Industry Issues in Raising Capital: The Oil and Gas Industry, Part 1

Created by EQUITIES Magazine

This new series of articles looks at issues related to raising capital in specific industries. While the federal government has lowered interest rates in an effort to stimulate capital development, borrowers and lenders remain wary.

In the third quarter of 2009, Keynes and Friedman advocates remain frustrated. Neither active government involvement nor an increased supply of money proves effective in stimulating borrowing. The financial tap is open, but only a drip moves through the pipes.

Oil and gas is the first industry to come under the microscope in this series. In all cases, these articles apply three broad criteria:

• The nature of the industry.
• Common sense for all lenders and borrowers: track record, risk and return, attractiveness of specific projects.
• An assessment of future prospects.

Oil and Gas Today

Despite the gloomy outlook across the spectrum of public companies, oil and gas investments remain attractive. During the first half of 2009, Sinopec Shanghai Petrochemical Co.’s (NYSE: SHI) acquisition of Addax Petroleum Corp. (TSX: AXC) ranks as one of the largest of the period. Sinopec, an oil refiner based in China, acquires highly prized oil reserves and expands the nature of its business.

Certainly, Sinopec’s actions indicate a belief that oil will provide an attractive profit stream going forward. This may run counter to the message from the federal government. Fuel-efficient cars, solar and wind energy, electric and hybrid cars, and the ubiquitous “renewable energy” drive the “Cash for Clunkers” program, and much public dialogue. How credible are these alternatives?

Ethanol, a renewable, spurred heated conversation during the 2008 national election. Advocates noted that corn is “renewable.” People saw ethanol as a replacement for oil. According to the Renewable Fuels Association, 9 billion gallons of ethanol were produced in 2008. In February 2009, Archer Daniels Midland Co. (NYSE: ADM) reported that 21% of U.S. ethanol capacity had been shut down because of weak demand and poor margins. These events in early 2009 followed a sharp drop in oil prices and considerable borrowing and building to expand ethanol production. No one can predict the future, but those who envisioned a steady rise in oil prices must have seen ethanol as a good bet. In fact, ethanol requires oil and would necessitate engine modifications, making the cost unattractive.

Windmills have gained great popularity. According to manta.com, 14 companies supply or install windmills in the United States. Geologists Pamela C. Dodds, Ph.D., and Arthur W. Dodds Jr. said, “Wind energy is unreliable because huge windmills (that is, those greater than 400 feet in height) can only produce electricity when the wind attains a speed of 8 miles per hour. Huge windmills are not designed to store energy, so any electricity produced by the windmills must enter the regional electrical grid system to be used immediately; otherwise, the electricity is unused.”

As of 2006, windmills produced about 26.6 billion kilowatt-hours, amounting to 0.4% of total U.S. electric production. A 2009 article in the Cleveland Plain Dealer states that a plan to build three to eight wind turbines on Lake Erie would cost between $78 million and $93 million. The article goes on to say that without subsidies, electricity would cost $0.23 per kwh. Current electricity cost to produce in the area—mainly fossil-fuel plants—runs from $0.04 to $0.09 cents per kwh. Of course, grants from federal and state governments would likely halve the $0.23 cents, but this hardly makes economic sense.

Solar energy also remains popular with those envisioning the future. According to zebu.uoregon.edu, solar-generated electricity costs from $0.25 to $0.50 per kwh to produce. Coal, hydro, nuclear, oil, and gas average $0.13, according to the same source. To date, solar has taken hold on a small scale only.

Nuclear power, likely the least expensive of all alternatives, retains the stigma of Chernobyl and Three Mile Island, especially along the East Coast. And so, with a commodius vicus, we return to oil and gas. According to Electric Power Monthly, coal-fired plants accounted for 46.1% of U.S. energy production, followed by nuclear at 21.0%, and 20.5% for natural gas. Coal remains a major energy source for the same reason natural gas and oil will remain in place: Existing plants rely on these energy sources. Substitutes are very expensive, unreliable, or pose enormous startup costs.

Oil and gas persist as central components of the U.S. economy. No practical substitutes exist. This bodes well for investments.

Be sure to read Part 2, which will offer the two most salient elements underlying successful business plans in oil and gas projects.

By Michael McTague
Michael McTague, Ph.D. is Senior Vice President at Able Global Partners, a financial consulting firm in New York City. He also teaches in the MBA program at American Public University System (APUS).