Submitted by Alan von Altendorf,
Let's begin with the Federal Reserve. Adding $1 trillion a year to its balance sheet sounds like big money. The Congressional Budget Office recently projected an $845 billion federal deficit in 2013. States and localities will likewise disburse more than they take in taxes -- so altogether let's say it adds up to $2+ trillion of fiscal and monetary stimulus, to prop up asset values and hopefully inspire U.S. households to borrow more and spend more. Good news for investors, right?
The fly in the ointment is energy. Global oil supply has plateaued and more demand will push up prices. Americans always think of themselves first, but we're not alone in consumption of energy. China, Japan, Korea, India, the EU, and exporters like Saudi Arabia and Russia are consumers, too. Last week Britain came within days of running out of natural gas until three LNG supertankers arrived from Qatar. Those cargoes were held, waiting to see who would pay the highest price. It was freezing cold in Britain, a pipeline from Belgium went down, and the Brits bid 30% above market for the LNG cargoes to stave off power blackouts, misery and death. Price was no object. They had to have emergency supplies and it's a seller's market.
That's the ugly truth about oil & gas, flat supply and high demand.
Oil inventories in particular are extremely tight. Spare production and market rigging are easily disproved. It's a competitive global market with thousands of brokers, shippers, production operators and service companies. OPEC quotas don't mean squat. Everyone is pumping as much as they can.
Oil matters first, most, and always because it powers 95% of U.S. transportation. Farm to market. Bunker fuel. Passenger cars. Jet aircraft. Heavy equipment for construction and mining. Asphalt for roads. Lubricants that every machine, every pump, everything with wheels has to have, including a commercial fleet of 350,000 big rigs and 25,000 diesel locomotives. Oil is our industrial lifeblood.
Are you thinking about natural gas? Good. Much of it came from oil fields. It got separated at the platform and piped away as a byproduct of oil production. There are numerous conventional gas fields in Texas, Louisiana, and the Outer Continental Shelf, all of them historically owned and operated and bankrolled by oil companies. Oil paid the freight for gas development.
Of the top 10 U.S. gas producers, oil companies currently deliver 12 Tcf a year, compared to 8 Tcf from big shale frackers. And there's a dirty secret about shale gas that no one wants to discuss. Bankruptcy. Horizontal fracking for dry gas is a money-losing business. Huge sums were invested in 2008 when gas was north of $10 mmbtu. At the time no one bothered to calculate the "full cycle" cost of drilling and fracturing thousands of pricey horizontal wells.
Throughout 2009 and 2010, shale drillers played hide the sausage with hedge contracts, until their bankers and investors saw an ocean of red ink operations. Petrohawk lost $1 billion and needed a particularly dumb white knight to rescue it, which ultimately cost BHP's CEO Marius Kloppers his job. I covered the BHP-Petrohawk acquisition when it was announced (link) with a follow-up (link). If you examine any of the shale drillers' financials, like Chesapeake, you'll find the same green eyeshade heroics of hedging to cover operating losses in 2009-10.
My theory is that they kept drilling to impress unsophisticated investors and stay busy while praying prices would come back. Lets assume they were well hedged at $10/mcf. It still costs them $8/mcf to find and produce that gas, so with the spot price at $4, they are losing $4/mcf. However, they are making $6/mcf on their hedge, for a net of $2/mcf. So basically you have an extremely unprofitable gas company, tied to a very profitable trading / hedging operation. They should have cut their losses on the drilling and cashed in their hedges at $6/mcf... [but] eliminating drilling means cutting staff, so they kept going, even though it was foolish and they ended up destroying a lot of shareholder wealth. [Oil Drum comment]
Two years ago drilling cratered, except to hold acreage by production, and dry gas shale operators started offloading property to foreign investors who liked the idea of bagging hard currency mineral rights. China didn't care if shale gas was a broken business model. It wanted the technology.
