Implications of Cheap Natural Gas on Public Policy and Investing

There are few prices in America that are more visible than the cost of gasoline at the pump which has recently been on a rapid upward march reminiscent of mid-2008.  At that time, price spikes brought the cost of gasoline to well over $4 per gallon in most of the country.  The causes of oil price spikes vary over time but we can be sure that any hint of turmoil in the Middle East will have this effect.  Although there is vigorous debate among economists regarding the specific price point at which oil will threaten the nascent economic recovery, there is no doubt that consumer confidence and spending would be adversely impacted if prices continue to rise at the current pace.

Historical Context

Investors like to examine pricing anomalies, particularly related to commodities that could be viewed as substitutes but trade at radically different prices.  One barrel of crude oil has approximately six times the energy content of one thousand cubic feet (mcf) of natural gas.  One mcf of natural gas is approximately equivalent to one million BTUs (MBTU).

Despite the energy equivalence, for a variety of reasons, the pricing relationship between oil and natural gas is almost never exactly six to one. Typically, a ratio of 10 to 1 has been more common in recent years, although the ratio varies widely as we discussed in an October 2009 article describing the issue in more detail.  More recently, we revisited the oil/gas pricing situation in December 2010.

Pricing Anomalies at  Extreme Levels

With the recent spike in oil prices due to political turmoil in North Africa and the Middle East, the ratio has approached extreme levels of approximately 25 as the chart below plotting the ratio of one barrel of WTI oil to 1 MBU of natural gas illustrates:

The following chart visually represents how extreme the current pricing situation is.  We are using WTI crude prices in the exhibit as a good proxy for domestic crude prices but the ratio would be even more extreme if Brent crude were used:

From a pure energy equivalence perspective, it costs in excess of four times as much to purchase crude oil compared to natural gas.  While oil has steadily increased in price over the past two years, the price of natural gas has continued to struggle to rally due to higher supply produced by shale plays in the United States. The oversupply of natural gas has caused some companies to switch their focus to shale oil plays, but this may not have more than a marginal impact in the short run.

Investing Implications

Natural gas appears to be cheap compared to oil and has been cheap for some time.  Speculating in commodities is a risky endeavor since pricing anomalies can persist for very long periods of time.  In addition, important fundamental factors related to supply help to explain at least part of the cheapness of natural gas relative to oil.  Here is what Warren Buffett had to say about natural gas in a recent CNBC interview:

JOE KERNAN: You haven’t really bought natural gas or oil in the ground or–typically, right?

BUFFETT : Not very often, no. And, you know, it–I don’t know–the oil picture five years from now will be to, you know, may be much more dependent on politics than whether I can pick the best geologist in the United States. And, you know, I know we’ll be using more natural gas, I know it’s got all kinds of advantages and it’s cheap on a BTU equivalent to oil and it’s cleaner and all kinds of things. But in the end the price depends on supply and demand. And even though demand will go up some, I don’t know whether supply’s going to go up even faster than that. And so far it’s been–the last few years I should say that, you know, natural gas has been pretty disappointing. It hasn’t been disappointing in terms of finding it, hasn’t been disappointing in terms of its performance, it’s just been–there’s been too much of it around. And I don’t know–I’m not good at figuring out, you know, whether that will change a year from now, or five years from now, and I’m not in that game.

We have written about Contango Oil & Gas company in the past and believe it has a low cost advantage over other producers and could benefit from increasing natural gas prices over time.  However, as Mr. Buffett says, the supply and demand dynamics could keep a lid on natural gas prices for many years even if demand increases but supply increases more quickly.  In this type of environment, the low cost producer should benefit, particularly if Contango CEO Ken Peak is correct regarding the need for $6 natural gas for shale plays to earn a 5 to 10 percent return.

Public Policy Implications

At a time when the price of oil is dictated largely by developments outside the United States, it appears almost self evident that sources of domestic energy should be considered for economic and national security reasons.  The argument for domestic energy is even stronger when one considers how much cheaper natural gas is compared to oil on an energy equivalent basis.  An added bonus is the fact that natural gas is a cleaner burning fuel compared to both coal and crude oil.

T. Boone Pickens, among others, have advocated wider use of natural gas.  Mr. Pickens believes that the 18-wheeler truck fleet could be converted to use natural gas rather than diesel:

About 70% of the oil we import is used as fuel for America’s 250 million cars and light trucks and 6.5 million heavy trucks. Nearly half of the oil used for transportation is used as diesel fuel to power 18-wheelers. Natural gas is the only alternative. It is not only more abundant; it costs half as much and emits almost 30% less carbon dioxide.

If, in the normal course of replacements, we exchanged those 6.5 million heavy trucks running on largely imported diesel for new ones running on domestic natural gas, we could reduce our imports by 2.5 million barrels per day. We would be able to reduce our dependence on oil from the Middle East by half in only seven years.

Public policy currently places a heavy emphasis on alternative energy sources including wind power and solar.  In addition, the United States has counterproductive policies that heavily subsidize the use of ethanol as a motor fuel, a practice that Berkshire Hathaway Vice Chairman Charlie Munger has called “monstrously stupid” due to the impact on food prices.  However, ethanol has a formidable lobby in Washington and enjoys bipartisan support.

Ultimately, if given the choice between spending $100 on a barrel of oil versus $23 on the equivalent energy provided by natural gas, a rational individual would favor natural gas purely based on the economics of the situation.  When one adds in the fact that natural gas is a cleaner burning fuel and is available in abundance from domestic sources, it is surprising that broader political support does not exist for wider use.

