August 31, 2010
Natural gas is a clean fuel for the U.S. Washington Politicians are starting to listen to senior industry executives but have yet to put a comprehensive and credible energy plan in place with a focus on investing in the U.S. energy future.
Nothing will stop the natural gas revival and industry consolidation which is well under way. However, sometimes the message has to be repeated, much like the military mantra; tell them what you are going to tell them, tell them, and then tell them what you told them, and tell them again. Financial markets have a very short memory as history has shown, so let’s tell them again.
The U.S. economy runs on three key factors; i) a stable housing market and; ii) affordable and dependable energy supply and; iii) stable employment environment. Without these three critical factors functioning properly, there will be no meaningful economic recovery in the U.S. economy.
The road to economic recovery all starts with truly cleaning up the banks, hedge funds and insurance companies' bad debts and overhauling the fragmented renewable energy and carbon emissions plans being debated in Washington.
The defunct residential and commercial real estate loans in the residential and commercial marketplace must be properly vetted, written down to net realizable value, and moved off the banks, hedge funds and insurance company books. Mr. Miller believes that continued subsidies and artificial stimulus plans will only prolong the necessary vetting of these distressed assets and delay a healthy economic recovery.
The Government should force this to happen through the Federal Reserve and it's control over Fannie Mae and Freddie Mac, among other Treasury functions, without preference for any specific group, despite the strong lobby by various special interests. There will be bankruptcies and liquidations; these are the cold hard facts of a capitalist society, which the U.S. Economy is founded upon.
The U.S. does need a credible and sensible energy policy and emissions plan. We have "abundant natural gas and coal resources" to support our energy needs for many years into the future, if properly deployed in conjunction with sustainable renewable energy resources for further usage into the industrial and consumer bases.
Mr. Miller also encourages investors to take this market opportunity to focus on core value of companies in all sectors. When the political dust settles, companies that generate cash flow, are positioned for growth, and are essential to the U.S. Economy like natural gas will still be core investments to all class of investors.
Why is Natural Gas Not in State of Permanent Excess Supply
Mr. Miller is a strong proponent of natural gas and called the revival of natural gas in 2009 but the gross inaccuracies being portrayed about Natural gas production, supply, and end use in Washington and select media require correction for the benefit of public interest. For reference see: http://www.investorideas.com/news/122909a.asp
Natural gas is utilized by three major class of consumers; i) the power generation industry; ii) the industrial complex; iii) the local utilities across the U.S. which distribute natural gas to individual homes and office buildings.
As Mr. Miller details in review of the "Dash to Natural Gas" of the 1990’s through 2003, a tremendous amount of natural gas fired power plants were constructed, some in "load centers" or major consumption areas, some in fringe areas like the southeast U.S. and some in outright poor locations.
To put the rationale to construct all of these natural gas fired power plants in layman terms, these natural gas fired power plants were supposed to replace the older coal fired power plants controlled by the regulated utilities across the country, be more efficient, and emit much less CO2, thus lowering the overall carbon footprint in the United States.
The industry forecast and thesis at that time was for natural gas to be priced at $3.50/$4.00/mmbtu in perpetuity, as natural gas was reported to be in oversupply, plentiful and would never in theory be interrupted, thus always available for firm deliver.
The plants were built on a scale never seen before in U.S. History, over $500 billion of debt was added to the top 80 utilities and natural gas companies going into 2001, and then the independent natural gas power plant market promptly crashed, went into financial distress and faded away from the mainstream.
The regulated utilities, with a few exceptions, would not close the older, less efficient, and larger carbon emitting coal plants, nuclear stranded cost were winding down and the owners of nuclear power plants in their regulated territories, had substantially reduced amortized cost basis, thus could sell their power cheaper than natural gas plants, and the U.S. never implemented a national energy plan, and natural gas was not always available in certain regions during peak demand, and thus not in oversupply.
These natural gas power plants are still on the ground, some running, some mothballed. If natural gas were truly "in permanent excess supply", the utilities would shut down hundreds of the coal plants running 24 hours a day across the country, fire up the natural gas plants under their control, and contract with the independent power producers who control the other natural gas plants. This has not happened during the past ten (10) years, nor will it happen anytime in the foreseeable future, until a transparent carbon emissions cost structure is in place for all industries in the United States.
It is very positive that independent gas producers have started to discover and exploit alternative means of extracting natural gas from shale and tight sands, within the U.S. borders, as Mr. Miller firmly believes and has advised Washington and the industry that it will become a "bridge" fuel by default. Despite the fact that Washington simply does not have the energy market knowledge or capacity to implement a credible energy plan for the U.S. at the current time.
The hope of a bi-partisan energy plan has escaped the current administration, despite continued counseling from Mr. Miller and many other senior energy executives. However, this does not mean that natural gas is overflowing out of every gas valve across the United States. Nor will it for quite some time.