Chart adapted from Berman and Pettinger (2010)
Exxon's purpose in acquiring shale driller XTO was to book reserves, not profits. "We are all losing our shirts," Rex Tillerson told the Council on Foreign Relations last June. "We're making no money [from gas production]. It's all in the red." Reserves replacement is a life or death problem for the oil majors. A quirk of accounting rules allow them to comingle assets and pretend that 6 mcf of proved gas reserves worth $20 at the wellhead = $100 barrel of Louisiana Light. As long as they don't have to produce any of that unprofitable gas, it looks good on the balance sheet.
What's happening at the majors is capitulation. Conventional gas production has been deliberately allowed to decline because there's no money in it. But smaller shale players are stuck. They have to keep producing to service their mountain of debt, pay dividends, and pay themselves fat salaries. The next two charts tell a ghastly story. Conventional gas is down, money-losing shale production up.
Energy maven Michael Fitzsimmons recently wrote that "supply and demand are coming back into alignment. In addition to substantial growth in the electrical generation sector, natural gas is also making significant progress in the transportation sector." [link] He expects a breakout to $5/mcf, once excess underground strorage is drawn down. Maybe so. But shale drillers need $8/mcf to break even, and the majors aren't going to spend another dime drilling for conventional gas. Which brings us to Sean Hannity's pie-in-the-sky reserves.
Mr. Hannity thinks shale gas is an inexhaustible resource.
With a steady supply of gas we'd be able to put people back to work... Environmentalists are unable to see that natural gas is not only more accessible, but more affordable. If America taps into its assets, we could become the world's leading exporter of natural gas.
[Hannity nationally sydicated radio broadcast 3/12/13]
Assuming that the spot price for gas moves north of $6 it's possible to see some more production. But how much, for how long? Forever? 100 years? -- or less than only a dozen years, during which prices will have to gap higher as various consumers bid for increasingly scarce gas?
The U.S. does not have 100 years of natural gas supply. There is a difference between resources and reserves that many outside the energy industry fail to grasp... The Potential Gas Committee is the standard for resource assessments because of the objectivity and credentials of its members, and its long and reliable history. In its 2011 biennial report, three categories of technically recoverable resources are identified: probable, possible, and speculative. The President and many others have taken the P.G.C. total of all three categories (2,170 Tcf) and divided by 2010 annual consumption of 24 Tcf. Much of this total resource is in accumulations too small to be produced at any price, is inaccessible to drilling, or too deep to recover economically. More relevant is the Committee's probable mean resources value of 550 Tcf of gas. [Berman, Feb 2012]
click to enlarge)
The future of natural gas is a long-term shortfall and significantly higher prices to bring production back.
I have long been puzzled by the economics of shale gas. I was never involved in shale, but was involved in drilling exploration wells in the Permian Basin. We stopped drilling for pure gas wells in 2009. We had a ten well project leased and ready to go when gas prices started collapsing. Our breakeven price was about $7/mcf, and $8 gave us a respectable profit. We drilled the first well, but put the rest on the shelf.
The Bakken Bust
Another one of Sean Hannity's brainless rants had listeners leaping for joy, because exponential fracking for oil in North Dakota, Montana, and the Texas Eagle Ford can produce an endless cornucopia of abundant, cheap U.S. gasoline, if we get those pesky environmentalists out of the way! America has so much shale oil that we could be the world's Number One oil producer and exporter! Never have to import another barrel of oil from the Middle East!
Okay. Reality check.
Whereas conventional wells like those in the Thunder Horse (deepwater Gulf of Mexico sandstone) reservoir produce at a rate of 40,000 bpd, only 14 of the nearly 9,000 wells in the Bakken produce more than 800 barrels per day, and the average well produces only 52 bpd.
