The shale gas "miracle" is overhyped and bound to disappoint. That's what energy expert Bill Powers argues in his upcoming book. But Powers tells The Energy Report that this could be a very good thing for oil and gas companies and their shareholders, and he is placing his bets accordingly.
The Energy Report: Bill, you have a new book coming out next spring entitled "Cold, Hungry and in the Dark: Exploding the Natural Gas Supply Myth." What is your basic argument?
Bill Powers: My thesis is that the importance of shale gas has been grossly overstated; the U.S. has nowhere close to a 100-year supply. This myth has been perpetuated by self-interested industry, media and politicians. Their mantra is that exploiting shale gas resources will promote untold economic growth, new jobs and lead us toward energy independence.
In the book, I take a very hard look at the facts. And I conclude that the U.S. has between a five- to seven-year supply of shale gas, and not 100 years. That is far lower than the rosy estimates put out by the U.S. Energy Information Administration and others. In the real world, many companies are taking write-downs of their reserves.
Importantly, I give examples of how certain people and institutions are promoting the shale gas myth even as they benefit from it economically. This book will change a lot of opinions about how large the shale gas resources really are in the U.S. and around the planet.
TER: How did you obtain your information?
BP: I spent three years doggedly researching this book. Most of the information came from publicly available sources. I used a fair amount of work done by Art Berman, who has written the forward for the book. Art is a leading expert on determining the productivity of shale gas plays. I contacted a lot of other geologists and petroleum engineering professionals and had them review my conclusions about declining production.
Put simply: There is production decline in the Haynesville and Barnett shales. Output is declining in the Woodford Shale in Oklahoma. Some of the older shale plays, such as the Fayetteville Shale, are starting to roll over. As these shale plays reverse direction and the Marcellus Shale slows down its production growth, overall U.S. production will fall. At the same time, Canadian production is falling. And Canada has historically been the main natural gas import source for the U.S. In fact, Canada has already experienced a significant decline in gas production—about 25%, since a peak in 2002—and has dramatically slowed its exports to the United States.
TER: What does this mean for investors?
BP: The decline is a set-up for a gas crisis, a supply crunch that will lead to much higher prices similar to what we saw in the 1970s.
Interestingly, during the lead-up to that crisis, the gas industry mounted a significant advertising campaign trumpeting the theme, "There's plenty of gas!" Now, it is true that there was a huge ramp-up for gas during the post-World War II period that lasted through the late 1960s as demand for gas for the U.S. manufacturing base grew rapidly. But we hit a production peak in the early 1970s during a time of rapidly growing demand. This led to a huge spike in prices that lasted until 1984.
It was very difficult to destroy demand, so the crisis was resolved by building hundreds of coal-fired power plants and dozens of nuclear power plants. But today, gas-fired plants are popular as we try to turn away from coal. This time around, those options are no longer available. Nuclear plants are still an option, but the time and money involved in keeping our aging nuclear power plant fleet operational, let alone building new plants, will be quite significant.
TER: How will the contraction of the natural gas supply affect its price?
BP: We will see a new equilibrium price for gas at much higher levels than the present. I vehemently disagree with industry observers who say that the U.S. is the next big exporter of liquefied natural gas (LNG). I believe that the U.S. will soon be increasing LNG imports, and that U.S. prices will move back to world levels.
We are currently seeing between $13 per thousand cubic feet (Mcf) and $15/Mcf in South America as Brazil and Argentina import LNG. We're seeing $17/Mcf in Japan and similar prices in Korea. The only place that is not increasing its LNG imports right now is Europe, and that is being made up for by increasing demand in Asia.
TER: How will a contracting supply affect the prospects of companies that are exploring and developing gas fields in North America today?
BP: The companies that can find new reserves of oil and gas will enter a golden era as prices skyrocket. There has been a lot of consolidation in the industry over the last five years. In Canada, very few juniors have started up since 2007. This is the fifth anniversary of the Halloween Massacre, when the Canadian government changed the laws regarding trusts, which really shrank the amount of capital going into junior companies.
