shale oil and shale natural gas (iii): shale gas

shale gas vs. shale oil

The impact of the development of shale oil deposits in the US is primarily macroeconomic and global.  The effects of shale natural gas, on the other hand, are very specific to the US.

Why?  …for natural gas, in almost all cases you need a pipeline to deliver it (the other (very expensive) option is cryogenics).

As I mentioned in my post two days ago, over the vast majority of my investing career an Mcf of natural gas (one thousand cubic feet, the basic unit) has sold at more or less the same price as oil, based on heating value.  Today an Mcf sells for only a fifth of that amount.

What happened?

The simple answer is “shale.”

Three factors, the first two of which natural gas and oil share in common:

1.  Most of the costs of finding oil and gas are up front–finding prospective acreage, buying mineral rights and then drilling a well. There’s also the cost of “dry holes,” meaning wells that come up empty.

In a successful well, outputs typically beings to flow to the surface without much assistance.  The out-of-pocket cost of delivering a unit of oil or gas, once the upfront money has been spent, is pretty low.  So prices can fall a lot before output is forced off the market by negative cash flow.

2.  It’s actually worse than that.  Petroleum engineers want to create a steady underground flow of output to a given well, to ensure that the most hydrocarbons will be drained before another well must be dug.  Stopping the flow creates the risk that output will start up later at way under the former rate–and that (expensive) extra wells have to be sunk to get at the oil or gas.

In the case of natural gas, sellers also typically have long-term contracts that require them to be able to deliver specified amounts. So they’re not free to turn off the taps, even if they wanted to.   Also, oil and gas sometimes both come out of the same well so the operator is stuck taking the latter to get at the former.  In this case, giving the gas away may be cheaper than reinjecting it into the ground–which is what most places require by law.

And, of course, the development company may need cash flow from its wells to pay salaries, service debt or fund capex.

3.  Unlike oil, natural gas can’t just be sold into a global commodity market, for use anywhere.  No pipeline network, no potential customers with gas furnaces and hookups to the local gas utility = cap the well.  The gas is worthless (this was the situation in the US right after WWII).

Today, the US is crisscrossed by huge networks of gas pipelines, so that’s not a problem.  But the customer base is relatively static in the short term (the pipeline thing).  In a situation where supply is expanding and demand is relatively inflexible, the only way for the market to clear is for prices to drop through the floor.    …which is what they’ve done.

It seems to me they’re going to stay there for a long while.

implications

Natural gas customers will continue to enjoy lower bills for heating and air conditioning.  For residential users, this means more money to spend on other stuff.  For industrial, it means higher profits.

Electric utilities are starting to substitute natural gas for coal in power generation.  Again, lower consumer and industrial prices.  European companies are already beginning to complain that their electricity costs are a competitive disadvantage.

The US petrochemicals industry is structured to use natural gas feedstocks;  Europe is based on oil.  …a huge advantage for US firms.

Foreign hydrocarbon-intensive industries are beginning to relocate plants to the US to benefit from low natural gas prices.  These are typically not labor-intensive operations.  So other than construction work, no employment bonanza.  But every little bit helps.

I think we’re still in the early innings of this story playing out.

investments?

I can think of three areas:

–strong consumer discretionary companies will probably enjoy a small, but continuing, tailwind

–shale oil and gas exploration/development companies.  I haven’t looked, but my instinct would be to zero in on small rather than large, and the lowest-cost operators.

–equipment suppliers (I own Chicago Bridge and Iron (CBI)), although these have had quite a run over the past six months.

 

shale oil and shale gas (ii): shale oil

conventional wisdom…

In recent years pre=shale oil),conventional wisdom about world oil supplies has been dominated by several ideas:

–that world oil production is at, or near a peak (Wikipedia has a good summary

–that steadily increasing demand will be generated by nations like China and India (when three billion Asians trade in bicycles for motorcycles, and then motorcycles for cars…), leading to sharp price increases

–the continuing pivotal role of OPEC–despite members’ competing national agendas–both in supplying oil to the rest of the world, and in asserting the rights of the oil-producing nations to be fully paid for selling their principal asset to the rest of the world

–the (oversimplified) asymmetry between major industrial oil consuming nations, which–ex the US–have little petroleum output of their own, and producing nations, with not much going for them economically other than oil

–the central role of the US, the largest and most profligate oil consumer in the world, in moving D-day for a supply crisis closer to the present.  Two powerful special interest groups, Big Oil and Big Autos, have forged a unique alliance to block the (demand-lowering, government spending-funding) taxation of oil and oil products that is the norm elsewhere.

