Things I Learned This Week at the Casino

May 12, 2023

Alma Mater. I have been involved with SMU and the business school for many years and serve on the Maguire Energy Institute’s board, in the Cox School of Business. I have also served as an “advisor” (I think it’s more of an observer) to the Spindletop Fund, an investment fund run by members of the Energy Club at Cox and students in energy programs. This year the acceptance rate was 27%, reflecting the large number of students that wanted to get in the program. The team noted that 3-4 years ago, few of their college peers were interested in energy or were specifically not interested, but the attitude among students has changed. This isn’t my observation but that of the seniors on the fund who have lived the shift. It is encouraging to say the least.

Exceptionally Impressed. And I have gotten to watch them grow up. First, my daughter is graduating next week from Wake Forest, so the graduating seniors of the Spindletop Fund are her age. I have seen a huge number of college students up close over the last five years and watched them grow up. That does not compare (except my daughter) to the level of maturity, confidence, depth of understanding and overall impressiveness as much as the Spindletop team this year. I have not been shy with commentary and correction over the years, but so much less was needed with this class. We had our final meeting and dinner this week.

Leadership. Bruce Bullock, Kumar Venkataraman, and Xavier Tison run the program, though Marsh Faram actually runs everything. Congrats. Dinner was at Javier’s. I have a son who is a freshman at CU, and I know how much he appreciates someone buying him a non-cafeteria meal. These guys were no different. Some are in fraternities, some not. Some partiers, some not. All exceptionally mature. Graduates are headed to banks, brokerage firms, less so companies and operators. Most seem to be going into investment banking. It used to swing from Consulting to Investment Banking and back. The latter seems ahead this time. Most are joining the firms where they interned last summer. It was an honor and pleasure to join you all for dinner and I wish you the best of all possible success and would take the “over” on a bet. Oh, and they killed their benchmark!

It Was a Week of Events. I am on the board of Merit Advisors, home of the “best financial solutions and vision to uncover overlooked savings”. I have long championed the optimization of the entire business model, not just our industry’s products and services. I was drawn to Merit by their ability to help companies do that, in ways the company itself cannot. Anyway, Merit had a meeting this week. The first part of the meeting was at the Winstar Hotel & Casino in Oklahoma. Odd experience. The area taken by blackjack, craps and roulette? A meeting room at the Hilton Westchase. The electronic games? Twice the size of OTC. At least.

Barrels & Clays was the name of the event. The morning included a private equity panel made up of Brian Seline, Partner, NGP Energy Capital; Benjamin Burns, Director at Lime Rock Partners; and Brett D. Knowles, Managing Director, EnCap’s Flatrock Midstream. John Daniels of Daniel Energy Partners (he needs no introduction) not only spoke in the morning, but he provided the BBQ Dinner for the event. And John knows BBQ. Following these guys insights, we went back across the state line to John Schmitz’s Stark Ranch for an afternoon of beer, burgers and ice cream, airboat rides on the Red River and sporting clay instruction from the Olympic Skeet Team. Great to see so many friends. There was a crowd. And John’s famous Midland BBQ. Thank you, Tony, Will, John and the entire Merit team. A great time was had by all.

Entertainment. One fun thing this week was ex-President Trump’s town hall meeting on CNN. I personally hope Mr. Trump does not run for president but democrats are doing everything in their power to make it happen. And it seems to be backfiring a bit. Watching the media’s heads explode following the interview was the real entertainment, though Mr. Trump did a fine job himself. AOC criticized CNN for losing control of the interview. That means that many of the “gotcha’s” didn’t work. There was cheering on several occasions. And this is Mr. Trump on CNN. They are almost as badly biased as MSNBC, whose only mission in life is examining January 6th. Every hour, every day. CNN takes breaks and reports some news too. But CNN didn’t invite Mr. Trump to the town hall to be generous, or nice, or supportive, or fair. You know when all the liberal leaders come down hard on CNN for “not being prepared”, you know who won that debate.

