The Energy Report: Numerous experts, including T. Boone Pickens and Porter Stansberry, have said that, thanks to natural gas shale recovery technology, the U.S. is set to become energy independent. In your new book, "Cold, Hungry and in the Dark: Exploding the Natural Gas Supply Myth," you say that the U.S. has only a five- to seven-year supply of shale gas rather than the 100 years estimated by the U.S. Energy Information Administration (EIA). What data are you consulting, and why are your conclusions so different from what the EIA projects?
Bill Powers: First of all, the EIA has since backtracked on its estimates of shale gas recoveries. At one time it was over 800 trillion cubic feet (800 Tcf), which is approximately a 40-year supply at current consumption rates. Due to reductions in estimated future recoveries in the Marcellus Shale and elsewhere, EIA estimates are now down to 400–500 Tcf, which is closer to a 20-year supply.
"T. Boone Pickens and Porter Stansberry provide very few facts to support their statements."
T. Boone Pickens and Porter Stansberry provide very few facts to support their statements. I use production history from shale plays that are currently in production. For the Barnett Shale, I use production history from the Texas Railroad Commission. For the Fayetteville Shale, I use production history from the Arkansas Oil and Gas Commission. I have examined the Department of Natural Resources' production reports for the Haynesville Shale. While there has been a big ramp-up in shale gas production, the evidence indicates that current production levels are not sustainable. In my book, I give substantial evidence that there may be 125–150 Tcf gas produced from shales in the future. That is a far cry from a 100-year supply.
TER: If the EIA's data are inaccurate, what information sources can investors turn to for reliable data?
BP: That's a tough question because it is very difficult to find independent information sources. The oil and gas industry funds a lot of these studies. MIT received money from Hess Corp.; Penn State has had controversy over its support from industry; Navigant Consulting has put out an industry-funded study. The Potential Gas Committee is also funded by the industry. Petroleum Geologist Art Berman has done some of the best work on shale gas productivity and decline curves—I cite him in my book. There are other sources out there, but they're relatively few.
Also, I document how the EIA has changed its methodology for collecting production data. The EIA has been substantially wrong—it has admitted this in the past. Last, I document the fundamental flaws in a widely cited report the EIA put out in July 2011 that went field by field through the shale gas and shale oil fields. There were numerous mistakes in that report.
TER: Your book starts with a warning that we're being set up for a replay of the 1970s gas crisis, but when we interviewed you in November 2012, readers commented on the perceived price manipulation that contributed to gas shortages 40 years ago. Is there more transparency now in reserve numbers and thus less chance of price manipulation?
BP: About 40 years ago, prices were set by the Federal Power Commission (FPC), which was the predecessor to the Department of Energy. Prices were not deregulated at the wellhead until the Wellhead Decontrol Act of 1989 accelerated the deregulation process that began in 1978. It is unlikely that there was price manipulation by producers. However, the SEC did not begin requiring publicly traded producers to put reserve numbers on their financial statements until 1978, so there was a lot of confusion and opaqueness surrounding industry reserve numbers. There is evidence that the American Gas Association (AGA), which supplied the FPC with the industry's reserve numbers at the time, would underestimate supply numbers. The FPC used the AGA's reserve data to set rates. That was quite a conflict of interest. Now, companies put out their reserve numbers on their financial statements and prices are deregulated.
"Investors should be aware that reserve numbers are estimates. . .They can be wildly off the mark."
Investors should be aware that reserve numbers are estimates made with incomplete knowledge by humans, and sometimes these reserves can be wildly off the mark. Numerous shale gas companies have taken significant write-downs over the last two years. For example, we saw Chesapeake Energy Corp. (CHK:NYSE) write down 4.6 Tcf of gas in Q2/12. That's over 20% of all of its reserves at the beginning of 2012. Other companies, such as BP Plc (BP:NYSE; BP:LSE), BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK), Exco Resources Inc. (EXCO:NYSE) and Range Resources Corp. (RRC:NYSE), all have taken write-downs.
The timeframe over which reserves are expected to be produced is rarely discussed. One of the big surprises to me in researching this book was that companies often book shale gas reserves over a 40–65-year period. Production history does not support this assumption that shale gas wells will produce for multiple decades. In fact, most shale gas wells will produce the majority of their reserves within their first five years of production. Expectations for multi-decade reserve life are just unrealistic for shale gas wells.
TER: Then what metrics should investors seek to get more accurate production projections?
"Be skeptical of companies that have a high ratio of proven undeveloped as a percentage of their total proven."
