Natural Gas And Coal Economics Bode Well For Gas To Liquids And Coal To Liquids

by: Robert Wagner

Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.

I recently wrote an article about the profitability of a gas-to-liquids (GTL) plant. The key point is that GTL is profitable at about a 10- or 11-to-1 ratio of oil to gas depending on if you use million cubic feet (MCF) or million BTUs (mmBTU). Right now, a barrel of crude oil sells for about $107 and natural gas goes for $3.67/mmBTU, for a ratio of about 29 -- well over the break-even level.

The biggest threat to any biofuel, coal-to-liquid (CTL), and/or GTL plant is the cost of their feedstock. People that originally planned for an ethanol plant back in 2004 were using estimated corn prices of $2.00 a bushel. The problem is that ethanol totally changed the market, and ethanol plants became their own worst enemies as their additional demand drove corn prices to levels that made ethanol unprofitable. Ethanol now consumes around 40% of U.S. corn production and has driven corn prices to over $6.00 as recently as mid-June. Biodiesel experienced the same phenomenon where soybean oil has tripled since 2002, and yellow grease, which used to be a waste product, now sells for over $0.34/lb.

Because farmland is of limited supply, and biofuels compete with demand for food, biofuels using food-based feedstocks are relatively inelastic when capacity utilization is so high. So the ability to satisfy a large percentage of our energy demand with these biofuels is highly unlikely, if not impossible. The more food that is diverted to biofuels, the less food there is to eat -- and that isn't a politically or economically favorable situation.

Cellulosic biofuels plants like KiOR (NASDAQ:KIOR) don't compete with food, and use far more elastic feedstocks. In my opinion, using non-food feedstocks are the only biofuels that have any realistic chance to survive in the long run. With a growing world population, the decisions come down to people starving or continued production of an inefficient and costly fuel. The starving people will most likely win that vote -- at least I hope so.

The other alternative to solving our energy problem is to simply use the abundant energy resources that we already have. The U.S. is considered the Saudi Arabia of coal and natural gas -- and if things continue as they have been, maybe even crude oil. More importantly, the U.S. government has been "waging a war on coal" in its efforts to bankrupt the major users of coal, coal-burning power plants.

'We are the Saudi Arabia of coal,' Cantor said.

More than 90% of U.S. coal production goes to generate electricity in the United States, according to the National Mining Association. Cantor explained his point about coal.

'We ought to be able to figure out a way to use that resource so that we can continue to compete,' he said.

Ironically, this "war on coal" may result in the unintended consequence of more coal and natural gas production. The reason is simple economics. By killing the demand for coal, the price of coal has fallen dramatically.

As the price of coal falls, the profitability of CTL plants increase. Right now the highest and best use for coal is generating kilowatts of electricity. One ton of coal can produce 1,870 Kwh of electricity. The national average price of a Kwh is around $0.128, so one ton of coal is worth about 1,870 x $0.128 = $239 worth of electricity. Even with that seemingly profitable venture, coal burning plants are closing all across the nations due to costly new regulations.

AKRON, Ohio -- FirstEnergy Corp. is planning to close two additional coal-fired power plants rather than clean them up to meet federal mercury emission standards... The move will eliminate the jobs of 380 employees... the company said it had estimated that the installation of new pollution control equipment at the two power plans would cost about $270 million... 'The decision is based on the cost of compliance with current and future environmental regulations in conjunction with the continued low market price for electricity,' the company said.

One ton of coal has the energy equivalent of about five barrels of oil, so the energy cost per unit is extreme low. Depending on the quality of the coal, a ton may cost only $10.00 or less. Recent advancements in CTL technology have developed a process that can produce 1.5 barrels of oil out of a ton of inexpensive Texas Lignite Coal. Clearly there is some waste in the system, leaving 3.5 barrels of energy un-utilized in the process, but it is still cost effective.

'We're improving the cost every day. We started off sometime ago at an uneconomical $17,000 a barrel. Today, we're at a cost of $28.84 a barrel,' said engineering dean Rick Billo.

Texas lignite coal is dirt cheap -- less than $18 a ton. A ton of coal will produce up to 1.5 barrels of oil.

Various studies estimate that CTL plants are profitable when oil gets above $45 to $50/barrel. The main problem being the huge barrier to entry to this industry. It takes over $500 billion to join the club.

In terms of economics, coal-based liquid fuel becomes viable when the per-barrel price of oil exceeds the $45-$50 range, according to separate studies. This is because of high front-end expenditures -- a 10,000 barrel-a-day plant could cost $600-$700 million or more to construct. All told, the refinement process is three to four times more expensive than refining an equivalent amount of oil. When biomass is mixed with coal, the process becomes even more expensive, and is only viable with oil prices above $90 per barrel, according to the Department of Energy.

