Michael Parham, McGladrey Capital Markets LLC, Costa Mesa, CA
The Golden State should instead consider calling itself the Black Gold—en State. According to Jim Boyd, vice chairman of the California Energy Commission, the state is the third largest consumer of oil in the world (behind the US and China), and by far the largest producer of heavy oil in the US. Unfortunately, California’s $1.5 trillion economy is not in third place, rather it is in sixth, seventh, or eighth place worldwide, depending on how one looks at such things.
There was a time when the state produced more than one out of every six barrels of oil produced domestically, but now its production represents half that amount. Environmental mistakes 40 years ago by a drilling rig offshore Santa Barbara, along with a steep production decline curve, ended California’s oil production dominance. But, the natural resource is still there, virtually untapped, as California sits on the largest proven reserves of heavy oil in the country (including Alaska).
With such a large consumption base, it is surprising that these reserves remain severely underdeveloped and under—invested. Moreover, while consumption continues to rise, these wells are becoming less productive each year and could greatly benefit from the latest advances in enhanced production techniques. Analysts estimate that within 10—15 years, California will import from abroad more than 90% of its hydrocarbon needs. In short, despite a wealth of black gold, California is not producing enough of the stuff to keep pace with its consumption.
Transfer of wealth leads to epic budget shortfall
What is not surprising is that California also leads the nation in budget shortfalls. This is due in no small part to a transfer of wealth each time a consumer fills up his car. Even when oil and gas prices are relatively low, Californians pay more than their fellow countrymen because of inadequate local distribution and refining capacity. When oil and gas prices are relatively high, the gap widens considerably, with even more wealth being transferred outside the state and outside the country. Either the state does something to keep the dollars here, or the budget shortfall will increase.
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For those lawmakers in Sacramento that would like to use this argument to increase the gas tax from its rate of 55 cents per gallon (which is already the highest in the country), a more sound policy might be to work on getting a bigger piece of action. A strategy to encourage producers to step up production would lead to potentially tens billions of dollars in income taxes alone, dwarfing the $3.5 billion received from the gas tax, without curbing consumption (and the receipts from consumption).
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At one point last fall, it appeared that California was in the middle of the perfect storm — high oil/gas/electricity prices, huge budget shortfall (in fact, no budget agreement at all until four months into the new fiscal year, with a $40 billion shortfall predicted for the current year), and no available credit. For the time being, energy prices have come down, but the budget deficit and credit markets have not exactly improved. California is predicted by its own Governor to run out of cash by March and will need to issue IOUs to vendors as of the date of this writing.
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But the cavalry is coming! With a $1 trillion stimulus and infrastructure plan on its way from Congress and the President, California is in dire need of a well thought—out and integrated statewide energy plan in order to make best use of these resources, if and when they arrive. In the meantime, California will just have to make better use of what it has — lots of heavy oil and lots of sunshine.
The California solution
An environmentally savvy, technologically advanced, investment—friendly approach to heavy oil development
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In order to be well thought—out, such a plan will need to pay homage to California’s past — which includes a checkered history of natural resource development. In the mid—1800’s the Gold Rush left the Sierra Nevada Mountains stripped, mining towns in shambles, and tens of thousands of workers jobless, many of whom were immigrants brought into the US to work for no other purpose and with no other skills.
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In the early 1900’s oil was found and by 1925, Los Angeles Basin was the world’s largest oil boom. Soon after, the offshore drilling era was born, but a blowout offshore Santa Barbara in 1969 spawned the environmental movement (hence we have “Earth Day”) and severely limited oil production (but it also led to a revolution in blowout preventer technology). In the late 1900’s forests were over—logged leading to another environmental movement which shut down the industry in the state and moved it to Oregon and Washington.
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Californians know a thing or two about the unintended consequences of environmentalist legislation. A seemingly good idea like protecting the beaches or the water table, leads to laws and permitting restrictions which undermine the environment and the economy further.
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This has occurred time and time again in California, and three instances come to mind: 1) the decision shut down offshore drilling because of a single spill, leading to an anemic state oil industry; 2) the decision to push for low—sulfur diesel and reformulated gasoline refineries, which led to a 20% reduction in capacity, many refineries being shut down, and MTBE leaks; and 3) a lack of marine terminals in Northern California due to shallow depths in the Bay Area, leading to more storage tanks and pipelines which have an adverse effect on the environment, environmental opposition to LNG terminals, and high distribution costs which are of course passed along to consumers.
