Update on Shale GasRevolution,pt. 1 - Analyst Blog



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Since I last wrote about the Shale Gas Revolution and its implications late in 2011, there have been many more important developments, as well as some new trends. 

New Shell GTL Plant in Louisiana 

The most important, and most recent, news is that Royal Dutch Shell ( RDS.A ) is apparently in the preliminary stages of feasibility and design work on a potentially huge, $10 billion, 2 million gallon per day (approximately 50,000 barrels per day) Gas-to-Liquids (GTL) facility in Louisiana, using abundant natural gas feedstock. 

This development is important for several reasons:     

Validation of Future Gas Abundance 

First, it validates the long-range forecast of persistently high volumes of economical natural gas.  Since the plant would not enter production until 2014 at the earliest, a gigantic, experienced GTL and gas producer must be confident that natural gas prices will remain a relative bargain, and that this will continue for a long time into the life of the plant. 

GTL Remains Attractive 

Second, despite being burned by the cost-overruns at its large Pearl GTL plant in Qatar, Shell still sees attractive returns in such a plant.  This is an important demonstration for other market participants, some of whom may decide to emulate Shell.  Indeed, Sasol ( SSL ) of South Africa already indicated a few months ago that it would build a large GTL plant in Louisiana. 

Export Capability 

Third, the plant is in good export position -- it will not be located inland to take advantage of the very cheapest natural gas prices in the heart of major shale gas plays, but close to tidewater for easy shipping of diesel and other liquids to Latin America and Europe. 

GTL More Attractive than LNG 

Fourth, it is very telling that Shell did not decide to work on building a Liquified Natural Gas, 'LNG,' facility to export gas from its own shale or offshore production.  While natural gas prices in Europe and elsewhere in the world are much higher than those in North America, the energy-equivalent prices of diesel and other petroleum products are at even more of a premium versus raw natural gas.   

While it may be cheaper to build gas liquifaction and re-gassification plants, their economics may not be able to overcome the huge price differential of products versus raw gas for a long time to come.  This could mean that new LNG plants for Kitimat, British Columbia, and Valdez or Anchorage, Alaska, and, more fancifully, Halifax, Nova Scotia, may not be built -- in favor of GTL plants. 

The implications of that last point are potentially profound.  The more natural gas that gets converted to liquids for export in North America -- rather than exported to East Asia, Europe, and elsewhere -- means natural gas that will not be sent into the world markets to reduce natural gas prices in those markets.   

Hence, relatively high prices may persist there, maintaining the already major incentives to drill for gas and associated liquids in other propitious shale formations.  In the U.K., Poland, and Ukraine, drilling is active, and showing some impressive results, although not much actual production thus far.   

Also, as Europe is densely populated, there are industrial and environmental issues that can delay full and rapid exploitation such as has occurred in North America. 

EU Nations Wish to Avoid Dependence on Russia 

There is a big strategic, and also commercial reason that European nations will likely become more enthusiastic drillers:  the wish to reduce an unhealthy reliance on one major supplier:  Russia.  The Ukraine and other European countries have had more than one cutoff of supply from pricing and payment disputes, and in mid-winter, too.  No customer is comfortable in having only one supplier, and Russia also has a record of being a difficult and untrustworthy trading and investment partner, as BP ( BP ) and Chevron ( CVX ) can attest.   

Environmental Trends Favor Gas Over Coal, Nuclear 

Another reason that shale gas exploration will likely receive a warmer reception in Europe in the future is their longer-term environmental goals, which have not been -- and in practice cannot be -- satisfied by renewable energy initiatives and incentives.  The governments of Germany, France, the U.K., and other European nations wish to downplay or eventually eliminate electricity production from coal plants, and from nuclear generators, too.  The only rapid, cheap and readily available other sort of energy will be shale gas, unless they wish to become further dependent on Russia, Central Asia or the Middle East. 

Pipelines and Drilling In Europe to Expand 

While the new pipeline in the Baltic that bypasses Ukraine -- and another one from the Caspian that bypasses both Ukraine and Russia en route to Europe -- ameliorate some of those dependency problems, the long-term outlook for shale gas and liquids in Europe remains rosy.  While it may not make much difference to the major oil companies' stock performance, it will help those of the oil and gas service companies, especially the hydraulic fracturing, 'fracking,' specialists. These companies will also benefit from new exploration in China. 