By far, the largest consumer of natural gas should be the power generation industry across the U.S. If CO2 limits are put in place by the Federal Government at some point in the future, or individual states through the imposition of CO2 non-attainment zones, displacing and disadvantaging coal fueled plants, and all or a large portion of the natural gas power plants on the ground today were to be run as base load (running 24 hours a day) plants, excluding the small gas peakers, a tremendous strain would be put on the natural gas distribution system (major pipelines and local distribution pipelines) and diminishing any "purported permanent excess supply.
Secondly, if the local utilities started pulling gas at higher rates through the City Gate (delivery points for natural gas to major retail consuming areas like Chicago, for example), due to retail consumers using a greater amount of natural gas, a further strain would be put on the distribution system, in addition to further diminishing any "purported permanent excess supply".
Thirdly, if the U.S. industrial complex started pulling more natural gas into their industrial facilities (the Texas/Louisiana petrochemical/refinery complex for example) a further strain would be put on the distribution system, in addition to further diminishing any "purported permanent excess supply".
Fourthly, if we start fueling truck fleets and other transportation vehicles with natural gas, the question must be asked, is supply sufficient at peak heating market demand time of the winter months and peak cooling season of the summer? Is the transmission and distribution system in place to handle such use of natural gas that we can say with authority that "natural gas is in permanent excess supply"?
Also, do we have the necessary "high deliverability gas storage facilities" (salt dome or depleted fields) to handle these large withdrawals and swings of natural gas to meet excessive demand, which would essentially break the current seasonal injection period during the summer months and withdrawals during the winter months?
There would be no injection season as the industry knows it today, and no historical statistics to use as a benchmark, thus prices would continue to be volatile, reflecting a more real time supply/demand ratio for physical natural gas and for future delivery (futures contract), which they should.
Those that can pay for the physical resource in real time would set the price of natural gas, and Mr. Miller is firmly convicted this will lead to higher prices and volatility, rather than lower prices and volatility. This is what is commonly referred to as a "free market".
The U.S. need substantial electricity transmission upgrades across the country. Take for example the construction of a wind park in the desert of Arizona or Nevada for example, without a transmission line to deliver any electricity produced to the end user. The wind park owner could say that he has excess power supply; however, he has no means of transmitting that power supply to an end user, rendering the wind power useless, which is a major problem facing the wind and solar industry today.
Finally, if natural gas were in "permanent excess supply" there would be no independent natural gas producers in business such as XTO (Exxon), EOG, DVN, CHK, APC, and many other independent producers critical to the future of the U.S. Energy industry and overall economy.
Also, signing long term contracts with end users to lock in a percentage of natural gas production is a long standing practice in the industry; alternatively locking in the price the natural gas producer receives through a long term natural gas swap.
These are a positive event for the industry, as long term contracts allow producers to gain financing of their production operations, not a negative sign or downward price signal. In fact, history has shown that the higher percentage of long term contracts put in place, the scarcity of supply principle takes over, and prices become more volatile and sensitive to supply/demand events, given a larger portion of the commodity is locked up and a smaller portion is available for the spot market or for future delivery. Thus natural gas prices rise.
There was a time in the 1980's when independent natural gas producers could not even get financing to produce the gas in the ground that they owned under conventional drilling and recovery methods, that's why we as an industry invented the gas bank deal structure, to help finance these producers and bring natural gas to market. We opened up the natural gas pipelines, deregulated the industry and created "open access", thus a free market.
If the U.S. were awash in natural gas, we would shut down the coal industry, stop building wind farms and solar farms, and there would be no need for a comprehensive energy plan for the U.S. to gain energy independence. We would simply flat-line natural gas prices.
This will not happen anytime in the near future. Natural gas is a fuel of the future, but price volatility will rise, not fall and this is not a bad thing. It is a sign of a healthy, vibrant, and credible asset class, "natural gas".
Winter/summer: There are Two Natural Gas Peak Seasons in the U.S.
Lest we forget, we constructed over 250,000 megawatts of natural gas fired generation in the U.S. ten years ago with efficient heat rates (energy conversion factors), and they will be used more often each year going forward, as we experience more extreme winters and summers.
Investors should keep in mind, that during peak season and usage, the mainline pipeline systems in the U.S operate at or near maximum capacity, and "statistical natural gas in storage" is not always available, which is why we have massive price spikes at the "City Gates" or major consuming and producing areas. (Chicago, New York, and Los Angeles, etc.)
Mr. Miller believes that the natural gas market is not currently pricing in winter demand properly and is not pricing in a normal summer peak demand, given the recession of 2009. The natural gas market has been lulled to sleep on price volatility, and is due for a massive correction to the upside either due to winter or summer peak usage, and what Mr. Miller also believes there are fundamental flaws in estimating working gas in storage, actual deliverability of gas when required and insufficient mainline transportation.
