Blog Migration

With new upgrades to my website, my blog is being migrated to FraimCPA.com. Please check there for any future posts.

Thanks,

Micah

Back to Blogging

Hello all:

I took the site down for about a year along with any articles I had previously posted. These have been added back onto the site. Hoping to have some new content on here soon.

Thanks,

Micah

The Future of Natural Gas

Originally Published May 2012:

The Future of Natural Gas

This is so broad a subject I hesitate to even try to fit it into one discussion. In my work I do a lot of research on natural gas. I don’t think any commodity is so widely talked about while being so woefully misunderstood. Lack of knowledge regarding industry operations combined with PR campaigns from gas industry and environmental groups have led to a mass of misinformation.

This has culminated in the following beliefs:

• New technologies have unlocked 100 years of domestic natural gas reserves
• Advanced techniques now allow more gas to be produced with fewer rigs and resources
• Because of the value of liquids being drilled for, “associated” (byproduct) natural gas can be profitable regardless of the price
• Because of the above two bullets, natural gas production will only increase
• Because of increased production, natural gas consumption can increase drastically while keeping the price within the $2-4/Mcf range

Regrettably, none of these claims are true. The amount of information that could be included here is immense. To try to avoid obfuscating the issue with excessive detail, I will try to keep it limited to main points.

Supply

Anyone who follows the energy markets has heard the claim: 100 years of clean energy. That sounds pretty great. Even if we doubled our natural gas consumption then we would have 50 years of supply – more than enough time to research alternative fuel sources. Unfortunately, the claim is outdated. The U.S. Geological Survey decreased their estimates to 20 years of marketable supply in August of last year. The issue? Marketable supply.

Geologist Art Berman has been spearheading this issue for some time. Shale reserves are vastly overstated for two reasons. First, the production from shale wells decreases 30-50% after the first year of production. In short, companies must constantly drill in order to maintain supply. Second, the reserves included in the original 100 year total are not economically viable to drill. That is, they are not concentrated enough to warrant the cost to extract the gas. Art’s graph of Barnett drilling highlights how concentrated the marketable reserves really are:

Priced into the market is the assumption that gas reserves are higher than they actually are and companies are making long-term decisions based on those beliefs. Yet at the same time, gas rig counts are constantly decreasing. The following shows rig data from Baker Hughes:

While associated gas from oil drilling has propped up natural gas production, it is not sufficient on its own. It is still a byproduct of the activity and is often flared. Low price has led to the decrease in gas rigs and the decrease in dedicated natural gas rigs appears to finally be decreasing withdrawals. We will discuss later why it has taken so long to do so.

Demand

Natural gas demand has been increasing drastically in the past few years, mostly in the domestic energy sector. The cheap price combined with an efficiency factor over coal generation has led to this being the most cost efficient fuel source. This is occurring at the same time when coal is getting hit with EPA regulations (CSAPR, MATS, CCS mandates on new plants, etc.) Installing the controls is extremely capital intensive ($500M+), which effectively regulates plants of <200MW out of existence. In addition, running the controls has a parasitic load estimated between 5-15% of the overall plant generation, which increases the cost.

Plants have to make long-term decisions at a time when environmental regulations are negatively impacting coal, natural gas prices are historically low, and the analysis by every energy firm is that those prices will stay that way. So given a weak electric market when these utilities are choosing which plants to run, which plants to close, and what new plants to build – natural gas has been their choice.

And while they have yet to make an impact on the market, there are several other opportunities for natural gas consumption. The price premium of international LNG over domestic natural gas prices makes LNG export very attractive if new terminals can get permits. Likewise, CNG and LNG vehicles are slowly gaining traction because of the low cost of natural gas relative to diesel. Clean Energy and other companies are working on natural gas trucking corridors to increase the possibility of conversion. The following from a natural gas convention in October of 2011 shows a summary of projected demand increases by 2020.

All of this paints a very rosy picture for the natural gas industry. But as any economist knows: the market always corrects. What is positive for demand is undoubtedly also positive for price.

Prices & Profitability

With supply likely stagnating because of the factors mentioned in the first section, increased demand will shift the equilibrium price. It has been estimated that a 2 Bcf/day increase in gas demand equates to a $2/Mcf price increase. Based on the gas industry’s projection above, that would theoretically increase natural gas to a minimum of $10.70/Mcf by 2020. This is a far cry from the $4.50 that is being projected by CERA and others.

