Published June 26, 2012

How Will North America Play Its Excellent Natural Gas Hand?

Dear Reader,

Before we get into today's dispatch on North America's natural gas future, I'd like to comment on breaking news in another energy sector: uranium. You may have seen that President Obama just declared a national emergency "to deal with the threat posed to the United States by the risk of nuclear proliferation created by the accumulation in the Russian Federation of a large volume of weapons-usable fissile material."

Isn't the Cold War over?, you ask. Don't we now work with the Russians in dismantling nuclear warheads? The answers are yes and yes. Moreover, there is absolutely no reason to be concerned about this "national emergency," because with this order President Obama is not trying to rile up old tensions or threaten Russia in any way. In fact, what he's doing is lobbing a conciliatory ball into Russia's court in the hopes that Putin will pick it up and play a game called "Let's Trade Uranium."

Here's the deal. The United States relies on Russia for half of the uranium that feeds US nuclear reactors. That uranium comes from a deal called "Megatons to Megawatts," struck in 1993, that saw Russia agree to dismantle some 20,000 old nuclear warheads and downblend the highly enriched uranium (HEU) in those warheads into the low enriched uranium (LEU) that is used to power nuclear reactors.

It has all gone very well so far. Since the first downblended LEU arrived in the US in 1994, both parties have honored their sides of the deal; the US has gone so far as to thrice declare that Russian goods on American soil related to the Megatons deal are protected, by order of the president. Today's executive order was the third iteration of that order of presidential protection.

Why is Obama reiterating that Megatons-related payments and properties are off-limits to all? Because Megatons is set to expire in about a year, and the United States is desperate to convince Russia to extend the deal. And we don't think Putin is interested at all.

You see, Megatons provides the US with a reliable source of inexpensive nuclear fuel. That's a hard thing to come by today. Global demand for uranium is set to climb 33% from 2010 to 2020, and then will climb almost that much again in the next ten years. Can production keep up? Not likely. That means prices are going up. Putin know this – in fact, he's been working for several years to position Russia to profit from the looming uranium-supply crunch.

Not only does Russia produce a fair bit of uranium, Putin also carries a fair bit of clout in neighboring Kazakhstan, the world's top uranium producer. So Russia already controls a lot of primary production… but that's just the start. Since primary production (from mines) will not be able to meet demand, secondary sources will become extra-important. There is only one significant secondary source – downblended warheads – and Russia operates some of the only facilities in the world that can downblend HEU into LEU.

Putin has positioned Russia to capitalize on the looming global uranium-supply crunch. That's why he will not be at all interested in extending the Megatons deal – why agree to old terms when the global uranium scene is now on a completely different stage? Instead, Putin will be more than happy to sit down and hammer out a new uranium supply deal.

Obama knows this. This executive order is his nod to Putin, his acknowledgment that Putin has the upper hand but the US still wants to play, and his underlying plea to Putin that he play nice. Because if he doesn't, the United States will find itself scrambling for a new uranium supplier.

Our subscribers are already familiar with this topic – we have written about what we're calling the Putinization of resources several times already. Vladimir Putin is a smart, savvy leader who has long believed that natural resources can be a source of great power. After analyzing Putin's moves to corner the uranium market, his efforts to control Europe's natural gas supplies, and his use of Russia's oil wealth to gain international heft, we laid out a plan letting our subscribers know how to profit from Putinization.

So, in summary, there's nothing to worry about in this "national emergency"… for now, at least. We'll continue to watch the cat-and-mouse activities between the countries in order to stay on top of the trends.

Marin Katusa
Chief Energy Investment Strategist
Casey Research

How Will North America Play Its Excellent Natural Gas Hand?

By Marin Katusa

News of a "monster" natural gas find in British Columbia has one again highlighted that North Americans need to make a choice. Do we want to keep the huge volumes of natural gas that have been discovered in recent years across the continent landlocked and transportable only by pipeline, or should we develop the infrastructure that will enable us to transport this fuel to the gas-hungry markets of Asia?

Both options come with advantages and drawbacks, of course. Keeping the fuel landlocked will keep prices depressed, likely so much so that many producers will be unable to turn a profit and will shut up shop. Building the infrastructure to transport natural gas to faraway shores is expensive, but more importantly it would commit the continent to a future of fracking, liquefying, and exporting natural gas, a decision that carries heavy environmental repercussions.