China Active in Shale, Abroad and Domestically 

China has made investments in North American oil and gas producers, in an effort to acquire expertise in shale formation exploration and exploitation.  Apparently, their state-controlled companies have begun some drilling in their own country, but the true extent of their success is not known.  It seems likely that it will take several years to increase production to a level where they can substitute gas for coal in power stations.  Coal has been the source of terrible air pollution in China and is a major health risk.   

The Chinese government is changing its energy policy to emphasize gas exploration and development to reduce its reliance on coal.  There should be opportunities for North American companies, but the probability for technology leakage is great.  What it could mean over the longer term is that the potential for very large exports of LNG to China may be muted, as they may produce much of what they consume.

However, some Chinese companies -- or the government -- could decide that they wish to go the GTL route; substitution of imports of crude by local production of diesel could do a lot to reduce unfavorable trade and funds flows, and make more business sense, too -- again, given the differential between the cost of GTL products versus those refined from crude oil.  China no longer has a significant trade surplus, other than with the U.S.

There are a couple of other wild cards, but they will take some years to play out: 

Japan Important in LNG, General Global Gas Demand 

The first is Japan.  While the Fukushima nuclear reactor disaster seems to have set the populace and the government on a path against the atom, some sober second thoughts might prevail when the costs of changing to gas for electricity generation are re-examined. The sunk costs of existing nuclear generators make the marginal cash costs seem compelling against the large capital costs entirely new generating facilities will require.   

Russia Could Take Much of Japanese Market 

Assuming that they will continue on the LNG road, Japan may find itself in a complicated situation.  As European gas production increases, Russian Far East production may get backed up and bottlenecked, in the way that Canadian and Bakken gas production is currently.  Russia is already proposing to China new pipelines to bring their excess gas to northeastern cities.  

Russia has not yet advanced any pipeline proposals to Japan, but it could make a lot of sense to both parties.  If that occurs, then there could be substantial gas-on-gas competition that will benefit the customer -- and be unpleasant for North American LNG exporters, increasing the attractiveness of building GTL plants versus LNG ones on the West Coast. 

South Asian Potential

The other wild card in global energy supply and demand is South Asia.  Pakistan and northwest India have become major oil and gas producing provinces of late, but their production has all been absorbed locally.  It is still largely unknown what the deep shale natural gas and liquids potential of both nations might be.  

As a large part of the global increase in oil demand in recent years has come from those nations, it could make a big difference what their reserves and production could reach, and how quickly.  Given how slowly industrial development and foreign investment there get approved -- and how unsettled and difficult many regions are in those nations -- it seems unlikely that they will be a factor in the near term.  If anything, more efficient coal exploitation in India has a greater likelihood of crowding out some gas and oil for electricity production, but that appears to be a longer-term proposition.

North American Oil Bottled Up

What all this means for North America is still a question.  Greater GTL and LNG investment can only help suck up some of the vast natural gas production, but it will take time.  U.S. oil is already trading at a large discount to world oil prices as shown by the West Texas Intermediate (versus Brent) spread.  

The large North Dakota Bakken volumes are getting backed up at Cushing, Oklahoma.  The Keystone XL pipeline the Obama administration and the state of Nebraska have stalled would not have removed that discount; it would actually increase as more Bakken and Canadian oil and oil sands bitumen would surge into Cushing.  Fortunately, the southern extension of Keystone is going ahead, and so is the reversal of another pipeline, both taking Cushing crude to the Gulf Coast.

Canadian Crude Discount Likely to Persist

The Canadian side of the saga is much sadder.  If Keystone XL’s northern leg gets built, it will take yet more crude into Oklahoma, increasing the glut, and maintaining or even increasing the discounting of mid-American oil.  One ameliorating factor is that all the shale gas that northern foothills formations in British Columbia and Alberta are producing helps keep costs for oils sands producers contained to some extent.  

It also makes large-volume, expensive bitumen upgrader facilities more appealing.  These plants take the dense, viscous bitumen extracted from the sand and use natural gas as an additional feedstock to produce high-value light synthetic crude oil.  It seems unlikely that either of these feedstocks will become scarce or more expensive anytime soon.

