c/o Basic Point - published by Cox advisors - no o
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Cheap Gas
Natural Gas
Natgas may be the only commodity that trades at a far lower price today than
at year-end 2008.
Its coupling with oil, which was solemnized by the SEC in 1982, has long
been a boon supplying lush pickin’s to oil companies’ financial reporting.
However, this obscure accounting practice has gone from the subliminal to
the ridiculous.
Natgas...has long been
a boon supplying
lush pickin’s to oil
companies’ financial
reporting.It may soon be recognized as perhaps the most dubious financial distortion
since thousands of putrid mortgage packages got Triple “A” ratings from
fee-hungry rating agencies back in the days when Wall Street was still
respected.
We have been complaining about this institutionalized overstatement of oil
company reserve life indices for five years. Perhaps we risk boring our loyal
clients by returning to discussion of this misleading practice. To date, no one
of prominence has joined our calls for fair reporting.
However, since it is part of the new, potentially huge, story about the likelihood
of sustained cheap gas prices, we need to allude to it again. Moreover, our long-
held view about gas prices seems to be confirmed by recent major strategic moves
among big oil and gas producers.
Here’s how the accounting has been handled:
• Oil companies generally produce both oil and gas. Most oilfields contain
both fuels. So oil companies use an industry formula to report their
combined gas and oil reserves in a single, simple, blended number in
their announced Reserve Life Indices.
• The Reserve Life Index is to oil companies what an actuary’s liability
valuation is to a life insurance company or pension fund. It discloses
how long the company can continue to produce at its current rate, based
on stated assumptions. The most important of these assumptions is that
natural gas reserves are included as oil equivalents based on 6 mcf of gas being
equivalent to a barrel of oil. The companies report their combined oil and gas
reserves in one number—the barrels of oil equivalent, or boe.
That is a scientifically-based law of industry accounting, because 6 mcf of
natgas produce as much energy as an average barrel of crude oil.
The formula worked well for many years.
But then, as oil prices kept climbing to new higher ranges and natgas stayed
lower-priced, it ceased to be pure science in the service of pure reporting.
Big Oil in general, and Exxon Mobil in particular, have always been comfortable
with this rule. Exxon bought Mobil in the 1990s primarily because of its
huge gas reserves and LNG operations in Indonesia that were supplying 34%
of Japanese gas imports a time Lee Raymond believed the Saudis would keep
oil prices below $35 a barrel for decades.
...
The supermajors’ liking turned to love of the SEC formula in recent years as
they failed to replace their oil production with major new discoveries, and
had big chunks of their published reserves looted by Chavez, Putin and other
such leaders with whom they had—naïvely—struck seemingly advantageous
deals in the 1990s.
That love has become a perverted passion in recent months, because US oil
and gas companies are finding so much shale and tight natgas, while their
reserves of oil in the ground in politically-secure regions of the world continue
to dwindle. So the six-to-one formula (which, in terms of financial window-
dressing might be better labeled “sex to one”) with oil at $84 effectively
prices natgas reserves at $14 per mcf while the actual market price is around
$4. Since the only time natgas has ever sold at $14 was right after Katrina,
the oil companies would appear to be straight-facedly predicting Katrinas as
the norm for years to come. We await with interest Big Oil’s defense of this
accounting rule if, as some prominent bulls maintain, oil gets back to $96.
Its natgas in the ground will then be valued at $16 per mcf—a price it has
never experienced.
This audacious overvaluation of assets that will not be actually sold for years
recalls how Wall Street was valuing its subprime-laced CDOs before the
Crash. Those valuations were legal according to the SEC, and even according
to the rules of Basel II, because they were backed by Triple A ratings from the
supposedly clear-eyed and unbiased ratings services.
One reason we routinely recommend that clients overweight exposure to the
oil sands companies is that what they produce and sell is oil, and one of their
biggest production costs is natgas. To be long oil and short gas is a superb
business model—except in oil industry accounting models.
