Senator Ben Sasse – 5 September 2015 CGOAL Letter

8/20/2019 Senator Ben Sasse – 5 September 2015 CGOAL Letter

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Senator Ben Sasse386A Russell Senate Office BuildingWashington, 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 Honorable Ben Sasse,

This is a request for Senator Sasse to meet with Senator Murkowski and request that the Chairman ofthe Senate Energy and Natural Resources Committee call one or more hearings — as needed —taking testimony from CEOs of petroleum corporations on how they will act in a scenario ofcontinued global low-oil prices when the National Interest might conflict with their fiduciary duty.

Neither Senator Sasse nor any of the twenty-two members of the Senate Energy and NaturalResources Committee (ENR) has responded to my numerous letters, which I have sent beginningFebruary 15, 2015. My letters explain what I believe should be considered a National Securityenergy 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 ofattention to the financial health of America’s “national resource” — the petroleum industry — in ascenario 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 NationalSecurity Act of 2015 have been assembled and amended without any apparent consideration for the petroleum industry’s financial stability under sustained low-oil-price scenarios. Yet, evidencemounts daily showing that catastrophe is imminent, when petroleum corporations cannot meet theirdebt obligations and petroleum production threatens to drop dramatically below near-termconsumption demands.

I believe taking sworn testimony from industry CEOs as to how they will weather the financial storm

would be responsible action by the Senate. Lacking such investigation undermines the Senate’scredibility and the legitimacy of those bills from national interest and public interest perspectives.

The attached documents should pique your keen interest. As your constituent, I ask you to act now.

Awaiting your response,

Douglas Grandt

Citizen Gas & Oil Advisory LobbyDouglas Grandt(510) 432-1452

P.O. Box 6603

Lincoln, NE68506-0603

5 September 2015

(Hand Delivered)


2/23

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-a-trillion-dollars-to-survive

At a time when the oil price is languishing at its lowest level in six years, producers needto 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 ofdistress, tripled in the past year, leaving 168 firms in North America, Europe and Asiaholding this debt, data compiled by Bloomberg show. The ratio of net debt to earnings isthe highest in two decades.

If oil stays at about $40 a barrel, the shakeout could be profound, according toKimberley Wood, a partner for oil mergers and acquisitions at Norton Rose FulbrightLLP 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 10years as companies emerge from this,” Wood said. “If oil prices stay at these levels, thenumber of bankruptcies and distress deals will undoubtedly increase.”

Debt repayments will increase for the rest of the decade, with $72 billion maturing thisyear, about $85 billion in 2016 and $129 billion in 2017, according to BMI Research. Atotal of about $550 billion in bonds and loans are due for repayment over the next fiveyears.


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U.S. drillers account for 20 percent of the debt due in 2015, Chinese companies ranksecond 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 morethan fourfold to 80 over the past year, according to data compiled by Bloomberg.Twenty`six European oil companies have bonds in that category, including GulfKeystone Petroleum Ltd. and EnQuest Plc.

Pressure Builds

Gulf Keystone can “satisfy all its obligations to both its contractors and creditors” afterauthorities in Kurdistan, where the company operates, committed to making monthlypayments for crude exports from September, Chief Financial Officer Sami Zouari said inan e`mail.

An EnQuest spokesman declined to comment.

Slumping crude prices are diminishing the value of oil reserves and reducing borrowingpower, even as pressure builds to find replacement fields.

Some earnings metrics are already breaching the lows of the 2008 financial crisis. Theprofit margin for the 108` member MSCI World Energy Sector Index, which includesExxon Mobil Corp. and Chevron Corp., is the lowest since at least 1995, the earliest forwhen data is available.

“There are several credits which simply won’t be able to refinance and extend maturitiesand they may need to raise additional equity,” said Eirik Rohmesmo, a credit analyst atClarksons Platou Securities AS in Oslo. “The question is: would they be able to do thatwith debt at these levels?”




