Shell's $12.5 Billion Gas To Diesel Idea: On The Brink Of Global Energy Revolution? (Part 2)

| About: Royal Dutch (RDS.A)

In the first article on Shell's (NYSE:RDS.A) (NYSE:RDS.B) plans for a $12.5 billion gas to liquids plant in Louisiana, I assumed success to be a given, in order for us to be able to contemplate what it would mean for the company as well as for the overall global energy picture. With success taken as a given, I pointed out that the global ramifications would be nothing less than revolutionary for the next few decades. It would affect issues such as peak oil, climate change, economic growth, thus our lives. For Shell, it would be an opportunity to not only weather the potentially tough times that would otherwise lie ahead for oil majors, but it would give it a chance to become the leader of the energy industry.

I approached the subject from a point of view which omitted the main dangers to the project's viability in my first article. I want to start this article by pointing out the main threat to its plans, which is by no means the only one.

Data: Texas Railroad Commission.

As the chart shows, the Barnett, which is one of the largest shale gas fields in the United States (probably second largest according to estimated reserves), peaked in less than a decade after the fracking method was applied intensively. The Haynesville field in Louisiana is down 30% since it peaked in 2011 (link). It took less than five years for this to happen. It still produces over 5.5 billion cubic feet of gas per day, which is very significant, but the future for this field is very uncertain, even if natural gas prices will rise significantly. Meanwhile, Gulf of Mexico offshore natural gas production declined significantly over the past decade. According to EIA data, 1.5 trillion cubic feet were extracted in 2012. In 2003, total production was 4.3 trillion cubic feet. The part of the United States where Shell and Sasol want to build their gas to liquids (GTL) plants does not seem to be doing very well in terms of future production prospects. Shell's plans to convert gas to liquids at a rate of perhaps 100,000-150,000 barrels per day would take up about 0.3 trillion cubic feet per year. Demand coming from the plant planned by competitor Sasol, which will also have almost 100,000 barrel per day capacity, would bring total demand by the gas to liquids conversion industry to about half a trillion cubic feet per year.

There are many other fields in the United States, like the Marcellus, which is by far the largest shale gas field and it is only now in the middle of production ramp-up. Eagle Ford in Texas is better known for liquid fuel extraction, but it contains large amounts of shale gas as well. The Utica field may have disappointed on the oil front, but it is thought to contain large amounts of natural gas. Aside from the Eagle Ford, the rest of the plays I mentioned, which are still increasing production, are not in the Gulf neighborhood where gas to liquid conversion is currently being planned.

Aside from the bleak prospects of the gas industry in the Gulf region, where production is in fact in decline, America's main supplier of gas exports, Canada is also in decline mode, according to EIA data. Canadian natural gas production declined steadily since 2002. Canada currently produces 30% less gas than it did a decade ago. It is a loss in yearly production of 1.6 trillion cubic feet in a decade's time. If the trend continues, Canadian exports to the United States will cease before 2030. It is within the context of potentially falling supplies from the Gulf region (offshore and onshore) as well as less gas available for export from Canada into the United States that we have to contemplate the good news from prospects such as the Marcellus and Utica shale gas fields. The current pace of production ramp-up at the Marcellus field may give some companies the impression that natural gas in the United States will continue to remain cheap for a long time to come, but I think caution is warranted given the production history of other shale gas fields.

Opposite and conflicting needs

Price is the only thing that can reverse the current trend of falling production in many of the gas plays. It is hard to project what price level it will take for the declining fields to come back to life and at the very least stop declining, or even start increasing production again. It is also very hard to project what is the rate of production increase given a certain level of price increase. What is certain is that the prices we see currently do not have much of a chance of lasting through the decade, which is just when Shell plans to inaugurate its proposed gas to liquids plant. It is clear therefore that if there is to be a project in the United States, it should not be projected based on current natural gas prices. I think it would be wise given the early production history of shale gas plays to plan the project on the assumption that once the plant is inaugurated, it will operate on natural gas in the $10 range, adjusted for inflation. The EIA estimates gas to diesel to be currently viable at a natural gas price of less than $6 per million BTUs, so it has much progress to make before it can reach viability in the $10 range.