Less talked about, but still important, is the activity of  hydrocarbon “national champions: in places like China and Japan.  These are firms, some publicly traded, whose main mission is to secure oil supplies for delivery to the home country in times of shortage.  To them, profits are a distant second to getting control of barrels.

Other forms of planning for the upcoming shortage have been high up on the political agendas of most countries (ex the US) for years.  The development of nuclear power generation is one prominent example.

…may be turned on its head,

in two ways:

1.  The situation of the US, as the glutton at the world energy table, is changing.  It’s not that we’re consuming less.  It’s that, thanks to shale oil, domestic oil production is beginning to increase.  Also, the extremely low relative price of domestic natural gas, thanks to shale gas (tomorrow’s topic) is prompting users who can do so to switch from oil to gas.  The shale revolution is also beginning to get foreign oil users to relocate plants to the US so they, too, can use cheap gas as a feedstock.

2.  The shale oil/gas business is so new that no one knows yet what deposits may lie within the borders of large European or Asian oil-consuming nations.  These may also be very large, although natural gas recovery faces the distribution infrastructure issues I outlined yesterday.

consequences

There are certainly geopolitical implications as/if the asymmetry between petroleum producers and petroleum users shifts.  If/as that happens, will the Middle East be as important in politics?  Probably not.

Commodities speculation based on the idea of ever-rising oil prices may abate.

Alternate energy, particularly forms requiring large government subsidies, may lose investment appeal.

The oil industry itself may shift further away from the idea of Indiana Jones-like exploration for mammoth new oilfields toward the profit calculations of pocket protector-equipped mining engineers assessing recovery prospects from well-mapped shale prospects.  This probably favors smaller companies over larger ones.

Energy exploration and development firms with marginal success rates, whose main appeal is therefore their leverage to rising energy prices, become (even) more speculative than before.

shale oil and shale gas (i): oil as an investment vs. natural gas

I want to write about the changes that horizontal drilling and hydraulic fracturing have made in the economics of oil and gas by allowing drillers to tap deposits in shale.  This is the first of three posts, and contains background.

what they have in common

Oil and natural gas are both hydrocarbon energy sources.

The same exploration and development companies look for both oil and gas.  They use the same geologists, the same sub-surface mapping tools, the same drilling equipment and the same oilfield service firms to make the actual holes in the ground.

Oil and natural gas often occur in proximity.  Sometimes a single well produces a mixture of the two.

In many areas, including the US, the government provides tax subsidies to encourage exploration.

A barrel of oil is roughly equivalent in heating value to 5,800 cubic feet of natural gas.  During much of my Wall Street career (I stared out as an oil analyst), the price of natural gas and the price of oil have been tied relatively closely to one another based on this heating value relationship.  In other words, if oil were selling at a price of $36 a barrel meant that natural gas would sell at more or less $6 an Mcf (thousand cubic feet).

That’s no longer true.  The current oil price of around $100 per barrel translates, on a heating value basis, into $16.67 per Mcf for natural gas.  Gas spent most of 2013 selling at about $3.50 an Mcf.  The recent severe cold spell in many of the densely populated parts of the country has caused the spot quote for gas to spike to a bit over $5 an Mcf..  That’s an anomaly that the arrival of warmer weather will correct,  but even today’s spot price is still less than a third of the heat equivalent price of crude,

how they’re different

Crude oil reaches the surface as a liquid.  In contrast, and as the name implies, natural gas reaches the surface as a gas.  This innocuous-sounding difference has enormous economic implications.

oil is easy to transport, natural gas isn’t

The most efficient way to move large amounts of either oil or gas from the wellhead is through a pipeline.  Often, when production begins in a new area, there’s no pipeline nearby, though.  Building one  is expensive and takes time.  That’s not a huge problem for crude oil.  It can be stored in a tank by the wellhead.  Trucks will come by periodically to take the oil away, either directly to a refinery, or to the railroad or a pipeline for further transport.

Natural gas is a different matter.  There’s no practical way to store it above ground, and there are no trucks made to transport it   In the past, for wells that produce both oil and gas, drillers would “flare” or burn away the natural gas just to get rid of it if no pipeline was available.  Today, the driller is most often required to pump the gas back down below the surface rather than simply destroying it.  For natural gas-only wells, no pipeline means seal up the well and wait.

One exception:  if the amounts of natural gas in a remote location are enormous, the natural gas can be cooled until it becomes a liquid and then transported to market in special refrigerator ships.  The cost of the required cryogenic plants + special ships + unfreezing operations at the buyer’s end can run into tens of billions of dollars, however.  So this requires lots of time, operational and financial planning, as well as the creation of long-term supply contracts.

lots of buyers for oil, not so many for gas

Early in my career, I studied an offshore oil and gas financing project in New Zealand.  The oil from the field was pumped directly into oil tankers that sailed away when full.  The natural gas got pumped back underground.