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Credit Ratings

Some U.S. producers gained breathing space by leveraging their low`cost assets toraise 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 worstperformers 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 toraise money cheaply. Standard & Poor’s cut the rating of Eni SpA, Italy’s biggest oilcompany, in April, while Moody’s Investors Service downgraded Tullow Oil Plc’s debt inMarch.

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 Rose’s Wood said. Smallerplayers, dependent on fewer assets, could have problems, she said.

“Clearly, those companies with debt to pay will have one eye firmly on oil prices,” saidChristopher Haines, a senior oil and gas analyst at BMI in London. “With revenuescollapsing and debt soon to mature, a growing number of companies may find

themselves unable to meet repayment schedules.”




5/23

Winter Is Coming For Upstream Oil And GasCompanies In 2015, Part 1 - Exxon Mobil

Sep. 3, 2015 | David Addison

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

Summary

• Bargains among upstream companies’ stocks are difficult to come by; currentvaluations discount much higher energy prices.

• Stress-testing upstream assets for lower oil and natural gas prices indicates thatmassive reserve quantity and balance sheet impairments may be due in 2015’s

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 Mobil’s stock valuation, like most other upstream companies’, is tied tocommodity prices.

"Winter is coming" for many upstream oil and gas companies. The precipitous 50% dropin crude oil prices over the past year will likely force many oil and gas exploration andproduction (E&P) companies to impair their upstream assets in this coming winter's 10-

K 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 digeststhe impending impairments and true impacts of lower prices, bargains may begin toappear. Until that time, even seasoned investors who are tempted to "buy the dip" in thestock prices of even the best upstream oil and gas companies should exercise restraint.

Accounting regulations compel companies with significant E&P operations toperiodically test the book values of upstream oil and gas assets for impairments.Furthermore, the SEC compels publicly held companies with significant upstreamassets 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 sanitycheck 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 thatExxon Mobil, as a company, can survive through the current commodity environment.However, Exxon Mobil's attractiveness as an investment in the company's stock isdubious. In order for the economic value of its net assets to match up with thecompany's stock price, energy prices must quickly recover to $100/Bbl oil and $30/Boe(~$5/Mcf) natural gas.


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


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Some Notes on Methodology

My core methodology for stress testing balance sheets is to estimate the economicbook values (EBV) of core assets. Estimating EBV simply involves creating an

economic balance sheet which converts certain accounting book values (ABV) toestimates of their fair or intrinsic values and/or discounted net present values underspecific macro- and micro-economic conditions. If and when capitalized costssignificantly overstate the modeled intrinsic values of the upstream assets at currentcommodity prices, one can assume that the economic values should be impaired. Thisapproach roughly mirrors common practices for impairment testing.

In this series, NPV analysis is applied to the upstream assets (i.e., oil and gasproducing 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 recentcommodity prices and the industry-standard 10% annualized discount rate which isapplied 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 eitherextremely accretive or deleterious, to qualitative interpretation. The economic values ofdownstream assets, when they are significant, are determined by a Nelson Complexityanalysis of their equivalent distillation capacities (see prior article on the fundamentalsof the refining business).

This methodology admittedly somewhat replicates reporting requirements. FASB Accounting Standards Codification (ASC) 932 requires publicly traded E&P companiesto disclose a standardized measure of discounted future cash flows (i.e., SECStandardized 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 usethe 12-month historical average of the beginning-of-month prices in determining reservequantities.

The standardized measure was originally intended to help interested parties seethrough accounting distortions caused by the use of disparate accounting methods. Itcan also sanity check capitalized costs of upstream assets and, to an extent, predictimpairments - 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. Naturalresource 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 recentcommodity prices - overwhelmingly, managements utilize discounted cash flowanalyses, vis-à-vis the standardized measure. If the book value is greater than thisestimate, 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 arecapitalized. Companies using the SE method are only required to impair assets whenthe carrying amounts of oil and gas properties are deemed to be unrecoverable (on anundiscounted basis).


