Fracking, Climate Change And What Gets Lost In The Shuffle

Includes: AG, EXK, FRAK, SLV, SLW
by: Dr. Stephen Leeb

Today as I pen these notes natural gas is trading at $3.89 per million BTU, down about 4 percent from Friday's close.

The news driving the commodity lower is not a sudden increase in production but forecasts of a warmer December than previously expected. Still, despite the drop natural gas is trading today at a higher price than its average over the past four years, or to be more precise, since the beginning of 2009.

Why pick 2009? Because it was the beginning of the surge in unconventional gas production: fracking started to take off right at the beginning of 2009. Now, readers know that we are not believers in fracking, or at least believers that fracking will change our energy calculus. If truth be told, I would side with Jeremy Grantham, CEO at GMO Capital and one of the financial world's sharpest thinkers, who recently wrote an opinion piece in Nature magazine in which he strongly implied that much of U.S. energy policy stems from the control Big Oil has over major policy decisions.

Moreover, given the abysmal record the International Energy Agency (which recently asserted that the U.S. would soon be energy independent) and the Department of Energy have had in overestimating U.S. and world production of energy, you would be hard pressed to say how so many intelligent people can be so wrong for so long - unless there was a very powerful force pushing them in a particular direction.

To set the record straight: My view is categorically not related to climate change or environmental issues. Indeed, I think the climatologists do themselves as well as everyone else an injustice when they argue that environmental degradation (which includes the release of methane, a greenhouse gas) is the reason we should halt fracking.

After much thought and research into this issue, I have concluded that we really have no way of measuring what we are doing to the climate. Indeed, it would not be surprising to find that the warming and rising sea levels could easily be part of a natural short-term (in a geological sense) cycle. Actually, it's arrogant to think that we can understand it, and primitive - like making a sacrifice to Thor - to think we can mitigate it.

A friend of mine who is a top mathematician at Yale argues that when models get as complex as the climate models we have today, they are likely to spit out nothing more than random numbers. That these models include very little role for the sun makes them much more (if that is even possible) suspect. Another friend, also at Yale, who is a world leader in his mathematical specialty, cites an e-mail, (that became available during Climategate) which evidenced that one of the key researchers of climate change did not understand a very basic statistical concept - that of regression, which underlies all the models on climate change.

Yet the climate is changing, I won't dispute that. But extrapolation is probably a better way of understanding what is going on, and politically it is probably a much more compelling argument. In other words, what we are witnessing is part of a cycle that could run for another five, 10, or 1,000 years: sea levels are rising and may continue to rise, precipitation patterns are changing and may continue to change, etc. I could accept that kind of thinking.

The difference between accepting the climate models and the extrapolation perspective is that the former argues that the only thing we can do is try to change the climate, while the latter acknowledges that we probably can't do that, but instead can at least try to control the costs of these possibly inexorable changes.

I found the Al Gore movie, "Inconvenient Truth," galling because it called for remediation without comparing the costs of remediation with those of providing infrastructure that would protect us against the various changes continued climate trends would bring. And, of course, there were no discussions of the positive benefits of climate change. I believe Freeman Dyson (one of the leading physicists of his time) has written quite a bit about positives from the ongoing climate trends. A couple of years ago an article appeared in Nature, penned by a number of Chinese scientists, which argued that there was a good case the ongoing changes in precipitation patterns might benefit Chinese agriculture. In other words, we can't even be sure that the net outcome of the current trends are going to be negative.

But some trends definitely are going to be negative, as the physical and human toll recently exacted by Hurricane Sandy illustrates. In 2009, the Army Corps of Engineers said that rising sea levels posed a serious threat to New York, and New Jersey. Clearly, it would likely have cost less money to protect against Sandy than repair the damage the storm caused. Moreover, had we been smart perhaps we could have found some other use for the dikes, etc. that would have been built. Instead, no money was spent on protection, and we simply throw up our hands and say that we are at the mercy of carbon-induced climate change.

Indeed, taking it a step further, the fact that in their zealotry and faulty science many climatologists are actually much more accurately characterized as religious ideologues than scientists makes it easy to ignore them - and not take into account what I think is the real question: resource scarcity.