Data Sources:

EIA:  Cushing OK WTI Spot Prices
EIA:  Natural Gas NYMEX Spot and Futures Prices

Disclosure:  Long Contango Oil & Gas.

Contango Provides Updated Perspective on Gulf of Mexico Situation

In a presentation today, Contango Oil & Gas CEO Kenneth Peak stated that the economics of oil and gas exploration in shallow Gulf of Mexico waters have improved significantly compared to 2008 conditions due to a dramatic decrease in dayrates for the jackup rigs used in shallow waters that has more than offset moderate increases in administrative and insurance costs.  Mr. Peak also spoke at length about the new permit process in place and Contango’s efforts to adapt to changing regulatory requirements.

Liability Caps Appear Unlikely to Change

In the wake of the Deepwater Horizon disaster last year, small firms such as Contango were facing the potential for ruinous insurance costs in the event of a significant increase to the $75 million liability cap specified under the Oil Pollution Act of 1990.  In early July when oil was still flowing from the Macondo well, Obama Administration officials indicated that lifting the liability cap would be a top priority.  White House energy advisor Carol Browner even specifically stated that smaller firms may need to exit the Gulf of Mexico entirely.

In his presentation, Mr. Peak stated that the new Congress is unlikely to change the $75 million cap.  As a result, Contango (and presumably other smaller firms) have been able to purchase insurance policies at rates not materially different from last year. The exhibit below is a slide from the presentation listing Contango’s insurance coverage in 2010 and 2011:

Permit Process

Mr. Peak also provided an update on the permit process that has nearly ground to a halt for both shallow and deepwater applications in the months since the Deepwater Horizon disaster.  Exploration firms are responsible for posting a bond equivalent to four times the “worst case discharge” estimate that could occur in the event of a spill.  Contango submitted applications using a methodology that turned out to be different than new estimates made by the BOEMRE.

Although Mr. Peak stated that he does not agree with the regulator’s higher estimate, he has revised the application and anticipates that future applications will not be held up for the same reason.  The following exhibit is a slide from the presentation outlining permit status for Contango’s prospects:

Gulf of Mexico Perspective

Mr. Peak spoke at length about the need for perspective when considering the safety profile of offshore drilling compared to other industrial activities in the United States.  Shallow water operators in particular have a solid track record and spills have been minimal.  While stressing that Contango takes workplace safety very seriously, Mr. Peak also noted that the industry accounts for a very small percentage of overall workplace fatalities.  The exhibit  below  is a slide from the presentation with some revealing facts regarding the safety profile of offshore exploration.

Mr. Peak also presented  a number of slides covering the economics of natural gas compared to other energy sources as well as the economics of shale plays versus offshore exploration.

Readers are encouraged to listen to the presentation or download the slides (pdf).  Contango ORE, the recent gold and rare earth spin-off which we have discussed in the past, also published a slide deck (pdf) although this material was not covered during the presentation.

Disclosure:  The author of this article owns shares of Contango Oil & Gas and Contango ORE.

Bernanke Persists in ‘Pushing on a String’ With QE2

The mid-term election results appear to match what market participants expected in the days leading up to voting yesterday.  We will refrain from political commentary other than to make the observation that there is a difference between “benign gridlock” when the country’s course is essentially sound and gridlock when our fiscal situation is heading for disaster — which to us seems more like a suicide pact than a political strategy.  Meanwhile, the Federal Reserve is set to announce the details of its second round of quantitative easing later today.  QE2 is essentially a euphemism for printing money, which in our modern economy takes the form of the Federal Reserve buying treasury bonds of intermediate to long term maturities.

Bill Gross has referred to QE2 as a ponzi scheme and this criticism does not seem out of place.  An excellent critique of QE2 appeared in Greenlight Capital’s third quarter letter (pdf) to partners which was published on November 1.  Greenlight points out that the Fed’s initiative is much more likely to cause adverse consequences than to achieve any meaningful improvement in economic growth or employment.

Uncertainty or Lack of Liquidity?

Unlike the situation that prevailed prior to the Fed’s first experiment with quantitative easing, it is not obvious that today’s problems are due to liquidity constraints given the much improved financial condition of the banking sector and corporate cash hoards that have grown rapidly during the recovery.  The economy is facing massive short term uncertainty related to the implementation of health care reform and the fact that tax policy has yet to be finalized for 2011.  Additionally, the long term fiscal condition of the United States is not one that is likely to improve in a highly divided and partisan environment that will persist through the 2012 election cycle. In this environment, it is only prudent to proceed very carefully when it comes to investing or hiring.

As Greenlight’s letter also points out, the Fed’s actions are intended to manipulate interest rates in a manner that encourages two specific behaviors that have ponzi-like attributes.  First, speculators are buying long term government bonds not with the idea of holding the securities to maturity but with the goal of selling these bonds to the Fed or to other speculators at higher prices once QE2 goes into effect.  This is essentially the “greater fool” theory of investing and is bound to end in tears for those who get caught holding the securities when the music stops.  Second, the Fed is explicitly hoping that lower interest rates will increase prices of other financial assets that are commonly valued using models dependent on prevailing interest rates.

When The Music Stops …

At some point, the Fed will have to unwind the QE2 experiment to avoid generating much higher inflation.  At that point, the music will stop and we will find out how much current Fed policy resembles a ponzi scheme.  With Ben Bernanke securely in his position as Fed Chairman until January 2014, it would be refreshing to see him take a longer term view of the situation given that political figures in Washington are unlikely to have a time horizon longer than the 734 days that remain between now and the 2012 election.

Disclosures:  None.