Like Corn Ethanol, It's Possible For Gas-To-Liquids To Be Too Successful

Includes: CHK, DVN, OXFCF, SSL
by: Tristan R. Brown


The shale gas boom in the U.S. has caused domestic natural gas prices to fall sharply since 2008. More importantly, it has caused the price of natural gas to diverge from the price of WTI crude, breaking a relationship between the two prices that has been very tight historically (for more details, see my article from last August on the subject).

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Henry Hub Natural Gas Spot Price data by YCharts

As a result of this divergence the U.S. Energy Information Administration [EIA] now forecasts the nominal price of natural gas in 2035 to be less than half of what it would be were the historical price relationship to continue.

Historical and forecast percent change in WTI and natural gas nominal prices, 1986-2035 (Source: EIA 2012 Annual Energy Outlook)

One consequence of this development is that U.S. gas-to-liquid (GTL) pathways now look far more economically feasible than they have in the past. GTL pathways convert natural gas to gasoline, diesel fuel, and jet fuel. Historically they have been unattractive within the U.S. due to the close relationship between natural gas and petroleum prices; any increases in their attractiveness resulting from higher transportation prices (and thus higher pathway output values) were quickly offset by higher natural gas feedstock costs. Shale gas production has created a new operating environment in which natural gas prices have fallen even as petroleum prices have risen. Several companies are now moving forward with plans to build large GTL facilities as a result, as detailed in my August article and, more recently, in an article by Bloomberg.

Corn ethanol's lesson

While the economics of GTL pathways look attractive at the moment, the experience of the U.S. corn ethanol industry is a valuable lesson for the nascent U.S. GTL industry. In 2005 a large gap opened between the prices of corn and WTI crude (see figure). This, combined with substantial federal government support for the corn ethanol industry in the forms of the Variable Ethanol Excise Tax Credit [VEETC] and the first Renewable Fuel Standard [RFS1], launched a period of growth in U.S. corn ethanol production that at times slowed, but never stopped, over the following seven years.

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WTI Crude Oil Spot Price data by YCharts

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US Fuel Ethanol Production data by YCharts

U.S. corn prices have largely tracked the increase in corn ethanol production since 2005 (but not completely - see figure), as the production increase has created additional demand for corn as ethanol feedstock.

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US Corn Farm Price Received data by YCharts

The increase in the price of corn (even prior to the recent drought in the Midwest) has been substantial enough to outstrip that in WTI crude (see figure). This has resulted in narrowing (and ultimately negative) gross profits for corn ethanol producers, causing them to shutter facilities in response. While it is the drought that has eliminated corn ethanol producer's profits, the tightening of the spread between WTI crude and corn prices since late 2010 due to continued increases in corn ethanol production set the stage for the industry's current economic environment; the drought simply pushed the diminished profits into negative territory.

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WTI Crude Oil Spot Price data by YCharts

GTL and natural gas prices

The GTL industry finds itself in a similar situation to the one the corn ethanol industry was in back in 2005. The spread between its feedstock (natural gas) and products (gasoline and diesel fuel) has greatly widened, promising significant initial gross profits for early producers. The economic attractiveness of GTL can be illustrated using numbers from the aforementioned Bloomberg article, which quotes GTL company Oxford Catalysts (OTCPK:OXFCF) as being able to produce a gallon of diesel via GTL for $1.57 at a 21 million gallon per year [MGY] facility, assuming a natural gas price of $4/mscf; a 21 MGY facility is further stated as costing $150 million. Assuming an annual capital charge equal to 15% of capital costs, annual facility operating costs (ex-feedstock) equal to 7% of capital costs, and a GTL yield of 1 gal diesel fuel per 272 scf natural gas, the facility's minimum fuel selling price [MFSP] (which is a function of both capital and operating costs) is calculated to be $2.64/gal. The EIA's 2012 Annual Energy Outlook [AEO] forecasts an average pre-tax diesel fuel price of $3.48/gal over the next 20 years, which results in a substantial spread for GTL producers under such a scenario. Even incorporating the EIA's forecast average 20-year natural gas price of $5.19/mscf yields a MFSP of $2.96/gal, which is still well under the forecast pre-tax diesel fuel price.

There is an important assumption behind this scenario, however. As the corn ethanol industry has learned, feedstock costs do not remain static if pathway production increases greatly. While the 2012 AEO does not forecast prices for a scenario involving large-scale GTL production in the U.S., it is possible to extrapolate the results of an AEO scenario involving increased use of natural gas fuel by heavy duty vehicles [HDV] to give us an indication of the sensitivity of future natural gas prices to demand. Please note that this is not a comprehensive econometric methodology and the results should not be given the same weight as the EIA's forecast. Rather, this numerical experiment demonstrates the inherent limitation behind the common assumption of static GTL feedstock costs.

