A House Divided

Is energy policy dividing the country in the same manner as the divergent commodities and manufacturing economies of the pre-Civil War United States?

Now, more than ever, lines are being drawn around the fundamental concepts of how to (literally) fuel our economy. States who have placed their land and shores "off limits" to drilling are populated by the same voters who decry American involvement in the Middle East, advocate the use of alternative fuels, complain about the high price of gasoline, and advocate ending so-called tax "breaks" for oil companies.

Policy aside, these divergent views represent fundamentally different views of the role of government and private enterprise--and the chasm seems to widen every day. A Secretary of Energy whose goal is to drive gasoline prices as high as possible is acting not as a referee in the market, but judge, jury and executioner. The same may be said for an administration for which government, not the market, decides which energy sources will grow through subsidies, while others are saddled with taxes and regulation, with the ultimate goal to drive the fuels of "yesterday" into the ground.

Even more alarming is that the government led view is simply not supported by facts, but dogma and religious-like zeal matched only by the Taliban. This should be an alarm to all Americans who value the liberty of the free market system, since once government controls energy, it controls the economy.

LOWER GAS PRICES REDUCE SPENDING, SLOW PRODUCTION, AND BRING OUT PROBLEMS IN POORLY CONSTRUCTED LEGAL RELATIONSHIPS

Natural gas stocks are getting hammered.

Gas prices down to just $2.77 per MMBtu and some analysts predict a fall to $2.50 per MMBtu is possible.

Add to that the fact that the Marcellus is just about the only area in the country where break-even prices are below $4.00.

It’s tough out there from a cash flow perspective, especially for companies who modeled their development on higher gas prices. This means look for reductions in capital expenditures and slowed production. Hopefully, this also means that prices will eventually rise and the market will sort out the problem.

However, thinly capitalized companies, with more exposure to short term price swings, might not survive the pain of such an adjustment. This includes many “low cost” producers who charged into the Marcellus on peak prices.

From a lawyer’s standpoint, these adjustments, shake outs, or whatever you wish to call them, have a way of bringing forth the flaws in old bargains to produce litigation. Low-cost producers were attractive a year ago, but some of them, and their counter-parties, acted with more expediency than common sense in crafting the legal aspects of their relationship. Unfortunately for those companies, this was a “pay less now versus pay much more later” scenario, with cash flow problems stemming from lower prices compounded by the distraction and expense of litigation.

It may be time to dust off those contracts.

LOOKING TO 2012: What are the major challenges are occupying the minds of senior executives at energy companies in today’s market?

A number of challenges, such as changing geopolitical relationships, the emergence of new competitors, changes in supply and demand dynamics, social and environmental pressures, and demographic shifts, are transforming and reshaping the oil and gas industry.

But there is one indisputable fact that affects not only our industry but the world as a whole: Global demand for energy will continue to increase dramatically, driven in large part by population growth and the strong desire of developing countries to achieve economic prosperity. Experts may disagree about the rate of growth, but there is no dispute that growth in the demand for energy is inevitable.

For non-NOC executives we have spoken to over the past year, the major challenges are, and will remain:

(1) Access to resources (reserve replacement),

The organic reserve replacement leader is Shell (164%), followed by BP (115%), and Hess (113%). Shell’s performance has been led by strong results in Southeast Asia/Australia where reserve bookings largely came from Australian natural gas and specifically from major LNG projects. BP benefited from strong performance in Africa, predominantly in Angola and Algeria, which will contribute 0.6 BBOE to proven reserves. Hess benefitted from positive revisions to existing reserves due to rising prices for crude oil and Hess’ disproportionately high leverage versus its peers. Organic results were weakest at Chevron (66%), Marathon (68%), and ConocoPhillips (85%). [ISI 2011]

(2) Cost (finding and development costs per barrel) and availability of services,

BP ($12/BOE), Shell ($14/BOE) and ExxonMobil ($14/BOE) hold the lowest future development costs per unit of undeveloped reserves. Marathon ($36/BOE), ConocoPhillips ($25/BOE), and Hess ($20/BOE) hold the highest future development costs. [ISI 2011]