A Big Deal. I listened to our fearless leader speak again about subsidies for Big Oil. You can tell he is running for something. So, I wanted to drill down a bit. It is estimated, by both industry sources and the President himself, that the subsidies are somewhere between $20-$30 billion, maybe as much as $50 billion. Wow. I decided to do a little research. The Environmental & Energy Study Institute put out a Fact Sheet - Fossil Fuel Subsidies: A Closer Look at Tax Breaks and Societal Costs (2019). While not covered in this fact sheet, another source of federal aid to the fossil fuel industry is the discounted cost of leasing federal lands for extraction. Some subsidies provide public assistance, such as the Low Income Home Energy Assistance Program, which assists low-income households with heating costs. About 80% of “tax breaks” are attributable to Oil & Gas and the balance with Coal. It is lengthy but important.

Direct Subsidies

Intangible Drilling Costs Deduction (26 U.S. Code § 263. Active). This provision allows companies to deduct a majority of the costs incurred from drilling new wells domestically. In its analysis of President Trump’s Fiscal Year 2017 Budget Proposal, the Joint Committee on Taxation (JCT) estimated that eliminating tax breaks for intangible drilling costs would generate $1.59 billion in revenue in 2017, or $13 billion in the next ten years.

Percentage Depletion (26 U.S. Code § 613. Active). Depletion is an accounting method that works much like depreciation, allowing businesses to deduct a certain amount from their taxable income as a reflection of declining production from a reserve over time. Percentage depletion allows firms to deduct a set percentage from their taxable income. This provision is limited to independent producers and royalty owners. With standard cost depletion, the depletion expense would be the percentage of capital costs relative to production, whereas in its analysis of the President’s Fiscal Year 2017 Budget Proposal, the JCT estimated that eliminating percentage depletion for coal, oil and natural gas would generate $12.9 billion in the next ten years.

Credit for Clean Coal Investment (Internal Revenue Code § 48A. Active and 48B. Inactive). These subsidies create a series of tax credits for energy investments, particularly for coal. In 2005, Congress authorized $1.5 billion in credits for integrated gasification combined cycle properties, with $800 million of this amount reserved specifically for coal projects. In 2008, additional incentives for carbon sequestration were added to IRC § 48B and 48A. These included 30 percent investment credits, which were made available for gasification projects that sequester 75 percent of carbon emissions, as well as advanced coal projects that sequester 65 percent of carbon emissions. Eliminating credits for investment in these projects would save $1 billion between 2017 and 2026.

Nonconventional Fuels Tax Credit (Internal Revenue Code § 45. Inactive). Sunset in 2014, this tax credit was created by the Crude Oil Windfall Profit Tax Act of 1980 to promote domestic energy production and reduce dependence on foreign oil. Although amendments to the act limited the list of qualifying fuel sources, this credit provided $12.2 billion to the coal industry from 2002-2010.

Indirect Subsidies

Last In, First Out Accounting (26 U.S. Code § 472. Active). The Last In, First Out accounting method (LIFO) allows oil and gas companies to sell the fuel most recently added to their reserves first, as opposed to selling older reserves first under the traditional First In, First Out (FIFO) method. This allows the most expensive reserves to be sold first, reducing the value of their inventory for taxation purposes.

Foreign Tax Credit (26 U.S. Code § 901. Active). Typically, when firms operating in foreign countries pay royalties abroad, they can deduct these expenses from their taxable income. Instead of claiming royalty payments as deductions, oil and gas companies are able to treat them as fully deductible foreign income tax. In 2016, the JCT estimated that closing this loophole for all American businesses operating in countries that do not tax corporate income would generate $12.7 billion in tax revenue over the course of the following decade.

Master Limited Partnerships (Internal Revenue Code § 7704. Active). Many oil and gas companies are structured as Master Limited Partnerships (MLPs). This structure combines the investment advantages of publicly traded corporations with the tax benefits of partnerships. While shareholders still pay personal income tax, the MLP itself is exempt from corporate income taxes. More than three-quarters of MLPs are fossil fuel companies. This provision is not available to renewable energy companies.

