With the collapse in the price of oil, it's time to ponder how the economics of U.S. shale plays will shake out and what that portends for power utilities.
While industry insiders argue that natural gas will continue to be plentiful and cheap, a multi-year study by the University of Texas recently concluded otherwise, and that gave us considerable pause.
After all, utilities are planning to spend billions of dollars to replace aging coal plants with gas-fired generation to meet upcoming EPA carbon-emissions rules, as well as benefit from low natural gas prices. However, if projections of a 100-year gas supply prove wrong, the utilities industry could suffer serious losses.
That's why utility investors should examine their portfolios to determine to what extent their holdings have a diversified resource mix.
In general, investors who want maximum safety should avoid utilities that have excessive exposure to any one resource. The one exception is when a utility owns an ample supply of proven reserves.
But otherwise, energy diversification is the name of the game for utility investors.
In fact, the utilities industry has been burned before by sudden spikes in the price of natural gas. In some cases, regulators refused to allow utilities to pass on the fuel cost to ratepayers, and investors took the hit in the form of lower earnings.
Though this does not happen often, when natural gas price spikes lead to higher bills and widespread consumer outcry, known in the industry as the "French Revolution effect," the relationship with regulators can become so contentious as to materially undermine a utility's earnings profile over a period of years.
Will the Glut of Natural Gas Continue?
Despite prolific output from U.S. shale plays, it could happen again.
According to a team of researchers from the University of Texas (UT), forecasts for natural gas production from shale formations have been overstated--a utility executive's worst nightmare.
The journal Nature, which published the group's findings in early December, reports that the team created new forecasts for the four most productive shale plays. These forecasts suggest that gas production will soon peak and then quickly drop.
This is a much more pessimistic outlook than those offered by the U.S. Energy Information Administration (EIA) and financial institutions such as Goldman Sachs.
In examining the assumptions underpinning bullish forecasts, the UT researchers found that past projections may have been overly optimistic, "in part because the government's predictions rely on coarse-grained studies of major shale formations."
By contrast, the Texas team analyzed these formations in far greater detail. They calculate that such formations have relatively small "sweet spots," where it will be profitable to extract gas.
We won't bore you with the details of UT's methodology, but the case for their approach was strengthened when two government researchers publicly acknowledged the shortcomings of their own effort versus that of the university's research team.
A Visit with the Gas Industry
Last week, I kept up my tradition of attending the holiday party at the Natural Gas Roundtable, a non-profit group focused on natural gas and energy policy.
Given the recent changes in market dynamics, I was eager to learn how top executives were responding to these challenges.
This year, the event was held at the Canadian embassy and hosted by the CEOs of the three major natural gas associations, the American Gas Association (Dave McCurdy), the Natural Gas Supply Association (Dena Wiggins), and the Canadian Gas Association (Timothy Egan).
Fittingly enough, the even kicked off with a roundtable discussion moderated by David Sweet, the president of the Natural Gas Roundtable.
He wasted no time in getting to the question on everyone's mind: What fallout should shale players expect given the collapse in oil prices?
The Natural Gas Supply Association's Dena Wiggins struck at the heart of concerns that supply estimates could be wrong.
She put the revisionists on notice by reminding the audience that if the 1966 estimate of 600 trillion cubic feet (Tcf) of gas in this country had proved accurate we would have run out of gas by now. "Obviously our resource estimate has increased exponentially, to 2,384 Tcf," she said.
To bolster the bullish case, her association published a paper defending the various estimates made by the Potential Gas Committee, whose number she cited at the roundtable, the Energy Information Administration (2,214 Tcf), and the National Petroleum Council (3,600 Tcf).
Furthermore, the paper noted that historically the industry has underestimated domestic supply.
Instead, Wiggins is more concerned about infrastructure than reserves. "One of our challenges is the infrastructure. The resource base is great. The production is great. We need the outlet to get that gas to market. There have been a lot of proposals to build additional infrastructure."
All of the association executives echoed this bullish sentiment, saying they believed that while some fields might be affected, natural gas would continue to flow given its abundance.
The bear market in crude would only affect those fields that produce both shale oil and gas, they said.
And for low-cost producers, Sweet noted, one benefit would be that labor and rig costs would come down due to less resource competition.
The roundtable then shifted to discussions about how the shale revolution was beneficial for manufacturing and exports; how better electric-gas coordination was needed; and the environmental and political challenges to developing pipeline infrastructure, among other topics.
At the cocktail hour afterward, I chatted with a fund manager invested in the natural gas space. We both had enjoyed the discussion but still had our doubts.
So we went over to where the American and Canadian gas association presidents were standing and pressed them on their very optimistic views.
While their remarks were reassuring, it bothers me that there's really no way to decide who's right. In the end, there are two very convincing narratives--one of natural gas abundance, the other of shortage--that are well argued and supported by industry experts.
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This article originally appeared in the Utility & Income column. Never miss an issue. Sign up to receive Utility & Income by email.
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