With all the talk of the world drowning in natural gas and embarking on a renewable energy revolution meant to save ourselves from climate change catastrophe, it is understandable why everyone is thinking that it is time to ditch coal as an investment holding. As a short-term bet, I see their point, but as a long-term bet, I think investing into a trend of increasing volumes of coal production is perhaps one of the best commodity plays out there and it actually has to do a lot with natural gas, which is coal's closest substitute. This will be part one of a two part series. Part one will be dedicated to the demand side of the equation, while part two will focus on supply.
Global electricity demand set to almost double in next three decades.
Exxon Mobil's global energy report to 2040, published a few months ago is one of my favorite tools and reference points when it comes to analyzing long-term energy or energy related trends. It is just a forecast, with many unknowns, which are yet to reveal themselves, which can easily render many aspects of the forecast useless perhaps in a few short years. I still think however that it makes some very important core predictions, which have a good chance of turning out to be reasonably accurate.
One of the most important forecasts within the report was the estimated increase of electricity production by 85% from 2010 levels by the year 2040. To put that into perspective, it would mean increased electricity demand equivalent to about 110% of the energy content contained within the roughly 120 trillion cubic feet of natural gas produced globally per year currently, according to EIA data. I find this figure to be very relevant and intriguing, especially given that Exxon based its forecasts on the assumption of average yearly global economic growth coming in at only 2.8% for the period. That is a full point lower than the average seen since the end of the Second World War. This means that the only thing aside from a sudden surge in global energy efficiency growth level, which would greatly exceed the one that is already factored into the forecast, it would take global economic dysfunction to prevent the forecast increase in electricity demand from materializing.
Exxon Mobil made some flawed assumptions.
When it comes to nuclear and renewable energy as future sources of electricity, I think Exxon Mobil has it largely right. Both sources of energy will contribute greatly to the push to meet the increasing global demand we expect to see in the next few decades in the absence of a total unraveling of the global economy in the meantime. I do not want to spend much time on analyzing the aspect of nuclear and renewables, such as wind and solar. The only thing I will say is that I expect to see more renewable energy than the Exxon report anticipates and less nuclear.
Exxon-Mobil forecast an increase of 150% in nuclear and natural gas electricity generation by 2040. The two largest contributors by far. Nuclear will most likely fall short, but as I stated, I believe the gap will be made up from a larger than expected increase in renewable energy. Natural gas is where I see a huge shortfall, and nothing to cover with except coal. Here is where I believe Exxon and many others fail to understand why global coal consumption will continue to increase at a robust pace. Natural gas, which is coal's closest substitute will experience far more robust demand than most people expect.
The Exxon study forecasts an increase in transportation energy demand of 40% by 2040. When we talk of transportation energy, we are talking mainly about liquid fuels. Natural gas is increasingly seen as a transportation fuel and Exxon acknowledged it in the report, forecasting that natural gas as a percentage of total transportation fuel demand will rise from 1% currently to 4% of the total by 2040. I believe they are wrong and in order to understand why they are so off course, it is important to look at oil supplies going forward.
Shale oil blinded us.
If one looks at the global production history of crude oil and condensate since 2005, it quickly becomes apparent that conventional crude oil fields have reached a collective peak despite the roughly 500% increase in average crude prices since the year 2000. The price increase did give rise to a jump in unconventional crude production volumes, which in fact gave us a roughly 3% increase in global crude oil production since 2005. It is not much, but in conjunction with an increase in other liquid fuels, such as ethanol and gas to liquids (GTL), it was enough to give the impression that a stagnation in conventional crude oil production is not the end of the world as the peak oil crowd predicted it would be. The bulk of that 3% increase in crude oil supplies came from the shale oil boom in the United States, mainly from two fields (Bakken and Eagle Ford), which fresh data supplied courtesy of the EIA shows us that the boom is already close to ending, less than a decade before it began, but not before contributing to an increase in US crude oil production of over two million barrels per day. That is the exact same increase we had in crude+condensate production since 2005, which means that all other sources of crude production are on a collective plateau.
