OGJ Newsletter

"The short-term outlook on the stocks is a bit more cloudy," Adkins acknowledged. Barring a major event affecting Middle East oil supplies, he said, "We see no highly visible catalyst over the next several weeks that could take these energy stocks to the next level."

Prices hold

Nonetheless, Adkins said, "We expect that moderately lower oil inventories in the second half of this year will hold oil prices in the high $20s/bbl range." More important for E&P and oil field service stocks, he said, "The onset of winter should reveal the fact that we are facing a major natural gas supply crunch. Regardless of weather conditions, we must see meaningfully higher natural gas prices this winter to offset the impact of significantly lower gas supply.

"The only fundamental question is: 'How soon will investors appreciate the consequences of a supply-driven natural gas shortage?'"

With the Philadelphia Oil Service Index (OSX) having climbed back nearly 60% after bottoming out last September, Adkins said, "Many investors are either taking a breather or taking their money and running." But he suggests "a little history lesson" for those thinking of opting out of E&P and oil service stocks.

History lessons

Adkins points to "two significant market up-cycles" in the past decade. The first began in early 1995 and peaked 33 months later in late 1997. The second started in March 1999 and peaked 18 months later in September 2000.

"Given our belief that the current cycle is more supply-driven than demand-driven," Adkins said, "it should take much longer to correct the underlying supply-demand imbalance. That means this cycle should last longer than the previous 11/2-year up-cycle." Moreover, he said, the speed of this upturn is greater than its two predecessors.

"During the 1995-97 and 1999-2000 bull runs, the OSX was up 40% and 54%, respectively, 8 months into the cycle. If investors had given up on the group after each of these runs, they would have missed out on 288% and 94% further upside, respectively," Adkins said. "Given that we are only 8 months into this current up-cycle, history and fundamentals would suggest it is way too early to bail out of the group [see table]." He said, "If the past is any indication of future performance, we still have a long way to go before we reach a peak."

Fundamentals

Adkins listed "fundamental reasons why this cycle will be able to see new highs":

• Higher natural gas prices due to an unprecedented supply crunch.
• Market consolidation.
• Stronger balance sheets among companies.
• Greater potential for increased earnings per share (EPS) overall.

"Unlike previous cycles where companies used excess cash flow to pay down debt, firms in this cycle will be able to boost spending to take advantage of higher natural gas prices," Adkins said. "Ultimately, higher gas prices will lead to a higher asset valuation for E&P companies, and a more consolidated, stronger market means increased EPS potential for oil service stocks." F

Commodity prices strengthen
Meanwhile, the determination exhibited by the Organization of Petroleum Exporting Countries to hold the line on production, coupled with Middle East tensions and continued concerns about Iraq, creates "an environment for maintaining [West Texas Intermediate] in the $24-30 price range in the second half," said Stephen A. Smith, founder of Stephen Smith Energy Associates, Natchez, Miss., in a recent report. Moreover, he said, "With current gas in [US] storage about 300-400 bcf over season norms, history would have suggested that current Henry Hub gas prices might lie in the $2-2.50[/MMbtu] range. That this is not the case should remind us that the slope of the gas inventory curve is often more important than the level."

Smith said, "The fact that the gas surplus has been cut in half since late February is the dominant driver of current gas prices."

Industry Scoreboard

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Industry Trends

GASOLINE RETAILERS didn't see windfall profits during the 3-day Memorial Day holiday weekend in the US, but the business of selling gasoline returned to profitability in the second quarter after many chain retailers and refiners experienced several months of red ink, reported Oil Price Information Service (OPIS) of Lakewood, NJ, in a new study.

As of May 29, the average retail service station was selling unleaded regular at a gross profit margin of about 12¢/gal, said OPIS. Second quarter retail profits were up substantially from the mostly single-digit margins of the first quarter.

