- The macro investment environment favors food and energy.
- 2019 natural gas sells for less than the current marginal cost of production.
- U.S. natural gas demand will ramp by 18 BCF/day by 2019.
- The U.S. needs to replace 19 BCF/day of supply each year due to declines.
- Drillers move over time from the core to less economic areas.
Macro Investment Environment
A stagflationary environment favors the prices of food and energy.
Central banks have flooded the world with liquidity. Prices have been bid up for almost every asset class. From stocks to bonds to real estate - every current (but not necessarily future) asset price is high… perhaps even over-priced.
Oil demand is ramping as supply costs jump. The EIA just released a report indicating 127 major oil and natural gas companies were cash flow negative by $110 billion for the year ending March 31, 2014. These same companies increased net debt by $106 billion and sold $73 billion of assets. Acceptable if the money was spent on establishing a 'brand' or on long-lived assets, but most of this money is going towards shale assets that are ~90% depleted within three years. Upstream (E&P) costs in the oil industry have risen threefold since 2000 but output is up just 14%. Geology is crushing technology.
2019 Natural Gas
The U.S. to world price of natural gas, and the ratio of the price of natgas to other energy sources are pulling on the price of U.S. natural gas like gravity. However, the market needs time to adjust. Time to work through the effects of both the over investment in shale gas and time to ramp the new sources of demand. The current average price of natgas in 2019 is $4.45 (as of 8/15/14).
Current Environment for Natgas
Note: the following sources are from the oil & gas industry; not environmental/anti-fracking groups whose forecast are even more bullish for natgas pricing.
Current Full Cycle Costs - Bill Gwozd, a senior VP with Ziff Energy consultancy estimates that the life-cycle cost for drilling a new well adds up to $6 per gigajoule (equivalent of $5.69 per MCF) of gas.
Let's assume the cost of water, wastewater disposal, frac sand and other materials; new regulations, higher interest rates, new taxes, land, increasing community pushback...only went up by 2% per year. Today's $5.69 natgas goes $6.28 by 2019.
If 2019 natgas went from its current $4.45 price to just $6.28 that's a 40% gain. Using 2:1 leverage (as I have) due to lower volatility in long-term futures and the low probability of another shale 'gold rush' right on the heels of the last one - increases the potential gain to over 80%.
It will not take until 2019 for the market to realize 2019 natgas is mispriced. The way long-term futures tend to trade is, "nothing, nothing, nothing, spike." The 80% return could occur within 6 months, 2 years, 5 years… or never fully materialize, of course.
E&P CEOs chime in on the above findings. For instance, Bill Thomas, CEO of EOG: "…we really would need $5.50 or a better price, and we would need to believe that $5.50 or better price would hang in there for multiple years before we'd even think about drilling dry gas."
Note that E&Ps make decisions based on sunk and go-forward costs, so their hurdle is lower than full-cycle cost. Also important to remember is the issue of marginal costs. When the current excesses are worked through, it will not be EOG's natgas that sets the price at Henry's Hub. The floor will be set by the marginal MCF; the highest cost producer required to meet demand.
Higher cost plays like the Haynesville shale require even higher prices. From Dion War, President of Baton Rouge Association of Landmen: "The Haynesville has entered the second phase of development - manufacturing and build out. This will be driven by revenues and cost metrics rather than the initial sunk costs of development (G&G, Land, Legal, Lease Acquisition). Production and profits will dictate the pace. Until the natural gas price ascends to a level that would warrant another wave of wholesale lease acquisition of $6 to $8-plus depending on the source… and subsequent build out into the lesser tiers, or another 'game changer' surfaces, things should remain static."
Hello! This is the equivalent of a real estate agent advising home buyers that home prices are too high, and that they should stay out of the market for a while.
Ramping Demand - PIRA consulting is tracking the growth of total supply and demand. In their latest update, they state demand is ramping as forecasted - which is twice as fast as the EIA predicts. PIRA foresees demand growing by an extra 18 BCF/D by 2019. "Toward the end of the decade, a rising call on supply led by the industrial sector and LNG exports likely will require contributions from higher cost sources of production."