Domestic Manufacturing Deduction (IRC §199. Inactive). Put in place in 2004, this subsidy supported a range of companies by decreasing their effective corporate tax rate. While this deduction was available to domestic manufacturers, it nevertheless benefitted fossil fuel companies by allowing “oil producers to claim a tax break intended for U.S. manufacturers to prevent job outsourcing”. The Office of Management and Budget estimated that repealing this deduction for coal and other hard mineral fossil fuels would have saved $173 million between 2012 and 2016. This subsidy was repealed by the Tax Cuts and Jobs Act (P.L. 115 – 97) starting fiscal year 2018.

Summary. The largest and most critical is the depletion issue. As the study notes, it is equivalent to depreciation in every other industry, and no one seems to want to take that away. Intangible costs and depletion are almost 70% of the total with the rest being mainly clean coal subsidies.

Educational Update. A month ago, we wrote about the lithium mining company, Pure Energy, whose stock went up almost 90% in two days after getting their permits for their “mine” in Nevada. It turns out, there is only one other lithium mine in the U.S. and it is also in Nevada, the Silver Peak mine, owned by Albemarle, a $22 million market cap public company whose revenues break down - lithium and polymer solutions (68.4%); - bromine (19.3%); - catalysts (12.3%). Pure Energy is now a $20 million market cap. So, all of the active lithium mines in the U.S. have a total value of $42 million. I am not as impressed as I expected to be. But a couple of interesting points – Pure’s Clayton Valley project takes up 23,300 acres. That is huge. Next, a “mine”? Tell me if any of this sounds familiar - the lithium deposit is a salty groundwater (brine) with high levels of lithium contained in a series of aquifers. The brine is ‘mined’ by drilling boreholes into the aquifers and pumping the brine to surface for lithium removal. The lithium brines are hosted within unconsolidated sediments (gravel, sand, silt, etc.) that infill the extensive and deep basin beneath Pure Energy’s claim area. To date they have encountered lithium-bearing brines from approximately 450 feet below ground level, down to approximately 2,000 feet below ground level in the northern portion of the property. Geophysics suggest that similar brine-bearing formations encountered so far during drilling and other attractive host horizons extend to much greater depths within the basin (up to 5,000 feet). And we get asked how OFS companies play in the renewables space? That sure sounded familiar. And the market? In 2014, Tesla announced building its gigafactory near Reno. The plant represents an estimated USD$100 billion in economic benefits for the state, plus 6,500 jobs with a USD$1.25 billion 20-year tax incentive package. So now we have learned a little bit more about the U.S. lithium market.

Memories Live On. “I cannot agree to vote for a full increase in the debt without any assurance that steps will be taken early next year to reduce the alarming increase in the deficits and the debt.” – Senator Joe Biden 1984

Predictions Evolve. “The Cooling World: ‘Climatologists are pessimistic that political leaders will take any positive action to compensate for the climatic change, or even to allay its effects.’” - Newsweek, 1975

No Real Reason. In 2020, via public records request, it was discovered that Supreme Court Justice Sotomayor’s trip to Rhode Island to give the URI commencement address included a free flight and hotel, which under federal law must be reported in an annual disclosure report but wasn’t. Her 2016 trips to universities in Illinois, New Jersey, Alaska, Wisconsin and Minnesota were also omitted. Justice Antonin Scalia, discussing his flight with Vice President Dick Cheney, concluded that “social courtesies, provided at government expense,” need not be disclosed. Numerous international trips were taken by justices Ruth Bader Ginsburg and Stephen Breyer, as well as other university and foundation-sponsored travel for many of the justices. Louisiana Senator Kennedy said, “They tried going after Justice Kavanaugh for buying baseball tickets, Justice Alito for having dinner with people who gossip, the wife of Chief Justice Roberts for hiring good lawyers, Justice Gorsuch for selling land in an LLC — which he properly disclosed — to a major donor to the Democratic Party, for God’s sakes, who he never even met, and Justice Thomas for having a rich friend.” Sounds like the 3rd grade.