Economics of natural gas to diesel conversion

Sunk Costs:

It is hard to get good information on the current economics of the conversion process of natural gas to diesel. It is also hard to estimate the capital spending involved in building refinery capacity, which processes conventional crude oil, but there is this example of a recent refinery project in Pakistan, where it is about $15,000 per barrel per day, which we can use as reference (link). Given the roughly $100,000 per barrel per day capacity, which is in fact a very optimistic estimate based on projects already in place in Qatar as well as Sasol's Louisiana GTL plant, which is in the process of being built, capacity cost of GTL is about 6-7 times higher than the cost of adding conventional refining capacity.

Operating Costs:

Looking at the cost of the feed material, we get an advantage for GTL. A barrel of oil costs about $100 and I assume this average price will be maintained for the next few decades, because prices going lower leads to supply destruction, while prices going higher leads to demand destruction. I assumed based on the brief look at US natural gas supply prospects for the long-term that prices will have to rise to $10 per million BTUs. Therefore, the current price ratio per unit of energy of about 4.7/1 for oil versus gas will narrow to about 1.7/1. Because a barrel of oil contains about 5.85 million BTUs, it is best for us to think of a barrel of oil equivalent in natural gas, which at an assumed future market price of $10 per million BTUs will cost $58.50.

The energy intensity of the gas to liquids process versus refining conventional oil is higher. Studies made by Sasol, Shell and Chevron have shown that the process efficiency of gas to liquids is about 60%, versus 90% for conventional refining (link). In other words, in the process of end use production in the gas to liquids process 40% of the energy contained in the feedstock is lost, versus 10% for crude oil refining.

Maintenance costs are also a factor worth keeping in mind. Gas to liquids production infrastructure is more expensive as we already established. It is more complex, therefore will be more expensive to maintain. Could not find any indication in terms of just how expensive it might be, but it seems the technology is prone to break down based on Shell's experience in Qatar. A more expensive facility will cost far more to maintain - it is that simple.

Environmental and political factors (may be the deciding factor)

There is no question of the fact that GTL will have a hard time going toe to toe with conventional gasoline and diesel due to its very high production costs. I do believe that if played right, companies producing GTL can simply avoid going toe to toe on price by finding ways for GTL to become a fuel of choice for municipal entities suffering from air quality problems. GTL diesel is cleaner burning than conventional diesel fuel. It does not produce as much smog and does not contain chemicals such as sulfur and aromatic compounds (link). Given the air pollution problems seen in many urban areas, it is conceivable that at some point we will have significant tax differentiation between conventional diesel and gasoline on one hand and GTL diesel on the other. It may be a way for cities like Beijing and others to better control their smog.

To put it in perspective, the spot price of diesel right now in the US is about $3 a gallon, according to EIA. The average retail price is $391 and 12% of that is taxes (link). Shell could potentially sell its diesel tax-free in places like Los Angeles, so they could go ahead and charge as much as other retailers would charge for their conventional diesel, given the tax regime enforced at the federal and state level. I am sure that GTL can easily win this concession, winning a pricing advantage in the process. Many governments may even consider subsidizing GTL as long as it will be sold in major urban centers with air quality issues.

The risk we insist on ignoring.

The main risk to investing into large-scale proliferation of GTL production facilities to the point where it becomes a significant component of the global liquid fuel supply may be that there may simply not be enough natural gas out there to satisfy one more significant source of demand. It may even be a challenge to satisfy the already forecast demand growth coming from electricity generation demand, as I pointed out in my last article.

The shale gas revolution may have given us a massive new source of energy, but we should not get carried away and pretend that it can solve all our energy needs for the rest of the century. We should pay attention to the fact that only a few years into this revolution, we already have major shale gas fields in decline at current natural gas prices. We should also pay attention to the fact that many initial estimates of shale gas resources were proven to be overly optimistic. Places like Poland and Hungary where exploratory work was done yielded far less gas and far more disappointment than initially expected. Initial estimates of shale gas in the United States were at first thousands of trillions of cubic feet. Now they are scaled back to hundreds of trillions of cubic feet after studies made by the USGS. I believe that in two or three decades, the US shale gas revolution will become only a memory of times of plenty, even if natural gas prices will rise to $10 or above. GTL facilities built in order to take advantage of current plentiful supplies will be built with the intent to produce for many decades to come. The risk lies in building these facilities across the world and in time realizing that we are not able or willing to allocate so much natural gas to GTL production.

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.