Gasoline margins nationwide averaged just 6.7¢/gal during first quarter 2002, down substantially from 10.8¢/gal during the same quarter in 2001. But gasoline profits have been negligible in areas featuring big discount retailers known as hypermarts, such as Wal-Mart Stores Inc. of Bentonville, Ark., and Costco Wholesale Corp. of Issaquah, Wash. Retailers competing against Wal-Mart in the Florida communities of Orlando and Tampa yielded average margins of only 1.6-3.1¢/gal this winter.

Wal-Mart gasoline fueling centers in those areas saw retail prices that averaged 3¢/gal below average wholesale costs, so marketers who matched the big discount stores' numbers would have seen negative margins on their sales, OPIS said. Retailers without Wal-Mart competitors selling gasoline reported much different numbers. For example, retailers in Gainesville, Fla., had average gasoline margins of nearly 14¢/gal during early 2002. The OPIS study looked at daily pricing of more than 100 Wal-Mart sites operated by Murphy Oil Corp. for the first quarter of 2002.

Despite negligible margins on gasoline, Murphy CEO Claiborne Deming told shareholders recently that about 110 new Wal-Mart gasoline sites are planned this year in the US. Murphy and Wal-Mart also will partner on new fuel sites in Canada, he said.

CANADIAN REFINERS are introducing technologies and changing manufacturing processes to reduce gasoline sulfur content to 30 ppm before 2005, the Canadian Petroleum Products Institute (CPPI) reported. CPPI member refiners-representing 80% of Canada's downstream petroleum industry-plan to cut the sulfur content of their gasoline by 90% before 2005. Currently, Canadian gasoline contains an average sulfur content of 280 ppm.

"I am pleased to tell you that all CPPI members are squarely on the road to reducing sulfur levels in gasoline," CPPI Pres. Alain Perez said. "The plans the companies have submitted represent a massive undertakingellipseinvolving a total expenditure of $1.8 billion." These large-scale projects are creating construction jobs at refineries across Canada. Engineering and construction have already started on many projects.

Canada's federal low-sulfur gasoline regulations require an interim average of 150 ppm of sulfur for gasoline and a final target of 30 ppm by 2005. Canada will average about 260 ppm sulfur in gasoline this summer, and most refiners will reach the 30 ppm goal in the second half of next year-more than 1 year ahead of the deadline, CPPI predicted.

Government Developments

THE INTERNATIONAL ENERGY AGENCY gave a generally favorable review of the National Energy Policy proposed by President George W. Bush in May 2001. The IEA said the US government's efforts will influence energy policy worldwide.

Robert Priddle, IEA executive director, welcomed the US government's focus on energy security through increased domestic production, energy infrastructure development, improved energy efficiency, stimulation of the use of renewable fuels, and greater international cooperation.

"US policy debate needs to be widened to include a realistic strategy for addressing the US contribution to global environmental problems. US energy policy is in transition," the report said.

Noting that US oil production declined from a peak of 11.3 million b/d in the 1970s to an average 8.1 million b/d in 2000, IEA acknowledged the Bush administration's efforts aimed at increasing that output. "Since successful expansion of production would contribute to the supply security of the US and the rest of the world, the [US] government is encouraged to make a major effort to convince the public that environmental problems can be overcome by appropriate measures," IEA said in a news release accompanying the report. IEA called the US natural gas market "extremely open and competitive."

"Total [US] refining capacity has not changed significantly in recent years," the report said, noting that US oil consumption totaled 19.6 million b/d in 2000-exceeding the previous record of 19.5 million b/d set in 1999.

"Of the total demand for oil in 2000, demand for motor gasoline accounted for a record high of 8.4 million b/d. This represents an increase of 9% over 1999, 24% over 1985, and 35% over the low point of the 1980s. However, gasoline's share of total oil product demand has been quite stable at 44% in 1985 and 1995, and 43% in 2000, reflecting parallel growth in demand for distillate, jet fuel, liquefied petroleum gases, and other petroleum products (see table). Despite higher gasoline and jet fuel prices in 2000, demand for ground and air transport continued to grow, although the outlook for air transport has changed since the terrorist attacks of September 2001," the report said.

