Mr. Miller would urge a healthy dose of skepticism on the US becoming a major exporter of Natural Gas. Within the last ten (10) years, the US has gone from abundant natural gas supply projections (i.e. dash to Natural Gas of late 1990's), to massive projected shortfalls of natural gas (i.e. development and construction of multiple LNG import terminals) and now back to projections of massive supplies of natural gas for the domestic and potential export market.
Mr. Miller would like to review some of the basic problems facing the US Natural Gas market, which will drive up prices significantly, most notably new and substantial environmental taxes will be levied on the "gas fracking" market by individual States to appease the public and replenish depleted State budget gaps, significant deficiencies in natural gas distribution infrastructure, and the unknown production decline curve variables associated with shale gas wells.
Mr. Miller's message is simple, don't get too excited about the US becoming a major natural gas exporter on the fly; there are significant very capital, infrastructure and environmental barriers.
Sometimes the message has to be repeated, much like the military mantra; tell them what you are going to tell them, tell them, and then tell them what you told them, and tell them again. Financial markets have a very short memory as history has shown, so lets tell them again.
The U.S. needs a credible and sensible energy policy and emissions plan. We also have significant infrastructure problems, an aging pipeline and gathering system, among other challenges.
Natural gas produces have attempted to put the "cart before the horse" and we are now stuck with excess gas supply. The U.S. critically needs pipeline, gathering and processing facilities and infrastructure, which will take another ten (10) years to build out in any meaningful scale.
Why is Natural Gas Not in State of Permanent Excess Supply
Mr. Miller is a strong proponent of natural gas and called the revival of natural gas in 2009, but the gross inaccuracies being portrayed about Natural gas production, supply, and end use require immediate correction for the benefit of public interest.
Natural gas is utilized by three major class of consumers; i) the power generation industry; ii) the industrial complex; iii) the local utilities across the U.S. which distribute natural gas to individual homes and office buildings.
As Mr. Miller details in review of the "Dash to Natural Gas" of the 1990?s through 2003, a tremendous amount of natural gas fired power plants were constructed, some in "demand centers" or major consumption areas, some in fringe areas like the southeast U.S. and some in outright poor locations. To put the rationale to construct all of these natural gas fired power plants in layman terms, these natural gas fired power plants were supposed to replace the older coal fired power plants controlled by the regulated utilities across the country, be more efficient, and emit much less CO2.
The industry forecast and thesis at that time was for natural gas to be priced at $3.50/$4.00/mmbtu in perpetuity, as natural gas was reported to be in oversupply, plentiful and would never in theory be interrupted, thus always available for firm deliver.
The plants were built on a scale never seen before in U.S. History, over $500 billion of debt was added to the top 80 utilities and natural gas companies going into 2001, and then the independent natural gas power plant market promptly crashed, went into financial distress and faded away from the mainstream.
The regulated utilities would not close the older, less efficient, and larger carbon emitting coal plants, nuclear stranded cost were winding down and the owners of nuclear power plants had substantially reduced amortized cost basis, thus could sell their power cheaper than natural gas plants, and the U.S. never implemented a national energy plan, and natural gas was not always available in certain regions during peak demand, and thus not in oversupply.
These natural gas power plants are still on the ground, some running, some mothballed. If natural gas were truly "in permanent excess supply", the utilities would immediately shut down hundreds of the coal plants running 24 hours a day across the country, fire up the natural gas plants under their control, and contract with the independent power producers who control the other natural gas plants.
This has not happened during the past ten (10) years, nor will it happen anytime in the foreseeable future.
It is very positive that independent gas producers have started to discover and exploit alternative means of extracting natural gas from shale and tight sands, within the U.S. borders, as Mr. Miller firmly believes and has advised Washington and the industry that it will become a "bridge" fuel by default. Despite the fact that Washington simply does not have the energy market knowledge or capacity to implement a credible energy plan for the U.S. at the current time.
The hope of a bi-partisan energy plan has escaped the current administration, despite continued counseling from Mr. Miller and many other senior energy executives.
