David Pursell speaks with Darley

Q1. What is the natural gas situation in Canada, and what effect might that have on the US?

The National Energy Board out of Calgary talked about their view of supply and it’s a very analytical approach to the supply to the western Canadian sedimentary base and they suggest that supply is going to be declining magnitude couple percent per year, for this year and next year, and then there’s no visibility beyond that, but that’s a relatively significant event because Canadian production growth has almost been a given, you know; death, taxes and production growth.

So when you think about how does that impact the US, because we are indeed US-centric here, if Canadian supply is down and demand is flat then there’s less gas available to import and makes a tight market even tighter. You know, if you go back twenty years or so, there were reserve life requirements on Canadian companies, I believe that number was 20 and of a reserve life of 20 or greater in order to export gas to the US.

That created a situation where people in essence inflated reserves and that for the most part has been worked through by more rigorous and conscientious reserve reporting but the concern is; do you see a backlash in Canadian politics…I can’t figure out American politics let alone Canadian politics…would there be a backlash in say, look, we can see out ten years from now and where we’ll be a no longer a net exporter of Gas, maybe we need to hold some for a later date and create some sort of restrictions on export volumes.

I don’t think that happens, but I would bet that decline in Canadian production certainly spurs that debate, so, those are the things that I look North of the Border and wonder politically how that’s gonna play out, particularly when, you know, if you think about it form an exporting country’s perspective, why are we paying, in Calgary, why are the citizens paying $6 for gas so that those over-consumptive folks South-of-the-border can, you know, drive their SUV’s and heat two homes and all that sort of thing, so… I think the debate will be interesting going forward and I think the Canadians always like to differentiate themselves from the US. I don’t know that there’s any meaningful change to supply policy, but I think you have to be mindful of that.

Q2. Can you tell us about the contrast between the official hydrocarbon energy analyses from Canada vs the US?

Well there’s no question, the supply analysis and the decline analysis done by the Department of Energy in Washington DC has been sophomoric at best. Historically it’s been just directionally flat wrong.

It is tough to estimate the magnitude of decline or growth in any given year but the US government, the Department of Energy, has historically assumed that there was a significant amount of excess productive capacity out there that just has not existed. I think they are quickly coming to the realisation that that was a bit if a fantasy - there is no excess capacity - but the folks in Calgary at the NEB have done a much better job of bottoms up analysing the real data and trying to come to some kind of concrete conclusions that, quite frankly, are probably not all that popular, but it’s the reality. It’s tough as a piece of a Government agency to be the bearer of bad news and the bad news is: Guess what? export volumes are going to be down, not up probably and that’s significantly different than it has been in the past.

Q3. Do you see signs that the US DoE (Department of Energy) is starting to recognise the dimensions of the coming energy crisis?

I see signs of it in the data that are just started to come out. They’ve over the last couple of months there’ve been some reports in which you look for subtle changes in wording and up until a couple months ago they were talking about supply growth in 2003, saying that ‘well supply will grow 3% because demand will grow 3%’.

Well, that’s wishful thinking. Just because demand grows, doesn’t mean supply will automatically grow. Supply is not a function of demand. Supply is a function of gas pricing, drilling activity level, availability of imports and on the drilling activity level, it’s really a question of (prospect quality-price bear quality?) (unclear) and it is absolutely not a function of demand, but it goes back to this inherent belief that there is excess capacity such that if demand grows, I just go out and open the valve a little bit more and get more production and they’ve kind of stopped using that - just because demands gonna grow – and they’ve actually started to talk about supply in a bit of a stand-alone environment. Plus conversations with the folks in DoE which makes be believe they’re finally getting it and getting it at the working level.

Q4: How do 'cornucopians', mainstream economists for instance, react to talk of supply problems with natural gas?

A: When we first started talking about challenges to natural gas supply back in 1998 and 1999 people looked at us like we were a bunch of Malthusian nutballs who lived in a shack in Montana next to the Unabomber. You know, we aren’t Malthusian nuts. We don’t think the sky is falling. The world is not coming to an end. But the world of $2 natural gas has come to an end and we are now in a world of higher natural gas prices. It’s tough to know what that equilibrium is, but it’s a whole lot higher than 2 bucks. And what happens is people will say, “Ah, you’re a crazy nutball.” But the market tends to change people’s minds pretty quickly, and $10 gas two years ago, we’ve got $6 gas today, it tends to make people rethink their notions because people don’t like to be wrong. Okay, it’s painfu1 sometimes to admit you’re wrong but it’s equally painful to continue to be wrong over and over and over again.

