Wednesday, November 3, 2010

Post Election Update: U.S. Natural Gas Industry

November 3, 2010-Now that the Republicans have regained control of Congress, a brief update on where the U.S. Natural Gas market is heading seems in order.

Key Themes Remain:

 Natural gas revival and industry consolidation which is well under way

-Capital wants to go to work

 There are Two Natural Gas Peak Seasons in the U.S.

-Don’t get lulled to sleep

 Production Decline Curves for Shale Gas Remain Serious Concern

-Chesapeake Energy Haynesville Production Results

 Renewable Energy: Politics and Ties to Wind and Solar

-American Wind Energy Association Data

 Distribution Problems-pipelines, LDC’s

-Substantial Infrastructure Investment Required

 Underground Storage Modeling Problems

-We are living in the dark ages

 Future of Short Sellers and Speculators

-Necessary but treacherous road


Natural gas revival and industry consolidation is well under way

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 scraping the currently flawed renewable energy and carbon emissions plans being proposed by the current administration.
The defunct 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.

The Government must force this to happen quickly and without preference for any specific group, despite the strong lobby by various groups. 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. needs 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 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.
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".
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.

The seasons are becoming obscured and 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 believes to be 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 Decline Curves for Shale Gas Remain Serious Concern
The natural gas production decline curve for shale and tight sands natural gas production is the wild card.

Take for example the experience of Chesapeake Energy (CHK), the dominant natural gas producer. First year decline rates for its Haynesville gas wells are, on average, 86 percent, according to published data. In fact, by the end of the third year, its wells are producing less than 8 percent of original recovery rates!

Moreover, the average of 44 Chesapeake gas wells (with at least 12-months worth of data) has proven initial EURs too optimistic: Given production declines, initial estimates of 6 Bcf were revised downward 60 percent to 2.4 Bcf, according to recent analysis prepared by well-known shale critic Arthur Berman, Labyrinth Consulting Services.

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

“The U.S. industry added 395 MW of wind power capacity in the third quarter of this year, making it the slowest quarter since 2007, according to the American Wind Energy Association's (AWEA) Third Quarter Market Report.

Year-to-date installations stood at 1,634 MW, down 72% from 2009. This year, wind projects in the U.S. are being installed at half the rate as in Europe, and one-third of the rate as in China, according to AWEA.
Mr. Miller has also provided endless advice to the current Democratic administration regarding renewable energy. Better to retreat, regroup, and reform for a later date in the future. Now that the Republicans have regained control of Congress, there will be new debate towards a more balanced US National Energy Policy.
The Department of Energy's own internal energy forecast, that 78-80 percent of the U.S. Energy will be supplied by fossil fuels by the year 2035. Facts the market must accept and deal with regarding energy policy.
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.

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

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 during the next 3-5 years.
Also, 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., as we found today with a natural gas withdrawal of 245 billion cubic feet of gas withdrawn from storage according to the EIA.

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 for all investors to consider, as the U.S. is burning through a lot of natural gas on a broader basis and demand is slated to grow much higher going forward. Investors considering a shelter from the market storm might do well to consider relatively cheap natural gas production companies as longer term investments.

Future of Short Sellers and Speculators

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 trade 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 heard 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.

Final Thoughts

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 2011 and beyond? The Energy industry is consolidating and 2010 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.

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This column, Energy Commentary from Karl Miller, is the opinion of Karl Miller. Content found in the articles is subject to the terms found in the InvestorIdeas.com disclaimer and does not represent a recommendation of investment advice by Mr. Miller. Investors should seek the advice of a qualified investment professional prior to making any investment decisions.

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