Sweet Spots - The 'sweet spots' key to oil, gas and mineral development. The history of extraction industries (with the assistance of Wall Street) is to generalize the results of the sweet spot/core to the entire play/deposit...and for an optimistic length of time.
Wood Mackenzie's Jen Snyder is an MIT graduate with 20 years experience in natgas. She is head of research for North American shale assets. Wood Mackenzie sees some limits to the resource. For example, gas production in the Marcellus Formation, which extends across New York State, Pennsylvania and West Virginia, has soared despite relatively low gas prices, driven in large part by especially prolific wells in northeastern Pennsylvania. But there are only so many wells to drill in that core area of the state. "In our view, by 2020, that inventory of wells will be exhausted," Snyder says.
David Hughes is an exception to the above list of experts in that he works for the Post Carbon Institute. Before casting his work aside, note that he is a geoscientist who has studied the energy resources of Canada for nearly four decades, including 32 years with the Geological Survey of Canada as a scientist and research manager.
More to the point, he absolutely nailed the write-down of the alleged mega-shale asset, the Monterrey shale, months before official sources like the EIA.
He has published a study on U.S. shale ironically titled, "Drill, Baby, Drill." At the very least, check out the shale maps showing the disparity in EURs throughout the play and how drillers have zeroed in these past couple years on a small portion of the vast area that makes up these plays. This move was the key in drillers achieving higher average EURs and lower costs...bringing profits (and bonuses) forward; while deferring taxes which created tax liabilities at some companies almost as large as their long-term debt.
Another source (from within the oil and gas industry this time) does not believe technology has lowered his firm's costs. Darren Gee is CEO of Peyto Exploration. Peyto is one of Canada's lowest cost producers and was recognized last year as "Producer of the Year" by Oilweek Magazine. In his June 2014 newsletter, Mr. Gee indicates that new technology has not lowered supply costs. The advantage of this new technology is that it unlocks additional resources and accelerates capital investment. "Our total costs are not lower today, or over the last several years, than they were before we started to use the 'new technology.' … We are making the same amount of return, just on a larger amount of capital."
Plausible Reasons for Mispricing of Long-Term Natgas
Producers are writing off billions in losses, selling land, leases and future production to stay in business in an attempt to continue investing in negative cash flow dry shale natural gas with wells that are ~90% depleted within three years. One of these activities is debt hedging natural gas to increase their borrowing base at the banks. This puts downward pressure on the futures curve.
It is also important to realize that it is very beneficial to the oil & gas industry to have the perception of low natural gas prices for years to come. It helps persuade decision makers to make capital investments in manufacturing plants, shut down coal plants, build LNG export terminals, etc. It helps with politicians who must decide on regulations, infrastructure subsidies, etc. There is a great deal of interest in keeping the natgas futures curve relatively flat.
Risks to Downside
2019 natgas contracts may not be honored. The hyper-leveraged economy could blow up. Natgas producers who sold these contracts could go out of business en masse.
A century-old extractive industry could make another technology leap forward that drives down costs to a level that would make up for the gradual move to less economic areas of the shale plays, ramping natgas demand and increasing costs in other parts of the full-cycle.
However, some believe that the recent 'technology gains' are more a function of zeroing in on the core of the play than on new technology. It may be more important to have contiguous shale that is porous enough for fracturing, yet not so porous so that the proppant will not hold open the fractures. Deep enough to be far away from water tables; yet not so deep as to make drilling cost prohibitive. 'New technology' makes Marcellus so cheap yet it does not make Haynesville cheap. Perhaps it has always been about geology.
Technology advances in competitive forms of energy - such a large improvement in solar efficiency or a dual-carbon battery. Such improvements would take years to implement, so they would have less effect on the price of natgas a few years out than a company whose value is the NPV of the next ~10 years.
Technology improvements that enable the easier use of natgas - such as an advancement in GTL technology … or Japan's dual-carbon battery. These are advancements that would accelerate the 'connection' to oil.
Middle East - What if the current trends in the Middle East continue and oil skyrockets? The technology exists today to move the U.S. off imported oil. It's really pretty simple. A small CNG tank could be installed in current vehicles for less than $3,000 per vehicle. The car runs on CNG the first 60 miles or so each day (which is less than most drive), then seamlessly switches to gasoline … if required.