The bigger North American companies are consolidating, because it is harder to acquire prospective land. Plus, the cost of drilling wells has gone up. But juniors that can find new reserves and that can increase production per share and cash-flow per share will have a wonderful rise over the next three to five years. Companies are helped by the upward trend of ever-higher oil prices and we will soon see much higher gas prices. And remember, all of this is happening at a time of historically low interest rates. So companies that can get to critical size and borrow money at today's low rates have a chance to deploy that capital into some very high-return projects. Good companies are trading at historically low multiples of cash flow or multiples of NAV (net asset value). So there are some great values out there that really make the energy sector attractive.
TER: What names do you like in the shale oil and gas space?
BP: Among larger U.S. companies, I like a $7 billion ($7B) company called Denbury Resources Inc. (DNR:NYSE). It is the second-largest producer of carbon dioxide (CO2)-flooded oil—or enhanced oil recovery using CO2. Denbury just sold its Bakken assets to Exxon Mobil Corp. (XOM:NYSE) for $1.5 billion (B). It has a very, very large resource base and growing production from its CO2 fields. It is very well managed and well capitalized.
Oil sands producers will benefit, such as MEG Energy (MEG:TSX), which is ramping up production. There has not been a lot of interest in the oil sands over the last couple of years because of the price differential between what the oil sands producers are getting and the higher price of WTI or Brent. But the differential has started to narrow during the last few weeks, and that is really going to benefit oil sands firms.
Another company that is very well positioned in the process of splitting itself apart is Petrobank Energy & Resources Ltd. (PBG:TSX). It is divesting ownership of its Petro Bakken assets to shareholders. Petro Bakken has a very unique set of assets. Even though it has had operational issues over the last couple of years, it will still be producing over 50,000 barrels a day going into year-end. It also pays a very substantial dividend, so investors in that company are getting paid to wait.
On the gas side, Advantage Oil and Gas Ltd. (AAV:NYSE; AAV:TSX) is very well managed and has a fine asset base. It is a very low-cost producer, and has a lot of room to grow profitably in a higher gas price environment—which is where we are headed.
PetroQuest Energy Inc. (PQ:NYSE) has good assets in the Mississippi Lime and significant offshore assets with high-production wells. Management has done a good job during a period of low gas prices by bringing in partners and hedging their risks. The company has kept its balance sheet intact and is well positioned to take advantage of a turn in gas prices.
TER: Does your analysis about the looming contraction in the supply of shale gas apply to shale oil?
BP: Shale oil is a significant resource, of course, but it is not a "game changer." It is in the same category with shale gas. The Bakken is a very material resource and it will provide decades of production. However, Bakken production has peaked in Saskatchewan. It has peaked in Montana. It is approaching its peak in North Dakota. This does not mean that we are running out of drilling locations, or that production is going to fall off a cliff tomorrow. However, I expect production to plateau before long. Something similar is happening in the Eagle Ford in Texas. A lot of the wells there have extremely high decline rates and production may be hitting a plateau. In the overall context of the United States, we see a continuous decline in the Gulf of Mexico and California. There is significant decline in Alaska. Those producers are struggling to keep up the flow through the Alyeska pipeline without having to do a major retrofit of the pipeline to put in more pumps due to the low throughput pressure. We are seeing a decline in California of about 15,000 barrels every year. The overall increase in oil production in the U.S. in the last few years has been wonderful, but many oil fields are getting long in the tooth, and I would expect a plateau to soon emerge.
TER: Will decline spur investment in alternative energy sources?
