Coal Is The Future (Part 2)

by: Zoltan Ban

In part one of this two part series I focused mainly on demand issues. I started by pointing out why I believe there is a huge source of future demand for natural gas, which is coal's main substitute, which is presently not being accounted for. Due to a shortfall in crude oil production, I expect natural gas to step in and fill the void. It is a void, which as I pointed out might reach as high as 55 trillion cubic feet per year by 2040. That is the equivalent to almost 50% of current global natural gas production.

For part two, I want to turn my focus to supply. I want to first of all look at natural gas supply in order to establish whether we should expect enough supply growth to cover the already expected and forecast increase in demand as well as the largely ignored potential source of demand growth. The list of potential sources of increased demand is very diverse, including sources such as electricity generation, de-salination efforts in the Middle East, the chemical industry, production of synthetic crude from oil sands. Main question is whether natural gas can cover all these needs as well as the surge in demand stemming from what I believe will shape out to be a huge shortfall in crude oil supply compared to expected demand in coming decades.

How much can natural gas do for us?

There is no doubt that decades from now global natural gas production will be much higher than currently. There are many sources yet to be fully tapped, which offer much potential. There is a push for more arctic natural gas drilling, Iran has huge reserves just waiting for sanctions to be lifted. New discoveries such as the ones made in the Mediterranean recently show us that there are more resources awaiting discovery and production.

By far the largest source of optimism is shale gas. I believe that while shale gas will provide us with very large volumes of natural gas in coming decades, it will fall way short of initial expectations. Estimates by the EIA of 7,300 trillion cubic feet of shale gas that are technically recoverable worldwide seem very unlikely, given the production profile of shale plays in the United States and paints a picture of wishful thinking. The signs that we will be disappointed are there already, only a few years after the fracking revolution began.

Downward revisions

Haynesville was one of the first fields in the United States where fracking was proven to be a successful operation in gas extraction. When the field started significant production through the fracking process, it was thought that it was the largest field to ever enter production in the lower 48 states. Reserves were estimated at 250 trillion cubic feet in 2008. By 2009, reserve estimates were cut to 75 trillion cubic feet, while currently we base our reserve estimates on a 2011 EIA study, which came up with 29.5 trillion cubic feet.

Haynesville was not the only field to suffer this fate. The Marcellus field, which is the largest shale gas field in the United States, was initially believed to contain as much as 410 trillion cubic feet of technically recoverable natural gas. This was the official EIA figure, until the United States Geological Survey agency came out with a technical study which put the figure to 84 trillion cubic feet.

Other initial estimates around the world such as Poland's potential shale gas reserves were recently slashed in the aftermath of some exploratory drilling. Initially estimated to hold as much as 170 trillion cubic feet of technically recoverable natural gas, now Poland's shale gas reserves are estimated at only a tenth of that volume and firms are starting to pull out (link).

It seems that a pattern is emerging where initial hopes for shale gas are too often dashed by reality, once drilling commences and we start to learn more about the reserves. Of the 7,300 trillion cubic feet of shale gas estimated by the EIA to be technically recoverable globally, most fields and regions have yet to be subjected to serious study and production attempts. Given that the prevailing trend is for steep reserve downgrades once we learn more, it should be expected at this point to see significant declines in reserve estimates in global shale gas in the coming years.

Of all the potential future supplies of natural gas, I believe shale gas will be the biggest disappointment, which stems not so much from lack of future contribution to the overall global natural gas supply, but because we simply expected too much and perhaps because we need much more than we can get. What is worse is that shale gas may reveal its full extent of disappointment right when we will need increasing supplies of natural gas the most. As I mentioned in the last article, global conventional crude oil production has been on a production plateau for almost a decade now. It may remain on a plateau for a decade longer, or perhaps even experience slight upward momentum in the next few years, but reality is that these fields are getting older and more depleted. The fact that despite experiencing a 500% increase in crude oil prices, we did not get an increase in conventional crude production but only a plateau says all we need to know about these fields. Despite all the noise we have been hearing about how the peak oil crowd is completely wrong, fact is that conventional petroleum production will probably start declining some time in the next decade or so.

The moment of peak conventional oil production and the moment of the revealing of the full extent of the disappointment of the shale gas industry will most likely coincide. We have the first clues of this courtesy of the field, which ushered in this young, intense and seemingly short-duration revolution.

Note: Data source US average yearly spot price: EIA. Data is only up to and including 2012. 2013 price based on current prices. Data source production: EIA.