And I think to a great degree the Enron scandal, call it Enron scandal in big letters, which encompasses all of the trading kind of mishaps and misdeeds, I think many people felt, if you went back six months ago, that much of the energy crisis was a figment of the trading community’s imagination, that it was all concocted. Now certainly there were misdeeds. Maybe they inflated some things but it’s tough to manipulate a market that’s not tight. And unfortunately I think people believe that there is no shortage of energy. I think John Q. Public believes “Ah, it’s all Enron. They made a movie about it and prices are coming down.” But now that Enron and others are gone and the other players have been marginalized to a great degree and you have $35 crude and $6 gas you start to run out of excuses other than the markets are tight. So we knew all along we were right. We’d done the work. And ultimately people kind of see the light, and if it takes the market pricing signals to be the beacon, well, so be it. And there’s still people who would argue that crude oil is going back down to $15, but they’re certainly in the minority now.

Q5. What does a declining supply of oil imply for the economy and society?

I think you’d be hard pressed to go back, even to the stone ages, and find a time period where there was cultural improvement, economic growth in a time where energy consumption declined. It hasn’t always been oil and gas it was burning trees and then it was coal and then it was oil and gas, but at the end of the day, growing economies use more energy.

They can, incrementally on the margin they can use it more efficiently, and if you look at the North American gas market, if you can’t supply the demand growth, you can’t have the demand.

So you know, that’s the risk globally, is we are reliant on oil and gas and if you can’t supply it, the market’s gonna make you become more efficient or it’s gonna make you push some of that demand towards alternative fuels. If you can’t supply it, you can’t have the demand and that can be a very painful process.

Q6. Do you think there will be negative economic growth if oil supply declines?

It’s hard to forecast, what’s interesting we’ve come through a period where we’ve had structurally higher oil prices for the last three years in the high 20’s and the low 30’s but yet demand has continued to grow even though we’ve had some very visible negative economic data-points in news and news flow, global demand has grown 0.4% per year for the last three years. It’s not stunning growth, where the prior ten years it was growing about 2% per year, but the fact is, demand contraction is a very rare and unique occurrence and you have to go back to the early 80’s to see significant demand contraction year after year after year.

I think it was three years running roughly down 6%, 4%, 2% and that was (inaudible) the Iranian Revolution price shock that sent the average motor gasoline price - adjusted in today’s dollars in 1980 was $2.50 a gallon the real price was about $25 - so it was a big impact to the economy and that ultimately created negative growth.

I worry about demand contraction. that’s probably more because my function is to do more with the public markets and, if you have demand contraction because of tight supply that’s bad for the market. It’s not necessarily positive for energy stocks, although it’s positive for commodity prices.

Q7: How can a supply decline possibly now be avoided or averted & are fuel cells the answer?

A: When we think about the Hubbert curve, and again I tend not to try to talk about that because I don’t want to be lumped into the Malthusian camp, but if you believe that non-OPEC supply is in structural decline that says OPEC better get on their horse and increase production. So in the nearest term, assuming they can actually make that happen, and that’s a real risk, you become more not less dependent upon countries with which you probably don’t want to become more dependent on. So you end up with we worry more about Saudi Arabia not less about Saudi Arabia. But ultimately yeah, if even when their production capacity rolls over you’re talking about less consumption of crude oil. So you make that up with coal? Probably not in the current Kyoto environment. So you have to find some alternatives. I mean, fundamentally you have to, and I think the market will make that happen. The question is what prices do oil and gas have to reach before you can have economic competition for that.

One of the numbers that I find interesting, if you think about fuel cells for a second everybody thinks fuel cells is the next big thing. I would love for that. But one of the issues for the fuel cell is most people believe that the first commercial version will be fueled by natural gas as the hydrogen source. Why is that? Because there’s already a distribution network across the country, so your local utility becomes your gas station, if you will, so there’s no more infrastructure bill. But think of the numbers, and this is the extreme but it’s interesting. We consume 9 million barrels a day of gasoline in the US. Assuming that we replace every gasoline-powered car with a fuel cell and that the fuel cells were twice as efficient as an internal combustion engine, which is a reasonably good assumption here, so we’d have to replace then 4 ½ million barrels a day of motor gasoline. On a BTU-equivalent basis that’s 27 billion cubic feet of natural gas a day. We’re a 60 billion market that we can’t supply. So where are we going to get that 27 billion cubic feet a day? It can’t happen. You can’t have meaningful growth of natural gas source fuel cells in North America. It can’t happen. So that’s kind of the flaw in this whole panacea of fuel cells. Now you probably have to have that first wave that’s fueled by gas in order to spur the development, the commercial acceptance, etc. But until you can bring a pure hydrogen source into the market it ain’t gonna happen.