Options. Sometimes I listen to an advertisement of a drug on TV and when they note all the potential side effects, you wonder if the drug is worse than the condition. I thought of that as I read the following statement on ammonia and its risks. Ammonia and hydrogen are two widely discussed lower-emission fuels that are being developed for mass use. What are the dangers of shipping ammonia? “SPECIAL REPORT | Burns, blindness and agonizing deaths: Burns, blindness, asphyxiation and agonizing death can all be caused by even moderate concentrations of ammonia — a highly toxic, hydrogen-derived chemical that is expected to become a major zero-carbon shipping fuel and international H2 carrier.” – Recharge News.

Education. Ammonia has a higher energy density, at 12.7 MJ/L, than even liquid hydrogen, at 8.5 MJ/L. Liquid hydrogen has to be stored at cryogenic conditions of –253 °C, whereas ammonia can be stored at a much less energy-intensive –33 °C. And ammonia, though hazardous to handle, is much less flammable than hydrogen. When ammonia is used in internal combustion engines as a fuel, the chemical reaction rate is slower than traditional fuels due to its high ignition temperature and low flame velocity. This slow chemical reaction rate though, causes ammonia to be discharged from the exhaust without burning.

Blurb. Houston-based private equity fund Pelican Energy Partners LP has added an automated drilling chokes company to its portfolio. The company acquired Corpus Christi, Texas-based Iron Horse Tools from Baton Rouge, and Louisiana-based PE firm Bluehenge Capital Partners. Iron Horse Tools employs over 150 people and operates across all U.S. shale plays, Pelican Energy Partners said. With the investment of Pelican Energy Partners, Iron Horse Tools will be able to expand its customer base, geographic presence and service offerings. PPHB LP served as the company’s financial adviser. Pelican Energy Partners is No. 6 on the Houston Business Journal’s 2023 Largest Houston-Area Venture Capital and Private Equity Firms List, based on its estimated $755 million in assets under management. The company has raised $563 million of committed capital and is investing out of its third fund, though in a very interesting move, they are raising a nuclear fund as well.

SMRs. “But we know that where we're getting to in the future, 10 years from now, over the coming decades, as we get towards a net zero world, the capacities we have in Canada to generate energy for the world through wind and solar and geothermal to hydro – which is a huge part of our mix right now – even a return to nuclear, which we’re very, very, very serious about and investing in some of the small modular reactors.” – President Trudeau. This seems to be an about-face by Canada’s ruling Liberal Party on its support of nuclear power. And the results are being seen. The government decided to extend the life of the Pickering Nuclear Generating Station and support the construction of a new Small Nuclear Reactor (SMR) in Darlington, Ontario. On that note, Westinghouse has “launched the AP300™ Small Modular Reactor, the only SMR based on an operating and advanced nuclear plant, our AP1000® reactor. A 300-MWe PWR, the AP300 SMR is an industry game-changer.” In January, the U.S. Nuclear Regulatory Commission certified the first SMR design for NuScale Power’s SMR. There are currently four SMRs in advanced stages of construction in Argentina, China and Russia, and several existing and newcomer nuclear energy countries are conducting SMR research and development. There are about 50 different designs though Westinghouse seems to have the lead. But the fact that we are talking about new nuclear facilities of ANY size being built is an amazing and good thing.

More is More. So, California set a record for the most renewable power generation ever in April. The chart below shows the strides made in increasing power from renewables. What is also interesting is that natural gas use set records as well. But wait. We are supposed to be displacing fossil fuels, not see their use increase!?!? Well, that is not the way it is working out. But don’t feel bad. Germany is running at 30% coal these days!

Snippets.

