The Coming Price War Between Crude Oil And Natural Gas

by: Peter F. Way, CFA

The big difference in energy these days, not just in the US but worldwide, is reliability of supply, particularly in the abundant availability of natural gas. That reliability allows, even forces, Natural Gas to be a major energy source competitor.

Extractive technologies of the past century relied on the location and exploitation of intense pockets of hydrocarbons in underground (and undersea) formations that often were the product of geologic shifts. Pockets that divided larger pools, or entrapped resources that might otherwise migrate. Or were empty. That made them hard to positively identify, even with sophisticated testing approaches and elaborate equipment.

The ultimate test, of drilling into a prospect perhaps a mile or more down, is always an expensive gamble. So the major deposits of the Middle East, when proven long ago to be huge, became production cost reference points because the relatively simple geology there made the odds very high for being able to produce under known circumstances. The likelihood of a "dry hole" well - all expense, no revenue - is miniscule.

Imagine the difference of being able to drill into the geology of a coal deposit, where entrapped swamps of plants from an archaeological past have been encapsulated, over tens of miles in many directions, without any underground disturbances over the ages. Exploratory drilling can define the deposit's perimeter, but in between those limits, drilling would be hard to come up "dry."

Now suppose that coal deposit had the misfortune to start out in Idaho, or Switzerland, or the Andes or Tibet - where mountains are vivid evidence of geology in motion? While oil wildcatting worldwide typically avoids such places, the contrasts of locations where E&P (exploration and production) companies are forced to work (since all the easy spots are gone) makes their tasks about as difficult as in the mountains.

Extraction technology is a very valuable combination of art and science because of the pervasive role played by energy in modern-day, mechanized society. So when its practitioners are hard pressed to find better (lower cost, higher recovery) ways to do things, sometimes the obvious is hidden in plain sight.

Putting the "aha!" in oversimplified terms, the breakthrough has been one of direction.

Instead of trying to vertically hit a tiny bulls-eye of a hiding target, why not probe a giant barn-door expanse of value for its relatively limited vertical dimension of thickness and sweet-spots, and then spend drilling funds horizontally for miles, extracting manna all the way?

Lots of learning had to be done, and is still going on, to make that possible. Underground "drive" pressures are very different between shale formations and hard rock. After explosive and hydraulic fracturing of the shale, gravity can become an ally instead of an adversary in the gathering of valuable product. Separation of fluids at surface-level presents differing challenges.

And not all "unconventional extraction" projects are profitable, even at near-$100 a barrel crude prices. But many are, and some could be, even with under-$30 markets. Skills developed from experience will make many more of those.

Even so, there may still be some Middle East properties with under-$10 costs, so the Saudis and their neighbors are not facing ruin. But the glory days of international oil are winding down.

The US is not the only place where large horizontal deposits of hydrocarbon-bearing shales are present. The payoff potentials for energy users worldwide are too important to be overlooked. Consuming countries already have national ownership roles in producing entities, and those will undoubtedly extend to the "unconventional," particularly where the resources are in the host country's own borders.

Here in the US, the role of Natural Gas has been kept minimal because of its irregular availability. NG previously has been produced in association with crude oil. Where NG was a byproduct, "associated" gas that was of small value, hazardous, and had no regular market, was simply "flared.," or burned in the open air.

Encounters of big Natural Gas reservoirs caused "bubbles" of supply, relative to demand (and transportation capacity) that put a chill on NG price - but rarely so on oil or oil product prices.

The initial efforts to use horizontal drilling and hydraulic fracturing were aimed at recovering NatGas, which as it turned out, was found in stupefying quantities, far more than could be handled. Since NG was the objective, much of that found has been shut in, awaiting the construction of take-away capacities that will transport it to market.

The costs of discovery are significant enough that few companies have the financial resources (internal or external) to do a lot of this. The question of the ultimate NG sale price is always a major limiting factor.

Those ready markets are largely in electrical generation, where "dirty" coal is the principal competitor, with huge ecological handicaps. But coal will fight hard if NG prices get above $4 per mmcf. So a practical ceiling may be developing if electric utilities are to be the only NG "growth" market.

At a $4 price, anywhere NG can be transported, NG should dominate the markets for home-heating and industrial space-heating. That is because heating oil is the competition, and the BTU-content comparisons leave no room for oil to compete at present price disparities. So here is one weak spot for oil.

But the biggest undeveloped market, already in the early stages of invasion, is in transportation. There CNG and LNG already can present upwards of 50% fuel savings for long-haul truckers and intense city-delivery ops like FedEx and UPS. As well as for non-electric municipal transit systems. It is here that refined oil - gasoline - faces its most serious challenge.