Wholesale natural gas prices are approximately $4/mmbtu today and we still have significant idle capacity of natural gas plants in the US. Keep that thought in mind, as it will become a very important factor in determining how much renewable energy each State in the US should be and can pay for above the marginal cost of natural gas electricity production.
By far, the largest consumer of natural gas should be the power generation industry across the U.S. If CO2 limits are put in place by the Federal Government at some point in the future, or individual states through the imposition of CO2 non-attainment zones, displacing and disadvantaging coal fueled plants, and all or a large portion of the natural gas power plants on the ground today were to be run as base load (running 24 hours a day) plants, excluding the small gas peakers, a tremendous strain would be put on the natural gas distribution system (major pipelines and local distribution pipelines) and diminishing any "purported permanent excess supply.
Secondly, if the local utilities started pulling gas at higher rates through the City Gate (delivery points for natural gas to major retail consuming areas like Chicago, for example), due to retail consumers using a greater amount of natural gas, a further strain would be put on the distribution system, in addition to further diminishing any "purported permanent excess supply".
Thirdly, if the U.S. industrial complex started pulling more natural gas into their industrial facilities (the Texas/Louisiana petrochemical/refinery complex for example) a further strain would be put on the distribution system, in addition to further diminishing any "purported permanent excess supply".
Fourthly, if we start fueling truck fleets and other transportation vehicles with natural gas, the question must be asked, is supply sufficient at peak heating market demand time of the winter months and peak cooling season of the summer? Is the transmission and distribution system in place to handle such use of natural gas that we can say with authority that "natural gas is in permanent excess supply"?
Also, do we have the necessary "high deliverability gas storage facilities" (salt dome or depleted fields) to handle these large withdrawals and swings of natural gas to meet excessive demand, which would essentially break the current seasonal injection period during the summer months and withdrawals during the winter months?
There would be no injection season as the industry knows it today, and no historical statistics to use as a benchmark, thus prices would continue to be volatile, reflecting a more real time supply/demand ratio for physical natural gas and for future delivery (futures contract), which they should.
Those that can pay for the physical resource in real time would set the price of natural gas, and Mr. Miller is firmly convicted this will lead to higher price volatility over time. This is what is commonly referred to as a "free market".
However, lower natural gas prices are the penalty for near term overproduction forecast to last through 2015.
Take for example the construction of a wind park in the desert of Arizona or Nevada for example, without a transmission line to deliver any electricity produced to the end user. The wind park owner could say that he has excess power supply; however, he has no means of transmitting that power supply to an end user, rendering the wind power useless.
If natural gas were in "permanent excess supply" there would be no independent natural gas producers in business such as XTO (Exxon), EOG, DVN, CHK, APC, and many other independent producers.
Also, signing long term contracts with end users to lock in a percentage of natural gas production is a long standing practice in the industry; alternatively locking in the price the natural gas producer receives through a long term natural gas swap.
These are a positive event for the industry, as long term contracts allow producers to gain financing of their production operations, not a negative sign or downward price signal. In fact, history has shown that the higher percentage of long term contracts put in place, the scarcity of supply principle takes over, and prices become more volatile and sensitive to supply/demand events, given a larger portion of the commodity is locked up and a smaller portion is available for the spot market or for future delivery. Thus natural gas prices rise.
There was a time in the 1980's when independent natural gas producers could not even get financing to produce the gas in the ground that they owned under conventional drilling and recovery methods, that's why we as an industry invented the gas bank deal structure, to help finance these producers and bring natural gas to market. We opened up the natural gas pipelines, deregulated the industry and created "open access", thus a free market.
If the U.S. were awash in natural gas, we would move to shut down the coal industry, stop building wind farms and solar farms, and there would be no need for a comprehensive energy plan for the U.S. to gain energy independence. We would simply flat-line natural gas prices at the $4/mmbtu price range.