BP: The amount of a company's reserves in its "proven undeveloped" category is important. Here's why: A few years ago, the SEC dramatically increased the ability of companies to book proven undeveloped reserves. This is the result of a change to the Oil and Gas Modernization Act in 2009, which assumed there was homogeneity across shale gas fields, meaning that future wells would be similar to producing wells. The act allowed for multiple offsets from a producing well, which in turn allowed for many companies to increase their proven undeveloped reserves. However, the proven undeveloped reserves are the ones that are most likely to be written down. Be skeptical of companies that have a high ratio of proven undeveloped as a percentage of their total proven. This is the riskiest category of proven reserves. That's a good place for investors to start.
Next, look at a company's cash flow statements. See how much it is spending and what it is getting for that spending. For example, how much is it able to grow production? Can it grow with its existing cash flow, or does it have to sell assets, issue new shares or take on debt? These are important indicators that will help you determine if a company's production is sustainable or if it can grow organically.
One of the best tools for investors is to see how competitors in the areas where it operates are doing, and therefore how realistic a company's projections are.
TER: Other experts, including Bob Moriarty and Marin Katusa, have talked about the end of cheap oil and the opportunities for companies to use technology like fracking to access new sources, even if it's going to cost more. But one of the arguments you make in your book is that higher prices will not trigger increased production. Can you elaborate?
BP: It's a question of the hard geological limits. From 1973–1984, the price of gas went up twelvefold, yet production went down more than 15%. This was not due to lack of trying; the number of rigs drilling in the United States increased substantially. Also, from 2001–2007, natural gas prices increased by 50%, and production went down. Throughout the long history of oil and gas production we've seen many fields decline despite high prices.
If we look at just oil fields, many have had increases in production from the application of technology. For example, when natural gas was injected into Prudhoe Bay, production went up briefly before going back down. When nitrogen was injected into the Cantarell Field in Mexico, production went up substantially before falling. In Kern River, California, when steam was injected into the field, production went up and it's now falling. There are hard limits to what extraction technologies can do.
While I do think that higher prices will bring out marginal production, today's level of shale gas production is unsustainable. Several shale gas fields are peaking or are very close to peaking, such as the Barnett, the Fayetteville, the Haynesville, the Arkoma Woodford. All of those fields will probably see production declines even in an environment of rising prices. Rising prices will certainly lead to increased production in younger fields, such as the Marcellus, but in other fields they're not going to make a difference.
TER: You talk about the improvements in technology that lead to renewed production in aging fields. Is there any reason to believe that we have exhausted our progress in technology?
"Technology advances are not linear. They come in clumps and they come unpredictably."
BP: Absolutely not. There is a lot of technology that can be applied. However, technology advances are not linear. They come in clumps and they come unpredictably. For example, there is potentially a lot of gas underneath the salt weld in the Gulf of Mexico. As of now there are zero wells in the Gulf of Mexico that produce from below the salt weld. Next week, trillions of cubic feet may be unlocked from beneath the salt weld, but it also may be decades before these resources are actually produced. We have just come through a period of very rapid advances in horizontal drilling and fracture technology, and the next phase of that may come a year from now, but it may come decades from now. That's why I'm very skeptical that technology advances will just happen to appear at the next price spike or that the next time we have a shortage of natural gas, technology will come to the rescue.
TER: Both hedging and production are falling because natural gas prices are below the cost of drilling and operating new wells. Will that lead to higher natural gas prices by the end of 2013?
BP: I believe so. Gas has been the best performing commodity in 2013 so far. I believe declining production in some of the bigger producing areas, such as Texas, Louisiana, Wyoming or the Gulf of Mexico, will lead to tightening supplies as well as higher prices later this year. We could easily see prices between $5–7 per thousand cubic feet ($5–7/Mcf) before the end of this year, given current storage levels and the demand we continue to see from the electrical power industry. A lot of this will have to do with the weather as well as economic activity, but gas prices have bottomed and they are now in the very early stages of what I believe will be a multi-year bull run that will take prices much higher than many people believe.
TER: In your January 2012 interview, you told The Energy Report that you expected gas prices to increase substantially. The price then was between $2.50–3 per million British thermal units ($2.50–3/MMBtu), and it has just recently broken $4/MMBtu. Is this the rate of increase you expected?