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Irrespective of accounting method, companies may not reverse impairments once theyhave 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 ofeconomic reality.

On the accounting end, if and when accounting convention significantly embellisheseconomic reality, investors should notionally impair the asset even if managementchooses not to or is not compelled. Moreover, publicly traded companies are onlyrequired to publish this information once annually - so when economic conditionschange, such as how energy prices have dropped in 2015, the company's latestinformation may not reflect the current economic reality.

Moreover, there may be significant variability in how different reservoir managersprepare standardized measures which severely limits their usefulness as a comparativevalue metric. I wager that any petroleum engineer out there will corroborate thatreservoir 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 notsupport 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 ratherinconsistencies in its preparation.

To compensate for the information lag as well as for uncertainty and inconsistency inmanagements' preparation of estimates, I utilize a uniform valuation methodology whichis accounting-methodology independent and which incorporates more recentinformation 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 futureiterations would be to prepare NPV estimates using futures strip pricing (i.e., the termstructure of futures prices).

Although an "economic stress test" approach may seem foreign to some, thismethodology is actually very relevant to many types of investors since it removesaccounting distortions created by different accounting methods. Also, being premised onestimating future cash flows, it give some insight into companies' abilities to sustaindividends, buybacks, interest payments, and even operating costs. Furthermore, manycompanies, especially independent producers, engage in debt covenants with lenders.

Lower cash flows and asset impairments can trigger breaches of these covenants whichcan unleash a flurry of negative consequences... all of which can lead to massiveinvestor losses.

Some final notes regarding methodology:

The standardized measure, because it is based on proved (1P) reserves, may bepredisposed to underestimating the economic values of underlying oil and gasassets. The SEC defines proved oil and gas reserves as those quantities of oiland gas which are expected to be economically producible with "reasonable


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certainty". The Society of Petroleum Engineers' (SPE) Petroleum ResourcesManagement System (PRMS) guides that if deterministic methods are used tomeasure reserve quantities, the SEC criteria (with some trivial differences inwording) 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 anestimate of proved and probable (1P + 2P) reserves (i.e., those which areexpected to be economically recoverable under a most likely scenario), no USregulatory body requires the disclosure of anything other than 1P reserves. Sincemy estimate of economic value is also premised on 1P reserves, I also am likelyto 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 refrainfrom couching value in terms of PV-10 since its preparation is non-uniform and itspresentation 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 residualasset values), NAV-centric approaches may not be appropriate.

Exxon Mobil Overview

Exxon Mobil is the super-major. In 2014, the company's upstream segment producedapproximately 3,970 MBoe/d. Its downstream segment is capable of distilling about5,248 MBbl/d of crude oil at a weighted average Nelson Complexity of 10.4. In 2014, itsrefineries produced about 4,480 MBbl/d of refined products. Its chemical division, whichis reported separately, produced nearly 24 metric tons of ethylene, polyethylene,

polypropylene and paraxylene in 2014. In addition, the company markets its productsthrough 4,754 owned/leased and 15,463 distributor/reseller retail sites globally throughthe Exxon, Esso and Mobil brands.

The Standardized Measure, Restated for Recent Prices

Table 1, below, contrasts Exxon Mobil's standardized measure of discounted cash flowsfrom oil and gas assets as presented in its 2014 10-K with an estimate of their value atcurrent commodity prices (i.e., $60/Bbl oil, $39/Boe NGL, and $18/Boe natural gas). Itake into account that Exxon Mobil typically realizes slightly lower than market prices onoil but also receives significantly greater than market price for its natural gas. The dragon realized oil prices can be attributed to the fact that the company also producessignificant quantities of bitumen and synthoil. Exxon Mobil receives an uplift on gasprices due to the fact the international natural prices are typically much higher than theyare in the United States.


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Table 1: Standardized Measure of Discounted Cash Flows from Oil and GasAssets, 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 revenuesfrom 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 $330billion in combined operating expenses and income taxes. Despite these cost savings,the expected net present value of discounted cash flows can be expected to decreaseby $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 ablenegotiate better terms with service providers and vendors.