Because of the huge supply and variety of cheap coal available on the markets, combined with technical advancements, CTL economics are very strong and likely to get stronger. The stronger the government works to kill the demand for coal, the more economical CTL will become. The government's efforts have been a complete disaster at lowering fuel prices, so with oil above $100/bbl and the prospects of pigs flying being better than wind and solar ever succeeding, fuel prices are likely to remain high. Investors shouldn't buy the green hype about wind and solar.

There is a reason Solyndra didn't power their plant with solar panels, and why GE doesn't power their plants with wind. The "green" economy is a lot like the mortgage industry before the 2008 crash, where the beneficiaries didn't have any "skin in the game." Environmental groups that push these industries wisely get the government to "invest" the tax payers' money -- they don't invest their own money in these projects. That is why when Solyndra and countless other wind and solar ventures go belly up, tax payers -- not the Sierra Club -- take the loss. Also, in my opinion, you shouldn't believe the "science" behind man-made global warming, climate change, and/or the coming ice age.

The economics for GTL are even better and more quantifiable than CTL. Natural gas is pretty much natural gas, and you don't have countless qualities of it trading on the markets like you do with coal. The key point, however, is once again that the biggest threat, outside government regulations, to these industries is the elasticity of their feedstock. The ideal industry would have a feedstock that has a highly elastic supply, so that an increase in demand won't drive its price higher. Natural gas looks to be one of those industries.

Since September 2011, the Baker Hughes Rig Count Index has been more than cut in half, with the rig count dropping from over 900 to around 370.

Click to enlarge images.

That 60% drop in producing wells resulted in a doubling of the price of natural gas, but even with a doubling in its price, the gas-to-oil ratio is still well above the 10 or 11 that is required to break even. More importantly, those capped wells represent potential future production that will help keep a lid on any future price increases.

Surprisingly, even with the capping of over 50% of the wells, production remains essentially unchanged.

This is due to various factors:

  1. The rigs targeting gas right now are likely targeting the most productive and economic wells, and the rigs that were put out of work were targeting the more marginal wells. This has resulted in a large cut in rigs, without a proportionate cut in supply.
  2. Rigs that are classified as targeting oil are not included in the natural gas rig count, and oil wells produce both oil and natural gas (often called 'associated gas' when it comes from an oil well). Oil prices have remained relatively robust, and the pace of oil drilling has remained frenzied, with the byproduct being associated natural gas production.
  3. Producers have become more efficient at producing more gas with less rigs due to advancing technology and deeper knowledge about the areas in which they are drilling.

Because supply hasn't decreased during the period when the price of natural gas doubled, one would have to conclude the price increase must have been caused by an increase in demand, most likely coming from power plants that have been converted from coal to gas.

Over the past year, the single most important change to the U.S. natural gas market has been the huge surge of gas demand related to power generators switching away from coal toward natural gas. Through just the first seven months of the year, we estimate that U.S. natural gas demand has surged by a whopping 5.5 Bcf/d, solely due to coal to gas-fired power switching, and for the full year, we expect 4.2 Bcf/d of switching.

With that kind of enormous and sudden boost in demand resulting in only a doubling of natural gas prices, and the gas-to-oil ratio only falling to 29-to-1, the economics of GTL look pretty promising.


The irony of Washington's war on fossil fuels is that it will most likely result in a greater demand for fossil fuels in the future, not less. As the price of coal and natural gas fall, the economics of CTL and GTL improve. Given that Washington is mostly focused on wind, solar and ethanol as solutions and I expect to see its totally ineffectual -- and some would say counterproductive -- energy policy continue, prices for fuel are unlikely to fall anytime soon. Combine that with the fact that it is doubtful that we will be powering jets with wind, heating our homes at night with solar, or the U.S. auto fleet upgrading to E15 and above vehicles anytime soon, the demand for conventional energy should remain intact as should the solid economics for CTL and GTL. Investors interested in CTL and GTL firms should study the Fischer-Tropsch process on which it is based, and then analyze companies like Sasol (NYSE:SOL), Shell (NYSE:RDS.A) Oxford Catalysts/Velocys (OCG), Syntroleum (NASDAQ:SYNM), and Rentech (NYSEMKT:RTK). Depressed coal and natural gas companies may be worth analyzing as well.

Disclosure: I am long SYNM. 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.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.