At Eagle Ford, which most likely surpassed the one million barrels per day production mark just recently, it now takes over 80,000 barrels per day in new production every month just to keep production steady according to the EIA data. Less than two years ago, at the beginning of 2012, it took only 30,000 barrels per day in new production to replace production lost from already producing wells every month. At the beginning of 2011, it took only 10,000 barrels per day in new production. For the month of November, 2013 it is predicted that total new production will be 105,000 barrels per day, so there will be a substantial net increase in production month on month of 24,000 barrels per day.
The rate of loss in production from existing fields continues to increase at a fast pace, so we could see within just a year the need to replace over 100,000 barrels per day in lost production every month. At the same time, there are signs that the rate of drilling is slowing somewhat as data from the Texas Railroad Commission shows us. In 2012 there were 4,100 drilling permits issued, while in the January to September period of this year there were 3,069 so we are on track to see slightly fewer wells drilled this year. Given that half of the estimated 22,000 wells to be ultimately drilled by the EIA have been drilled already, we should expect a more pronounced slowdown in drilling next year. Eagle Ford could peak less than five years after the fracking boom started in the field. It will be a peak at an impressive rate of over a million barrels per day, which will make it one of the top five producing fields globally. Given the furious pace of decline in production of the existing wells, the decline rate after the peak will probably be equally impressive.
The Bakken field had a gentler rise in production volumes compared to Eagle Ford. The fracking revolution started in the Bakken in 2008. It will also reach production of over a million barrels per day in a few months most likely, making it another field with the distinct honor of having produced over a million barrels per day, which not too many fields around the world have ever laid claim to. It currently takes over 60,000 barrels per day in new production to replace lost production from existing fields every month. At the beginning of 2012, it took 30,000 barrels in new production every month to replace production lost from existing wells. The pace of drilling is slower in the Bakken, so for November of this year 86,000 barrels in new production will be added, yielding a net increase in the field of 26,000 barrels per day month on month, but the direction towards a peak in production may not be much different from the one at Eagle Ford. It might be delayed by a few years and the rate of decline will likely be more gentle, but even at the Bakken field, we are looking at going from a fracking caused ramp-up in production to a peak and decline in less than a decade.
There is currently no shale oil or oil shale (kerogen) ramp-up to be expected anywhere else in the United States within the next few years. The Monterey field in California is one field where it is believed that the same potential as at Bakken and Eagle Ford may exist, but currently companies are struggling to overcome technical challenges and there is no guarantee that they ever will. As for other shale oil fields around the world, a few promising prospects were identified in places like Argentina and Russia, but we shall have to see what will come out of it, if anything. Bottom line is that given what we learned over the past few years about shale oil fields, we should not expect fracking for oil to be responsible for a large proportion of the expected increase in liquid fuels production by 2040. In fact, it is probable that by then, the revolution will have come and gone already.
A 30 million barrels per day hole to fill by 2040.
There is little doubt that the Exxon forecast for a 40% increase in energy demand coming from transportation needs by 2040 will materialize, given that the two main factors; economic growth, which they factored in to be much slower and technological change, where they forecast a doubling of average car efficiency by 2040 are both accounted for. This effectively means that there will be a 40% increase in liquid fuels demand on top of the 90 million barrels per day consumed presently.
On the supply side, everyone is betting that unconventional sources such as shale oil, oil shale, heavy oil, deep water oil, oil sands and bio fuels will fill the gap. Oil shale (kerogen) has little potential of happening. Shell Oil's recent decision to pull out from their pilot program after decades of research is further recent proof of the resource's un-viability. Bio fuels were once thought to have huge potential, but I feel it was a huge mistake to start down that road given that there are currently billions of people who are under-nourished. It is a terrible mis-allocation of resources, which defies basic economic theory, because humanity's collective well-being is most certainly not being enhanced. Shale oil will be an old story by 2040, because by then it will provide far less oil than it does now, even if many prospects around the world will turn out. Some prospects such as oil sands, heavy oil and deep water will have enduring success. On the other hand, should we expect conventional oil, which is already on a production plateau for almost a decade now to maintain that plateau until 2040? It is wishful thinking and we cannot fill the gas tanks on it.