Furthermore, the Exxon Mobil's 2014 presentation of the standardized measure likelyoverstates future income taxes. Actual income taxes are likely to be much lower due tooffsetting depreciation, amortization, and depletion expenses which can be chargedagainst net income.



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Since Exxon Mobil uses the SE method to capitalize reserve quantities, I do not believemanagement will be compelled to impair proved reserve quantities or significantlyreduce future development expenses. Although many projects will have negative NPVsat a 10% discount rate and at $60/Bbl crude oil (i.e., Alberta oil sands), simplifyingassumptions 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 ananomaly in relation to other E&P companies.

Economic Book Value Analysis

The following EBV analysis contrasts the accounting and economic book values ofExxon Mobil's common stock using inputs from the restated standardized measure aswell as a few other key adjustments.

Table 2: EBV Analysis, Exxon Mobil

(all amounts are in millions USD, except as otherwise noted)



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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 assetsoffsets the $79 billion impairment to downstream assets (which notionally include thoseheld by the chemicals segment).

The upward adjustment of downstream assets reflects my belief that Exxon Mobil's5,250 MBbl/d atmospheric crude distillation capacity (52,480 MBbl/d of equivalentdistillation capacity (EDC) at a weighted average Nelson Complexity of 10.4) at a long-run utilization rate of 85% warrants a significantly higher valuation than its 2014 bookvalue of $37.6 billion. Put into context with 2014's oil and gas production of 3968.5MBoe/d, Exxon Mobil is every bit, if not more, a downstream enterprise as it isupstream.

The fact that downstream assets are major beneficiaries of falling crude oil and naturalgas prices did not influence my upward adjustment of Exxon Mobil's downstream assetvalues.



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If energy prices do not recover, I estimate that the accounting basis of Exxon Mobil's netassets 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 conditionsfor long-term shareholder value creation, the fact that equity is expected to remainsignificantly 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 isapproximately 60% lower than it current market price at current energy prices. In orderfor the EBV and market value to balance each other out, energy prices need to return tomuch 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 managementteam has a long term focus, it has diversified and integrated operations, displaysconservative accountancy, is historically a low cost producer, has a long-lived reserves,has been able to consistently replace its reserves, possesses a technological edge overmost competitors in finding and developing oil and gas properties, possesses immenseeconomies of scale, and has access to cheap capital (2014 cost of debt was around1%; 2014 all-in cost of capital was around 3.5%).

In addition, I believe that the company's sophisticated downstream and chemicalsdivisions hide the real strength of sensible vertical integration in the oil and gasbusiness: survivability. Relatively stable cash flows from downstream operations bufferthe hyper-cyclical economics of upstream operations. Furthermore, downstreamoperations are typically beneficiaries of lower commodity prices since the prices ofrefined products and consumer goods tend to be "sticky". When energy prices tank, as

they have, increased profits from downstream activities are expected to offset lowerprofits from upstream activities. Exxon's downstream, in effect, hedges a significantamount 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 thrivethrough 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 thoughExxon Mobil's underlying asset base is still able to produce significant cash and hasimmense value, the stock price is too high if current commodity prices prevail. If crudeoil 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 asymmetricupside.

Unfortunately, the intrinsic value of Exxon Mobil's stock is tied to commodity priceswhich 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? Whywouldn't I just go out and buy crude oil or natural gas futures contracts?



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However, Exxon Mobil's somewhat drab future at lower energy prices appears toglimmer 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 futureproduction is not economic if current prices are to prevail. As a result, the values ofbalance sheet and reserve quantity impairments disclosed in this winter's 10-K and 20-Fannual reports could be staggering.

Carbon Tracker Initiative's Oil & Gas Majors: Fact Sheets strongly corroborates myposition. The info paper utilizes Rystad's Energy UCube database (among the mostthorough of any upstream oil and gas project database) to analyze capital spending andpotential production in order to arrive at estimated "break-even" costs for associateddevelopment projects. This break-even cost is the price of oil which is required foreconomic rationalization (i.e., "sanction").