This will not happen anytime in the near future. Natural gas is a fuel of the future, but price volatility will rise, not fall and this is not a bad thing. It is a sign of a healthy, vibrant, and credible asset class.
Winter/summer: There are Two Natural Gas Peak Seasons in the U.S.
Lest we forget, we constructed over 250,000 megawatts of natural gas fired generation in the U.S. ten years ago with efficient heat rates (energy conversion factors), and they will be used more often each year going forward, as we experience more extreme winters and summers.
Investors should keep in mind, that during peak season and usage, the mainline pipeline systems in the U.S operate at or near maximum capacity, and "statistical natural gas in storage" is not always available, which is why we have massive price spikes at the "City Gates" or major consuming and producing areas. (Chicago, New York, and Los Angeles, etc.)
"Mr. Miller believes that the natural gas market is not currently pricing in winter demand properly and is not pricing in a normal summer peak demand, given the recession, not pricing in the environmental taxes forthcoming, not pricing in the substantial increases in transportation and distribution infrastructure and other potential federal charges.
Mr. Miller believes there are fundamental flaws in estimating working gas in storage, actual deliverability of gas when required, insufficient mainline transportation and future environmental taxes ."
While the NYMEX Natural Gas Futures Contract is a useful reference, what is more important is what is happening on the ground at the wellhead, compression station, storage facility, power plants and industrial consumers and the City gates.
Mr. Miller's often cites the example of building a wind farm in the desert; you can build the most efficient wind farm money can buy today, but if you don't have wind, and you don't have a transmission line and a massive renewable energy credit and federal tax credit, you have scrap value. Thus, natural gas in the ground or in storage is not natural gas in the pipeline, or at the demand center.
The US is in a completely new paradigm and there is a significant lack of experienced energy executives capable of managing off of these new operations, market risk, and political factors.
Production Questions-Decline Profile
The natural gas production decline curve for shale and tight sands natural gas production is the wild card, and lack of robust and long term production data is a significant risk to reserve projections.
The decline trend in natural gas well production is dictated by natural geologic formations, rock and fluid properties among other factors. Thus, a major advantage of decline trend analysis is inclusion of all production and operating conditions that would influence the performance of natural gas wells.
For illustrative purposes, the standard declines (observed in field cases and whose mathematical forms are derived empirically) are:
- Exponential decline
- Harmonic decline
- Hyperbolic decline
As an example a study was done on a few specific wells for production histories of fractured low permeability gas wells in the Piceance Basin in Northern Colorado, which are characterized by a sharp initial decline followed by a long transition into exponential decline.
These two decline periods correspond to linear and pseudo steady-state flow, respectively. Predicting rates and reserves based on test data or short production Predicting decline rates and reserves based on test data or short production histories is difficult using conventional decline curve analysis, thus making shale gas and tight sands production curves difficult to forecast.
The usual approach to predicting reserves by decline curve analysis, in this type of well, is to arbitrarily assign a high exponential decline rate for the first two or three years, followed by a lower decline. Another approach is to find a hyperbolic decline curve to fit the early tine data and extrapolate to estimate future rates. Both of these approaches can result in large errors in calculated reserves.
"Simply put, we don?t know how steep the production decline curve will be for non-traditional natural gas production will be. There is no quantitative evidence that analyst can use today to support excess supply of natural gas in the future, further pressuring prices to the upside."
Renewable Energy: Politics and Ties to Unstable Wind and Solar
Mr. Miller has also provided endless advice to the current democratic administration regarding renewable energy. Better to retreat, regroup, and reform for a later date in the future. Additionally, it seems the Democrats did not bother to even look into the Department of Energy's own internal energy forecast, that 78-80 percent of the U.S. Energy will be supplied by fossil fuels by the year 2035.
The public companies in the renewable energy sector will continue to be very volatile and face extreme pressures and difficulty to deliver the promised growth in net earnings and tangible asset growth. The renewable energy sector is still a very long way from competing with the net cost of fossil fuels as measured by generation energy source and recouping the required substantial investments necessary to justify the current sector valuations.
