A Depression in Natural Gas Prices May Prove Bullish For China

 |  Includes: FEECQ, PCEEF
by: James Finch

If you’re living in San Antonio, St. Louis or even Albany, New York, you are probably not thinking much about global warming. Abrupt climate change may very well be on your mind. Some thought January started off like early springtime. And, of course, the energy bears were cheering. But less than ten days ago, AccuWeather’s Chief Long-Range Forecaster Joe Bastardi wrote: “This winter could parallel severe winters of the past.” For the energy bears, Bastardi warned: “Those who think that winter 2006-2007 is going to remain mild are in for a shock.”

That shock came this past week and this may not be the last of it. Bastardi believes the current weather pattern could mimic the cold and stormy winters of 1965-66 and 1957-58. “A worst-case scenario would be if this winter plays out as did the winter of 1977-1978.”

snowIn a telephone interview with AccuWeather’s Chuck Caracozza, he told us he’s seeing a cold pattern taking shape and that this could play catch up from the warmer December-January many enjoyed.

We asked energy commentator Phil Flynn of Alaron Trading for his thoughts.

"If the forecasters are correct, then we may have seen the lows in natural gas,” he told us. “But, we need more than a two-week cold blast. We need something that lasts from February into March.”

Flynn believes a winter which some forecasters are predicting could challenge the high gas storage levels. He said: “We have well above the five-year average of storage levels.” And should the weather compare to some of those past winter nightmares? “If we get a good old-fashioned winter, then we might find those storage levels are not as comfortable as we thought.” Flynn also observed, “then, we’ll find out how adequate those gas supplies really are.”

How comfortable should traders become with those storage levels? According to the International Energy Agency, the world’s focus on natural gas could overcome oil’s dominant position, sometime over the next fifty years. Crude inventories are being burned off nearly twice as rapidly as gas. For example, according to Andy Flower, who consults for the LNG industry, the world’s shortage of Liquid Natural Gas [LNG] could continue through 2011 or longer. No major energy company planned activities to increase LNG production. That’s because costs to build LNG plants have tripled over the past six years, says Bechtel Group, the largest U.S. contractor.

Eventually, demand for gas and the subsequent soaring price will catch up on a global scale, in much the same way we now view crude oil with the recent higher lows. Imagine your reaction a decade ago if you read that traders were wondering if crude oil would again drop below $50/barrel? Natural gas might well emerge as a more widely followed commodity, as early as next month, should the weather forecasters have correctly predicted a vengeful winter.

Why Gas?

Natural gas has a lot going for it. As part of the push for cleaner air, lower CO2 emissions and to help reverse abrupt climate change, natural gas is often mentioned as a preferable alternative to coal-fired power plants. True, it lacks the excitement of nuclear energy and the subsequent momentum built into the uranium price. But, natural gas is no longer the cheap fuel it was five or ten years ago.

Demand for gas has gone up in the world’s most emerging economies. Countries such as China are championing gas as an integral part of their energy mix. And for good reason. Primarily, a coal-fueled economy China has severely suffered by not having depended upon gas to meet its growing economic needs. According to a September 2002 World Bank Policy Research Working Paper, air pollution from coal burning reportedly causes about 300,000 premature deaths every year. By the year in which this report was published, six of the world’s most polluted cities were in China.

In her highly acclaimed book, The River Runs Black (Cornell University Press, 2004), Elizabeth C. Economy wrote:

“One positive environmental trend is the steady expansion of coal gas and natural gas for district heating in urban areas: since 1985, their use has increased more than five times.”

The author praised China’s stronger attempts to fuel this country through hydroelectricity and natural gas.

The energy fuel North Americans believe suffers from excess capacity – and which according to Phil Flynn, those levels might be challenged with a wintry winter – China can not seem to obtain sufficient quantities to help ‘green’ its economy while maintaining double-digit economic growth. Previously, we wrote about China’s burgeoning demand for natural gas, in which this country signed on to own about 1.1 trillion cubic feet of Australian gas. The country can not appear to obtain sufficient foreign-produced gas and the shortage of LNG construction is likely to impact the country’s desire to increase gas consumption in its energy mix. The shortage of natural gas supply could reach between 30 and 40 billion cubic meters by 2010, according to one Chinese government estimate.