One reason we have never recommended Ex xon Mobile(as efficiently managed
as it famously is) for commodity stock portfolios is that its Reserve Life Index
stated in barrels of oil equivalent (boe) is heavily weighted to gas, and its oil
reserves, (apart from the heavy oil and oil sands its owns in Alberta through
its 69% ownership of Imperial Oil) are dwindling, and include levels of
political risk ranging across the spectrum from low to absurd.
When geologists and petroleum engineers at companies such as Devon
Energy, Chesapeake and XTO cracked the code on producing vast quantities
of gas through fracking (fracturing of tight rocks) and horizontal drilling,
they transformed the outlook for energy prices.
...We have been telling clients for more than a year to invest in oil producers,
and to avoid gas producers. The more we have learned about the humongous
quantities of natgas that exist in the Lower 48 states of the US and much of
Northern and Central Europe, the more we have been inclined to view natgas
as a blessing for gas consumers in the US and Europe, and bad news for
investors in natgas stocks—and for Messrs. Putin and Chavez. (Yes, Virginia,
there is some good news in this story.)
Nothing we have written in the past two years has evoked such strong
opposition from clients—including some of the smartest investors we
know.
We start with the obvious:
• Investors in Natgas futures and the Natgas ETF have lost money during a
commodity bull market, while investors in oil have won handsomely. Why
should things get better for those who’ve been gas-bagged for so long?
• Seemingly the only constraint on putting more gas into storage is that
almost all the storage space is allocated.
• We are finally escaping from one of the roughest winters in decades, yet
natgas prices languish at $4. How cold does it have to get to absorb all
the gas being developed?
• The government, (which is, we admit, not necessarily the most reliable
source), estimates that recoverable reserves of natgas are enough to meet
the nation’s demand for the rest of this century, whereas oil reserves may
only last for another four decades.
• Perhaps the only thing that could get gas to go to profitable levels is for
some big players to go bust or slash their shale exploration budgets and
write down the value of their reserves.
The clients point out:
• Average decline rates of shale gas production are far above oil—roughly
70% in the first year.
• The well-managed companies which acquired big land spreads before
the operational challenges to horizontal drilling and fracking were fully
resolved are profitable at $7 gas.
• The US Energy Dept’s production statistics aren’t credible. A Wall Street
Journal story (April 5, 2010) reported that the Department now realizes
“it has been overstating output…The Energy Information Administration,
the statistical unit of the Energy Department has uncovered a fundamental
problem in the way it collects data from producers across the country—it
surveys only large producers and extrapolates findings across the
industry…the EIA plans to change its methodology this month resulting
in ‘significant’ downward revisions in some areas.”
Some of the big gas producers, such as EOG Resources, argue that the EIA’s
overstatements “helped push prices to seven-year lows in 2009….the EIA data
showed that gas supply rose 4% in 2009 despite a 60% decline in onshore
gas rigs.”
The margin for error is said by industry people to be about 10%. “’It’s getting
ridiculously large,” said Ben Dell, analyst with Sanford C. Bernstein.”
We have read some of Bernstein’s well-researched and strongly bullish
studies on natgas and can understand why they would be upset about the
government’s sloppy work.
This recalls our oft-told tale about the OECD’s energy division, the Paris-
based International Energy Agency, which under-estimated oil consumption,
year after year. They finally admitted that they hadn’t bothered to research
China’s consumption carefully, “because it isn’t a member of the OECD.”
We have routinely characterized the staff of this agency as tax-exempt
boulevardiers living splendidly in Paris, luxuriating in enviable job security,
because, although they were always wrong, they still managed to live well in
an expensive and beautiful city.
We don’t know whether the Washington-based staff of the EIA are frères sous
la peau of those boulevardiers, (although Washington was built on a Parisian
model), but we aren’t surprised that those worthies find it pleasanter to make
a few phone calls to people they know at EOG, XTO and other biggies, rather
than trekking around Midland, Henry Hub, and other such oil centers to talk
to bosses of small operating firms who may lack a proper appreciation of the
intelligence and insight of experts from Washington, and may actually not
understand the nuances of Obaman energy policy.