The paper concludes that 34% of oil majors' total planned capital expenditures requireoil prices of $95+/Bbl for economic sanction. The info paper was published in of August2014, when oil prices were right around $95/Bbl. Even so, the paper claims that up to22% of planned future spending on projects were candidates for deferral or outrightcancellation.

Forget for a moment that petroleum is a finite and depleting resource which society maynot 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 ofsupply 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 relativelyfixed 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 thenear term when prices rise. Under such conditions, a large price change can benecessary to rebalance physical supply and demand."

In other words, prices will have to either a) remain low long enough drive excesscapacity 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 asprices remain above lifting costs and associated non-income related taxes ($15-$30/Bbl

is typical, according to SA contributor Christopher Aublinger's research on productioncosts), producers will keep on pumping. Moreover, lower prices may have actuallyincented many producers to maintain and even increase production levels in order tomeet interest payments and stay in good financial standing with lenders.

Eventually, energy prices will recover. When producers are forced to reinvest to keepproduction levels consistent with demand, the marginal producers will begin to feel the



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sting of replacing (i.e., finding and developing (F&D)) depleted reserves. After onefactors 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 affectsproduction. If production contracts too rapidly, global prices could respond very violentlyto the upside. Even though much higher prices would seem a boon to oil and gasproducers, extreme price fluctuations doom the boom and bust commodities cycle torepeat itself.

All of this speculation about commodity prices should be, of course, tangential to asound investment thesis. However, closer inspection reveals that investing in almostany 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 muchof my free time to learning the industry in order to capitalize on the panic that was sureto ensue. I had originally envisioned buying cheap, over-looked upstream oil and gasassets and then watching my net worth skyrocket. However, sanity checks revealed thatthe oil and gas sector was already being very closely monitored by legions of analystswho were already eagerly gobbling up any low-hanging fruit. It was also quickly clearthat the stock prices of most upstream companies were still being discounted for muchhigher energy prices.

Even though my machinations of cruising around town in a brand-new Cadillac, adornedin crocodile leather boots and a Stetson hat (à la J.R. Ewing of TV show Dallas), havebeen temporarily foiled by reality, I do still cling to the idea that opportunities forinvesting in upstream assets may present themselves.

Perhaps, the "winter is coming" thesis will play out, allowing patient investors to dive inand scoop up some sweet deals. When asset write-downs that I am projecting becomepublic knowledge, the ensuing sell-off could result in more easily spotted bargains. Untilthat time, I believe that potential investors in upstream oil and gas companies shouldeither move on to greener pastures or continue to face scouring the wasteland in searchof elusive value.



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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,” oris 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 Headedin 2015-16? In it, I said that persistent very low prices could be a sign that we arereaching 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 productionleads 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 debtfor a while (since adding cheap debt helps make unaffordable big items seemaffordable), 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 findstudent 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 growthof the world economy. With slow economic growth comes low demand for commoditiesthat 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 inrecent years.

A chart I showed in my January post was this one:

Figure 1. World Oil Supply (production including biofuels, natural gas liquids) and Brentmonthly 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 theadverse impact high oil prices had on the economy, and partly because of a contractionin debt amounts at that time. It was only when banks were bailed out and the UnitedStates began its first round of Quantitative Easing (QE) to get longer term interest ratesdown 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, andfactories. This also helped pump energy prices back up again.

The price of oil was trending slightly downward between 2011 and 2014, suggesting thateven then, prices were subject to an underlying downward trend. In mid-2014, there wasa big downdraft in prices, which coincided with the end of US QE3 and with slowergrowth in debt in China. Prices rose for a time, but have recently dropped again, relatedto slowing Chinese, and thus world, economic growth. In part, China’s slowdown isoccurring because it has reached limits regarding how many homes, roads and factoriesit needs.