And in reality, supply has the very real possibility of not just stagnating but decreasing. Despite claims to the contrary by natural gas companies, natural gas needs to be somewhere between the $5.50-9.00/Mcf range for drilling to be profitable. Encana, Chesapeake, and others have been forced to announce cutbacks because of the low gas price and associated gas simply cannot fill the void in the long-term. The graph below shows how this is already starting to occur.

The graph below highlights how volatile gas has been within the last decade.

Bottom line: with demand increasing and supply at best remaining constant, price will increase. As it has throughout history, once enough conversion has taken place the price will spike drastically.

Other Miscellaneous Factors

The question that seems to have confused people and led them to agree with analysts who ostensibly have knowledge of the industry is this: “Why so long? Gas prices have been below marginal costs for some time. Why now? If prices haven’t already shifted, why would they do so now?” In addition to the reasons listed above, there are some mitigating factors that have gone into this.

The first is that new natural gas supply has outstripped pipeline capacity. As old pipeline routes have become obsolete due to new shale resources, the pipeline industry has not been building new pipelines as quickly as drilling companies have drilled new wells. This has created a massive supply glut with no outlet to utilities and other customers who would potentially buy the gas.

This supply glut combined with an unusually warm winter has created stored gas levels that have never been seen before. Storage capacity will likely fill up this summer – forcing drilled gas to either be capped or flared. This excess of stored gas creates excessive supply even as drilling and production decrease.

Then we must look at the drillers themselves. Savvy companies were able to take advantage of long-term price hedges. This enabled them to get a relatively premium price for their gas even as the market price was collapsing. These favorable hedges have now either expired or are soon expiring. Those same companies also had lease agreements that mandated that they drill with no consideration to price. Again, those old lease agreements are expiring and companies are not entering into new ones (read: decreased production).

Conclusion

The combined effect of this is fairly clear. Demand has and will continue to increase. If historic well depletion rates hold true and rig counts continue on their current path, supply will at best remain constant. And mitigating factors that have kept production and storage levels high are slowly going away. This will lead to further decreases in drilling until the inevitable happens when gas price goes back up and drilling becomes profitable again.

Might this take several years? Absolutely. But projections of a slow, incredibly stable increase in gas price for the 30 next years when it has been nothing but unstable in the past are patently absurd.

Greek Exit: Big Surprise?

Originally Published May 2012:

Greek Exit: Big Surprise?

Let me begin by disclaiming that this is a viewpoint I stole from Stratfor. It is not of my own making.

I was at a conference in St. Petersburg, FL last November. On the first day, the opening speaker was giving an overview of general market conditions and made a few comments that I could just not wrap my head around. She was talking about the EU and said that they were very confident that while conditions in Greece were difficult it would not exit the EU. She said that France/Germany would work to ensure this would positively not happen. After the presentation I raised my hand and raised this question:

“Since its inception as a modern nation Greece has operated on the verge of bankruptcy and has avoided it in a combination of three ways:

1.      By tourism, by which no country can sustain itself with exclusively

2.      By maritime trade, which has shifted to larger countries with more modern ports

3.      And by acting as a hub for larger nations to invade its neighboring nations

With #1 being insufficient on its own, #2 decreasing, and #3 not looking to be any sort of option in the near future, how is Greece to sustain itself? It falsified financial information to gain admission into the EU and its economic landscape is only worsening. It has been and likely will continue to be on the verge of default. The analysis I have read has said that Greek withdrawal from the EU is not only likely but somewhat inevitable. How do you justify saying it will remain the EU?”

The speaker rambled off some comments about how the ramifications for a Greek exit would be very difficult, other countries would not want for that to happen, it would just be really, really hard, etc. The attendee next to me leaned over and whispered “I think you stumped her.”

No one has ever claimed that a Greek exit would not be painful. No one has ever claimed it would be the preferred approach. Greece leaving would send ripples to Spain and Italy and make an already undesirable debt market even more difficult to sell to investors. No one wants this to happen.

But it seems increasingly unlikely that it can be avoided. Germany has a superior river network and higher worker efficiency. The only way a smaller country such as Greece can remain trade competitive is by currency devaluation – which is not an option with the Euro. So it will continue to struggle in the current system.

If Greece ends up leaving the EU, is it really a surprise? 

Chinese Growth Expectations

Originally published May 2012:

Chinese Growth Expectations

Where to begin…

The chances of this being read by anyone are incredibly slim. I am not a reporter. I am not an economist. I am not anyone with any kind of fame. I am a CPA and energy analyst. Still, for my own sanity I would like a public, published record of what I have been saying for over a year now: there is a very real chance that the Chinese economy will not meet growth expectations. Why this viewpoint has not even been heard by most people, let alone agreed with, is incredibly peculiar to me. Is it because Chinese growth is considered so vital to global economic health given austerity measures in Europe and tenuous growth domestically? Is the thought that China could slow down (let alone go into recession) so frightening that no one dares breathe the word? Is there some incredible phenomenon of groupthink occurring? Are people afraid to be the only person who voices an opposing opinion?