Isn’t it ironic that about $37 billion in natural gas is burned off every year because insufficient quantity can be transported through pipelines, or because excess gas is pumped underground to drive more crude oil to the surface, while a growing country such as China can not obtain sufficient gas to meet its energy needs? According to a January 15th Associated Press report, Beijing is trying to encourage its consumers to spend more and develop more ‘brand names.’ Along the same lines, that is what state-owned China United Coalbed Methane [CUCBM] has been doing over the past decade – offering what China has plenty of in return for piece of the eventual economic returns.

By attracting foreign capital and more advanced technology, CUCBM has struck deals with major energy companies, and a handful of promising (and connected, but) smaller companies. Generally, the companies pay for the exploratory, often confirmatory, costs to develop a coal gas resource in exchange for a 60-percent production-sharing contract. CUCBM has awarded land areas about the size of Delaware or larger for a 40-percent slice of the future production on those projects. More recently, the Chinese Yuan’s currency appreciation enabled China’s financial system more flexibility and should later end barriers to money entering and leaving the country.

While we’ve eschewed coverage on the Canadian CBM companies, many of whom nearly vaporized over the latter half of 2006 and could remain stagnant, we believe one might find encouragement with the fledgling companies advancing their CBM projects in China. ‘All gas is local,’ the energy experts have advised us. While the price of gas may differ from Iran and to Australia, or from Alberta to China, perception among investors tends to remain consistent: Sell when gas is falling; buy when it is rising. The underlying commodity may have unjustly impacted the shares of companies developing their projects in China. What happens to the flattened shares of those companies when natural gas prices turn?

One can look at the work achieved by Houston-based Far East Energy Corporation (FEEC) over the past few years. Through its agreements with ConocoPhillips (NYSE:COP) and CUCBM, the company’s progress in China’s leading coal region, Shanxi Province has finally begun to show strong promise. In a January 11th news release, Far East remarked upon the high permeability and gas content of its five horizontal wells, comparing the potential to “prolific wells similar to those in America’s San Juan Basin or Australia’s Fairview Field.”

The company’s Chief Executive noted in the release:

“The Fairview Field is a very productive field that may be a good analog to what we have discovered in our Shouyang focus area.”

Of course, the CEO also warns that it is too early, prior to sustained production from the wells, to make such comparisons.

comparison cbm plays
Early drilling by Pacific Asia China Energy (OTC:PCEEF) in southern China confirms the favorable gas content found by Far East Energy in northern China. Both exploration companies compare well against some of the top coalbed methane producing regions in the United States and Canada.

We don’t believe Far East Energy’s claims to be anomalous, but may very well be confirmed with the expansion of their well field. Discovery of highly encouraging gas content also compares with reports we’ve studied from a similar Canadian company, Pacific Asia China Energy. The gas content on the scf/t basis from this company’s drilling in the Longtan coal formation of Baotian-Qingshan Basin in China’s Guizhou province favorably compared with the Manville coal formation in the Alberta Plains Deep Basin, the Fruitland coal formation in New Mexico’s San Juan Basin and the Pottsville coal formation in Alabama’s Warrior Basin.

Both companies made great strides in 2006 while natural gas prices became increasingly depressed. At this writing, NYMEX February natural gas traded last at $6.697. Far East Energy suffered through a proxy battle this past fourth quarter, but appears to have moved forward – announcing two new vertical wells to be drilled. After favorable preliminary results from the initial drilling, Pacific Asia China Energy has commenced plans for an initial pilot test production program.

There may be a potential reward for Pacific Asia China Energy, which is in addition to any success the company may have in developing its CBM concessions. In an October 2006 interview with the Pacific Asia China Energy VP/Exploration Dr. David Marchioni and in a December 2006 audio interview with executive vice president Steven Khan, it appears the company may generate revenues during 2007 because of the company’s joint venture with Australia’s Mitchell Drilling to lease a drill rig.

The company has an exclusive for China coalbed methane drilling with Mitchell, through this joint venture, which could become a valuable cash cow to help finance further exploration on its CUCBM concessions. Mitchell’s proprietary Dymaxion drilling technology is an example of why the Chinese invited foreign-owned companies to help develop their CBM properties. With the funds the companies invest to develop these properties, they also bring advanced technology to ameliorate China’s ongoing energy crisis.

If indeed the natural gas price bottoms because of the weather risk, putting a frown on the faces of energy bears, then one of the first places investors might smile could be with the developments in China.