INDIA is reviewing its hydrocarbon supply security.

The Indian Prime Minister's Office (PMO) has revived an earlier plan to build strategic petroleum reserves as a way to protect the country from possible oil supply disruptions. The move assumed significance last week as nuclear rivals India and Pakistan appeared to be on the brink of war over their disputed Kashmir border.

Government officials recently met with petroleum industry representatives to discuss the need for maintaining strategic oil reserves. Simultaneously, the PMO decided that it would appoint a consortium of agencies to review hydrocarbon security and to develop a contingency plan. A senior official said that the contingency plan would address the possibility of a long-term disruption in oil supply, a prolonged spike in crude oil prices, and persisting conflicts with Pakistan.

Meanwhile, the PMO is awaiting a report from the Institute of Defense Studies and Analysis concerning the security of oil reserves.

Quick Takes

Statoil ASA has terminated its charter with a unit of Fred Olsen Energy ASA for the Byford Dolphin semisubmersible drilling rig, citing inadequate safety measures. The contract for the rig, which was owned by Dolphin AS, was originally to run until Oct. 8.

Most recently, Byford Dolphin had been working on ExxonMobil Corp.'s Sigyn discovery in the Norwegian North Sea when an accident on the rig killed a worker in April. Statoil was using the rig to drill on behalf of ExxonMobil's Norwegian unit, as Sigyn was to be tied back to Statoil's Sleipner East field.

"Safety on this rig does not meet contractual requirements, and new measures adopted after a fatal accident on [Apr. 17] have not been satisfactorily followed up," said Henrik Carlsen, Statoil executive vice-president, exploration and production, Norway.

The findings from an investigation into the accident-launched by Statoil shortly after the incident occurred-re- vealed that a 200 kg spool piece dropped through a hole in the drill floor and fell 14 m to the working platform below. "The accident was triggered by the hole in the drill floor being inadequately secured," Statoil reported. The report concluded that other factors were involved in the accident, including inadequate planning, insufficient understanding of risk, and failure to ensure that procedures were observed.

Houston-based Apache Corp. last month announced two oil and gas finds in Egypt, marking that company's eighth and ninth discoveries worldwide this year.

First, Apache made an oil discovery in its Khalda concession in Egypt's Western Desert. On test, the Selkit-1X well flowed 5,103 b/d of oil from the top 31 ft of a 64-ft column, "which represents the thickest, best-developed Kharita sands yet encountered this far west of [the company's] Qarun concession, 225 miles away," Apache said.

The well flowed 40.3

Apache holds 100% contractor interest in the concession.

"We have encountered Kharita pay at Khalda, but never of this quality," said Steve Farris, Apache president and chief operating officer. "This is an entirely new play on the concession, and we're excited about the possibility that it may extend beneath our Renpet field, located 4 miles west of the discovery."

In the coming months, Farris said that Apache will drill 2 wells to test Kharita sands in Renpet field. Previous wells in Renpet have tested only shallower Bahariya pay, Farris added.

"Based on the results of this initial test, 25 ft of Upper Kharita pay, as well as Upper and Lower Bahariya potential, will be tested from additional wellbores," the company said, adding that it plans to delineate the new field with additional wells in next few months.

Second, Apache's Abu Sir-1X (Blue prospect) deepwater well, located 42 miles off Egypt, tested at a rate of 17.4 MMcfd through a 38/64-in. choke with 2,095 psi flowing tubing pressure from perforations in the Pliocene Kafr El Sheikh at 6,620-724 ft.

Apache officials said testing conditions were less than ideal. "This test was conducted over a 104-ft interval that represents the least prospective portion of the 311-ft potential gas pay column. The flow rate was restricted by equipment limitations and the unconsolidated nature of the reservoir, so we ran extensive pressure build-ups to establish the zone's productivity, calculating the absolute open flow potential at 90.4 MMcfd," Farris said. "Based on these results, we see no need to test the remaining pay."

