth in global oil demand slowed to 1% in 2006, compared with a 4% increase at its peak in 2004.
On a bullish note, the Wall Street Journal reported Saturday that the Cantarell Field in Mexico, the world's second largest oil field, continues to decline faster than predicted. According to the Mexican government, output at the field declined by half a million barrels last year, with 1.99 million barrels per day produced in January 2006 compared to only 1.5 million barrels per day in December. Although Pemex was able to offset some of the decline in production, Mexico's December production fell by 0.4 million barrels per day to under 3 million barrels per day, its lowest output since 2000. For 2007, most are expecting Cantarell's production decline rate to continue to increase.
We believe that Mexico's problems mirror the problems facing the global oil markets. The majority of the world's largest oil fields are mature and could be facing sharp declines in the near future.
On the natural gas front, gas prices are trading up this morning as the market is still expecting cool winter weather across the Midwest and East Coast, as depicted in the 8-14 day outlook.
"Stat of the Week": The Ethanol Construction Boom: A Growing Driver of U.S. Natural Gas Demand Natural gas is the fuel of choice for the ethanol industry, and the ongoing ethanol plant construction boom bodes well for domestic gas demand. This is especially true because ethanol plants provide a source of industrial gas demand, which does not have the sharp seasonality associated with residential gas demand. While obviously ethanol-driven gas demand cannot compensate for, say, a second consecutive winter of warmer-than-normal weather, it certainly helps. As the new ethanol plants, most of them gas-fired, commence operation, we expect gas demand to increase as a result. This will naturally be a gradual, long-term process - not a sudden spike - but it is nonetheless a theme of which energy investors should be aware. Depending on the specific assumptions, we see the potential for new ethanol plants to add between 0.7% and 1.0% to domestic gas demand over the next 18 to 36 months. This is a meaningful increase within the context of what tends to be a slow-growing market, and so we view it as a bullish driver for U.S. natural gas prices in the coming years.
Chesapeake Energy (CHK/$29.00/Strong Buy): Adverse jury award in West Virginia. The company announced that its subsidiary, Chesapeake Appalachia LLC, and NiSource subsidiary Columbia Energy Group, received an unfavorable jury judgment regarding royalties on production in West Virginia. The verdict against the defendants totaled $404 million, including $134 million in compensatory damages and $270 million in punitive damages. Chesapeake was surprised by the verdict, which also holds a negative impact for all gas producers in West Virginia. To note, the case was filed in 2003 against Columbia Natural Resources LLC before it was acquired by Chesapeake (and subsequently renamed "Chesapeake Appalachia LLC"). Chesapeake had previously set aside a legal reserve that it believes will cover any judgment, including a prospective appeal.
SunPower Corp. (SPWR/$43.30/Outperform) plans offering of convertible debt. SunPower has filed with the SEC for a proposed offering of $130 million of senior convertible debentures, due 2027 (potentially upsized to $149.5 million). The interest rate, conversion rate, conversion price, and other terms will be determined at the time of pricing. Net proceeds will be used for working capital and capital expenditures. In a related transaction, the company will also issue common shares on a lending basis to facilitate hedging by the convertible investors.
Cameron International (CAM/$52.02/Outperform) settled a class action lawsuit for a total charge of $9.0 million, or $0.05 per share. The results will be included in the company's upcoming 4Q06 earnings release (scheduled for Friday of this week). The lawsuit, filed in 2002, stems from contaminated underground water near a former manufacturing facility in Houston, Texas.
On Friday, Rowan Companies (RDC/$30.91/Outperform) announced that it has lost the lawsuit regarding the Rowan-Halifax, but said it plans to appeal. Rowan operated the Rowan-Halifax under a charter agreement that spanned from 1984-2008. Recall that during the summer of 2005, the Rowan-Halifax was lost in a hurricane. Rowan was responsible for the insurance on the rig, and had insured it for $43.4 million. Rowan was of the understanding that this amount satisfied the charter agreement and was sufficient to cover the $6.3 million carrying value of Rowan's equipment that was installed on the rig. However, the owner of the rig believed that the rig should have been insured for the fair market value of $83 million. On January 25, it was announced that the court ruled that Rowan will be liable for the difference between the owner's claim and the insurance amount (~$40 million). Rowan adamantly believes that it is in the right and plans to actively pursue an appeal to overturn the most recent ruling. If Rowan is not able to win an appeal, the ~$40 million that the company will have to pay will obviously take down potential free cash and therefore hurt interest income. However, aside from potentially lower interest income, we believe this to be an historical event and therefore it should not affect numbers going forward.
Magellan Midstream Partners (MMP/$39.89/Strong Buy) and Magellan Midstream Holdings (MGG/$24.23/Strong Buy) announce distribution increases. Magellan Midstream Partners declared an increase from $0.59/unit to $0.6025/unit ($2.41/unit annualized), which was in-line with our estimate. The general partner, Magellan Midstream Holdings, also declared a distribution increase from $0.233/unit to $0.246/unit ($0.984/unit annualized), which was slightly above our estimate of $0.245/unit. The distributions represent increases of 2.1% and 5.6% over the prior quarter for the LP and GP units, respectively. The two entities are scheduled to report earnings on Wednesday.
Barron's article comments on the ethanol market. Barron's published an article entitled "Review & Preview Follow-Up: The Limits of Ethanol" this past weekend, discussing the recent weakness in ethanol prices and the resulting sell-off in ethanol company shares. The article points out that corn prices soared exactly at the same time as oil prices (and hence gasoline and ethanol prices) fell, putting pressure on the crush spread and hence the profitability of these companies. The article also suggests that the U.S. corn industry will struggle to produce the necessary corn to meet the ethanol industry's growing demand. Bottom line: This was a fairly balanced piece on the recent challenges faced by the ethanol industry, and of course we do not dispute that ethanol profit margins inherently get squeezed when oil prices are down and corn prices are up. But given our long-term bullish view on oil prices ($70 vs. $55 currently), along with the potential for sustainable growth in U.S. corn supply driven by greater per-acre productivity, we think margins are set to rebound as 2007 progresses and beyond.
The Baker-Hughes (BHI/$66.63/Strong Buy) rig count was down 46 from last week to 1,699; the rig count is now up 14% y/y.
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