But, just as those sustained UN faux pas didn’t hold back the oil boom, we’re
not sure that rectifying the EIA’s data will drive gas prices skyward. Natgas for
delivery during the prospective mid-December chills of yearend 2012 is only
priced at $6.20—a week after the release of the Wall Street Journal story—
which had no apparent effect on gas prices.
What counts is gas in storage, and those numbers presumably aren’t fiddled,
because that would constitute fraud.
What also counts is published industry estimates of how much gas that wasn’t
counted in the national inventory five years ago is now counted as probable
and possible because of technology breakthroughs—and it is huge.
Again, clients tell us all that gas won’t be hitting the market because so many
small operators will go bankrupt.
But we like scarcity stories, not surplus stories where only the fittest and the fibbers
survive.
From our perspective, the following tentative conclusions can be drawn:
1. Natgas will remain alluringly cheap relative to oil, and will gain market
share where substitution is feasible—such as in chemicals and plastics.
2. Natgas will gain market share in industrial heating from residual oil.
3. Those gigantic LNG projects in Qatar and Iran will not proceed as rapidly
as had been assumed.
4. There will be no further LNG deals that involve shipments into the US
east coast or California.
5. The native groups that managed to stall the various Arctic pipeline projects
have done a big favor to Big Oil, and have done great disservice to Sarah
Palin and the taxpayers of Alaska. Those projects will not proceed. If and
when the pipelines are eventually built, it will be because the Chinese
owners of the resources will have ordered the construction and obtained
compliance from any unruly natives.
6. If, as industry experts expect, there are huge shale and tight gas opportunities
in central Europe, that will be splendid news for the Eurozone and will
offset some of the economic problems from grunting and growling
PIIGS.
7. In that case, Putin’s power over pusillanimous politicians in Western Europe
will shrink sharply. This could turn out to be the best news for Western
European lovers of liberty since the Fall of Bolshevism in Russia.
8. If natgas remains plentiful and cheap, it will begin to invade oil’s dominance
in transportation. Already, thanks to T. Boone Pickens-promoted subsidies,
it is attracting interest from government-related trucks and buses. Perhaps
Washington will make natgas the next ethanol, replete with subsidies,
tariffs, and forced allocations—in which case demand would soar and
prices would rise.
As this was being written, we got some news about how EOG, a well-run oil
and gas producer and one of the shale kingpins, is rebalancing its strategies.
It is apparently not content to rely on the phantom valuation of reserves the
SEC accepts.
According to The Wall Street Journal, “It plans to boost production of crude
oil, particularly unconventional shale oil. Those plans require higher capital
expenditures of $5.1 billion this year. True, that is much more than the $3.5
billion Citigroup expects the company to make in operating cash flow. But
EOG plans to sell up to $1.5 billion of gas assets to help bridge the gap.”
Who will buy those assets and how will they be priced?
We have some personal experience with this process because the only
American shale gas-levered stock we held in the Coxe Commodity Strategy
Fund (TSX: COX.UN) was XTO Energy—our hedge against being completely
wrong about gas prices. We were pleased to be able to sell it very profitably
when Exxon Mobil made its first major corporate acquisition since it bought
Mobil. How profitable all that shale production will be for XOM remains
to be seen, but those assets will do wonders for the acquirer’s Reserve Life
Index, whose oil component has been falling almost as fast as the reserves in
the Social Security Trust Fund.
Sustained cheap gas and restrained oil prices are together good reason to
feel more confident about the pricing outlook for industrial metals—and
about the future profitability of some of the major gold mining companies.
It is also a reason to feel more confident about farmers’ net incomes—which
bodes well for the farm equipment manufacturers and fertilizer and seed
producers.