The CNG tank could be filled each night through the home's current natgas system. The current CNG home refueling device (Phill) costs $3,000. However, both GE and Westinghouse are working on their own versions. Eaton plans to have a $500 device on the market by 2015. These devices could be as commonplace as washers and dryers.
The current oil to natgas ratio is 25. The historic average before the "shale gale" was 10. Since oil and gas do not directly compete today, this is more of an interesting factoid than something in which to base an investment decision. This relationship is just an upside potential. If natgas gets "connected" to oil using our current automobiles and current fuel infrastructure with the objective of getting passenger vehicles off imported oil with a Manhattan Project sense of urgency, the ratio goes back to 10:1 or lower.
Interest Rates - Rising rates will be particularly onerous on capital intensive, negative cash-flow businesses with quickly depreciating assets. The fossil fuel industry has been labeled the "Subprime Danger of this Cycle." Higher rates could hurt valuations of oil & natgas companies while at the same time increasing the price of natgas itself.
Medical/Health Issues - The Concerned Health Professionals of New York just published their 70-page study (with 340 references) outlining these fracking concerns:
"Air pollution, Water contamination, Inherent engineering problems that worsen with time, Radioactive releases, Occupational health and safety hazards, Noise pollution, Light pollution and stress, Earthquake and seismic activity, Abandoned and active oil and natural gas wells (as pathways for gas and fluid migration), Flood risks, Threats to agriculture and soil quality, Threats to the climate system, Inaccurate jobs claims, Increased crime rates, and threats to property value and mortgages and Inflated estimates of oil and gas reserves and profitability."
We learn more with each passing year about the effects of fracking. Who foresaw that injecting frack wastewater would cause earthquakes? No one understands the long-term consequences of fracking with the new chemicals, higher pressures and spatial intensity. Not suggesting a ban on fracking will occur - just that the costs to address these issues is trending up.
Community Push Back Continues to Grow - over 400 communities have enacted measures to ban or limit fracking. These local communities are not watching the movie Gasland and then natgas industry commercials, and coming to a decision. They are living through it. With time and experience comes knowledge. When a community has other sources of income; other uses for the land - fracking and all that it entails is less acceptable. The more communities that ban fracking; the more fracking pushes up against population centers - the higher the costs.
Climate Change - without debating whether it is real or not - the preponderance of experts (in the U.S. and worldwide) believe that it is. If significant weather events affecting large groups of people continue - like a large hurricane hitting NYC for example - you can bet it will be pegged to climate change and efforts will accelerate to move off coal.
At current low long-term natgas price levels, investors buying these contracts actually help natgas end users. As it now stands, E&P companies are refusing to invest in future production until they can lock in higher future prices (see EOG quote above). This results in shortages and price spikes when supply cannot meet demand.
The future is unknowable, but most of the trends already in motion are supportive of higher future natgas pricing. The same cannot be said for the other places to invest your money in the oil & gas sector. Many trends above will increase E&P company costs and lower profitability. The 'picks and shovels' investment in pipelines, etc. is well advertised and may be appropriately valued.
Near-term natgas is as variable as the weather. As for natgas futures in a year or two - we are still dealing with the excesses of shale investment while demand catches up. Also, we have to guess whether E&P CEOs will try to grow an empire with other people's money or be conservative, cut investment until prices rise and risk the wrath of Wall Street for not growing production.
When you invest in an oil and natgas company, you invest in…oil and natgas. It is natgas that is mispriced; the same cannot be said for $90 oil - so why invest in oil?
When you invest in an oil and natgas company, you effectively invest in the futures strip for approximately 10 years forward - since that is the best guess of their future revenue stream. Natgas supply has outpaced demand, so why invest in the next few years of low natgas prices? And why take the risk of technology/pollution issues negatively affecting oil & gas company assets in the 2020s?
Bet on the 'puck' continuing to travel in the same general direction it is moving. Bet on the trends currently in motion to continue in motion … even accelerate. Pick a 'sweet spot' and I suggest that the sweet spot for natgas is 2019.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Long 2018/19 natgas futures; short EUR/USD in an equal dollar amount.