Q8: Is the mention of 'Freedom Fuel' (hydrogen) in the recent US State of the Union speech, the first real admission by the Bush administration that they don't know what to do about oil peak?

A: I think in terms of who wins and loses based on what Bush says and if you think about what matters in a post September 11th world as we have Iraq, you know Afghanistan is still an issue, you’ve got Iraq and you’ve got North Korea. It’s a secure supply of fuel. It used to be domestically abundant and environmentally sound, which was natural gas. It’s no longer domestically abundant. Domestically abundant becomes the critical word, and that’s coal. And the coal folks continue, I think, to benefit from energy policy in this kind of environment.

Q9: If building large numbers of LNG (Liquefied Natural Gas) terminals is dangerous, what does that say about the future for nuclear power, given that 9/11 has shown that almost anything is possible?

A: What I find interesting is the soccer moms aren’t going to let you build an LNG plant on a coast because of the fears of terrorists. No way do you build a nuclear plant. No way. I think, again that’s a relatively significant internal debate here about that. Politically I don’t see that happening. I don’t think it can. I don’t think anyone has got the political will to fight the soccer moms out there who will absolutely lay down in front of the bulldozers before they let another nuclear plant get built.

Q10: With Canada's gas declining, Mexico importing from the US, and problematic outlooks for coal and nuclear, how do you see the energy future for the US?

A: You look out 10 years and that’s the real issue. Because if you’re going to build a nuclear plant and have it online ten years from now you’d better be thinking about it today. And it’s kind of this next decade is I think very critical to how we proceed with regard to energy, and I think September 11th has certainly changed people’s focus on what’s important. Fortunately for me I don’t have to make these decisions I just have to analyze what those decisions might mean. Because I think it’s tough. I think the calculus is very difficult when you think about all of the variables that go into the equation.

You’ve got McKinsey Delta gas, you’ve got Alaska gas, but those pipelines are almost a lifetime away it seems like. That helps on the margin, but it’s not a solution. There should be more gas in Mexico but yet Mexico continues to be a net importer of gas, not a net exporter of gas. That situation is not going to be changed anytime soon. Pemex is a bad oil company. They’re an even worse natural gas company. And that’s the reality. You’ve got the other hemispheric neighbor who has oil also has a Castro wanna-be as a president and that’s Venezuela. So he’s taking PDVSA, which is a very very well run national oil company, firing all the top level guys, and he’s turning PDVSA into Pemex as a means of political control. So you look around and say, “Well, if we can’t get it from Canada we’re going to have to continue to rely on Middle Eastern supplies.” And that’s I think a tough pill to swallow in this current environment.

Q11: Do you think the US has designs on Iraqi oil?

A: No, I don’t. I know there’s some conspiracy theorists out there that the US wants to control Iraqi oil fields. I don’t think that anybody in Washington is under the illusion that’s gonna be easy to control a change of government. I would expect that there would be some supply growth out of a post-Saddam Iraq, but I think it’s quite simply they want to get him out of there and I don’t think oil policy has entered into that equation. You know, it’s interesting when you look at Bush he gets criticized because he’s an oil guy and that everything he does is to help his oil friends. Well, the best thing he could do would be to keep Saddam Hussein in power. Keep him in a box, UN sanctions on him, lack of investment, Iraq production growth wont grow and it puts pressure on the rest of OPEC to fuel global demand growth. The last thing an oil guy wants is for Iraq to ramp production up from 2 million barrels a day to who knows what over the next few years. So I guess when you have your hands over the red phone you can’t please all of the people all of the time.

Q12: What happens if the attack Iraq 'goes wrong'?

A: Well yeah, the chance of regional escalation of any military conflict in Iraq, the chance of that is greater than zero. You know that after September 11th anything is possible, given that 16 of the 14 or the 18, or whatever the number was of the hijackers were Saudis. So there’s a fairly significant element of unrest and with a longer military engagement in Iraq, if it happens, the longer it lasts the more likely you get some form of spillover and civil unrest. To the extreme of you wake up one day and you’re in the middle of the 1979 Iranian revolution and the son of Ayatollah Khomeini is now running Saudi Arabia and says 8 million barrels a day is too much, let’s do 3, and now you’ve got a problem. I mean that’s the real issue with Iraq, the real concern from an energy perspective. I don’t know how you handicap that.