How Transportation Has Affected Energy And How It Will Be Impacting Energy Stocks Next

Includes: GAZ, OIL, XOM
by: Peter F. Way, CFA

Transportation is perhaps the most major influence on world energy sources, usages and prices. Here's why.

Geography vs. Geology

Energy from other than animal and human efforts has been the greatest lever in the progress of living standards of mankind. But the sources of that energy are not always (or even often) immediately available where needed or wanted. They usually must be transported.

Or, in some cases, the needs may be transported to the available energy. A classic example of that is the production of aluminum, where electrical energy is its principal production cost element. Aluminum refineries are usually sited where hydroelectric capacity is abundant and its cost is minimized. Or where local coal or other fuels can be burned to generate electricity cheaply.

Why not the other way around, and move the electricity to where the aluminum end-products are being consumed? Because electricity doesn't travel well, with a lot of it getting lost in the trip. Mileage is not its friend, especially at low current levels.

Concentrations of humans are usually dictated more by geography than by geology. Ports, weather, easy access, and a variety of other reasons typically win over the subterranean circumstances of where the most-used energy sources live. So most frequently the energy sources get extracted from the geology and are brought to the geographic locations of the users.

Delivered-Cost Pricing

Because energy is so important to all mankind's progress, need for it pervades the world, and over time markets have been developed and become extremely sophisticated in translating the delivered costs of energy in terms of local pricing. In the process, key starting-points or reference points for energy costs have become accepted.

Those reference points typically are based on the energy sources with the lowest costs of production, as delivered at or near to large usage concentrations. Most recently the defining circumstances produce crude oil for U.S. markets and for European consumption as those references. The product specifications are known as West Texas Intermediate [WTI] and North Sea (Brent), because of the competitive realities of having lowest-delivered-cost product at those points for distribution.

In the U.S., extensive pipeline networks make crude available, while for Europe shipping lanes from the middle-east, Africa, and Latin America augment the local North Sea production. The transportation costs of getting the crude to those reference points in each case are reflected in the market quotes for either WTI or Brent. Beyond that, the world markets system elaborately provides for transportation costs, even from one port to another.

While crude oil is the "low-cost" reference commodity, refined products have market quotes scaled from crude, reflecting "crack spreads" that measure refineries' competitive abilities to earn a profit from their activities.

Energy-Source Competition

But in truth, all energy sources are in competition with one another. Their usual competitive meeting-point is in their contained heat-release capacities, where the heat either is of usefulness itself, or may be applied to an intermediary, like water, to produce electricity. The standard for heat measurement is the British Thermal Unit, or BTU.

Sorry for the length of the "Energy 101" academic course explanation. But now that we may be all on the same minimal page, here is what is new and important for the future: Crude oil is being displaced by natural gas as the "low-cost" energy source.

Advances in extraction technologies are making this change occur. Those advances are most usually described as horizontal drilling and hydraulic fracturing (fracking), although companion technologies may also play a part. Production cost reductions are only one dimension to this revolution. The other important dimension is that economically recoverable reserves of energy are being vastly expanded.

That evolution is bound to be upsetting to many existing crude oil owners and controllers. Equally upset are producers and owners of competitive energy sources who at the margin will be driven out of business, unless they can find major cost reductions of their own.

So, what happens as this displacement occurs? The reduced production costs are a combination of much larger geologic reserves structures to be developed from each well drilled, and from the fact that not only natural gas is being recovered from the same effort. Crude oil, often of more desirable quality than standard-spec crude, is being recovered in association with the natgas.

With conventional (vertical drilling) extraction procedures natural gas often is associated with the crude recovery, but often only in nuisance proportions that can be risky to the high-paying liquid target activities. If so, it is often "flared" by burning in open air to dispose of it "harmlessly."

The irregular nature of major natgas occurrences from conventional recovery that were regarded as economically exploitable on their own prevented the development of usage markets that called for reliably available sources. Natgas became principally a source of plastics and other chemicals, and a seasonal commercial and home-heating usage market.

How NatGas Abundance Changes Things

Now, along with the huge, reliable volumes of natural gas available for recovery by these "unconventional" extractive techniques, there comes a presence of high-quality crude and other petroleum liquids. The liquids can be in such volume that they often have greater paystream value proportions than the natgas.

But the liquids are in the unavoidable company of huge volumes of natgas, which needs a market. When early "unconventional" production was forced into established natgas markets, it pushed prices in U.S. markets down from $7 per million BTUs to less than $2. Its share of the joint production paystream costs was much less than it might have been, but production was not diminished as a result.