Why not ues the natural gas in New Zealand?   …lots of infrastructure needed.

One thing was the cost of the required miles-long pipeline to shore.   But that wasn’t the main issue.  To get the gas to residential/commercial users, local distribution companies would need to be formed.  These firms would then have to tear up all the streets in town to lay pipelines to everyone’s doors.  Potential users would have to either replace or modify their existing oil burners  so that they could use gas.  The expense would be enormous.  So, too, the disruption to daily life.  And you couldn’t force citizens to use gas, could you?  So it would be hard to guess in advance if there would be any payoff to all this.

Another example:  in the early 1980s the US tried to promote natural gas as automotive fuel.  The effort foundered on the lack of places to refuel.  No one wanted to buy natural gas-powered cars if there were no service stations.  No company wanted to build a national chain of natural gas service stations if there were no cars.  The plans did result in the creation of fleets of natural gas-powered local delivery trucks, but little else.

the big difference

Oil can move to markets all around the world.  Natural gas generally can’t.

More tomorrow.

the shakeup at Pimco

Pimco shakeup

Last week bond management giant Pimco announced a number of high-level promotions.  But the biggest headline was the resignation of its well-known market commentator Mohamed El-Erian.  Mr. El-Erian, who will remain a consultant to Pimco’s parent, the German insurance company Allianz, had been touted as the heir to Bill Gross (who is Pimco’s version of Warren Buffett) when he was hired back from Harvard in 2007.

Why?

foundering equity business

A small part of this is an effort to revitalize the equity business Pimco launched several years.  It hasn’t had notable success so far.  Maybe this area didn’t have the strongest leadership.  But Pimco’s main overall marketing message continues to be that bonds are a better choice than stocks.  Hard to sell a product when your own company is telling potential customers to stay away.

who succeeds Bill Gross?

The main issue, however, is Mr. Gross himself, who will be 70 years old on his next birthday.

When a star manager reaches, say 60, the first question any potential pension client (prompted by the pension consulting firm he hires) asks in a due diligence interview will invariably be “Who is your successor?”  The client, who is spending hundreds of thousands of dollars on the search for a new manager, has two worries:  what happens if the star retires?, and what happens if the star stays on but (think: any aging sports figure) begins operating at only a fraction of his former speed?

While the manager’s performance remains stellar, this may not be a serious obstacle.  But if it begins to become merely ordinary, as seems to be the case today with Pimco, the age/successor becomes key.

That’s how I read last week’s news.  The promotion to deputy CIO of two bond managers with long practical investment experience and visible track records attributable to them says to me that clients weren’t happy with the idea of Mr. El-Erian as Mr. Gross’s successor.

Three possible reasons:

1.  Mr. El-Erian is in his mid-50s.  If Mr. Gross were to work for another five years (he’s tweeted he’s up for another 40!), then the age question recurs, only with Mr. El-Erian as the subject.  So to have a credible succession story Pimco needs forty-somethings.

2.  Mr. El-Erian’s credentials are unusual.  He’s an expert on emerging markets debt, which makes up only a tiny fraction of the total bond universe.  He worked for two years as the CIO of Harvard’s endowment, where it isn’t clear whether he had a positive or negative effect on returns.  The scanty press reports I’ve read suggest the latter.  Since his return to Pimco, Mr. El-Erian’s main role seems to have been as the public marketing face of the firm, where his professorial demeanor and/or his Pimco connection make him vary popular with financial talk show hosts.

It could be that Mr. El-Erian doesn’t have a long enough, or strong enough, identifiable track record as a portfolio manager for clients to take a chance on him.

3.  It might also be that one or more of the the forty-somethings–who have strong track records identified with them–were about to leave, either to start their own firms or to join a rival.   Their motivation to depart would be that the door to advancement was closed at Pimco by Mr. El-Erian’s presence.   If so, Pimco would have been compelled to choose between them and Mr. El-Erian.

Of course, it’s possible that…

4.  … Mr. El-Erian is leaving Pimco voluntarily.  But the lack of detail he’s providing about his future plans suggests otherwise.

why it’s good that China’s growth is slowing

One of the reasons for the current selloff in world equity markets is worry that China’s growth is slowing.

I think these fears are based on a misunderstanding of what’s going on in the Middle Kingdom.

As I see it, a reformist regime in Beijing is trying to break a recurring cycle of wasteful residential/commercial construction and creation of inefficient, low value-added, highly polluting basic industry that has marked many regions of the country.

