This note was originally published at 8am on October 09, 2014 for Hedgeye subscribers.
“If I were investing in oil and gas stocks, there is one question I would ask CEO’s: what portion of your capital is going to have to go in to stay even?”
-Gwyn Morgan, Former CEO of EnCana, 2002
Shale Gas now accounts for 40% of all U.S. natural gas produced, with its share expected to increase to 53% by 2040 according to EIA estimates. The U.S. has approximately 31 years of current aggregate domestic natural gas production in technically recoverable shale reserves (assuming all natural gas produced is from shale: ~60 years of recoverable reserves at peak estimated production levels).
The Bureau of Labor Statistics (BLS) recently reported that the largest employment increases since the shale revolution commenced circa 2006 have occurred in the four U.S. states which just so happened to have engaged in the heaviest amount of hydraulic fracturing: North Dakota, Louisiana, Oklahoma, and Texas.
Although an increase in overall drilling has ceased, the production of natural gas has increased dramatically. Companies can produce 6x the amount of natural gas they could from the same well in 2010. Smarter, more efficient drilling and better technology have contributed to the increase in well productivity in the last few years.
Many domestic industries benefit from the increase in U.S. natural gas production from the petrochemicals and fertilizers space to the iron, steel, and glass manufacturing players. With an abundance of this resource seemingly available at what should be cheap prices for years to come, why not take advantage?
- Collectively embrace new projects
- Quickly approve LNG Export terminals to help both domestic producers and the trade balance
- Build an interconnected domestic network of pipelines
Why bite the hand that feeds?
Back to the Global Macro Grind…
Just to (again) re-iterate our preferred #QUAD4 positioning (GROWTH SLOWING, INFLATION DECELERATING):
- We still like bonds (treasuries and munis)
- We still think growth and inflation are slowing in the U.S.
- We still have no evidence to suggest the monetary policy response in #Quad4 is anything but dovish
We outlined the outlook for the domestic economy in a #QUAD4 scenario in our macro themes call last week (ping sales@hedgeye.com for replay access).
If there was any question about the Fed-fueled leverage embedded in overall market levels, Janet Yellen’s dovish commentary that lifted the S&P 500 44 handles off the lows to close on the highs of the day should give some insight as to why the economy and the stock market become diverged (even for long periods of time)… UNTIL IT ENDS.
The global economy was cited as “weaker than anticipated” yesterday and the stock market rallied +2.3% off the lows.
The release of the Fed minutes from the September 16-17 meeting revealed that committee members were worried that:
“further gains in the dollar could hurt exports and damp inflation”
- The S&P 500 airlifted off the lows to close +1.7% d/d
- The 10-Yr yield backed up for the fourth consecutive day and is now at a new YTD LOW (2.28%) with every tick
- The USD retreated 44 bps (RED AGAIN THIS MORNING)
- Gold is ripping this morning on the follow through (+1.6%)
Why not just buy stocks and let the Fed have their “Free Lunch” as my colleague Christian Drake explained in Tuesday’s Early Look? Why complain? Why bite the hand that feeds?
While the Fed can admittedly talk the currency in either direction, a #QUAD4 scenario also implies the existence of deflationary headwinds in the commodity space.
The answer to Gwyn Morgan’s aforementioned quote is difficult to answer at the beginning of a project.
Which E&P projects are NPV positive? How can we possibly know?
With so much uncertainty in energy prices years into the future, this question is often left unanswered until it’s boom or bust. Energy companies certainly don’t like the disinflation of prices since mid-summer.
As you can see in today’s chart, the Thomson Reuters Wildcatter’s Index (small and mid-cap E&Ps) has retreated -33% from its June YTD highs. If you top-ticked that move, it was the same day you shorted oil at the 2014 highs.
The steep premiums for natural gas in some parts of the United States shed light on the capital intensive nature of investing in the re-birth of the North American energy boom fueled by evolutionary production of shale rock resources.
While the onsite production is ramping-up across the country and flooding the market with supply, refining and transportation availability is still lacking, causing large premiums in those regions where it’s difficult to distribute resources. Developing the infrastructure requires time, and the profitability of each project is at the mercy of unpredictable oil and gas prices.
Marginal production costs in the Utica and Marcellus regions in Ohio, Pennsylvania, and West Virginia are as low as anywhere in the country. Yet, natural gas futures for January delivery in New England are priced $15 (highest nationally). If a producer in Utica could produce and refine for, call it $3, the spread is $12, so why not build a pipeline? Assume a pipeline was built from Harrison, WV to Boston (656 miles) at $3M/MILE (low-end of the cost structure). The all in cost is approximately $2Bn.
While it’s easy to field one side of the argument to produce more oil and gas, create jobs, and export the extra supply (amidst a global slowdown), lower prices are squeezing domestic producers. With the lever-up, invest now-benefit later nature of the business, the most- sound companies who have picked the best projects to undertake will be able to withstand a further sell-off in oil and gas prices.
Rankings of Marginal Production Costs of U.S. Shale Plays (Lowest to Highest):
- Utica
- Southwest Marcellus
- Permian
- Northeast Marcellus
- Eagle Ford
- Granite Wash
- Niobrara
- Barnett
- Haynesville
Rankings of Natural Gas Production per New Rig (Highest to Lowest):
- Marcellus
- Haynesville
- Utica
- Niobrara
- Eagle Ford
- Bakken
- Permian
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.30-2.45%
SPX 1930-1975
RUT 1072-1123
DAX 8938-9317
VIX 14.16-17.58
USD 85.01-85.99
EUR/USD 1.26-1.28
Pound 1.60-1.62
WTI Oil 86.82-93.17
Nat. Gas 3.81-4.05
Gold 1195-1235
Copper 2.98-3.07
Ben Ryan
Analyst