Reversal of Pipeline Liquids in Canada

Another pipeline that, until recently, was dedicated to taking in imported oil in eastern Canada for refining and marketing in Ontario and Quebec may be reversed, to take mid-American oil to those markets, and perhaps to refineries to export the products overseas where the prices are higher.  This could be done relatively quickly, without significant environmental review.

New Environmental Review for Canadian Pipelines

Speaking of environmental review, the new budget released by the Conservative government in Ottawa last week outlined new, streamlined procedures for environmental review and intervention, with the goal of drastically reducing the time required to plan, design, review and approve a pipeline project or facility.  

This also will apply retroactively to current projects, such asEnbridge’s (ENB - Snapshot Report) Northern Gateway oil pipeline from Bruderheim, near Edmonton, to Kitimat, on the Pacific Coast.  This project has become very contentious, with many First Nations and environmental groups opposing it on grounds of safety and possible catastrophic environmental damage.  

Kinder Morgan (KMP - Analyst Report) has also indicated it plans to more than double its already existing oil pipeline capacity from Edmonton to Vancouver, which should not suffer significant regulatory intervention since it is the same route and right-of-way.

Another Gas Pipeline to British Columbia Coast

A natural gas pipeline, planned by Kinder Morgan, that will take a similar route to Northern Gateway is encountering no opposition at all, and will take excess gas to proposed LNG plants at Kitimat.  Northern Gateway is crucial to the oil sands, as the producers there have a triple discount (North American to world, Canadian to American, bitumen to conventional light or medium crude) that is a huge opportunity cost, now, and could make them vulnerable to a downward price shock should another recession occur.

In contrast, environmental concerns about pipelines, aside from Keystone XL, are not much of an issue in the United States.  However, fracking concerns are definitely an issue, but there are some signs that they are diminishing.

Fracking Controversy May Be Declining

In the case of Encana’s (ECA - Analyst Report) operations in Wyoming, Environmental Protection Agency officials are apparently moderating their claims and accusations of contamination of water at a non-shale drill site.  In Pennsylvania, contamination of water at some shale gas wells now is known to be the result of faulty casing of well bores in the region of the water table, and not fracking itself, which occurs far below the water table level.  

High water consumption has become more of an issue, especially in areas that are more arid, like North Dakota.  However, drillers such as Chesapeake (CHK - Analyst Report), have countered that they clean and recycle a high percentage of the water they use in fracking.

Washington More Positive on Gas, Fracking

In another positive sign, President Obama has been sounding more conciliatory, even boosterish, about natural gas use and development.  He officiated at the dedication of a new Compressed Natural Gas (CNG) fueling facility along a planned, and virtually complete ‘natural gas corridor’ linking Long Beach California along major highways to Salt Lake City, Utah.  

The intention is to foster conversion of long-haul trucks to CNG.  Initial conversion is expensive, despite federal incentives, but the payback is much quicker, now, with relatively cheap gas versus diesel fuel costs.  

It seems likely that whatever administration takes the White House later this year, natural gas will receive a lot of attention and support.  In recent months, even in the current business conditions and public policy climate, a new steel plant was announced for eastern Ohio, and a chemical plant for western Pennsylvania -- both enabled by and predicated on abundant, cheap natural gas.  

As gas utilities’ older, more expensive gas contracts with producers expire over the next few quarters and years, smaller businesses and other consumers like governments and hospitals (and ordinary North American households) should start to realize substantial heating and cooling savings, increasing disposable income and putting extra life into the sluggish economic recovery.

Food, etc. Price Rises to Moderate, Perhaps Decline

Food price increases may even moderate if nitrogen fertilizer prices flatten or decline with the lower costs of their feedstock, natural gas.  Ethane from the gas will be cheaper and in abundance, lowering costs of plastics, inks, paints, adhesives, solvents and other synthetic materials.  

Bakken liquids are already making Gulf Coast and other refiners more competitive, as those companies have a big spread, now, between their costs and their gasoline and diesel output prices. (Diesel is determined by high Brent-equivalent oil pricing in international markets, which is why U.S. pump prices are high and hurting consumers even as producers are getting the lower, bottled-up West Texas Intermediate price).

The shale gas revolution continues.  Its full effects are yet to come.



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