The problem:

1.  Every local or regional government official is a member of the Communist Party.  Officials get promoted if the areas they’re in charge of show full employment and rising GDP.

The easiest way to achieve both is to support the building of large housing complexes and of (inefficient but) labor-intensive plants that produce, say, steel or chemicals.  The fact that, once up, the housing tracts may remain empty, or that there are already too many such plants spouting pollution in China (and that, in consequence, they have little chance to make profits) is a problem for another day.  Maybe the officials in question will already be promoted to higher office and be gone before anyone works this out.

2.  The easiest way to get funding for dubious projects is to call on the head of the local state-owned bank.  That person is also a Party official who, like the mayor or governor, is judged on producing growth.  For the banker, it’s loan growth.  Even if he has doubts, it’s very hard to say no to a higher-ranking Party member.  So the bank ends up facilitating the building of these white elephants, while also piling up a bunch of toxic loans that will eventually undermine its balance sheet.

3.  Banks have already gotten repeated orders from Beijing not to do this kind of dodgy lending.  But “the mountains are high and the emperor is far away,” as the saying goes.  So banks acquiesce to local pressure.  They also appear to be using the time-honored ploy of financial institutions around the world of creating and funding non-bank entities that will actually carry out lending that’s forbidden.  So off-balance-sheet liabilities are piling up.

4.  There’s also an issue of corruption, of lavish gifts given by the project sponsors to Party officials to get the worthless projects rolling.  Beijing has been talking for at least a half-decade about how seeing Party members enrich themselves through their control of economic development undermines the legitimacy of the Party and can lead to social unrest (which is perennially the Party’s greatest fear).  The current regime appears to be taking this issue very seriously and to be cracking down on corruption in a way that’s very visible in the falloff in sales growth for Western luxury goods makers.

my take

Breaking the tendency of local/regional governments to create “phantom” GDP will take time.  And, to the degree it’s successful, it will result in GDP growth that is not only lower, but unpredictably so.

I think investors in China-related equities will be relatively unaffected by lack of predictability and modest weakness in overall GDP growth.   Just avoid real estate and basic industry for now.

stocks in lockstep: what’s going on

US stocks have been travelling more or less in a herd–with, statistically speaking,  little to distinguish he performance of one individual issue from the next.  This sort of thing often happens at the start of a bull market, not almost five years in.

In other posts I’ve described 2013 as a year of “normalization” of the stock market.  During bear markets, fearful investors shift their focus from buying stocks based on anticipated earnings a year or so in the future to concentrating on reacting to actual earnings as they’re released.  Normally, six months or so into a recovery investors begin to reverse this stance and begin to value stocks based on (higher) future earnings rather than historicals.  During this period the market’s price earnings multiple expands.

After the Great Recession, that didn’t happen until 2013.  It took almost four years, plus two years of Treasury security losses–and the expectation that the returns from fixed income would remain negligible for a considerable time to come–for many investors to be willing to take the risk of investing in stocks again.

I think three points are important:

1.  It seems to me that any cyclical asset allocation shift away from bonds has already run its course.  Individual Baby Boomers, who hold much of the wealth in the US, have a distinct age-appropriate preference for income-generating investments. So they’re going to continue to hold some bonds, no matter how poorly they perform.   Also, in what I expect will be a flattish year for stocks, there will be little pain-induced motivation from equity gains to make further asset allocation shifts.

In addition, institutional investors appear to have reached their maximum allowable allocation to equities after a year in which the performance differential between stocks and bonds has been massive.  They may actually be forced to sell equities–although my sense is the reason institutions continue to hire hedge funds (despite a decade of continuous horrific underperformance of traditional managers) is to get around their investment guidelines by reclassifying equity exposure as “alternative” investments.

–I’ve believed for some time that the Great Recession shattered individuals’ belief in the merits of actively managed equity mutual funds.  A shift to index products, ETFs or mutual funds, would explain why stocks have risen across the board.  True, many hedge funds are run by former traders who lack the skill to analyze individual stocks, so they’re index-only players, too.  But that’s been true for years.  Their behavior doesn’t explain why there was less differentiation among stocks in 2013 than in 2010 or 2011.

–Last year’s homogeneity sets up a potential bonanza for stock pickers this year.  There may be some segments of the stock market–the 100 largest names by market cap?  the top 200?– where the asset allocation mindset will continue to dominate, however.  My guess is it will be better to look among smaller names and among stocks that have short histories being publicly traded.  But the important thing for now is to pay attention to the market’s behavior as we get through the quirks of January and into a more normal market next month.