Meanwhile, electric utilities that had been buying coal at an equivalent heat content for $4, got very interested in long-term natural gas contracts. Their interest in committing to such contracts helps fund the pipeline construction needed to economically deliver the gas to them. The usage of coal by utilities in 2012 declined by 6% in that year alone, displaced by natural gas, even before pipeline expansions.

Coal is in big trouble, and knows it. That industry will try hard to remain competitive, but general thinking is that the $4 price per million BTUs may be as low as the major producers can go. Many marginal miners are going to go out of business, and some already have. But the presence of coal competition puts something of a ceiling on natgas prices of around $4 per million BTUs.

The transportation part of this competition is that most "steam coal" sold to utilities is delivered by rail. The per-mile transit cost of the most economical unit trains cannot begin to compete with per-mile costs of natural gas pipelines across any appreciable distance. Long-haul rail lines transporting coal are very vulnerable in this fight.

But should natgas take over half, or even more, of coal's utilities market, there is likely to still be large volumes of producible natgas looking for a market. The immediate answer being pursued by Exxon (NYSE:XOM) and some others is to export the natural gas. It can be shipped in liquefied form, and such traffic already exists. One port facility in Texas, originally intended to provide imported natgas to the U.S. is being turned around with exports intended to be aimed at European markets where prices of $13 per million BTUs exist.

In southern Texas, where natgas from the unconventional Eagle Ford field producers needs an outlet, a pipeline is being built to transport as much as 3Bcf/d (billion cubic feet per day) to Mexico where prices are better than double the current U.S. $3.25 per million BTUs. In 2010 Mexican offtake of U.S.-produced natgas was less than 1Bcf/d.

Prospects for World-Wide NatGas Prices

But such international pricing opportunities are likely to not last long. British, Dutch, Norwegian, Chinese, and other major national oil giants are quick to adapt worthwhile extractive technologies. Any country with significant coal-bed geologies is likely to find low-cost production opportunities similar to those occurring here. While there will be some lag behind our cutting-edge technology, $13 prices abroad are likely to be short-lived. And local production will always have the transportation advantage.

Many European countries will welcome becoming freed from reliance on Russian gas pipelines.

So an export market for U.S. natgas is probably not a long-term answer. It does not need to be, since there is a better one. Better for consumers, but maybe not for some producers.

Transportation's Changing Role

Transportation again becomes a focus of the discussion. But not as a cost; instead it is the market.

Heat-content physics is the driving economic force here. In the U.S., by far the dominant fuel for land transportation is gasoline. A gallon of gasoline contains some 125,000 BTUs of usable energy, so it takes some 8 gallons to equal 1 million BTUs. That could cost at the pump anywhere from $25 to $35.

If the producer-level market price of natgas is held to $4 per million BTUs, and it takes another $4 to get it into a pump alongside the gasoline (and diesel) pump(s), $8 looks a lot more attractive than even $25.

(By the way, in California, diesel is priced above high-test, even at economical outlets.)

But can ordinary cars burn natural gas? In many other countries automobiles that were originally made to use gasoline have been converted to natural gas quite successfully. Conversion kits are widely available elsewhere, but in a country that has the best government that money can buy they are not permitted to be made or imported.

Heavy engines for trucks, busses, and other equipment being built here by Cummins-Westport are being substituted for the original motive power plants in locally-driven applications like UPS and FedEx. The necessary network of geographically-dispersed refueling stations to serve long-haul truckers is initially in place along major cross-country routes and is being expanded.

But with the obvious potential impact on the revenues and profit margins of present-day integrated oil producing majors, no rush to "serve" the public is likely, and every effort that can be made legally will likely be exercised to inhibit the widespread appearance of natural gas fueled automobiles here.

Still, the economic appeal of cutting transportation fuel costs by half or more for the bulk of the voting public probably will at some point gather political strength. Which reminds me of what the head economist at the New York Investment Counsel firm that first hired me as a research analyst just out of graduate school said: "Only in the U.S. is Economics taught. Everywhere else they teach Political Economics."

The Future Major Competitors

There are only a dozen or so major international oil producers now, fewer with significant stakes in the US energy market. The Rockefeller-days of Trust-controlling markets are not likely to persist here now, where there are over four-dozen U.S. Exploration & Production firms actively pursuing unconventional extraction technologies that generate such volumes of natural gas, seeking effective uses. Their competitive presence is bound to get stronger and continue to be felt in the marketplace. Our next article will offer investment comparisons among several of them.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.