Here's how it stacks up. North America has trillions of cubic feet of a fuel that the energy-hungry developing economies of the world want. Knowing that the easy oil and gas of the world are gone, those developing economies are desperate to lock down oil and gas supplies for the future. As their desire for our gas climbs, so will the price they are willing to pay.

In short, it's going to be hard to say no for long – the financial incentive will be too strong. That's why we see North America becoming a significant exporter of liquefied natural gas (LNG)… but not for years. It will take a long time for North America to develop substantial LNG infrastructure. In the meantime, who will benefit? Let's investigate.

Apache's Monster Find

Back in 2009, Houston-based Apache Corp. drilled a well in the Liard Basin of northern British Columbia. It was just a normal exploration well, like the thousands it had drilled before in its quest to find gas reservoirs. Then the drill hit gas.

It hit so much gas that Apache didn't release results from the well until last week, almost three years later, because the company wanted to snap up as much of the surrounding land as possible.

You do that when a single well produces 21 million cubic feet per day in its first month. Making things even better, the well was only fracked six times – in many other shale reservoirs wells are fracked as many as 18 times to enable the gas to flow freely.

Apache has now drilled three wells in the Liard, with a fourth under way, and has examined logs from 16 others drilled since the 1960s. With those results in hand the company believes the Liard could be "the best unconventional gas reservoir in North America."

Based on initial results, the company estimates that the Liard Basin holds 210 trillion cubic feet (tcf) of natural gas, of which 48 tcf is recoverable. For comparison, total US recoverable gas reserves stand at 300 tcf.

The wells drilled to date, which are spaced more than 25 km apart, are producing gas into an existing pipeline that runs south from the Northwest Territories. Apache says the fact that all the wells are performing very similarly indicates the reservoir is very robust. To give itself the best chance to tap into that robust reservoir, Apache has secured about 174,000 hectares of land in the Liard, an area that is 150 km northwest of the town of Fort Nelson and 100 km west of Horn River, another substantial BC shale gas play.

The Downside Of Shale Gas Riches

Even with only a few wells completed, there is little doubt about the importance of the Liard discovery. It is huge – so huge that Apache believes its Liard wells could be profitable at a gas price of just $2.57 per MMBtu, almost as low as current North American natural gas prices.

Gas prices in North America have been pretty volatile over the last 15 years, spiking at least four times. Discounting those short-lived price spikes, the Henry Hub spot price has ranged from just under $2 to almost $8 per MMBtu – a wide range. We are presently near the bottom of that range.

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There's a simple reason why prices are plunging: supplies are sky high.

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This is the shale gas phenomenon. The ability to tap into natural gas trapped within tight rock formations known as shale basins has unlocked trillions of cubic feet of natural gas, pushing US gas reserves from 162 tcf in 1993 to 273 tcf in 2009. (Official US Energy Information Administration data for US gas reserves is currently only available until the end of 2009, though estimates from other reputable sources such as the US Geological Survey put today's US gas reserves above 300 tcf.)

It is simple supply and demand: Supplies have risen dramatically, and demand is struggling to catch up. That is, demand within North America is struggling to catch up. There is demand aplenty in other parts of the world; and in those places prices are much higher.

In Northeast Asia, strong demand from Japan and South Korea is keeping LNG prices near US$17 per MMBtu. Yes, that is more than six times higher than the current Henry Hub spot price of US$2.70 per MMBtu. It is worth noting, too, that $2.70 per MMBtu is a relatively good price for Henry Hub, one propped up in the last few weeks by warm weather and hurricane threats. By contrast, in April the North American gas benchmark fell to just US$1.86 per MMBtu; prices have hovered near just $2 for several months.

Weak gas prices like that have several effects. First, swaths of North American gas producers are cutting back on production. They do not see a need to supply more gas to an already oversupplied market and, more importantly, many actually lose money producing gas at these prices. Second, if prices remain this depressed for a sustained period, producers will start writing down their reserves counts. A "reserve" is a volume of fuel that is economic to produce using current technology. When prices are high, lots of gas reserves are economic – even very tight shale deposits requiring multiple fracs to get the gas flowing. When prices dive, it becomes more costly than it is worth to produce gas from these challenging and expensive tight gas deposits, which means they lose their reserve status.

In short, North America's gas companies flooded their own market, drowning out any chance that good prices will return anytime soon.