The EIA forecasts that the increased demand for natural gas resulting from increased use of natural gas fuel in HDVs causes a rise in Henry Hub spot prices (see figure), which is to be expected.

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Correlation between the Henry Hub spot price increase and U.S. transportation sector natural gas demand increase under the 2012 AEO HDV NG Potential scenario, 2012-2035

While the EIA doesn't forecast natural gas prices for a scenario involving a demand increase of more than 1.8 trillion scf over its reference scenario, the above regression can be used to calculate prices for further demand increases. By adjusting these demand increases to the quantity of natural gas required to supply a 21 MGY GTL facility, we can estimate the increase to the EIA's reference scenario natural gas prices under additional scenarios involving different GTL production volumes (see figure). Finally, these new natural gas prices can be fed back into the MFSP calculation to determine the level of total GTL production that will result in the pathway no longer being competitive with petroleum due to high feedstock prices; in other words, the level of GTL production that causes the GTL MFSP to exceed $3.48/gal (the EIA's average 20-year pre-tax price of diesel fuel) due to higher natural gas prices.

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Increase in natural gas price over the 2012 AEO 20-year average according to total U.S. GTL production

This methodology calculates a MFSP at a 21 MGY GTL facility of $3.48/gal when the natural gas price reaches $7.09/mscf, or an increase of $1.90/mscf over the 2012 AEO average 20-year price. The above figure shows that this price increase is reached when total U.S. GTL production equals 17 billion gallons per year [BGY]. This is not an insubstantial number; annual U.S. corn ethanol production in 2011 was 8.2 BGY on a diesel fuel-equivalent basis. That said, this assumes that natural gas consumption for electricity generation increases by a total of 9% over the next 20 years (from 7.9 trillion scf to 8.6 trillion scf), and U.S. natural gas exports increase by 2.6 trillion scf. Any substantial increase over this reference scenario in the replacement of coal with natural gas for electric power, or exports of natural gas by either pipeline or LNG facilities, will lower the GTL production threshold.

Furthermore, this calculation does not take into account lower diesel fuel prices resulting from greater diesel fuel supply due to GTL production, which would lower the threshold still further. The 2012 AEO projects total U.S. demand of gasoline, diesel fuel, and jet fuel (GTL can yield all three, although gasoline requires additional processing) in 2031 to be 209 BGY, so even an optimistic scenario suggests that GTL will be able to supply only a small fraction of U.S. transportation fuels before GTL products are no longer cost-competitive with petroleum products.

As a final note, this calculation does not consider large-scale GTL facilities such as Pearl GTL in Qatar, which yields 2100 MGY of liquid fuels. In theory larger facilities are able to take advantage of economies of scale to reduce MFSP via lower unit capital costs; a scaling factor of 0.6 is commonly used to account for this advantage. However, the Pearl GTL facility incurred total capital costs of up to $19 billion, which translates to a scaling factor of 1.05 based on the 21 MGY facility numbers provided in the Bloomberg article (a scaling factor greater than unity suggests diseconomies of scale, in which unit capital costs increase as capacity does). The use of the 21 MGY facility numbers is therefore an optimistic assumption.


The breakdown of the relationship between the prices of natural gas and WTI crude in the U.S. has created a favorable economic environment for domestic GTL producers. This environment is expected to continue to be favorable over the next 20 years, according to the EIA's 2012 Annual Energy Outlook, although higher natural gas prices over that period will make it less favorable with time. While GTL will be able to play a role as a domestic producer of transportation fuel, its contributions will be capped by higher natural gas prices resulting from increased natural gas demand. While this article employs optimistic assumptions, it finds that GTL is unlikely to meet more than a small fraction of U.S. transportation fuel demand, at which point continued production will no longer be cost-competitive with petroleum. Much as the U.S. corn ethanol industry has out-priced itself from the market due to increased corn demand, the GTL industry will reach a similar point before it is able to substantially displace petroleum consumption.

From an investment standpoint, investors looking to gain long-term exposure to increased GTL production in the future will be better served by investing in companies with a heavy emphasis on natural gas production, such as Chesapeake Energy (NYSE:CHK) and Devon Energy (NYSE:DVN), than they will by potential GTL producers such as Oxford Catalysts and Sasol (NYSE:SSL). GTL producers will be faced with high initial capital costs and diminishing gross profits over time due to higher feedstock costs as total production increases. Natural gas producers, on the other hand, will benefit from the higher natural gas prices resulting from increased GTL production; indeed, this is one reason that Chesapeake Energy has invested heavily in both LNG and GTL companies. Unlike GTL producers, the long-term prospects of U.S. natural gas producers will be greatly enhanced by widespread domestic 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.