Industry organic finding and development costs were $17/BOE during 2008-2010 which compares to $17/BOE during the previous 5-year period. The result falls to $14/BOE when including reserve additions from oil sands, which were considered mining activities before 2009. Total replacement costs, which include reserve additions from oil sands and acquisitions, were $15/BOE for integrated oils during the period. Organic finding and development costs which exclude the impact of acquisitions and oil sands bookings were best at BP ($9), Shell ($11/BOE), and ExxonMobil ($13/BOE). The highest or worst organic replacement cost performance emanated from Marathon ($29/BOE), Chevron ($25/BOE), and Hess ($21/BOE). [ISI 2011]

The discounted value of future development costs minus current capitalized expenses on current production are highest at Marathon, ConocoPhillips and Total. The companies with the best positioning in this area are Hess, Shell, and BP.

(3) Availability of skilled personnel.

Global geopolitical forces are creating a highly volatile, rapidly fluctuating crude oil and gas market. Global competition for depleting resources continues to drive the need to lower operating costs and increase finding and recovery rates. The number of skilled resources continues to decline. Shareholders are pressuring companies for a return on their investments that is commensurate with other long-term investment strategies.

Integrated Oil Performs Well, but what's next?

While there is definitely a range on performance, profits remain near record levels for "Big Oil" and the larger independents are growing larger. In E&P, both cash on cash returns and production income are up. Current integrated oil financial expectations and valuations are higher than they have been in a decade. Integrated oil companies in particular have outperformed S&P Energy and matched the S&P 500. For example, BP, COP, CVX, and OXY continue to hold strong investment potential.

ConocoPhillips (COP) is a good example of the current strength of integrated oil companies. COP equity leads its peers over the past few years, and the company appears poised to perform at even higher levels through 2012. COP’s major businesses are both high quality performers and well positioned from a competitive standpoint in their respective markets. COP's balance sheet appears strong with pro-forma dividend yields at 5% and 3% for E&P and R&M.

Investors will, however, want to avoid/sell under-funded gas focused companies (i.e., those with a poor gas/oil/NGL mix) due to what I consider to be the almost certainty of pain from a future "Marcellus fallout." Under-funded companies with greater gas exposure will find the markets less hospitable for obvious reasons.

So, in general, things look good for integrated companies and larger independents.

But what's next?

Virtually all current global oil demand growth emanates from non-OECD countries, led by Latin America, the Middle-East and Asia in 2011-2012. However, in the short term, even non-OECD demand projections fell in the past few months due to higher fuel prices, and slower economic growth. Chinese oil demand picked up by six percent in August, but was offset by weaker overall global demand. Slow economic growth, lower coal prices, heavy rains (which means lower agricultural demand and increased supply of hydroelectric power) and the release of stored inventory through "destocking" have all contributed to recent demand growth projections. Global oil demand growth is projected to slow to 0.9 and 1.3 MMBPD in 2011-2012. Non-OECD demand growth remains positive but, of course price increases will certainly impact demand in Asia, Latin America, FSU countries and Africa. These non-OECD areas represent approximately 80% of projected global demand growth in 2011-2012. Lower consumption in these countries would be negative for crude oil prices.

What strategies are best for dealing with these variables? How do companies weather the new challenges that arise every day?

I would like to hear from you, the reader, with your opinions on prospects for companies considering the current market.

What are your predictions for 2012?

A Foreigner's Perspective on Labor in the Brazilian Oil & Gas Industry

Due to the breakneck speed at which the pre-salt discoveries have fueled growth in Brazil, most companies, Brazilian and foreign alike, know it is difficult to procure all of the skilled labor required for operations.

The lack of qualified employees owes in part to the historically deficient Brazilian public education system. This system produces few candidates qualified to become petroleum engineers, geologists, geophysics, technicians, etc. As a result, many companies are obliged to create their own training centers to educate employees. Petrobras, for example, established an eleven-month-long training program for newly hired engineers to strengthen their knowledge before releasing them into the field.

Another solution is outsourcing through the importation of foreign employees. According to the Brazilian Labor Ministry, the number of authorized foreign workers rose 30% in 2010 alone. This number, however, does not mean the skilled labor shortage will be solved anytime soon since demand far exceeds even this dramatic growth. The reason for this is that Brazilian work visas can be a challenge to obtain and procuring permanent visas requires even more lengthy and expensive immigration procedures.