The company is operator, with a 55% interest in the Abu Sir well. RWE-DEA AG has a 28.333% interest, and BP PLC holds the remaining 16.667%. The well was drilled to a TD of 7,530 ft. in 3,255 ft of water.

Apache and its partners have identified seven prospects and leads in the deepwater portion, but "have only scratched the surface" of the concession's 2.3 million acres, he said (OGJ, May 20, 2002, p. 20).

Horizon Energy Development BV, a unit of National Fuel Gas Co., Buffalo, NY, has signed a joint development agreement with ACEA SPA, Rome's public electric utility, to build a 400 Mw combined-cycle, natural gas-fired power plant.

The plant is to be built in Montenero di Bisaccia, Italy. The partners will establish a project company in Italy, of which Horizon Energy and ACEA each will own 50%.

Horizon Energy and ACEA expect the project to reach financial close during 2003. Plant construction is slated for completion by June 2005, and the plant is expected to be in operation by September 2005.

"Italy recently issued a decree expediting the development of new electric generation plants," said Bruce Hale, Horizon Energy managing director, in noting project incentives.

Total project financing requirements are estimated at $180 million, Horizon Energy said. Through an associated agreement yet to be negotiated, ACEA plans to purchase the power plant's entire output for 15 years. ACEA will market the power.

The US Department of Justice and the US Environ- mental Protection Agency sued Olympic Pipe Line Co. and Shell Pipeline Co. LP in connection with a June 1999 gasoline pipeline rupture near Bellingham, Wash.

The companies are negotiating with federal prosecutors and hope to reach a settlement this year, industry sources said.

But with no legal resolution yet, federal authorities filed civil charges against both companies in the US Court for the Western District of Washington.

DOJ and EPA also have filed separate criminal proceedings in the pipeline accident. A criminal indictment was issued against Shell, Olympic, and three of their employees on Sept. 13, 2001.

Shell Pipeline owns a third of Olympic. Shell Pipeline's predecessor, Equilon Pipeline Co., managed the pipeline at the time of the accident.

Federal officials, alleging gross negligence by Shell and Olympic, seek civil fines of up to $18.6 million against each company, depending on the quantity of gasoline discharged. The complaint alleges that the rupture stemmed from negligence in the pipeline's operation and maintenance.

The spilled 230,000 gal of gasoline ignited into a fireball that killed three people, injured nine others, and caused property and environmental damage (OGJ Online, Feb. 7, 2001).

The lawsuit also seeks to impose pipeline management, maintenance, and repair requirements on Olympic to prevent or minimize future spills.

Meanwhile, Congress is considering giving the federal government stronger authority in oil, natural gas, and product pipeline inspections. x

In other pipeline news, Columbia Gas Transmission Corp., Fairfax, Va., will file an appeal with the US Department of Commerce before June 10, contesting a move by the New York Department of State (DOS) to block construction of the proposed Millennium pipeline project across the Hudson River, a company spokesman told OGJ. DOS early last month "again raised concerns about our coastal zone consistency certification," said Karl Brack, with Columbia Gas, builder of the proposed Millennium pipeline. DOS is required by regulation to issue a decision on coastal zone consistency within 6 months after receipt of that information. "Based on our documentation, the agency has missed compliance with this regulation on three separate occasions,' said company officials. The same week that DOS raised its objection, project officials received a letter from officials at the New York Department of Environmental Conservation (DEC), indicating that agency was "conceptually satisfied" with the company's blasting plan for the Hudson River, based on recent review of an independent blasting analysis. DEC issued a water quality permit for the project in 1997, and project officials worked through that department to develop what they described as "an innovative crossing procedure that greatly minimizes environmental disturbance."

