Commodities: Energy revolutions
Forget renewables. Anthony Harrington finds that the technology that might really disrupt your portfolio's traditional oil exposures - and much else besides - could be shale gas extraction
The huge spread between the price of oil which, by 4 April 2011, had hit highs of $120/bbl, and the price of natural gas, which was $4.17 per 1,000 cubic feet at the end of March in the US, is a puzzle for the uninitiated and a dilemma for investors. To make things more difficult, the relationship between the price of oil and the price of natural gas varies dramatically between Europe, Asia and North America.
"The starting point for any analysis of the relationship between the price of oil and natural gas is their energy equivalence," explains Pau Morilla-Giner, head of alternative investments, equities and commodities at London & Capital. "A barrel of crude oil is about equivalent to 5,800 cubic feet of gas, so the price of gas per 1,000 cubic feet, the usual unit of measure for forward gas prices, should logically be about one sixth the price of oil." The current spread, of course, is way off this ‘logical' figure in all three markets.
However, there are real difficulties for particular markets in arbitraging away large differences in the energy/price equivalence of oil and gas. In many instances, of course, there is no easy arbitrage possible because the two fuels are not equivalent in their use. Natural gas is used primarily for heating and power generation, while oil is very important for transport. However, the further the price ratio tips out of balance, the more pressure there is for companies and markets to explore direct equivalences, such as the use of compressed natural gas for transport or to generate the hydrogen for fuel cells, displacing oil.
In Europe, Russian and Norwegian gas is hugely important and both nations have pegged the price of gas as closely as they can to that of oil. In Asia, a shortage of natural gas for power generation results in a very big global business shipping liquefied natural gas (LNG) to the region and persistent high prices. LNG-related investments have looked somewhat difficult since the US cut back imports following the development of vast domestic reserves of shale gas, but the post-tsunami nuclear crisis at Japan's Fukushima reactors looks likely to push the country heavily towards gas-fired generation over the next decade. And this sudden elevation of gas over nuclear means that LNG once again looks interesting over the next two to three years.
Then there is North America and its shale gas - sufficient for its energy needs for the next century, according to some experts. Advanced extraction techniques based on deep vertical drilling and hydro-fracturing of the shale with a high-pressure cocktail of water, sand and chemicals have considerably extended production capacity. It has been a complete game changer for the US, taking it from being a massive importer of oil and gas to being on the road to energy self sufficiency for long enough for other sources of energy generation, such as nuclear fission from deuterium and tritium, to become mainstream technologies.
The US is not unique in having shale gas reserves, but they are on a different scale to those in Russia, the Middle East, Iran, and off the coast of Venezuela. "The key point for investors is that shale gas in the US and Canada can really change the balance of power among energy producers," says Morilla. Today, the world is accustomed to OPEC dictating pricing to some extent. Developments in the US could very well have a broad impact on energy pricing over the next few years.
One potential show stopper, or at least a potential production cost escalator, is the environmental controversy currently raging around ‘hydro-fracking'. Opponents claim that the chemicals used are potentially hazardous to health and to the soil. It is true that shale gas production companies do not like revealing the individual formulae for the fluids pumped down their wells, but they claim that this is for competitive advantage (since it aids gas flow) and that the formulae are intellectual property.
Angelos Damaskos, CEO of Sector Investment Managers, and manager of its Junior Oils Trust, points out that extensive research on the potential harmful effects of hydro-fracking has yet to draw any conclusive proof of danger to people or environment. He, along with many energy specialists, does not see the protests derailing shale gas unless absolutely damning proof emerges concerning danger to human health. Energy independence for the US is too big a goal, he says.
However, in one respect at least, shale gas is not good news for environmentally friendly power generation. Peter Michaelis, head of sustainable and responsible investment at Aviva, says that one immediate effect of the sheer scale of the effort being put into shale gas extraction is to put the brakes on many renewables projects that might otherwise have moved forward. "The point is that since you can buy four times the energy in gas, by comparison with oil, this has driven electricity prices down," he explains. "So even with subsidies, which layer onto the top of existing electricity prices, renewables projects no longer look as attractive to investors."
Although Michaelis is doubtful that the US shale gas phenomenon can be duplicated in Europe, even if extensive reserves were found - mineral rights ownership is trickier, planning regimes are tighter and public opposition is likely to be more vociferous - Aviva has still taken a small position in a Polish company that is exploring for shale gas, on the grounds that the Poland's desire for energy security makes this a safer play.