[Derik Andreoli, 12/12/11]
(click to enlarge)
Presently the estimated breakeven price for the average well in the Bakken formation in North Dakota is $80-$90/bbl. In plain language this means that presently the commercial profitability for new wells is barely positive. The average well now yields around 85 000 bbls during the first 12 months of production and then experiences a year over year decline of 40%. The recent trend for newer wells is one of a perceptible decline in well productivity.
[Rune Likvern, 1/1/13]
While production continues to ramp up daily, there is one part of western North Dakota where the excitement of oil has gone bust. Chesapeake's attempt to find the southern edge of the Bakken is being described as the largest failure in drilling in the state since the 1980s...Tanks are there, collecting nothing. Well heads are in place, abandoned... Director of Mineral Resources for North Dakota, Lynn Helms said: 'There's only one well that's made any measurable oil, and it's about 10 percent oil at best, 90% water.' Chesapeake invested $60 million in the prospect of hitting oil. That excludes money spent on leases. 'Because all the drilling had been taking place north of there and the geological risk was zero, it made it look too easy. So in terms of the technology of drilling and fracking, well prepared, but in terms of geology probably not,' said Helms.
With 55 to 85% yearly decline rates how are those investors going to look in five years; especially in places like the Bakken which have $10 million wells. Eagle Ford has dismal production (143 b/d)...Chesapeake got into the shale gas game early, and is now selling everything the company has to stay out of receivership. Decline rates were much higher than originally projected. The rest of the shale industry will find the same thing happening to them.
(click to enlarge)
The government is going to be pretty damned disappointed and upset if unconventional oil turns out to be a colossal bust. And there is something funny about that EIA chart (above). Ignore the big purple blob of Tight Lower 48 and look closely at the black line and right hand scale. EIA thinks crude is going to $160 a barrel. No wonder DOE policy wonks expect shale drillers to poke around forever in marginal plays. 90% water cut sounds ok all of a sudden at $160 a barrel.
With Bernanke printing free money for the foreseeable future, and incredibly low HY rates of 5-6%, any wacky business plan is good to go, assuming that drilling contractors and completion companies don't go bankrupt with Obamacare. I also doubt their ability to keep costs down in the future. Each horizontal completion needs 1 million gallons of fresh water and someplace to get rid of it after contamination by radioactive, poisonous and corrosive formation chemicals. But broadly speaking, cheap HY funding rocket fueled the shale boom, and in the near term I expect another round of free drinks on the Fed's tab for North Dakota's roughnecks. Yee-haw!
Former Kansas City Fed president and vice chairman of the FDIC, Thomas M. Hoenig, isn't having any of it. "This system [of pumping liquidity into money center banks] distorts the market and turns appropriate risk-taking into recklessness," he warned in a WaPo op-ed last Friday.
Well, duh. Obama is throwing billions at solar and biofuels. Recklessness is the order of the day, all day, every day, to make America "energy independent" and to save the planet, of course.
The U.S Department of Defense is the world's largest consumer of refined petroleum -- gasoline, diesel, and jet fuel -- for which it pays about $3.00 a gallon because it buys tens of millions of gallons at a whack. But DoD is under tremendous pressure to "go green" and switch to biofuels. Here's the price per gallon the Pentagon paid for algae, wax and peanut oil fuel. And they had a clear winner! Fat and sugar were a bargain at slightly over $25 a gallon.
Death By Regulation
I'm a very old fashioned, simple analyst. I look at the geology, the balance sheet, and the company management. One of Houston's best is W&T Offshore (WTI) -- and it's a heartbreaker. Currently trading at a $14 handle, if you do the math on shareholder equity and common shares outstanding, it might be worth $7.
Let me repeat, so there's no misunderstanding. W&T Offshore is a superb small company, with the right stuff subsurface and a terrific management team. Absolutely first class offshore operator. Very high rate of success. (Disclosure: No position long or short in WTI and no business relationship past or present with the company or any of its employees or managers.)
No question about WTI's integrity. Reserves are audited by Netherland Sewell. If ever there was a minnow that deserved investor loyalty and a blank check to grow the business, it's W&T Offshore. But I can't recommend it as a buy, and it breaks my heart to say sell.