Problem, Solution

The problem for North America's gas producers is that their gas is landlocked. Natural gas has to travel by pipeline – in its gas form it takes up a lot of volume per unit of energy produced, which means it is never worth the cost of transportation to ship it. So North America's gas producers are generating a product that has to find buyers in North America.

Or they could condense their product down into a liquid, rendering it transportable. That's the beauty of LNG – it is natural gas in a reduced-volume format, which means it can be loaded onto tankers and shipped across oceans.

If North Americans want to take advantage of their newfound natural gas wealth, LNG is the way forward. We can use some of the fuel at home, of course, and will use more and more if ideas like converting the continent's transport trucks to natural gas take hold. But the trillions of cubic feet of gas contained in shale basins from the Liard Basin in British Columbia to the Fort Worth Basin in Texas are more than we can use – so much more, in fact, that prices will remain too low for producers to bother producing it, and these gas reserves will revert to being geologic curiosities rather than economic resources.

That is one choice: keeping our natural gas landlocked and committing producers to years – perhaps decades – of rock-bottom pricing. The other choice is to build gas liquefaction facilities on our coasts and send our gas wealth across the oceans to markets in need. The economics of this choice are pretty clear. Even though LNG plants cost billions to build, the size of the resource here and the expectation of continued strong gas demand in the developing world put the calculations back in the black pretty quickly.

So economics are not the question. The question, instead, is environmental. Does North America want to become an LNG exporter? The economic upsides include jobs and money, but the environmental concerns include new pipelines, tankers transiting coastal waters, more drilling and fracking of natural gas wells, and the knowledge that we are enabling a continued global addiction to fossil fuels.

It's a choice that will play out in the news media over the next few years, as interested parties start vying for permission to start these multiyear construction projects. Construction is just about to begin on North America's first gas liquefaction plant, being built by Cheniere Energy at Sabine Pass, on the Gulf of Mexico near the Louisiana-Texas border. The project is expected to cost $10 billion and will not be complete until late 2015, but Cheniere has already signed offtake deals with BG Group of the UK, Gas Natural Fenosa of Spain, Gail of India, and Kogas of South Korea that account for almost 90% of the plant's expected output.

The demand is there. The opposition is there, too – Cheniere spent years trying to get regulatory approval for Sabine Pass, against the protestations of groups such as the Sierra Club.

The bottom line is that even though environmental concerns continue to hang over its natural gas industry, they are unlikely to prevent North America from eventually exporting LNG in earnest. There are simply too many jobs and too much money at stake.

However, there's a far more important dynamic for the US to consider than just cash. In fact, expanding the country's natural gas industry could counteract a growing foreign threat.

Additional Links and Reads

Oil Advances with Equities as Brent's Premium Widens (BloombergBusinessWeek)

Oil prices climbed along with US markets to start the last week of June, on news that housing prices fell less than expected and speculation that inventories declined the previous week. West Texas Intermediate crude for August delivery rose to $79.36 a barrel, though prices are still down 23% this quarter.

"Tight Oil" Output Likely to Double by 2035 (Calgary Herald)

In its first official forecast, the US government is predicting the oil production from tight formations like the Bakken shale will double in the next two decades. Output from eight regions covered in the US Energy Information Administration report will swell to 1.2 million barrels per day (bpd) by 2035, up from 720,000 bpd this year.

Natural Gas Prices Are Down But Capital Spending Surges (CNBC)

Abundant shale gas resources may have put a damper on natural gas prices in North America that is slowing output in the short term, but the gas bounty is spurring tens of billions of dollars in capital investment by a reinvigorated industry looking to the future. Investments in pipelines and other natural gas infrastructure are expected to enter the trillions of dollars over the next 20 to 30 years.

Japan Nuclear Minister Speeds Up Fukushima Cleanup (Reuters)

Workers at the crippled Fukushima nuclear plant will begin removing fuel rods from damaged reactors this year, a task that is happening a year ahead of schedule in an effort to address concerns that a new quake could cause further damage and radioactive fallout. Overall, decommissioning and cleaning up the Fukushima site is expected to take at least ten years.

For Oil Executives, the Fracking Revolution Raised Specter of a Gas Flashback (Globe and Mail)

In assessing whether rising output from North America's tight oil basins could depress oil prices in the way that production from shale basins hammered gas prices, the energy analyst behind this article concludes that tight oil could help ease prices, but global demand for oil will temper any significant price slides. Regardless, the big winners in the oil sector will always be those with the lowest production costs.