And this makes all the difference in the world when it comes to understanding and developing policies to deal with fracking. That is to say, instead of trying to find real solutions in the form of new energies to deal with resource scarcity and ways of controlling the costs of rising temperatures, the debate becomes a quasi-religious battle between the acolytes of eternal oil (read Big Oil) and the crusaders against climate change. In this context, the idea that money spent on developing new energies is actually money very well spent simply gets lost in the shuffle.

Lately the arguments that fracking will create energy independence are pretty common, but tend to ignore a lot that is happening right in front of our eyes. For example, the depletion rate from either oil or gas fracking is far greater than in the case of traditional wells. In oil fracking it is especially severe, with 60 percent depletion in the first year not uncommon. The only way to keep production up is to continually add more rigs. This is the reason that dedicated frackers such as Chesapeake Energy (in gas) and Continental Resources (in oil) have seen capital expenditures rise considerably faster than fracking profits. In other words, while these companies are profitable, once you subtract capital expenditures from the earnings you come up with a negative number. In the case of Chesapeake the number is an extraordinary negative 70 percent of total equity. Not surprisingly, the company has been forced to restructure.

Add to these arguments that the low hanging fruit is always picked first, and that in many cases such seemingly low hanging fruit is much harder to pick than appears at first glance. For example, BHP Billiton (NYSE:BHP), the world's leading commodity company, paid a king's ransom for a tract of land that was close to another tract that was producing a lot of gas. As Chevron (NYSE:CVX) and many others have said, "close" in distance is not a guarantee of "close" in geological properties. Now BHP has put on indefinite hold plans for developing that property.

As a separate issue there is also the question of water - not simply involving issues of contamination, which are undecided - but the fact that fracking requires much more water than conventional drilling. Water, save for desalination efforts, is a commodity that has likely peaked in the wake of rising demand - as reflected in the fact that the past two years have been catastrophic for food harvests. I have no idea what future precipitation will be, but as I said before, climate trends, for whatever reason, do tend to persist. And that means that if our energy policy is based on fracking we will be facing a horrific choice between food (the largest consumer of water) and energy (the second-largest consumer of water.)

There is also the issue of methane, the major component of natural gas. Methane is a much lighter and less dense hydrocarbon than oil, which is one of the reasons it trades on a BTU basis at a huge discount to oil. To convert methane into heavier molecules, and thus into forms usable for transportation, as well as other applications such as chemical feedstocks, requires a lot of energy and water. Until we figure out how to convert the light molecules of methane into heavier ones in a way that is less costly, not just in dollar terms but in energy terms, natural gas will be basically used as a substitute for coal and not as a broad-based answer to our energy problems.

The Chinese seem to get the entire problem in spades. Yes, they have positioned themselves as adamant about pollution control. But the reason is much more related to resource scarcity than the impact on climate. (And as I said above, the Chinese may in fact be benefiting from climate change.)

Looking at what you might call the "supply side" of hydrocarbon fuel, China appears to take seriously not only the impact of "peak oil," but peak coal, as well, within the next decade. Thus, by 2020 the Chinese are aiming to have 15 percent of their entire energy produced by renewables, which include nuclear, hydro, wind and solar. Moreover, given that their goals for some of these energies continue to rise 15 percent may turn out to be conservative. Indeed, projections for photovoltaics have risen from 20 gigs in 2020 to what appears to be nearly 40 gigs by 2015. One hundred gigs by 2020 is hardly a far out guess.

One major advantage to photovoltaics is that it is one of the very few energy sources that does not need any water. A disadvantage is that it uses quite a bit of silver, and indeed by 2020 is likely to be the largest consumer of silver by far.

We don't want to leave you with just a lot of philosophising but rather conclude by urging to stay away from dedicated frackers and make sure you have a core holding of silver in your portfolio. This would include silver ETF iShares Silver Trust (NYSEARCA:SLV) as well as established and growing silver stocks such as First Majestic Silver (NYSE:AG), Endeavour Silver Corp (NYSE:EXK), and though we still have some qualms about it, Silver Wheaton (NYSE:SLW) as well. To be honest, Silver Wheaton held up much better than we expected when silver dropped, and based on an expectation of rising silver prices, the stock is not expensive in terms of familiar metrics such as P/E.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.