Sunday, April 15, 2012

The dumbest guys in the room: Is Cheniere Energy a contrarian indicator for natural gas?

Some people seem to have a knack for hopping aboard a trend just before it ends. Cheniere Energy Inc., owner of the largest liquefied natural gas (LNG) import facility in the United States, appears to be a case in point. In the world of finance, Cheniere would be what is called a contrary indicator, one that suggests that a trend is about to reverse.

In late 2004 when Cheniere received federal approval to construct a new LNG import facility at Cameron Parish, Louisiana, most experts believed U.S. natural gas production was already entering a long-term irreversible decline. Imported LNG would be needed to meet natural gas demand in the coming years. Named Sabine Pass, the facility received its first LNG cargo in April 2008 near the tail end of the last natural gas bull market. Prices peaked above $13 per thousand cubic feet (mcf) just two months later. It would have been a supremely good time to short everything related to natural gas. In the months that followed Cheniere's stock price collapsed.

Four years later U.S. natural gas prices hover around $2 per mcf due to a glut caused by a flood of new production from deep shale deposits. Domestic demand for high-cost imported LNG has evaporated. With Europeans bidding $12 for LNG cargoes and Asians bidding $16, there is simply no way for Cheniere to obtain LNG supplies that can compete with $2 natural gas.

So, Cheniere is reversing course. It is now building an export terminal at Sabine Pass and another one in Corpus Christi, Texas. Trying to put a good gloss on its wasted investment in import facilities at Sabine Pass, Cheniere tells investors on its website that it is "currently developing our proposed liquefaction project at our Sabine Pass terminal which would transform the terminal into a bi-directional LNG processing facility." Why anyone would simultaneously import and export LNG from the same facility is not explained.

The company's enthusiasm results from claims that the United States now has a 100-year supply of natural gas. That enthusiasm is shared by investors who seem unbothered by the actual data. The 100-year claim derives from an industry estimate of total resources, a significant portion of which will never turn into actual reserves. There is no evidence to suggest that all these resources will be both technically recoverable and economically profitable.

Proven U.S. reserves amount to only 11.5 years of consumption at 2010 rates. If we include proven and probable reserves, the number is 22 years, hardly a figure that inspires confidence that there will be adequate supplies available for export in the coming decades. In the same linked piece author Art Berman, a petroleum geologist and consultant who has carefully studied the state data for U.S. natural gas production, concludes that all major natural gas producing areas except Louisiana appear to be peaking in their rate of production. These include "Texas, Louisiana, Wyoming, Oklahoma, Gulf of Mexico Outer Continental Shelf, and New Mexico [which] account for roughly 75% of U.S. natural gas supply and, therefore, provide a useful proxy for total U.S gas production."

It is worth quoting Berman at length to get the flavor of his analysis:
For several years, we have been asked to believe that less is more, that more oil and gas can be produced from shale than was produced from better reservoirs over the past century. We have been told more recently that the U.S. has enough natural gas to last for 100 years. We have been presented with an improbable business model that has no barriers to entry except access to capital, that provides a source of cheap and abundant gas, and that somehow also allows for great profit. Despite three decades of experience with tight sandstone and coal-bed methane production that yielded low-margin returns and less supply than originally advertised, we are expected to believe that poorer-quality shale reservoirs will somehow provide superior returns and make the U.S. energy independent. Shale gas advocates point to the large volumes of produced gas and the participation of major oil companies in the plays as indications of success. But advocates rarely address details about profitability and they never mention failed wells.

Shale gas plays are an important and permanent part of our energy future. We need the gas because there are fewer remaining plays in the U.S. that have the potential to meet demand. A careful review of the facts, however, casts doubt on the extent to which shale plays can meet supply expectations except at much higher prices.(my emphasis)

The entire piece should be required reading for anyone involved in energy policy or who is thinking about investing in anything related to natural gas. The upshot for investors is that natural gas prices are likely to recover much sooner than most analysts are predicting. Gas rig counts in North America tumbled from 906 during the first week of November to 624 last week. This is the lowest number of gas rigs deployed since 2002. As the count continues to fall, new production capacity will slip in the face of a 32 percent annual production decline rate. That's not a typo. The U.S. must now replace one-third of its natural gas production capacity each year just to stay even. Shale gas wells contribute to much of the problem with a first-year decline averaging 65 percent and a two-year decline rate around 80 percent.

The rotary drills will only return to the shale gas fields when prices reach levels that are actually profitable which Berman estimates to be at least $4 per mcf for existing plays and up to $9 per mcf for some new ones. What this implies is much slower growth in supplies, something anticipated by the U.S. Energy Information Administration in its 2012 Annual Energy Outlook which projects that natural gas production will rise from 24.2 trillion cubic feet (tcf) in 2011 to 27.7 tcf in 2035, hardly a bonanza. Still, the EIA buys into the idea that the United States will become a net exporter of gas in 2021.

But Berman is skeptical believing that shale gas supplies will prove so challenging to extract that the country will find itself importing natural gas for a long time to come. If that's so, then we can look at Cheniere's decision to build natural gas export terminals as the perfect contrarian sign that U.S. natural gas prices are nearing their lows and will rise in the years to come.

The U.S. Congress and federal regulators may yet rue the day that they approved natural gas export terminals. Since such terminals typically enter into multi-decade contracts to ensure that they can recoup their costs, natural gas may be going out of the country just when domestic supplies are needed the most.

Cheniere expects its liquefaction plant, which liquefies natural gas by cooling it to -260 degrees F, to start operating in 2015. If that year marks the beginning of a sustained climb in U.S. natural gas prices brought on by increasing strains on domestic supplies, Cheniere will retain its usefulness as a contrary indicator. Increasingly expensive domestic gas may then result in small profit margins or even losses for exporters such as Cheniere. Between now and then, however, the hype surrounding U.S. natural gas supplies and LNG exports may help enrich a few Cheniere investors who are savvy enough to cash out before reality catches up with the company's stock price.

Disclosure: I have no investments related to Cheniere Energy Inc.

Kurt Cobb is the author of the peak-oil-themed thriller, Prelude, and a columnist for the Paris-based science news site Scitizen. His work has also been featured on Energy Bulletin, The Oil Drum, 321energy, Common Dreams, Le Monde Diplomatique, EV World, and many other sites. He maintains a blog called Resource Insights.

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