BP: Yes, absolutely. Electricity prices are often set by the highest-cost producer. Until recently, those electricity producers used natural gas as their feedstock. Low natural gas prices have depressed electricity prices in some areas. This makes the economics of a lot of alternative energy projects very difficult. But as gas prices rise, electricity prices will also rise. This will make solar and wind projects more viable. For example, in California, electricity prices rose significantly over the last decade despite falling gas prices. But as the efficiency of solar panels has improved, solar costs have declined and reached grid parity. Residential solar makes a lot of sense in California. And as solar efficiencies continue to improve, costs will continue to fall.
TER: Let's talk about shifting patterns of supply and demand for natural gas around the world. How will this impact the North American producers?
BP: Let's start by looking at Trinidad and Tobago, which supplies the United States with 50% of its LNG imports. The country has taken huge write-down of its gas reserves. Production declined in 2011 and will likely decline again in 2012. The country has only nine years of proven reserves left. Trinidad and Tobago needs to find new sources of gas to feed the very large fertilizer plants operating on the island and maintain exports.
Another example of declining gas exports is Indonesia. Historically, Indonesia has been the largest exporter of LNG in Asia. In 2006, the Indonesian government changed the law to focus more on internal consumption and to create jobs for 200 million (200M) people. It cut down on LNG exports beginning in 2007. I expect that trend to continue as the country switches from being an oil exporter to an oil importer.
In the Middle East, the United Arab Emirates was an exporter of LNG for decades; it is now an importer. Dubai imports LNG. Fujairah will soon become an importer. Kuwait now imports LNG. Oman has reduced exports to focus on building its steel industry. The trend of decline is happening everywhere. I discuss this quite a bit in my book.
TER: Do you think that international markets pay enough attention to finding and developing new oil and gas resources?
BP: It's a very difficult thing to explore as the world becomes more and more resource mature and resource nationalism rises. It is very difficult to explore off the coast of Nigeria or in Russia or in Iraq, where the political situation is very unstable. Fifteen years ago, Exxon Mobil was divesting its onshore U.S. assets. Now, Statoil ASA (STO:NYSE; STL:OSE) has come to the United States in a significant way for the Bakken. BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) is buying into the shale gas and shale oil business in the United States. Frankly, onshore in North America is not the easiest place to operate. But there are not a lot of other options available right now.
TER: What are the likely impacts in industrial and residential demand in oil and gas prices for North America during the next decade or so?
BP: Efficiency will improve. The U.S. has already dropped its demand for oil by about 2M barrels from its peak in 2007. Part of this was due to the recession; part of it is due to an increase in the miles-per-gallon standard. The trend will continue as it becomes more and more unaffordable for people to drive cars.
And we will see efficiencies in the structure of the electricity grid. The U.S. currently wastes around two-thirds of the consumable electricity that goes into the power grid through line loss. I envision a trend toward distributed energy production. People will put solar panels on their rooftops and sell sun power to their neighbors. The big utilities are fighting this tooth and nail in California. But there is a movement toward electricity co-ops. As electricity becomes more expensive, people will find other ways to conserve. Demand will increase for residential geothermal heating and cooling; the economics of geothermal home heating and cooling systems have improved drastically in the last 20 years, and it continues to get better. We will also see the emergence of an electric car industry. It's had a rocky start, but it will move forward as gas prices in the U.S. go north of $5 per gallon.
TER: How much weight do you suggest that investors put on gas shares in their portfolios?
BP: It depends upon the individual investor's profile. Everybody is different. But there are some great gas companies that are fairly cheap. Ultra Petroleum Corp. (UPL:NYSE) is a very inexpensive well run, low-cost producer. The bottom line is that investing in things that are out of style at the moment are often the greatest investments.
TER: It's been a very interesting talk, Bill, thank you.
BP: You are quite welcome.
By. Peter Byrne of The Energy Report
Bill Powers is the editor of Powers Energy Investor and is also the author of the upcoming book "Cold, Hungry and in the Dark: Exploding the Natural Gas Supply Myth." Powers has devoted the last 15 years to studying and analyzing the energy sector, driven by his desire to uncover unrecognized trends in the industry and identify outstanding opportunities for retail and institutional investors.