Commodities: All hail the shale
The US natural gas revolution is not just an arcane energy issue. Martin Steward considers its potential to reverberate throughout the entire economy - and your portfolio
Revolutionary natural gas production from US shale fields has unleashed one of the
most dramatic bear markets in history, pushing benchmark futures down 86% from $13.69/mbtu in June 2008 to $1.90/mbtu in April 2012. Those $10-plus prices, new horizontal drilling and hydrofracturing technology and the ‘hold-by-production' regime that requires companies to drill to retain leases, spurred an enormous wave of supply. A mild 2011-12 winter left storage facilities bursting. It could all add up to a major re-ordering of the US energy markets - and the wider economy.
Since the initial hold-by-production scramble, costs of extraction have been driven down considerably - but very few wells are profitable at $2/mbtu. Research from Neuberger Berman reflects the consensus that, while many of the ‘core' dry shale gas wells make money at $4/mbtu, once those ‘cores' are depleted the breakeven price is probably close to $5-6/mbtu. Futures suggests sub-$4/mbtu gas until 2015-06, as does pricing in gas equity markets.
But then there are ‘wet' gas wells that give up liquids like propane, ethane and butane. These are much more closely tied to the oil price, subsidising the gas production and divorcing it from today's uneconomic $2.50/mbtu price.
"The number of gas rigs has dropped dramatically," says Mark Hume, a senior analyst at First State Investments. "But it hasn't dropped as much as it might because many have been moved to liquids plays."
Marc van Loo, head of energy & utilities equity research at ING Investment Management, notes that Devon Energy expects its total gas production to remain flat this year despite its plans to drill no dry gas wells. "That's an argument for the gas bears in the US," he says.
But even if those bears have it wrong, sub-$4/mbtu gas still looks very cheap next to (oil-related) European and Asian prices at two, three or even four-times that. Predictably, there has been talk of US exports. US companies built coastal liquid natural gas (LNG) terminals to take imports before the shale revolution - Cheniere Energy Partners is heaving a sigh of relief now that its facility in the Sabine Pass looks safe from mothballs. Will new terminals follow?
"There's more to exporting than $3/mbtu natural gas," says Thiemo Lang, manager of Sustainable Asset Management's Smart Energy fund. "Liquefaction adds maybe $3.50; shipping another $3. So you'll want to sell the LNG at $12. That might help Japan and Korea renegotiate their existing contracts with Middle Eastern suppliers, but ultimately the costs will prevent the development of a truly global market."
Shawn Trudeau, a research analyst at Neuberger Berman, agrees: "A lot of Asian buyers are eager to see it, but realistically liquefaction capacity would be a severe bottleneck."
Exports could take the form of products - from fertiliser to plastics - sold to markets where they are priced off of oil. Both Shell and Statoil are mulling US gas-to-liquids plants and Chevron Phillips is building a petrochemical ‘cracker' on the Gulf Coast. But the economics of shipping remain the same, and most expect this cheap feedstock to continue to be directed domestically.
"It's critical for companies who want to [get involved in exports] to move early, because I don't think the US will approve more than one or two of these projects," as Van Loo puts it. "It makes more sense to keep the gas in the US to make chemical and steel companies more competitive and create jobs."
According to a December 2011 paper by IHS Global Insight for America's Natural Gas Alliance, the shale gas industry supported 600,000 jobs in 2010 and will support 1.6m by 2035. Without it, US LNG imports would push the gas price up by at least 100%.
"Would you want to be the President who doubled gas prices?" asks Christopher Wheaton, manager of the Allianz RCM Energy fund. Against the example of Cheniere and its import-conversion project, Pascal Menges, manager of Lombard Odier's global energy portfolios, cites companies like Total telling him they remain doubtful that authorities will grant long-term export licences.
The domestic gains are already noticeable to the US consumer. The IHS paper estimates that lower electricity bills mean an extra $926 per year in disposable income for the average household between now and 2015. Diane Sobin, a US equities manager at Threadneedle, says this "tailwind" has kept the US consumer "fairly resilient even during the worst of times". And this is before any substantial shift away from coal-fired power.
This is an indication of the lateral thinking required to assess shale gas as a risk and opportunity. The consumer will benefit more than the regulated utility from cheaper feedstock. It might seem equally obvious that cheap gas will put pressure on upstream energy companies, but Menges cautions that the "geographically-advantaged" ones near to shale fields (Southwestern Energy, say) present significant value versus those that have strained their balance sheets acquiring acreage (like Chesapeake Energy).
Indeed, location is everything. "Around the Marcellus and other areas, there are multiple companies suddenly sitting on golden eggs," says Scott Walker, utilities equity research analyst, MFS Investment Management. "And these are low-growth annuity businesses."