In an age where people take outlandish stances purely for some degree of notoriety and iconoclasm, few people raising legitimate concerns regarding the almost universally held belief of sustained Chinese growth is amazing. The key to the whole issue is this: the Chinese economy is based on growth, not profitability. The Chinese government invests tremendous time and resources to expand its growth and sphere of influence. So long as the growth continues as it has recently, everything is fine. If it does not, the economy begins to resemble a Ponzi scheme and everything falls apart. There are some areas of concern regarding the sustainability of this growth. For ease of reading I have attempted to group them into two main categories, although they are absolutely intertwined and overlap with one another.

Costs

China has had one main competitive advantage in recent memory: low cost of production. For goods that required less worker expertise, artificially low wage rates and other low cost factors allowed China unmatched cost to productivity ratios. But the landscape is changing:

o   Chinese wage rates increased 150% from 1999 to 2006 and are increasing at a rate of 15-20% per year. Per the Boston Consulting Group, this will reduce China’s labor cost advantage from 55% to 39% by 2015.

o   Asian market LNG (liquefied natural gas) prices range from $12-16 while domestic natural gas prices have been hovering between $2-4 (the sustainability of which is another discussion altogether). Asian LNG prices will only continue to go up as Japan continues its nuclear phase-out and continues to import additional LNG. This naturally means shipping and energy costs will increase for Chinese produced products.

o   Chinese land prices are increasing.

o   Indonesia and other nations are increasing their capabilities and are cost-competitive with Chinese goods.

So we can see that the Chinese cost advantage has taken a major hit and will likely continue to do so. But the story does not end there.

Demand

China is not a usable resource rich nation. Supposedly massive shale resources will not be able to be utilized because water is so scarce in most parts of the nation. This leaves China to use its lower quality coal reserves, import higher quality coal from Australia and the U.S., and import oil and LNG from neighboring Arab nations.

So what is a nation to do when it does not have the ability to export natural resources and wishes to grow? It has a few options. It can export services (as India sometimes does). It can attempt to be self-sufficient and live in isolation (North Korea and apartheid-era South Africa). Or it can import raw goods, transform them, and attempt to sell the finished product. This has obviously been the Chinese approach and has worked well for some time. But consider the environment in which the Chinese economy now operates.

Chinese domestic demand cannot begin to match its production. This necessitates significant exports to other countries, mainly the U.S. and Europe. The current Eurozone crisis (that has too many factors to even begin to discuss here) threatens the whole global system. This bleeds over into the U.S. where recovery has been mixed. And when economic conditions and the outlook are uncertain, those without employment have hardly anything to spend and those who are employed have a decreased MPC. In the wake of decreased demand, Chinese exports not only need to be sustained, they need to grow in order for their GDP to increase.

This does not even begin to mention the oftentimes strained relationship between China and some of its consumer countries. Recently, China not following EU trade sanctions against Iranian oil exports led to tense conversations between the countries involved. Differences in governmental and human rights ideologies frequently put China at odds with the U.S and EU. If any of these things ever caused a significant rift between China and one of its main consumers, it would have no other means to recover the loss.

Combined Effect

The combination of these factors leaves China in a very unpleasant situation. Japan of the 1990s looked very similar to the China of today. Growth was exploding at historic rates, its influence was expanding, and by all counts Japan looked to be the next global superpower. Then the economic outlook worsened, growth slowed, and the economy collapsed. That is not a forecast of what will happen to China today, but it does highlight the possibility and reason for concern.

The one way China could help guarantee sustained growth would be to have guaranteed demand. With global demand decreasing, China would need to capture a greater portion of overall demand by making sure their goods are the lowest cost. Historically this would be done by deflation, wage reductions, and general slowdown. The problem? Growth and inflation go hand in hand. China simply cannot effectively combat inflation while trying to grow at ~9% per year. This means wages will continue to rise, which takes away its main competitive advantage, which only further reduces demand. And if demand falls, so does the nation.

Again, this is not a prediction of what will happen. This is not me looking into a crystal ball to tell the world China’s fate. China may very well continue to grow and the economy continue to be stable. This is simply to highlight that the almost unanimously held belief that China will undoubtedly and absolutely grow and expand is far from true.