While this might suggest that California is a leader in the environmental movement, in truth it is the root of the problem. Despite its reputation as a progressive and “green” state, California also is second only to Texas in pollution. Unfortunately, while this fact might encourage “green” infrastructure development, it has also led to a byzantine set of permitting requirements from state and federal agencies, and an inhospitable environment for infrastructure investment.
As such, even though it has the reserves, and is a hotbed of “green” technology, California is not a very good host to those companies that might be able to produce, develop, refine, and distribute hydrocarbons in the most efficient, quick, and clean manner.
Technology and investment friendly
Fortunately, California does not need to be a guinea pig in the effort to devise a strategy for developing its resources. For example, California could borrow from the oil sands playbook in Alberta, Canada, to capitalize on the lessons learned and avoid the mistakes made by Albertans. Such a plan might include:
- investing in enhanced oil recovery (EOR) techniques and infrastructure to produce, distribute, and market its immense heavy oil resources. According to a DOE report prepared in March 2005 by Advanced Resources International, the top three findings were —
- California has a large “stranded oil” resource base that will be left in the ground following the use of today’s oil recovery practices;
- Much of California’s large “stranded oil” resource base is amenable to CO2 enhanced oil recovery; and
- Application of miscible and immiscible CO2—EOR would enable a significant portion of California’s “stranded oil” to be recovered. The report found that at least 5 billion barrels of oil is recoverable from this method in California alone, and 89 billion nationwide. Next generation EOR techniques — which include innovative flood design, well placement, viscosity enhancers, miscibility reducers, increased volumes of CO2 injection, and real—time flood performance diagnostics and control — will likely lead to an additional 8 billion barrels recovered in California. For the environmentalist, take note — this will also use up more than 25 tcf of CO2 in order to implement, using up greenhouse gasses which were destined for the upper atmosphere.
- developing hydrotreater cogeneration refineries, CO2 sequestration, and CO2 storage. Such “green” initiatives will lead to enhanced production, lower capital outlay, and lower operating costs. Refineries could ultimately become electricity producers and sell power to the grid with this method. E&P producers would take harmful gasses and pump them downhole in order to enhance production as previously noted. Used—up reservoirs underground could become useful storage sites for these gasses once their enhanced production is depleted.
- creating a more hospitable permitting environment to attract such investment; California’s Governor signed Executive Order S—14—08 which establishes a “one—stop” process for permitting renewable energy facilities. Such a fast track process to support these techniques would greatly facilitate investment into the state from E&P companies, who are loathe to expend scarce resources only to wait years for approval (or rejection). Alberta was able to entice tens of billions of dollars of investment into the far North to develop its oil sands, where there is no infrastructure to speak of, and when production costs exceeded the price of oil significantly.
- devising a royalty scheme with the E&P companies that would reduce or eliminate the perennial state budget deficit, speed development, and win support across the political spectrum. The chart below shows that Alberta collected an amount in 2006 that equates roughly to California’s entire budget shortfall of $15 billion in the same year, with such royalty receipts representing almost 30% of its entire budget. EOR alone might account for up to 13 billion barrels, representing a value of over $500 billion at today’s prices. Royalties of 20% may provide over $100 billion directly to the state over its recovery period, which is much faster than the oil sands of Alberta and requires far less investment. Moreover, California can learn from the Alberta example and avoid costly investments into techniques which are not effective for the State’s heavy oil, such as steam assisted gravity drainage (SAGD).
- implementing an energy producer “bail—out” which supports investment into renewable resources such as solar, geothermal, wind, nuclear, and fuel cells alongside, rather than in lieu of, oil & gas. In fact, the latter might serve as champions of the former, by being first to create “green” refineries, disposing of excess CO2 by using it to enhance production as noted above, storing LNG and myriad ideas which will might be called “green” because of their impact on cash flow as much as their impact on the environment. The end result would be more energy at lower costs for Californians, a smaller environmental footprint, independence from exogenous energy price shocks, along with significant growth in jobs, income and state coffers.
The California Energy Commission produces a report (Integrated Energy Policy Report) and updates it each year. The 2008 report has nothing in it related to development of heavy oil or the potential for offshore drilling. Until the CEC acknowledges their existence, and incorporates them into a sound integration policy, Californians should expect to continue seeing their wealth leave the state and their government services underfunded. OGFJ
About the Author
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Michael Parham is a managing director at McGladrey Capital Markets LLC. His background includes mergers, acquisitions, corporate finance, and restructuring. He previously served as an associate director at Peter J. Solomon Co. and a vice president in the M&A department of Credit Lyonnais Securities and Daiwa Securities America in New York. Parham is a graduate of Dartmouth College and received an MBA from New York University’s Leonard N. Stern School of Business.