I gave a list of likely changes to expect in my January post. These haven’t changed. I

won’t repeat them all here. Instead, I will give an overview of what is going wrong andoffer 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 islikely to collapse. Back in 2008, the world financial system almost collapsed.This time, our chances of avoiding collapse are very slim.

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

3 We don’t know how fast things will unravel, but things are likely to bequite different in as short a time as a year. World financial leaders arelikely to “pull out the stops,” trying to keep things together. A big part of ourproblem is too much debt. This is hard to fix, because reducing debt reducesdemand and makes commodity prices fall further. With low prices, production ofcommodities is likely to fall. For example, food production using fossil fuel inputsis likely to greatly decline over time, as is oil, gas, and coal production.

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

5 Our economy is a self-organized networked system that continuouslydissipates energy, known in physics as a dissipative structure. Otherexamples of dissipative structures include all plants and animals (includinghumans) 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 ofprior civilizations that have collapsed. This appears to have happened whenthe 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 headedtoward collapse, just like the other economies.

6 The reason that collapse happens quickly has to do with debt andderivatives. Our networked economy requires debt in order to extract fossilfuels from the ground and to create renewable energy sources, for severalreasons: (a) Producers don’t have to save up as much money in advance, (b)Middle-men making products that use energy products (such cars andrefrigerators) can “finance” their factories, so they don’t have to save up as much,(c) Consumers can afford to buy “big-ticket” items like homes and cars, with theuse of plans that allow monthly payments, so they don’t have to save up as much,

and (d) Most importantly, debt helps raise the price of commodities of allsorts (including oil and electricity), because it allows more customers to affordproducts that use them. The problem as the economy slows, and as we add moreand more debt, is that eventually debt collapses. This happens because theeconomy fails to grow enough to allow the economy to generate sufficient goodsand services to keep the system going–that is, pay adequate wages, even to non-elite 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 withthe debt component.

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




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Where Did Modeling of Energy and the Economy Go Wrong?

1 Today’s general level of understanding about how the economy works, and energy’s relationship to the economy, is dismallylow. Economics has generally denied that energy has more than a very indirectrelationship 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 foodproduction and medicines, among other things. Yet environmentalists often believe that the world economy can somehow continue as today, without fossilfuels. 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.

2 Economics modeling is based on observations of how the economy worked when we were far from limits of a finite world. The indicationsfrom this modeling are not at all generalizable to the situation when we arereaching limits of a finite world. The expectation of economists, based on past

situations, is that prices will rise when there is scarcity. This expectation iscompletely 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 topurchase high-priced goods like homes, cars, and refrigerators. All of theseproducts are created using commodities, so a lack of adequate wages tends to“feed back” through the system as low commodity prices. This is exactly theopposite of what standard economic models predict.

3 M. King Hubbert’s “peak oil” analysis provided a best-case scenariothat was clearly unrealistic, but it was taken literally by his followers.One of Hubbert’s sources of optimism was to assume that another energyproduct, 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 Hubbert’s 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 muchequivalent to the output of a perpetual motion machine, adding an endlessamount of cheap energy that can be substituted for fossil fuels. A related sourceof optimism has to do with the shape of a curve that is created by the sum ofcurves 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 currentdevices) is available for what is being modeled–here fossil fuels. When theamount of extraction is determined by price, and price can quickly swing fromhigh to low, there is good reason to believe that the shape of the sum curve will bequite 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: WolframMathworld.

4 The world economy operates on energy flows in a given year, eventhough most analysts today are accustomed to thinking on adiscounted 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 doesn’tsatisfy our need for food when we are hungry. Similarly, our vehicles run on oilthat has recently been extracted; our electrical system operates on electricity thathas been produced, essentially simultaneously. The very close relationship in

time between production and consumption of energy products is in sharpcontrast to the way the financial system works. It makes promises, such as theavailability of bank deposits, the amounts of pension payments, and thecontinuing value of corporate stocks, far out into the future. When thesepromises 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 happeningin the near future.