Expansion of that market depends on two things: 1) availability of NG fuels on a wide geographic basis, and 2) vehicles designed for or converted to the use of NG fuel.

Task 1 is being promoted by the company Clean Energy Fuels Corp. (NASDAQ:CLNE) and obstructed by the Big Oil club, which knows exactly what its accomplishment is likely to do to profits.

Task 2 at the consumer level only has one NG-fuel-designed vehicle (by Honda (NYSE:HMC)) and now serious, developed engines designed by a subsidiary of Cummins (CMI) for truck and large vehicle usage. Conversion kits to adapt existing internal combustion engines of passenger vehicles, in widespread use elsewhere in the world, are prohibited by law here in the US. (Guess why?)

As the public becomes increasingly aware of the savings potential for them, major political issues are bound to arise. DC politicians in thrall to "K Street" interests (lobby-central, for the uninformed) are likely to face exciting times when discussions become widespread of possible $1.50 to $2 a gallon gasoline equivalents from NG forms.

Is it possible that "elected representatives" might eventually outnumber "bought" ones?

Meanwhile, back at the wellhead, conventional and unconventional producers all, to some degree, are confronted with dual product joint-costs. But while the "seven sisters" of international oil used to be able to dominate industry economics due to their size, now the capacities of the rest of the producing crowd have been significantly expanded. And their proportionate interests between oil and Natural Gas are no longer so well aligned.

Stormy times are ahead. We bet that market-makers in stocks will maintain highly competitive, well-informed sources as to which outfits present attractive capital-employment choices. Right now, in their view, there are very few under-appreciated energy equities. Not so much from hazardous market prices, as just from unrewarding ones. Here are some of the better prospects.

Independent Exploration And Production Companies:

We daily evaluate the meaning of what prices Market-Makers are willing to pay to hedge the risks they must take, in order to "fill" the volume buy and sell orders their big-money fund manager clients are demanding. The outcomes of that analysis for each of over 2,000 widely-held and actively-traded stocks is a range of prices likely enough to occur that the MMs will spend some of what could be trade spread profits on risk protection - in both directions.

Our standard of seeking buy candidates with at least a +5% upside-minus-downside odds-weighted price change prospect in the next 3 months identifies ten to twelve possibilities in the above picture. The subsequent test of how well each has done, following a time-disciplined investment process triggered by prior like forecast circumstances, is far less encouraging.

The best current candidates have been Energy XXI (NASDAQ:EXXI) and Bonanza Creek Energy (NYSE:BCEI). Each has had over 100 prior forecasts at least as favored as to upside vs. downside as now. In them BCEI made buyers a profit 86% of the time, with an overall gain of +12%, including the losing hands. At an average holding period of 32 market days, the annual rate of gain has been +143%. Worst-case drawdown days averaged -8%.

EXXI's experiences have been almost as good, winning profits 78% of the time at just under +12%, with the bad outcomes included. There it took 43 market days to bring them all home, so the annual rate of gain was +91%. The average worst-case drawdowns from cost were -10%.

The next-best E&P candidates were Continental Resources (NYSE:CLR) and Rosetta Resources (NASDAQ:ROSE), with wins in several hundred prior instances each, at a 3 out of 4 rate. But with loss-included gains of 7%+ and holding periods of over 8 weeks, annual rates of gain were in the low to mid +50%s for both. Maximum drawdowns averaged -9% and -10%.

Oil Services and Transportation:

Comparisons here are difficult because Phillips66 (NYSE:PSX) has only a year in existence, and it has been a most favorable period for refiners and pipelines. Out of the year's 252 market days, one out of every five has had forecasts at least as appealing as today's. Every single one of the 51 was closed out at a profit - no losses.

The gains averaged +11½% and took an unbelievably short 20 market days, or four weeks on average. Compounding at a rate of 13 times in a year those experiences averaged an annual rate of +284%. Maximum price drawdowns from cost were a trivial -3%.

How long that might continue into the future is an unknown that all similar firms share. But the competition all has multi-year histories spanning periods of far less favorable experiences. The fate of a PSX during such periods is not knowable.

We can, however, look at the past year for the closest competitors to see what prior forecasts like the current produced. When we do, Oceaneering International (NYSE:OII) generated the best all-like-forecast closeout returns of +8.4%, and it took holding periods of twice the length of PSX. That cut the annual rate down to +66%.

The selectivity involved in PSX's identifications from its current Range Index level (35) makes it clear that the market-makers have an excellent insight into this stock's prospects, with the result that there are no close investment selection competitors.

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.

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