Net Generation Shares by Energy Source: Total (All Sectors)
Coal - 46.8%
Natural Gas - 20.3%
Nuclear - 21.2%
Petroleum - 1.3%
Other Energy Sources - 3.9% Hydroelectric Conventional - 6.5%
Source: Energy Information Administration
Distribution Problems-pipelines, LDC's
Investors should keep in mind, that during peak season and usage, the mainline pipeline systems in the U.S operate at or near maximum capacity, and "statistical natural gas in storage" is not always available, which is why we have massive price spikes at the "City Gates" or major consuming and producing areas. (Chicago, New York, etc.)
Do not be fooled or lulled to sleep by looking at one static statistic that says we have massive excess natural gas in storage in perpetuity. This is not only not true, it is quite the opposite, we have massive infrastructure problems and a very old core pipeline and gathering system in the US and lack of pipeline transmission and laterals to for new production to service power plants and industrial users.
We have lost much of our executive expertise related to natural gas and oil contracting, hedging, and risk management over the last ten to fifteen years in the U.S. Don't be misled by a natural gas or oil producer announcing that they have hedged part of their production output as being something negative.
These are powerful facts and circumstances for all investors to consider, as the U.S. is burning more natural gas and domestic demand is slated to grow much higher going forward. Investors considering a shelter from the market storm might do well to consider natural gas production companies, especially at current price levels.
A Closer Look at What Risks the Short Sellers and Speculators Face and Their Future
Financial speculators trade the financial energy commodities, primarily natural gas and oil due to the liquidity and ease of clearing and leverage they can use to establish their positions. That is the advantage of having a functioning and healthy financial system.
However, when that system breaks down, the results are severe and swift and immediately impact each and every financial institution that is providing leverage to the hedge funds; the clearinghouses seize financial assets and go into the market for immediate liquidation, which ripples through the market instantaneously in what the market refers to as systemic risk. In layman?s terms it?s a good old fashioned run on the bank and it?s not pretty and always leaves casualties.
Yet the age old problem shorts encounter when everyone piles into the same trade as they are today is they start sitting on top of each other, amplifying the systemic risk and crowding the potential orderly exit door, much like airplanes circling a busy airport, racked, stacked, and packed, as air traffic controllers would say.
Eventually each plane must land or crash for lack of fuel as every airplane has limited fuel reserves to circle the airport for a certain period of time. Traders are gambling that they have enough reserve fuel to stay aloft and not crash land.
How does that relate to energy commodities and the massive traffic jam we have in the natural gas and oil markets today? Well lets look at some basic issues facing these investors, who by are packed like sardines in a trade, which is not novel, not unique, and certainly not complex.
Speculation is a double edged sword, when it works, rewards are generous, when the blade turns, and the results are catastrophic, especially if everyone is sitting in the same sardine can, much like the mortgage backed securities trade which took down Lehman Brothers, Bear Stearns, Merrill, and almost the entire financial system.
There was no exit door big enough to allow the heard to get out quickly, efficiently and with any meaningful capital, as the market quickly went against them, thus the run on the bank.
The natural gas power plant construction boom/bust was a debt fiasco in itself, which led to the bankruptcy of NRG, PG&E National Energy Group, Mirant, and almost bankrupted many other companies including El Paso Energy, Williams, etc.
What is most important is what is happening on the ground at the wellhead, compression station, storage facility, power plants and industrial consumers and the City gates.
Summary: Natural Gas may again bust, most likely in the Producer Sector as they have, as Mr. Miller advised, put the "cart before the horse", causing substantial oversupply, racked up massive debt and leasehold obligations, and driven the net price for wet and dry gas down to uneconomical levels.
This column, Energy Commentary from Karl Miller, is the opinion of Karl Miller.
Content found in the articles is subject to the terms found in the InvestorIdeas.com disclaimer and does not represent a recommendation of investment advice. Investors should seek the advice of a qualified investment professional prior to making any investment decisions.
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