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5 Changes in the financial system have huge potential to disrupt theoperation of the energy flow system. Demand in a given year comes from acombination 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 beenpositive. 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 tobring 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 toextract oil, coal and natural gas. This is a major reason why the system tends tocrash.

6 Researchers are expected to follow in the steps of researchers beforethem, rather than starting from a basic understudying of the wholeproblem. Trying to understand the whole problem, rather than simply trying tolook at a small segment of a problem is difficult, especially if a researcher isexpected 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 tendsto simply repeat past errors. This problem is hard to correct, because the field ofenergy and the economy cuts across many areas of study. It is hard for anyone tounderstand the full picture.

7 In the area of energy and the economy, it is very tempting to tellpeople what they want to hear. If a researcher doesn’t understand how thesystem of energy and the economy works, and needs to guess, the guesses thatare most likely to be favorably received when it comes time for publication are theones 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.” Theavailability of financial grants on topics that appear hopeful adds to this effect.

8 Energy Returned on Energy Investment (EROEI) analysis doesn’treally get to the point of today’s problems. Many people have high hopesfor EROEI analysis, and indeed, it does make some progress in figuring out whatis happening. But it misses many important points. One of them is that there aremany different kinds of EROEI. The kind that matters, in terms of keeping theeconomy from collapsing, is the return on human labor. This type of EROEI isequivalent to after-tax wages of non-elite workers. This kind of return tends todrop too low if the total quantity of energy being used to leverage human laboris 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 isrestricted.

9 Instead of looking at wages of workers, most EROEI analyses considerreturns on fossil fuel energy–something that is at least part of thepuzzle, 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 todiscounted cash flow. The two are not at all equivalent. What the economy needsis cash flow energy now, not modeled energy production in the future. Cash flowanalyses 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 outputsin the same calendar year. Man-made renewables will tend to do badly in suchanalyses, because considerable energy is used in making them, but the energyprovided is primarily modeled future energy production, assuming that thecurrent economy can continue to operate as today–something 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 havetoday longer. But if the system is collapsing, the whole plan is futile. We end upextracting more coal and oil today, in order to add wind or solar PV to what willsoon 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 afinancial system. So if we add man-made renewables, most of what we get is theirshort-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 1972analysis of limits of a finite world, published in the book “The Limits to Growth” byDonella Meadows and others. It models what can be expected to happen, if populationand resource extraction grow as expected, gradually tapering off as diminishing returnsare encountered. The base model seems to indicate that a collapse will happen aboutnow.

Figure 5. Base scenario from 1972 Limits to Growth, printed using today’s graphics byCharles 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 themodel was put together based on physical quantities of goods and people, withoutconsidering the role the financial system, particularly debt, plays. I expect that debt would tend to make collapse quicker. Also, the modelers had no experience withinteractions 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 initialdownturn, cannot be relied on. So we end up with something like Figure 6, as about allthat we can rely on.

Figure 6. Figure 5, truncated shortly after industrial output per capita (grey) and foodper 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 arefacing a predicament that doesn’t have a real solution. We can make the best of what wehave today, and we can try to strengthen bonds with family and friends. We can try todiversify our financial resources, so if one bank encounters problems early on, it won’t 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, givenadequate preparation. This may or may not be true. The only kind of renewables that wecan 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 today’s technology,such as solar panels and a pump adapted for use with solar panels, needs to plan for theday when that technology fails. At that point, hard decisions will need to be maderegarding how the group will live without the technology.

We can’t say that no one warned us about the predicament we are facing. Instead, wechose not to listen. Public officials gave a further push in this direction, by channeling

research funds toward distant theoretically solvable problems, instead of understandingthe true nature of what we are up against. Too many people took what Hubbert saidliterally, without understanding that what he offered was a best-case scenario, if wecould find something equivalent to a perpetual motion machine to help us out of ourpredicament.

Documents

Senator Ben Sasse – 5 September 2015 CGOAL Letter