What makes natural gas particularly attractive in the medium term, Michaelis says, is that global reserves of natural gas are so much more abundant than oil reserves. "By 1960 we had discovered 500bn barrels of oil reserves, globally," he says. "Between 2000 and 2010 E&P [exploration and production] companies could only discover one fifth of that amount. It is likely that oil supply, in the medium term, is more constrained than most investors think." He sees a good deal of complacency, even now at $120/bbl.
With around 100m barrels of oil per day as the likely maximum global output, and the world currently consuming around 86m a day, there is very little leeway for any fall-off in production. However, while Michaelis sees natural gas as the logical replacement fuel over the next 20 years, he points out that oil prices stabilising at $150/bbl could bring capital-intensive oil sands production, and the oil-from-coal techniques pioneered by South Africa's Sasol, into play, keeping oil in the energy mix for decades to come.
Still, the ‘profit window' on oil sands - with a $95/bbl breakeven price today, which could well increase as environmental considerations push up production costs - is extremely narrow. Moreover, the main market for Canadian oil sands production is the US, which is enacting low carbon legislation that could rule them out for transport fuel. In comparison, natural gas is a "no brainer", in the words of Douglas Cogan, a director of Climate Risk Management at MSCI who recently completed a report on oil sands. Similarly, Colin O'Shea, head of commodities at Hermes Fund Management, notes that natural gas is increasingly seen as an interesting commodity play by many of the firm's big life and pension fund clients.
And there are other applications opening up for gas. Thanks to its ability to be brought online very rapidly, one of the major plays across all three regions is going to be its use as a power generation fuel to backstop renewable wind and solar energy while the wind isn't blowing and the sun isn't shining. The fact that it has a relatively clean carbon profile, despite being a hydrocarbon, also works in its favour. Thiemo Lang, portfolio manager for the Sustainable Asset Management (SAM) Smart Energy fund, points out that in electricity production, natural gas produces half the CO2 emissions of coal and oil-fired plants. "You also don't have sulphur or other emissions, which makes it very clean burning," he says. (As we went to press, the first major study of methane emissions from shale gas extraction was published by Robert Howarth and Cornell University, presenting evidence that may challenge these claims).
Natural gas also received a real boost from a recent speech by US President Barak Obama announcing the US's latest stance on energy policy. This sets a target of 80% of the US's energy requirements from "clean energy sources" by 2035. These are defined as renewables, nuclear, clean coal, hydropower, biomass and "efficient natural gas". Obama's speech also included initiatives to promote the use of compressed natural gas to power bus fleets and lorries.
Geoff Jay, oil and energy analyst at Janus Capital, points out that, for now, the US is not well set up for a wholesale conversion of electricity generation from coal to gas, so there will be considerable inertia to overcome. "Today, electricity generation uses coal for base-load production, and natural gas is used for peaks in demand. It is not designed to run 100% of the time," he says. Jay expects to see moves in the US towards manufacturing closer to the consumer, and suggests that this could generate sufficient demand for gas in the medium term to help arbitrage away the massive US price spread between oil and gas.
Jonathan Waghorn, co-portfolio manager on Investec Asset Management's Global Energy fund, says that there will continue to be fantastic arbitrage possibilities between gas and oil for a long time to come. "Asian gas prices are still $13 per 1,000 cubic feet, but with the medium-term oil price at over $100, even this price is low and should be over $16. The US price is ridiculously low, equating to around $24 per barrel of oil." He points out that the Marcellus shale find in New York is the second largest deposit of natural gas in the world.
"It is a total game changer, particularly for US industry," he says. "For example, it makes the large-scale production of fertiliser economically viable again in the US for the first time in decades. You can buy a gas contract today in the US for 25 years at $7 per 1,000 cubic feet, which is fantastic for manufacturers."
For Waghorn, the simplest way for any investor to play natural gas at present is to buy equity stakes in the owners of the resource. "We're buying natural gas equity stakes and we expect to see a good lift in asset values either when gas prices rise, or when the majors target the companies we hold," he says.
However, while the future looks rosy for US shale gas over the medium term - say five to 10 years - it is very much a buy-and-hold play right now. Producers are facing very challenging times. Whereas in 2010 they were able to hedge production for 2011 at around $5, that is not really available in 2011 for forward hedging: by the end of March 2011 front-month prices had slipped to $4.17, with a summer period to come.
Total US gas storage capacity is about 4.1trn cubic feet and, according to O'Shea at Hermes, without another scorching hot summer like last year's, that will be close to maxed-out. The resulting price falls would hurt those rig operators which do not have plenty of capital to see them through a long spell of sub-production pricing for gas.