Natural gas is the most likely plug in the gap.
I recently wrote two articles (link1, link2) on Shell Oil's plans to build a new gas to liquids (GTL) plant in Louisiana. It is a plan, which is mirrored by Sasol, its main competitor in the field. I believe this is the beginning of a great shift in the energy world. Shell Oil will most likely give up gradually on chasing oil extraction prospects and focus instead on producing natural gas and transforming a large chunk of its own production as well as contracted volumes into GTL products. Sasol and others will do the same. It is a response to dwindling lucrative and geopolitically safe oil prospects available to non-state owned companies. It will play a much larger role in fulfilling our transportation needs than the 4% of the total forecast by Exxon. Together with other trends such as compressed natural gas, GTL will fill most of the 30 million barrels per day gap left by crude oil, which up to now was the traditional provider of liquid fuels. I see no other viable candidate out there aside from some technologies on the fringe, such as electric cars, which will only contribute relatively insignificant additions to the global car fleet.
Given the overly optimistic expectations for crude oil production from both conventional and unconventional sources, the largely unexpected gap will represent a source of natural gas demand, which is currently largely ignored and not accounted for in most mainstream forecasts. If natural gas will have to provide for the equivalent of 30 million barrels per day in new un-covered transport energy demand, it will be equivalent to 55 trillion cubic feet of natural gas per year (without factoring in energy loss stemming from GTL conversion). In other words, this unaccounted for source of demand for natural gas alone would require a 50% increase in global natural gas production by 2040 just to meet the demand for new transport needs.
It is within this context that we have to view the future of coal. Its main substitute in electricity generation is natural gas, while natural gas is the closest substitute for oil. It is currently a much-coveted substitute, because it is cleaner burning at a similar price. Politicians as well as firms looking to meet CO2 reduction goals are eager to take advantage of such a favorable, costless way of showing a green streak. It remains to be seen however if this option will continue to be available in the longer term, or whether we will reach a point in the not too distant future when the trend will be reversed. For this article, we established that natural gas will likely have other major sources of demand, which currently are not being factored in due to an over-reliance on optimistic forecasts about future oil production prospects. Exxon did not consider this factor when it forecast coal demand to remain largely flat for the next few decades.
Coal demand will not be flat, in fact I expect it will become the number one source of energy by 2040, while natural gas will come in second. Oil will fall from number one to the third spot, mainly as a result of production constraints, which will create a huge shift in resource allocation. In order to figure out the actual size of this shift we have to look at the supply side of the equation, which I reserved for part two of this two part series.
For now we can already see other sources of demand however. Coal to liquids (CTL) will become more popular with countries wishing to convert their coal reserves into liquid fuels. China is going ahead with adding CTL capacity. Construction for a plant started in September, which will have a capacity of four million tons per year (link). Other plants around the world, including in the United States will most likely be built in the years and decades to come.
We should also remember that there is global steel production, which currently takes up about 750 million tons of coking coal annually. Steel demand is set to rise by about 3% in the short-term (link) and coal demand will likely rise accordingly. If the trend holds for the next few decades, this alone could add almost billion tons per year worth of global coal demand by 2040.
In the end, electricity production is where the bulk of potential demand for coal will come from. In this article I pointed out a roughly 55 trillion cubic feet potential demand for natural gas, which has not been accounted for in the forecast to 2040 and therefore can mean an equivalent of two billion tons of additional coal per year needed for electricity generation. Some may be tempted to claim that natural gas can take care of all of it. Extra transportation fuel as well as keep up with global electricity demand are easy tasks for natural gas, now that we have fracking as a way to get it out of the ground. I do not believe that to be the case. I also believe that we are a bit overoptimistic on coal supplies as well, which reinforces my view that coal is a good potential long-term investment, given that there are some potential scarcity issues. We shall leave the details to part two of the series as we examine supplies of coal and gas.
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.