Pipelines owned by the likes of Williams Partners, Spectra Energy and Kinder Morgan, which used to take gas from the south (where LNG was imported) to the north-east (where the Marcellus shale is now exploited), can be re-engineered to reverse that flow. Dominion Resources is a good example of a regulated utility that also owns well-positioned pipeline and storage facilities.
There are significant risks attached to some business models. Companies that own gathering and transmission infrastructure often also own - or are ploughing capex into - the equipment that separates gas from liquids at wet gas wells.
"That is a particularly big profit opportunity today," says Sandy Pomeroy, manager of Neuberger's Global Thematic Opportunities strategy. "But our concern is that that gas-to-oil spread will normalise over the next several years to 8-to-1, rather than the 50-to-1 that these companies are enjoying today."
Less risky, perhaps, are the engineering companies like Jacobs, Foster Wheeler, Fluor and others engaged in everything from pipeline maintenance to building petrochemical plants - not to mention the industries for which these facilities are being built.
"It was assumed that OECD countries were post-industrial, but maybe that isn't the case anymore in the US," suggests Wheaton. Energy-hungry cement, steel and chemical companies are set to be the biggest beneficiaries, agrees Van Loo: "They compete with European and Asian companies whose input prices are much higher."
Even over the past decade, when petrochemical plants ran down, industry accounted for 28% of US gas consumption (almost as much as commercial and residential users combined). Analysts report ‘caution' around capex - $10/mbtu gas is not a distant memory - but there is increasing willingness to project 20 years of sub-$6/mbtu and a handful of new petrochemical plants are already under consideration. "Just two years ago you'd have been thought crazy to suggest that new ethylene crackers could be planned for the OECD, let alone the US," says Wheaton.
US equity fund managers outside the energy sector, like Sobin at Threadneedle, are picking up on the potential. "As the building blocks of manufacturing expand we expect to see downstream plastics companies setting up manufacturing facilities closer to the ethylene supply chain, for example," she says. "Those industries will now not only have lower-cost feed stock, they will also be closer to the demand, lowering logistics costs. And these industries serve everything from autos to housing, and are served by everything from trucking to railroads, which we are also positive on."
As if these ripple effects weren't enough, there is what Neuberger Berman calls "the real game changer" - gas-powered vehicles. The car-crazy US accounts for just 1% of the world's compressed natural gas (CNG) vehicles, and yet Numberger Berman estimates that natural gas would have to spike to $24/mbtu, or gasoline fall to $1.25/gallon, to make drivers indifferent between the two fuels. There is movement: Honda has introduced units for refuelling its gas-powered Civic GX straight from the home supply, and GM, Ford and Chrysler have announced hybrid pickups for 2013 that can toggle between gas and gasoline.
"The hybrid model could get the market past consumers' fear of limited range," says Trudeau. "But as time passes we expect to see a build-out of infrastructure like natural-gas filling stations, which would enable the auto manufacturers to start offering CNG-only vehicles."
Again, this promises multiple opportunities. Lang at SAM notes that Clean Energy Fuels is building a gas station network for commercial fleets, as are a couple of bus companies. "Then you have companies like Fuel System Solutions and Westport, which supply equipment for upgrading vehicles to run on natural gas," he adds. Car manufacturers will benefit from cheaper energy costs, as will manufacturers of the plastic parts for those cars. Sobin even notes the finance opportunities of this renewed industry for banks like PNC and Wells Fargo.
There is a long lead time associated with this, dependent upon factors like consumer appetite for CNG-powered cars - but, nonetheless, a scenario of resurgent US manufacturing seems less and less fanciful. IHS reckons lower gas prices will be adding 2.9% extra industrial production by 2017, and almost 5% by 2035.
"There are some industries that could benefit on the margins, but we would describe it as additive rather than completely transformational," Pomeroy cautions. "[Cheap gas] won't do any harm, but we think industries will return to the US for other reasons - chiefly, rising wages in Asia."
Still, Sobin says that natural gas is "an extremely important component" of Threadneedle's decision-making. "Putting the government aside and looking at the two other big pillars of GDP - manufacturing and the consumer - we think that this development will have a significant impact on both."
Indeed, some analysts wouldn't discount the government. In 2010, shale gas contributed more than $76bn to US GDP and $18.6bn in tax and royalty revenues, and IHS reckons it will generate almost $1trn in government revenue over the next 25 years. Shale oil and CNG vehicles could slash US oil imports. That's a double whammy on the US budget and trade deficits, a major support for the US dollar - oh, and by the way, it could totally transform the geopolitical landscape.
It is very early days in the shale gas revolution, but the immediate effects have been startling. However uncertain, the potential impact - from buoyant consumers and resurgent manufacturers through a global market in cheap energy to a once-in-a-century windfall for the US - could hardly be overstated. You almost certainly have more natural gas risk in your portfolio than you realise. For that reason alone, the coming of shale should not be ignored.