Moreover, company officials said the final environmental impact statement issued by the Federal Energy Regulatory Commission "includes an extensive review of the proposed crossing plan, including analysis of several alternative routes. FERC staff concluded decisively that Millennium's crossing proposal was appropriate and the best of all available options." DOS officials want project officials to reconsider three alternative routes that the company said were previously rejected by federal officials.

BP Pipelines Vietnam BV and BP Exploration Operating Co. Ltd. let contract to BJ Process & Pipeline Services (BJPPS) to provide pipeline commissioning and testing services for the BP Nam Con Son gas project in Viet Na. BP serves as operator of the $1.3 billion Nam Con Son integrated gas-to-power project now under construction off the southern province of Ba Ria-Vung Tau. The project entails the development of the Lan Tay and Lan Do natural gas fields on Block 6/1, construction of a 400 km pipeline to bring the gas ashore, and a gas-fired power station. The project also involves the construction of an offshore steel production platform and an onshore gas processing terminal. The new BP platform is 360 km off Vung Tau, with the primary pipeline surfacing with a safety valve at Long Hai, continuing 8 km over land to the new terminal at Dinh Co. BP will operate the platform, pipeline, and terminal on behalf of its partner firms: Petrovietnam, India's Oil & Natural Gas Corp. unit ONGC Videsh Ltd., and Conoco Inc. x

A unit of Royal Dutch/Shell Group has finalized an agreement to purchase up to a total of 3.7 million tonnes of LNG during 2004-09 from partners in the Australian North West Shelf venture, said project participant BHP Billiton Ltd. This agreement and others support the venture's LNG train expansion.

The contract's actual volume will depend on the volume of LNG that the North West Shelf venture partners commit to long-term customers in Japan, South Korea, China, and Taiwan. Shell will use the LNG to develop market opportunities outside those markets.

Earlier this year, Osaka Gas Co. Ltd. agreed to purchase 1 million tonnes/year of LNG from the expansion project for 30 years, beginning in 2004 (OGJ Online, Mar. 19, 2002). Last year, the North West Shelf venture agreed to sell 1.37 million tonnes/year of LNG from the expansion project to Tokyo Gas Co. Ltd. and Toho Gas Co. Ltd. (OGJ Online, Jan. 16, 2001).

The North West Shelf venture's $2.4 billion LNG expansion project-currently under way-includes a fourth LNG train at the onshore gas plant on Australia's Burrup Peninsula. First LNG from the fourth train is scheduled for mid-2004.

Cabinda Gulf Oil Co. (CABGOC), a unit of Chev- ronTexaco Corp., awarded a $660 million contract to a consortium of Stolt Offshore SA and Daewoo Shipbuilding & Marine Engineering Co. Ltd. (DSME) for its Sanha gas-condensate fields development project on Block 0 off Angola. Of this total, Stolt Offshore expects to receive $240 million, $15 million of which it will book in 2002.

The contract calls for the engineering, procurement, installation, and commissioning of five offshore platforms with two linking bridges, the modification of three existing platforms, and the installation of 100 km of subsea pipelines. These pipelines, 4-30 in., will be laid in 100 m of water.

Most of the platform construction will be performed at the Stolt Offshore-operated Sonamet yard at Lobito in Angola, the company said. Once completed, the facilities will be installed in the Sanha and Bomboco fields in the Cabinda area off Angola.

National Industrial Gases Co. (GAS), a unit of Saudi Basic Industries Corp. (SABIC), let a $93 million lump sum contract to Germany's Linde AG for the construction of an air separation unit at SABIC's Al Jubail petrochemical complex at Riyadh.

The unit, which GAS claims will be one of the world's largest, will increase GAS's air products output capacity to 8,600 tonnes/day from 5,600 tonnes/day by 2004. The unit is expected to reach completion by late 2004. The plant, which will have capacity of 3,000 tonnes/day of oxygen, also will produce nitrogen, argon, krypton, and xenon.

Linde has already supplied GAS with other air separation units in Saudi Arabia, at Yanbu and Al Jubail.