The burden for an "importer" of foreign labor does not end with the visa process. Foreign workers need to pass through an acculturation program and require relocation support which is extremely burdensome to the hiring company. This, together with the higher salaries paid to skilled oil and gas workers, substantially increases payroll and general operating costs.

The fun does not stop there.

Many foreign companies who have experienced light labor regulation in other Latin American countries are often surprised by the relatively onerous and inflexible Brazilian labor laws and the influence of powerful labor unions. The current, protectionist labor laws are derived from the "corporatist" labor code of the fascist government of Benito Mussolini. In fact, the Brazilian labor code is so pro-employee that a collective bargaining agreement may prevail over both the Labor Code and the Constitution if it is more beneficial to the employee. It should be no surprise then, that employee termination is also extremely difficult, with expensive severance provisions common.

To say Brazilian unions are powerful is a gross understatement. In Brazil, workers automatically "join" a union, defined by the region the worker works in, and his field of work. A worker, by law, must pay dues to that union (one day’s salary per year). In Brazil there are around 18,000 labor unions, all deeply rooted in their respective sectors, with guaranteed dues to fund their operations and enormous political influence.

This clash of labor culture may make life difficult for foreign companies doing business in Brazil. Those who fail to put this critical element into the mix when developing a plan to enter the Brazilian market, place the success of their entire venture at risk.

Patent Reform Legislation Brings Host of Changes to US Patent Law

The Leahy-Smith America Invents Act, signed by President Obama into law on September 16, 2011, is the culmination of patent reform efforts taking years. Making several significant and long-awaited changes to US patent law and a myriad of potentially less significant changes, the Act as a whole likely represents the most substantial change to US patent law since 1952. This blog entry summarizes the Act’s most important changes.

Adoption of a "First to File" Patent System

Harmonizing American patent practice with the rest of the world’s most advanced economies – and representing its single biggest change – the Act converts the US patent system from "first to invent" to "first to file." In other words, priority will be established on the basis of when a patent application is filed, and not on the basis of which inventor first conceived and reduced the invention to practice. Limited exceptions to the "first to file" regime are available for an inventor who files an application within one year of his or her first disclosure (for example, at a conference).

Some critics charge that this change will create a "race to the PTO" that unfairly burdens individuals and small entities that may not have the resources to file applications as promptly as large companies. Advocates contend that the change will reduce the expense of the patent process and of patent infringement litigation, enabling innovators to put the money saved to research, development and the creation of new industries and jobs. Time will tell who is right.

The Act will eventually eliminate patent interference practice because the earliest filing date of competing applications will establish priority. Consequently, to address claims that a patentee copied his or her claimed invention from an earlier inventor, the Act creates a new category of "derivation" petitions. Derivation petitions allow an alleged first inventor to file a petition with the PTO – or a civil action in US District Court – within one year of a patent’s issue date or one year of a patent application's publication date, seeking to have the patent or patent publication deemed derivative.

Post-Grant Proceedings

The second significant change comes in the form of two new post-grant opposition proceedings. The first – "inter partes review" – will replace the inter partes reexamination process. It allows any person (except the patent owner) to challenge an issued patent within the first nine months following its issuance on grounds of anticipation or obviousness. The PTO standard for allowing the review to proceed is "that there is a reasonable likelihood that the requester would prevail with respect to at least one of the claims challenged in the request." Discovery is available. Although the existing ex parte reexamination process is left intact, a patent owner dissatisfied with the result of an ex parte reexamination may appeal only to the Federal Circuit; it no longer may do so in district court.

"Post-grant review," the second new mechanism, allows a party to oppose a patent within the first nine months following issuance on any invalidity ground (including any requirement under Section 112 of the Patent Act other than best mode).

Prior Commercial Use

Section 273 of the Patent Act has provided alleged infringers of business method patents with a "prior commercial use" defense. The Act’s third significant change is its expansion of this defense to infringement claims involving any type of patent. Doing so will protect innovators who have chosen to maintain inventions or processes as trade secrets against infringement claims brought by later claimed inventors.

False Marking

The rash of recent false marking cases that have flooded district courts over the past two years will soon be gone. The Act eliminates the private enforcement of false marking claims except as to those who can show a competitive injury. Because the Act expressly covers all cases pending on the Act’s effective date, we expect all but a very few cases around the country will be dismissed.