The succubus that's draining WTI financially is regulation. The latest 10-K calmly explains why this excellent oil finder is hanging on by a thread. If you want to understand why U.S. conventional oil production is trending downward, year after year, this is why:
BOEM [Dept of Interior] may require any of our operations on federal leases to be suspended or terminated... Numerous governmental departments issue rules and regulations to implement and enforce such laws, which are often difficult and costly to comply with and which carry substantial civil and even criminal penalties for failure to comply... Environmental laws and regulations have been subject to frequent changes over the years, and the imposition of more stringent requirements could have a material adverse effect upon our capital expenditures, earnings or competitive position, including the suspension or cessation of operations in affected areas... The Comprehensive Environmental Response, Compensation, and Liability Act imposes liability, without regard to fault, on certain classes of persons that are considered to be responsible for the release of a "hazardous substance" into the environment... In addition, companies that incur liability frequently also confront third-party claims because it is not uncommon for neighboring landowners and other third parties to file claims for personal injury and property damage allegedly caused by hazardous substances or other pollutants released into the environment from a polluted site.
Just boilerplate? Not in WTI's case.
The United States Attorney's Office for the Eastern District of Louisiana, along with the Criminal Investigation Division of the EPA conducted a federal grand jury investigation beginning in late 2010 of environmental compliance matters relating to surface discharges and reporting on four of our offshore platforms in the Gulf of Mexico in 2009... Cameron Parish landowners filed suits in the 38th Judicial District Court against the Company and several other defendants unrelated to us... alleged that property they own has been contaminated or otherwise damaged by the defendants' oil and gas exploration and production activities... During 2012, we settled claims with certain landowners and paid $10.0 million. We assessed the remaining claims to be probable and have accrued $1.3 million in our contingent liabilities... we cannot state with certainty that our estimates of additional exposure are accurate concerning this matter. On September 21, 2012, we were served with a complaint in a qui tam action filed under the federal False Claims Act by an employee of a Company contractor... A qui tam action is a lawsuit brought by a private citizen seeking civil penalties or damages against a person or company on behalf of the government for alleged violations of law. If the claims are successful, the person filing the suit may recover a percentage of the damages or penalty from the lawsuit as a reward for exposing a wrongdoing... The alleged environmental violations include allegations of discharges of relatively small amounts of oil... the same allegations involved in the federal grand jury investigation.
Anyone killed or injured? No. An oil slick? No. A few barrels spilled and a forgotten journal entry. If you've seen a video of an offshore drilling crew at work, it's miraculous that a handful of men control hundreds of barrels of drilling mud and produced water, volatile poison gases that have to be flared or connected to an undersea pipeline, and thousands of barrels of flowing crude without spilling a drop.
A good company ruined -- because a contractor blabbed to the Feds, knowing that it would pay him a fat "whistlebower" reward and civil suits would pay landowners miles away, without proof of damage to their land. Ready for full context? Natural seeps in the Gulf of Mexico spew 500,000 barrels of gooey oil and sticky tar, each and every year. Has absolutely nothing to do with WTI's offshore operations.
(click to enlarge)
There is no hope whatsoever of so-called U.S. "energy indepedence" unless three things happen. Environmental rules have to be wound back to 1970 standards -- in other words, disband the EPA and make civil plaintiffs show actual harm, not just hypothetical harm because someone goofed on a sheaf of mandated paperwork. Second, stop wasting taxpayer money on nonsense like $25 per gallon biofuel.
Third and most urgently, stop subsidizing Wall Street. Let the market decide what interest rates make sense, rewarding companies who can find and produce oil, instead of gorging themselves sick on artificially cheap junk bonds that money-losing shale swindlers will never pay off.
Everything the Fed does ultimately leads to less economic activity, less savings and more debt resulting in poverty for Americans, not prosperity.