Monday, April 2, 2012

Natural Gas

I've spent a fair bit of time over the past few years reading up on peak oil, and I think I have a better than average understanding of the dynamics of oil and gas. However this has not led to any spectacular investment success, and quite often just the opposite.

A quick note on peak oil: all this means is that someday, oil production will hit a maximum. This has been labelled a "theory" although it really just simple common sense. If oil is finite, eventually it will start running out. Unless you believe in abiotic oil - a truly unproven theory where oil is spontaneously created somehow deep underground, and seeps into the crust so new supplies of oil are constantly available. As with all things, we tend to go after the biggest, easiest rewards first; this is simply being efficient. So what's left is generally in smaller fields and increasingly more difficult to get at. The real peak oil debate is not so much whether the concept is valid, but when do we hit the peak? It could be centuries from now, or just a few years away, or months, or it may have already happened.

Oil is a global market, since the commodity has recognized standards such as Brent and WTI, and is relatively easily transported across land and sea. Relatively with respect to natural gas, which does not really operate on a global market. The main reason is it is hard to transport natural gas across an ocean. It can be liquefied, but this is expensive, technically challenging, and if I recall about 20% of the energy content is used up in the process. Although liquefied natural gas use is growing quickly, it only accounts for about 11% of worldwide natural gas. Japan is a big LNG importer, especially since they had to shut down their nuclear system - right now they pay close to ten times the North American spot price for Russian LNG.

Gas is really a continental market since you can really only supply markets connected to the wells by pipeline. In North America the recent news is all about shale gas, and how new breakthroughs in fracturing are able to unlock huge amounts of natural gas. Double current reserves, according to the International Energy Agency. I don't know if there has been a frenzy of shale gas production or if it's more based on expectations, but natural gas prices have plummeted: $1.98 per million BTUs Henry Hub spot at the moment. This benchmark spent most of the last decade over $5 including a couple of spikes in 2005 and 2008 over $12.

Unlike many commodities, energy has hard numbers to work with. Specifically, you can determine the amount of energy in oil, gas, coal, etc., and figure out which are more or less expensive as fuels. Granted the substitution can be a little sticky. You don't switch from unleaded gasoline to natural gas in your tank based on daily prices. But if trends continue long enough, a natural gas vehicle could become an option. There are about 5.8 million BTUs of energy in a barrel of oil. So you would expect a barrel of oil to cost about 6 times the price of a million BTUs of natural gas (the standard unit of measure). So why is oil over $100/bbl and gas is two bucks? This is 50:1 in price compared to 6:1 energy, so you could say natural gas should be over $16 and at current prices is a screaming bargain.

What caught my attention was the production cost of these shale gas wells - the breakeven price is over $8 per MMBtu. So you have North American natural gas that is worth $16 in energy, requires $8 to produce, and is selling for $2. This challenges everything I think I know about economics.

Maybe when you see a twenty-dollar bill on the sidewalk you shouldn't think it over too much, just pick it up and put it in your pocket. But I've played gas ETFs a couple of times before, thankfully with very small stakes, and never won. Experience tells me I don't know what I'm doing. Fundamentals say this gas price is unsustainably low and must go up. The real question with all investing is not what but when? I think I'm talking myself into another small-money gamble here, all the while knowing it will probably break my heart once again.

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