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.

 

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