While the NYMEX Natural Gas Futures Contract is a useful reference, what is more important is what is happening on the ground at the wellhead, compression station, storage facility, power plants and industrial consumers and the City gates.
Remember Mr. Miller's example of the wind farm in the desert, you can build the most efficient wind farm money can buy today, but if you don't have wind, and you don't have a transmission line and a massive renewable energy credit and federal tax credit, you have scrap value. Thus, natural gas in storage is not natural gas in the pipeline, or at the demand center.
It is a very positive thing that we have producers and some semblance of a financial system left that can actually still underwrite a long term gas contracts or financial hedges, as that is a skill set and art that has been lost on the industry for quite some time, as well as a limited number of financial institutions that have the credit and capability to participate in that arena.
The say one never forgets how to ride a bike, but in Natural Gas case, industry veterans like Mr. Miller and a select few others have had to step in and not only teach the U.S. Government what the natural gas market is, but have had to drive many aspects of the industry recovery and recognition, which includes a tremendous amount of education for the general public, media and younger financial bankers and traders.
Finally, don't go to sleep looking at the NYMEX futures contract and believe you have a grip on where natural gas prices or the market structure is going. The Futures contract is purely for speculative purposes and true producers and physical participant’s hedge and trade via the over the counter natural gas swap market, physical delivery points and use the natural gas forward price curve beyond eighteen (18) months.
Natural Gas is back in the mainstream, it is here to stay, and it is not going away just because a weather forecaster says that next week, next month, or next year are going to be a degree cooler or hotter. Core commodities have staying power, and Natural Gas has been revived and a very big way.
Production Questions-Decline Profile
The natural gas production decline curve for shale and tight sands natural gas production is the wild card.
The decline trend in natural gas well production is dictated by natural geologic formations, rock and fluid properties among other factors. Thus, a major advantage of decline trend analysis is inclusion of all production and operating conditions that would influence the performance of natural gas wells.
For illustrative purposes, the standard declines (observed in field cases and whose mathematical forms are derived empirically) are:
* Exponential decline
* Harmonic decline
* Hyperbolic decline
As an example a study was done on a few specific wells for production histories of fractured low permeability gas wells in the Piceance Basin in Northern Colorado, which are characterized by a sharp initial decline followed by a long transition into exponential decline.
These two decline periods correspond to linear and pseudo steady-state flow, respectively. Predicting rates and reserves based on test data or short production Predicting decline rates and reserves based on test data or short production histories is difficult using conventional decline curve analysis, thus making shale gas and tight sands production curves difficult to forecast.
The usual approach to predicting reserves by decline curve analysis, in this type of well, is to arbitrarily assign a high exponential decline rate for the first two or three years, followed by a lower decline. Another approach is to find a hyperbolic decline curve to fit the early tine data and extrapolate to estimate future rates. Both of these approaches can result in large errors in calculated reserves.
"Simply put, we don’t know how steep the production decline curve will be for non-traditional natural gas production will be. There is no quantitative evidence that analyst can use today to support excess supply of natural gas in the future, further pressuring prices to the upside."
Renewable Energy: Politics and Ties to Wind and Solar
Lower carbon emitting energy production is the future. Mr. Miller has provided advice to the current administration regarding renewable energy policy. Better to regroup and reform a comprehensive energy policy for the future. The Department of Energy's own internal energy forecast predict that 78-80 percent of the U.S. Energy will be supplied by fossil fuels by the year 2035.
The renewable energy sector is still a very long way from competing with the net cost of fossil fuels as measured by generation energy source and recouping the required substantial investments necessary to justify the current sector valuations.
Net Generation Shares by Energy Source: Total (All Sectors)
Coal - 46.8%
Natural Gas - 20.3%
Nuclear - 21.2%
Petroleum - 1.3%
Other Energy Sources - 3.9% Hydroelectric Conventional - 6.5%
Source: Energy Information Administration
Distribution Problems-pipelines, LDC’s
Investors should keep in mind, that during peak season and usage, the mainline pipeline systems in the U.S operate at or near maximum capacity, and "statistical natural gas in storage" is not always available, which is why we have massive price spikes at the "City Gates" or major consuming and producing areas. (Chicago, New York, etc.)
Do not be fooled or lulled to sleep by looking at one static statistic that says we have massive excess natural gas in storage in perpetuity. This is not only not true, it is quite the opposite, we have massive infrastructure problems, lack of pipeline transmission and laterals to service power plants and industrial users, as evidenced by the major natural gas delivery curtailments this past two weeks across the country.
