Shale shock … energy investors wake in fright

PORTFOLIO POINT: From famine to feast, the world now has abundant supplies of energy resources. Investors in shale gas companies should watch the demand signs.

Best bets in Australia’s accelerating shale gas rush are the South Australian specialists, Santos and Beach Energy, but anyone tempted to take the shale plunge should do so with their eyes wide open because success in the field might not mean higher profits for producers.

The upside of the shale revolution, which started in the US five years ago, is dramatically increased production rates of natural gas and associated oil.

The downside is dramatically lower oil and gas prices.

The best measure of how shale gas and oil is re-shaping the energy business is contained in the latest edition of World Energy Outlook produced by the Paris-based International Energy Agency. It predicts that the US will:

• Displace Russia by 2015 as the world’s biggest gas producer.
• Overtake Saudi Arabia as the world’s biggest oil producer by 2020, and
• Become self-sufficient in energy by 2035.

What’s happening is a very pure example of the most basic economic forces at work. Rising supply is meeting flat demand, driving down energy prices. This leads to a zero-sum game that is delivering benefits to energy consumers, but not energy investors.

For the most part, the biggest winners from what’s happening in SA’s Cooper Basin, and in other oil and gas exploration sites around Australia, will not be energy investors. Rather, it will be industrial and household gas customers.

The Cooper, however, is where the shale drilling action will be hottest because (apart from the Perth Basin) it is the oil and gas-rich part of Australia best served by pipelines which connect gas supply with gas demand.

Investors in oil and gas companies will enjoy some benefits, but if the US experience is a guide the explorers could well become their own worst enemies, competing for market share in the only way they can – by cutting prices.

That’s why the early movers in the shale game could do well thanks to increased gas sales, but will probably suffer the same profit crunch when supply rises to satisfy demand, and then some.

In many ways, Australia’s hunt for gas and oil trapped in rocks once considered too “tight” to flow is tracking the trailblazing efforts in the US. The initial excitement of discovery in the US gave way to the dismay of over-production followed by recent signs of steadier and more profitable output as markets have adjusted and some gas wells shut in.

BHP Billiton’s experience in the US follows that trend, initially over-paying in a dash to acquire exploration acreage and early-stage production, only to be whacked by a collapsing gas price, which fell from US$13 per million British thermal units to less than US$3/mbtu. Gas prices are now recovering, with a focus on extracting oil liquids from the shale formations being drilled.

After a painful start in the business of shale-gas production, including a $2.84 billion asset-value write-down, BHP Billiton is now plotting a major expansion of gas output, including the possible liquefaction of some gas for export to Asia as LNG, competing directly with Australian-produced LNG.

What’s happening in the shale-gas operations of BHP Billiton contains a number of lessons for investors, including:

• Gas is gas (it is largely methane) and it really doesn’t matter where it comes from – conventional sources or unconventional such as from coal seams or tight shales.
• Gas can be transported by pipeline or ship, and the LNG industry is growing faster than the oil export industry.
• Gas will go to where it gets the highest price, and that’s Asia.
• Australia’s high domestic cost environment is putting it at a disadvantage with the US despite a head-start in the LNG business.
• The US gas glut has already destabilised the world coal industry, with cheap gas displacing coal in the electricity industry, and driving some Australian coal out of the Asian market.
• Champions of renewable energy have nothing to smile about because cheap gas is also a major competitor with wind and solar power, forcing governments to pay higher subsidies to justify renewable investment.

If anyone claims that six-to-12 months ago they could see what’s happening in the US gas market, and the knock-on global consequences, they’re probably not telling the truth.

I certainly did not associate the growing US gas glut with falling demand for Australian coal, even though both commodities are essentially competing in the same global energy market.

Nor has the decline in US oil imports yet been fully factored into the global oil market, though the economic force is the same, albeit in reverse. Gas has driven US coal onto the world market, and is driving foreign oil out of US ports.

The net effect is a surplus of energy, falling prices and an outlook which must have true believers in the theory of “peak oil” wondering what happened to their computer models, which had been predicting an oil price above US$200 a barrel by now (when in fact prices are closer to US$110).

It’s the same with coal. At this time last year, coal was still king of the energy world and any number of experts saw no reason to change their view. In fact, coal was looking even stronger after the Fukushima nuclear meltdown in Japan.

Today, coal is confronting a crisis. It has been dethroned by US gas, as has oil to a certain extent by declining US oil imports.

Eventually peak oil will become a potential factor, but for the next few decades (and possibly longer) it has been postponed thanks to a series of technology breakthroughs which are shaking the energy sector to its core.

Directional drilling is one of the technologies. It means that drillers no longer simply send a vertical spear into the ground to extract surrounding oil and gas. They track the oil-rich layers, gaining kilometres of extra exposure to trapped liquids and gas.

Rock fracturing (fraccing) is the other, and while controversial to some people it is a key factor in cracking open deep and tightly-packed rock to achieve spectacular oil and gas flows.

Australia’s first taste of shale gas is coming from the Moomba No.191 well in the Cooper Basin, which Santos “turned on” six weeks ago at an eye-catching start-up rate of 3 million cubic feet of gas a day. It is still running today at 2.5cf/d, much higher than was initially expected.

Why Moomba No.191 is proving to be such a prolific producer is unknown. It could be that gas is flowing from unexpected layers of rock, or that the primary target, the Murteree shale, is going to be a richer source of gas than expected.

Whatever the reason, the success of the Moomba well flags Australia’s entry into the world of shale gas. Not that it has had the slightest effect on the share price of Santos, which was trading at $11.28 on October 1 when production started, and is down to recent trades around $10.62.

The same price declines can be measured in most of the other shale-gas explorers I’ve mentioned over the past two years.

Winners and losers in a major story on shale gas published on Eureka Report on March 5 include:

• AWE (code AWE), down from $1.78 on March 5 to recent trades at $1.33.
• Buru Energy (BRU), up from $2.33 to $2.71.
• Senex Energy (SXY), down from 97c to 68.5c.
• New Standard (NSE), down from 55.5c to 30c.
• Norwest Energy (NWE), up from 5.8c to 7.8c, and
• Beach (BPT), down from $1.52 to $1.37.

Each of those stocks is worth monitoring thanks to their status as early movers into shale-gas, but it is Beach and Santos which have the best tenement positions in the Cooper Basin. Both have already “booked” conditional resources of several trillion cubic feet of gas – enough to start SA’s own LNG export business, if that becomes the best way to profit from the resource.

While every gas-rich layer of rock will require different techniques for successful production, the success of the first Moomba well is signalling that Australia has joined a game that I first noted (or overlooked to be more accurate) when visiting oil exploration projects in Texas seven years ago.

Back then, oilmen talked quietly about drilling in the Barnett shales, unsure whether the explorers were pioneers chasing a potential winner, or just another generation of risk-takers doomed to fail because the gas and oil liquids would never flow from such tightly-packed rocks – a view which had stood the test of 80 years of exploration.

Thinking back about those conversations over breakfast in a shed at the annual meeting of the North Texas Oil and Gas Association in Wichita Falls, pioneer is clearly the correct answer.

I didn’t see the shale revolution back then, and neither did anyone else.

Today, it is different. The drilling is done. The gas is flowing, and the early movers have made a fortune, though mainly from selling tenements to later arrivals such as BHP Billiton.

The challenge now is to work out how a world enjoying an energy surplus will perform, and to discard the popular views that there is an imminent energy shortage.

Recognising how an energy glut is replacing an energy shortage, it becomes clear that an investment portfolio re-think is in order.