BP: I would expect prices to continue to go up, but the rate of their rising is unknowable because so much depends on market perception rather than the availability of supply. The market continues to believe that there will be relatively cheap gas for several more years. This belief is slowly eroding, and the rate at which this erodes will be reflected in the upward movement of gas prices. But the trend is very clear.
TER: If increased prices don't make for increased production, how relevant is the natural gas price for investors in the space?
BP: It's still very relevant because rising gas prices increase the cash flow gas companies can generate, especially low-cost producers. A number of companies are very cheap, some are richly priced. But there are many companies, both Canadian and American, that have good projects that are very cheap on almost every metric by historical standards. These are low-cost producers, well managed. There's a great opportunity for investors who believe that gas prices are going to rise.
TER: Will large or small companies be better able to make a profit in the future? Do you see any particular companies that are well positioned?
BP: It's difficult for companies in the junior space in Canada to profit from some of the rise in gas prices, simply because of the high cost of drilling new wells. Advantage Oil and Gas Ltd. (AAV:NYSE; AAV:TSX) has a great project and it looks like the company may be doubling its Montney production by 2015. Bellatrix Exploration Ltd. (BXE:TSX) has good gas production and some interesting projects that it's moving forward. In the United States, Southwestern Energy Co. (SWN:NYSE) has had good success in the Fayetteville and now is having success in the Marcellus. It is a low-cost producer that has been able to fund most of its growth through cash flow. Ultra Petroleum Corp. (UPL:NYSE) is cheap by historical standards, and it's a low-cost producer. It has good assets in Wyoming as well as in the Marcellus. All four of those companies are big enough to attract institutional investors once the market is confident the price of natural gas will continue its upward movement. Those are at the top of my mind as companies that are best positioned.
TER: You warn of a coming a natural gas deliverability crisis and the impact that will have on the economy, leaving people cold, hungry, unemployed and in the dark. How can investors participate in the upside of a possible solution?
BP: One of the best ways for investors to mitigate what I believe will be a 1970s-style natural gas crisis that will occur sometime in the next few years is to consider companies that have leverage to rising gas prices, and I have mentioned some of those. There also are a number of companies that will profit as the rebound in alternative energy really hits home. There's a cascading effect from higher natural gas prices. Higher prices will raise the cost of electricity and lead to higher home heating bills. Increased gas prices will also lead to higher food prices because of the amount of gas that's used in fertilizers.
"We will see a rebound in alternative energy companies."
We will see a rebound in alternative energy companies. People will reconsider nuclear power, especially smaller nuclear plants that can be built modularly and have less safety risk. We will see further gains in solar and in wind. Solar power is coming close to grid parity in areas like California. Even though alternative energy companies have had a very difficult time over the last few years, for investors that really want to dig in, this is an area that is going to rebound and I think the worst is behind it. There's been a big shakeout. For investors who can take a longer-term horizon, I think there are some fantastic companies that are very attractively priced.
TER: Can you name some companies that you think that could be part of this solution?
BP: Babcock & Wilcox Co. (BWC:NYSE) is the leader in smaller nuclear plants. It's had extensive experience in building nuclear plants over the years. In the solar space, given the carnage that has occurred, it's still difficult to see which companies are going to profit, but First Solar Inc. (FSLR:NYSE) has survived. Others will make it through to the next boom in the solar industry, but there are not going to be as many competitors the next time around. I think that keeping an eye on those companies that are likely to survive is a great start for right now.
TER: Are some of these solutions riskier than others?
BP: Absolutely. Technology is changing very quickly and the price point at which some of these solutions are going to work varies. With that being said, this is what leads to opportunities for investors—finding the companies that have the best technology and that are well funded. Those are the companies that will flourish as electricity prices rise and home heating prices rise. But there's still a lot of uncertainty in the alternative energy space as far as who the big winners are going to be the next time around.
TER: Bill, I appreciate your time.
BP: Thank you very much. It was a pleasure speaking with you.
Bill Powers is an independent analyst, private investor and author of the book "Cold, Hungry and in the Dark: Exploding the Natural Gas Supply Myth." Bill is the former editor of the Powers Energy Investor, Canadian Energy Viewpoint and U.S. Energy Investor. He has published investment research on the oil and gas industry since 2002 and sits on the Board of Directors of Calgary-based Arsenal Energy. An active investor for over 25 years, Powers has devoted the last 15 years to studying and analyzing the energy sector, driven by his desire to uncover superior investment opportunities.
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1) Tom Armistead conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: None.
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3) Bill Powers: I or my family own shares of the following companies mentioned in this interview: None. I personally am or my family is paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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