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November 12, 2012
Inside this week’s update...
***** Crucial issues both Presidential candidates hardly talked about
***** What’s the truth about shale oil and gas production?
***** Two very different energy plays for smart investors
With the election now history, it makes sense to take a look at some of the issues that are crucial to the country’s future – but did not receive any meaningful airtime from the candidates.
Front and center would be energy and its two very close bedfellows, water and food. Our nation has seemingly made a bet on the continued success of shale oil and gas. Judging by the past few years, the bet makes some sense as both gas and oil production have risen sharply in the U.S. But is this bet (i.e., the trends supporting it) sustainable?
Two important voices say “No!” The first is Bill Powers, who has been an active participant in the energy industry for more than 15 years as an energy-focused money manager and is currently working in an executive role for several energy firms. The second is Art Berman, a geologist for over 35 years who is well known for his view that shale gas reserves are dramatically overstated.
Powers is completing a book entitled “Cold, Hungry and in the Dark: Exploding the Natural Gas Supply Myth,” and he admits that he owes a big chunk of his thinking to Art Berman and other geologists he has interviewed. The book is scheduled to appear in the spring and will be available on Amazon, with a Forward written by Berman.
There are several arguments that Powers and Berman make. Foremost is that gas production from most shale formations has begun to decline. Of the country’s major shale formations the only one that is not either in decline or flattening out is Marcellus. The analysts also argue that the Department of Energy (DOE) has dramatically overstated its shale reserves estimates for both future production and even current production, too.
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This kind of argument may seem a bit conspiratorial, but we have seen it before. At the beginning of the century, the DOE presented utterly fanciful data about future oil production. For example, they (along with their sister organization the International Energy Agency) claimed that Saudi Arabia would have no problem in ramping up oil production to 20 million barrels a day or more. We were assured that oil prices would remain in the range that prevailed throughout the 1990s – on average about $20 a barrel. Of course the Saudis have never come close to that 20 mbpd level, and prices, as you know, have set one annual average high after another.
Both Powers and Berman cite the rapid decline in oil and gas shale well production as the basis of their arguments. A chart which both rely on contrasts the Pollyannaish forecasts of the DOE with the actual decline rates. For example, since March 2011 the DOE data show a 4 percent rise in gas production in Texas, while the data from the Texas state energy agency, whose reputation for accuracy is unsurpassed, show a nearly 10 percent decline in gas production! Powers and Berman’s argument, of course, is that if you cannot get current production rates right, then what are the chances of getting future rates right? Obviously pretty slim, indeed.
Another argument that both analysts use is based on the profitability of those companies engaged in shale drilling. The two largest participants here are Chesapeake Energy (CHK) on the gas side and Continental Resources (CLR) on the oil side. The current financials of both leave a lot to be desired. For avatar of shale gas Chesapeake, the company’s free cash flow has been negative for more than five years. And for CLR, the last year of positive free cash flow was 2006. Particularly troubling is that both companies have been for the large part reporting decent profits. This is especially true for CLR, whose profits have risen six-fold since 2009. So how can free cash flow be negative in the face of solid earnings and rising production?
The answer to this question is really the crux of the entire problem with shale. Unlike conventional oil and gas wells, depletion rates for shale oil and gas wells are extremely high – in some cases more than 30 percent a year. What this means is that in order to increase production you have to put in ever-greater amounts of capital. For CHK the free cash flow yield is a staggering minus 70 percent! In other words, capital expenditures for both have been rising by amounts that exceed gains in earnings. This is hardly a recipe for long-term growth, and indeed, it is disturbing that revenue for CHK is expected to decline in the future, while for Continental the rate of gain in revenues is expected to slow. These companies appear to be running ever faster just to stay in place.
Eventually they will run out of breath. And indeed, CHK has already had to sharply change its business plan.
The writing on the wall from CHK and CLR, according to our analysis, is that increasing the flow of gas and oil from shale formations is likely to prove to be a losing venture in the long-term. For Powers the long-term is about seven years, while for Berman it’s no more than 10-15 years. Berman does not offer a long-term projection for gas, but Powers believes natural gas could end up trading in double digits.
Of course, it makes sense to argue that if gas prices go up, so will shale production of gas. And to some extent that’s true. But keep a couple of points in mind: First, the low hanging fruit has already been picked when it comes to shale production; and second is that the dynamics of shale, viz., the high depletion rates, are not going to change. So even with higher prices you will still be running in place, even if perhaps the pace will be a bit slower at first. Eventually, the increased number of rigs required to keep production from declining will overwhelm any reasonable cost for gas. Remember, at a certain point there will be a gas price that necessitates a switch to other fuels. Already with gas up to just $3.50, for example, we are seeing substitution back to coal.
Is there still money to be made by producing oil and gas? Berman does not offer any recommendations, as investments are really not part of his métier. Powers, however, who has run energy funds and energy companies, is drawn to companies that produce conventional hydrocarbons and are not dependent on shale. One of his recommendations is a high-risk play in our Growth Portfolio, Denbury Resources (DNR), which is a leader in tertiary recovery. The company has access to a large stock of carbon dioxide that it uses to reinvigorate wells which have been abandoned by other producers. The stock trades at a deep discount to the underlying value of its reserves. Also noteworthy is that the company recently sold its stake in the Bakken oil shale.
Another recommendation that Powers makes is Ultra Petroleum (UPL). Like Denbury, the company does not depend on fracking for its production, and will be a major winner once natural gas prices rise in earnest. The stock currently trades at about a 30 percent discount to the net present value of its reserves, implying a well-measured target somewhere in the 30’s. Moreover, if gas prices rise, that discount based on the current share price will widen.
Thus there are, in fact, smart investment plays in this sector. What’s crucial is that they’re based on the realities of oil and gas production, and not the many fantasies prevalent in today’s media and markets.
Yours for security and growth,
Stephen Leeb, Ph.D.
Editor, The Complete Investor
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