Underground Storage Modeling Problems
Mr. Miller suggest everyone, especially energy traders remember that there is a Western region of the U.S. (often overlooked), and that region consumes a large amount of natural gas both in winter and summer, so it’s not all about the Eastern U.S.
The net result is that in Mr. Miller's opinion natural gas withdrawals have been understated and the weather volatility combined with the undervalued summer volatility will drive oil and natural gas prices up substantially higher in 2010.
We have lost much of our executive expertise related to natural gas and oil contracting, hedging, and risk management over the last ten to fifteen years in the U.S. Don't be misled by a natural gas or oil producer announcing that they have hedged part of their production output as being something negative.
These are powerful facts and circumstances at work for all investors to consider, as the U.S. is burning through a lot more natural gas and demand is slated to grow much higher going forward. Investors considering a shelter from the market storm might do well to consider natural gas production companies.
A Closer Look at What Risks the Short Sellers and Speculators Face and Their Future:
Financial short sellers and speculators trade the financial energy commodities, primarily natural gas and oil due to the liquidity and ease of clearing and leverage they can use to establish their positions. That is the advantage of having a functioning and healthy financial system.
However, when that system breaks down, the results are severe and swift and immediately impact each and every financial institution that is providing leverage to the hedge funds or in this case "shorts"; the clearinghouses seize financial assets and go into the market for immediate liquidation, which ripples through the market instantaneously in what the market refers to as systemic risk. In layman’s terms it’s a good old fashioned run on the bank and it’s not pretty and always leaves casualties.
Yet the age old problem shorts encounter when everyone piles into the same transaction as they are today is they start sitting on top of each other, amplifying the systemic risk and crowding the potential orderly exit door, much like airplanes circling a busy airport, racked, stacked, and packed, as air traffic controllers would say.
Eventually each plane must land or crash for lack of fuel as every airplane has limited fuel reserves to circle the airport for a certain period of time. Short sellers are gambling that they have enough reserve fuel to stay aloft and not crash land.
How does that relate to energy commodities and the massive traffic jam we have in the natural gas and oil markets today called the "shorts", well let’s look at some basic issues facing these investors, who by are packed like sardines in a trade, which is not novel, not unique, and certainly not complex.
Speculation is a double edged sword, when it works, rewards are generous, when the blade turns, and the results are catastrophic, especially if everyone is sitting in the same sardine can, much like the mortgage backed securities trade which took down Lehman Brothers, Bear Stearns, Merrill, and almost the entire financial system.
There was no exit door big enough to allow the herd to get out quickly, efficiently and with any meaningful capital, as the market quickly went against them, thus the run on the bank.
Power plant construction was a debt fiasco in itself, which led to the bankruptcy of NRG, PG&E National Energy Group, Mirant, and almost bankrupted many other companies
Remember there are two (2) peak energy demand seasons in the U.S. and we constructed over 250,000 megawatts of natural gas fired generation in the U.S. ten years ago with efficient heat rates (energy conversion factors), and they will be used more often each year going forward, as we experience more extreme winters and summers; case in point, the current winter 2010 which is forecasted to be the worst in 15 years.
As mentioned, NYMEX Natural Gas Futures Contract is a useful price reference, what is more important is what is happening on the ground at the wellhead, compression station, storage facility, power plants and industrial consumers and the City gates.
Do not be fooled or lulled to sleep by looking at one static statistic that says we have massive excess natural gas in storage in perpetuity. The situation on the ground is quite the opposite, we have massive infrastructure problems in the U.S., lack of pipeline transmission and laterals to service power plants and industrial users, as evidenced by the major natural gas delivery curtailments in late December and early January, or to use the analogy, a jammed exit door.
As Mr. Miller points out that traditional storage models have become dated and are grossly underestimating the true injections and withdrawals of natural gas in the U.S. leading to substantial standard deviations in analyst estimates and reported withdrawals.
Core commodities have staying power, and Natural Gas has been revived and a very big way. A true energy investor rarely has to look at NYMEX to know what is happening in the market, whether long or short. They know the physical market and infrastructure and watch closely to see when the sardine can is packed full.
It will be interesting to see how long the "shorts" can stay aloft in this environment and how much leverage the financial institutions and clearinghouses are willing to provide them.
How Do Investors Navigate in the Natural Gas Sector?
That is, how does one navigate the volatility of the market to position their portfolios in the energy sector for the balance of 2010 and beyond? Mr. Miller has already opined on multiple occasions the markets will set permanent new floor prices by year end despite any errant forecast correction in the broader markets.
The Energy industry is consolidating and 2010/11 will be a year that major industry market participants position their portfolios for the next 20-30 years, thus making prices somewhat immune to broader market issues.
Natural Gas is back in the mainstream, it is here to stay, and it is not going away just because a weather forecaster says that next week, next month, or next year are going to be a degree cooler or hotter.