Had Germany kept its nuclear plants running from 2010, it could have slashed its use of coal for electricity to 13% by now. Instead, today coal provides 31% of electricity.
2006 debt ceiling increase vote: both Schumer and Biden voted "no", citing too much debt.
Battery powered. Tesla is opening a Megafactory in Shanghai, China that will create Megapacks, or large batteries that can store enough energy to power about 3,600 homes for one hour.
Car parks could collapse under the weight of electric cars. Electric vehicles are typically much heavier than petrol or diesel cars, with their batteries accounting for a lot of the extra weight. – UK Telegraph.

Front of the Class. Forbes had an interesting article on how there was more E&P M&A last year than seen so far this year. But one interesting commonality among deals getting done is location. The Eagle Ford Shale. What had kind of been the red-headed stepchild of the industry, behind the Permian, the Marcellus, the Bakken, and the Hayesville has been the Eagle Ford. And if you disagree with the priority of the list, it can’t be by much. The Eagle Ford has no indigenous sand to improve its operating costs, the rocks can be complicated, and zones fragmented. But the deals focused on the Eagle Ford have accounted for more than $5 billion in total value, smoking the Permian so far this year. “It was the best quarter for the Eagle Ford in almost ten years,” Andrew Dittmar, Director at Enverus said in an interview. “One of the top three, certainly, since 2010.”

Money Gets Tight.

Headlines.

Robert de Niro Welcomes his 7th Child at 79 Years of Age.
Study: Describing Breastfeeding as ‘Natural’ is Unethical Because It Reinforces Gender Roles.
Terrorists warned to avoid London during King’s coronation.

Oil Light. Speculators are once again fleeing the oil market, setting the stage for more extreme price swings. Money managers dumped their net-bullish oil holdings by 19%, the biggest drop in six weeks. The positions are now at the lowest seasonal level in more than a decade. The exodus comes amid another crash for oil, driven by concerns over the economy. WTI futures have tumbled for three straight weeks, even briefly plunging to the lowest level since late 2021.

New, Used or Electric. New car prices are through the roof. $700 per month for a $35,000 car is common even if a $35,000 car is not. A recent study shows that many Americans are priced out of the new car market. Spending on new cars by the lower 20% of earners dropped to its lowest level in 11 years. They are not affordable to the everyday man. Interest rates have piled on the issue, compounding the new and used car cost. In late April, GM announced it would scrap production of its top-selling electric vehicle, the Chevy Bolt, wiping out one of the most affordable EVs in the country. That continues a longtime trend. In 2017, for example, there were 11 models available on the U.S. market for less than $20,000, according to Cox data. By the end of 2022, there were four. Then, by March 2023, only 2. The end result is a widening gap between those who can afford new cars and those who can’t. The average price of a new car in the United States hit $48,008 in March, up 30 percent from March 2020, according to Kelley Blue Book.

Any and all comments, arguments and rebuttals are welcome!

In addition to my association with PPHB, I serve on three private company boards. Merit Advisors is a property valuation company and I have long been a fan of optimizing how a business is run, not just the tools we make. Merit is in the business of savings companies’ money, actual cash, by doing a much more in-depth and realistic view of equipment and reserve valuations and I am very impressed with their work. I am also on the advisory board of Preng & Associates, a leading executive search boutique that specializes in all things related to Energy & Power. Nova is a gas compression company run by a very dynamic CEO with a very strong board and ownership.

I service on the Advisory board of the Energy Workforce & Technology Council (formerly PESA), the National Ocean Industries Association (NOIA), and the Maguire Energy Institute at SMU my alma mater.

jim

214-755-3914 | james.wicklund@pphb.com

Leveraging deep industry knowledge and experience, since its formation in 2003, PPHB has advised on more than 180 transactions exceeding $11 Billion in total value. PPHB advises in mergers & acquisitions, both sell-side and buy-side, raises institutional private equity and debt and offers debt and restructuring advisory services. The firm provides clients with proven investment banking partners, committed to the industry, and committed to success.