As the chart above shows, the Haynesville shale gas field peaked only half a decade after the shale gas revolution started. It has been on a declining path for two years now. At first, the drop in North American gas prices was thought to be the main reason, but natural gas prices rose significantly since the low price of $2, to the current price of around $3.50. It is still some way off the $6 range where many people believe that shale gas extraction will become profitable, but still, the rise in prices we have seen should have sent a price signal to firms to increase their activity. That has not happened thus far. It is not happening in other shale gas plays either, like in the Barnett and Fayetteville, both of which are also past their peak only a few years after production through hydraulic fracturing method commenced.

Some will argue that the decline we see in these fields is purely a function of price, but if we look at the EIA data on the Haynesville, the story of price is not the only one. Currently it takes an addition of 330 million cubic feet per day in new production additions each month just to keep production flat, which is not happening at the moment, which is why production in declining. Simple logic would suggest that if we were to see a significant increase in price we would see a reverse of the declining trend due to more intensive drilling. The EIA data however shows that intensified drilling will also bring an intensification of the decline rate of the existing wells. In 2011, the rate of decline of the legacy wells per month reached a high of 600 million cubic feet, which coincides with significantly more robust drilling activity in the field. In the 2010-11 period there were as many as 230-240 rigs drilling the field. Currently there are less than 50 (link).

Bottom line is that an increase in drilling activity will most likely fail to produce a sustained reverse of the current declining trend. After more than half a decade of hydraulic fracturing we can say with confidence that shale gas can give us short-term spikes in production, followed by the long struggle just to keep it from fading away too fast. If most global shale gas reserves will be brought into production before 2030, we may be looking at a welcome global spike in production, followed by steady decline thereafter. This means that by 2040 we may in fact be looking at a peak in global natural gas production, in the absence of other significant yet to be counted sources being brought online.

Coal Supply.

Part one of this two part series as well as the beginning of this article focused on establishing that the demand for coal is going to be there, mainly because of the supply/demand picture of coal's main substitute, natural gas. There is no question that demand for coal will be there in my view, in the absence of extreme global economic hardship. As I pointed out in the first article, I expect an increase in demand by about 3 billion tons per year by 2040 on top of current demand of about 9 billion tons per year.

The number one factor in delivering a continually increasing supply of global coal is price of production versus the maximum price tolerance of the market. We now know the price of oil can go for a sustained period over $100 a barrel, but not over $120, before demand destruction in the form of a struggling economy starts to set in. For coal, it is hard to determine with precision what is the maximum achievable price level within the economy. It is something we will only learn about when we get there.

What we do know right now is that the average cost of coal production in many major producing regions is rising dramatically. In Australia, for instance production costs since 2006 rose by 71% in Australian dollar terms (link). The cost of coal production in the United States has doubled since 2000 according to EIA data. The EIA expects that from now on cost of production will only increase by about 1.5% per year adjusted for inflation. The average marginal cost of production in China is thought to be in the $80-100 range. Current thermal coal spot price is around $55 (link), which means that the Chinese are already producing major quantities of coal at a loss.

What all these data tell us is that the marginal price of coal is on the rise and it is currently rising fast. It is in many ways no different than the rise we saw in oil, where the marginal price was in the $15-$20 in the 1990s while now it is in the $80-120 range. In other words we need the current price in order to keep the world economy supplied.

I do believe that the ceiling price is much higher than current marginal production price. We could absorb a doubling or even tripling of coal prices in current dollars, without suffering an economic meltdown. The question I have however is whether such a price increase will be enough to lead to our ability to extract the estimated trillion-ton reserve we currently assume to have based on official estimates such as the ones we have courtesy of the EIA and BP. The fact that the marginal cost of production is increasing so rapidly in many major coal producing regions tells me that perhaps large volumes of the supposed reserves are not going to be economically recoverable even if we can sustain a tripling of the spot price for coal in the next few decades. In other worlds, just as crude oil that would currently cost over $200 per barrel to produce, will likely remain in the ground forever, so will all the tons of coal which may be more expensive to recover than our maximum acceptable price which we can sustain given our economic needs. The fast-paced increase in costs of coal production we are currently witnessing suggests to me that we in fact do not have more than 100 years worth of coal reserves at current consumption rates as mainstream establishments currently suggest.

In conclusion, I want to point out that all the main ingredients needed to give rise to a trend which will in the next few decades test the economic price ceiling of coal are in place. Demand for coal will be there as I pointed out through my analysis of its main substitute, natural gas. The marginal price of coal production is rising at a relatively fast pace, just as it did in the case of crude oil in the last decade. The fact that current rate of coal production price increase may be an indication of coal reserves being overstated gives us the scarcity factor. Therefore, I believe that for those who have the time and patience to allow for returns to come in, this is a good time to start looking at taking positions directly or indirectly in coal mining activity related investment opportunities. There is no rush to jump in, but it is time to start contemplating the best ways to play this for the long term.

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.