The Good and Bad News Regarding PTO Fees

After siphoning off the funds collected by the PTO over the years, Congress heeded the PTO’s call to cease doing so. The Act thus allows the PTO to keep essentially all of the fees that it collects, which presumably will be used to hire more personnel and reduce the ever-increasing backlog of pending applications, reexaminations and PTO appeals. That’s the good news.

The bad news is that on September 26 (10 days after the Act’s effective date), all patent fees – including filing fees, national fees, examination fees, issue fees, disclaimer fees, appeal fees, maintenance fees, patent search fees and continued examination fees – rise by 15 percent. The Act also introduces a "prioritized examination" mechanism that, for an additional fee of US$4,800, will accelerate examination of an application deemed "important to the national economy or national competitiveness."

Nuisance Claims Are Out: Supreme Court Removes Weapon From Activist Arsenal

On June 20, 2011 the US Supreme Court issued its long-awaited decision in American Electric Power Co., Inc. v. Connecticut, holding that the Clean Air Act’s scheme for US EPA regulation of carbon dioxide and other greenhouse gases (GHGs) displaces federal common law nuisance claims seeking reduction of GHGs to address global warming. The decision reinforces the Court’s prior decision in Massachusetts v. EPA that the Clean Air Act authorizes federal regulation of GHGs and places US EPA, as opposed to the courts, front and center in the debate over control of GHG emissions.

In 2004 eight states, New York City and several private land trusts filed suits in the US District Court for the Southern District of New York against five major electric power companies alleging that the defendants were the "largest emitters of carbon dioxide in the United States," and their emissions substantially and unreasonably interfered with public rights in violation of the federal common law of interstate nuisance or, alternatively, state nuisance law. The plaintiffs alleged that these emissions were a public nuisance for contributing to global warming and sought injunctive relief requiring the defendants to cap and reduce GHG emissions by specific percentages each year for at least a decade.

The district court dismissed both suits as involving non-justiciable political questions. On appeal the Second Circuit reversed and found that plaintiffs had stated a claim under the federal common law of nuisance because US EPA had not promulgated any rule regulating GHGs. The Second Circuit found that until US EPA exercised its authority to regulate GHGs, displacement of the claim by the Clean Air Act could not occur.

The US Supreme Court was divided on whether the plaintiffs had standing to bring this claim and affirmed the lower court’s exercise of jurisdiction by default. The Court was united, however, in its conclusion that "the Clean Air Act and the EPA actions it authorizes displace any federal common law right to seek abatement of carbon-dioxide emissions from fossil-fuel fired power plants." In Massachusetts v. EPA, the US Supreme Court clearly identified carbon dioxide as "air pollution." The Clean Air Act directs US EPA to identify categories of sources that contribute significantly to air pollution and are reasonably expected to endanger public health or welfare. Once US EPA identifies those categories, it must regulate the existing sources and establish performance standards for emissions from new and modified sources in each category. The Court found that these provisions of the Act provide an adequate avenue for the plaintiffs to petition US EPA to initiate rulemaking and to seek judicial review of US EPA’s regulatory decisions. Under this framework, the Clean Air Act "speaks directly" to the issue of carbon dioxide emissions from power plants, displacing federal common law public nuisance suits and leaving no room for courts to issue ad hoc decisions through common law suits.

The Court disagreed with the Second Circuit’s conclusion that federal common law could not be displaced until US EPA had actually exercised its jurisdiction over carbon dioxide emissions by issuing regulations. The Court found that it was Congress’s delegation of authority to US EPA that displaces federal common law, not US EPA’s exercise of that delegation. Citing the Massachusetts decision, the Court concluded such a delegation had occurred here for GHG emissions, thus placing the burden of balancing regulatory policies on US EPA, not the courts. If US EPA decides against regulating a particular source category in making these policy choices, the courts may not step in and force regulation under common law theories.

While the Supreme Court’s decision removes federal nuisance law as a mechanism for plaintiffs to seek to impose emission controls on GHG emitters, the decision leaves open the possibility for that relief under state nuisance law. The Court indicated that the availability of state law claims would depend upon the preemptive effect of the Clean Air Act, an issue that remains open on remand. Disposition of these issues will provide yet another important indication of the role courts will play in the continuing regulation of greenhouse gas emissions, if any.