Thoughts on oil and gas (Oct 2014)

  1. Ethane prices will collapse.  The pricing for natural gas liquids (NGLs) will also probably collapse though I am less sure of that.
  2. There is a very high amount of fraud when it comes to exploration and production (E&P) companies.  This creates opportunities on the short side and makes the long side difficult.
  3. Going forward, midstream will be an attractive place to be for shareholders.

Ethane and NGL pricing

Originally, shale companies targeted wells that produced “dry” natural gas since they were the most economic.  Due to the industry’s success, the pricing for natural gas fell dramatically.  Because of this, the industry is moving towards drilling “wet” natural gas wells that produce more ethane, natural gas liquids, and light oil.  “Wet” versus “dry” refers to the ethane content of the natural gas that is produced.

It turns out that the ethane content in natural gas is a problem.  Ethane makes natural gas burn hotter.  Unfortunately, most equipment cannot handle the higher temperature so this gas cannot be marketed.  Excessive ethane must be removed with special cyrogenic processing plants.  In some areas of the US, there is insufficient processing capacity to process all this wet gas.  In North Dakota, some natural gas is being intentionally flared and wasted (this is an environmental tragedy).  In the Utica shale play, some wells were shut-in due to insufficient infrastructure.

Going forward, there will be huge demand for midstream assets- gathering pipelines, processing plants, and transportation infrastructure to move the various products produced.  I think it’s obvious that once this infrastructure is in place, ethane pricing will drop dramatically.  If shale companies continue to produce ethane as a by-product from going after NGLs and light oil, there will be a glut of ethane.  The oversupply may last for a long time.

If history repeats itself, then the current focus on wetter gas plays will likely cause a massive drop in the prices for natural gas liquids.  A drop in NGL prices will not be good for shareholders in shale-related stocks that are chasing wet gas plays.

Gulf of Mexico

Previously, the GOM was a significant producer of natural gas and NGLs.  Because shale economics have improved dramatically versus the GOM, the economics of GOM drilling is not as good as it used to be.  Drilling companies that own jack-up rigs that can only be used to drill in shallow waters (e.g. the shallow parts of the GOM) will continue to be hurt by the shale boom.  Contango Oil and Gas’s existing GOM wells will be hurt if NGL prices continue to drop.

Improving shale technology

Shale companies continue to innovate and to drive their costs down with longer laterals, more fracturing stages, etc. etc.  For example, Southwestern Energy Company’s investor presentations often provide data on improved productivity.  This may create dynamics similar to textiles or semiconductors.  The benefits of constantly improving technology will mostly go to consumers; shareholders and capitalists will see little benefit because competition will drive out profits.  Improving technology can sometimes result in irrational competition as industry players make expansion decisions on current commodity pricing rather than future pricing (which will likely be lower due to continual advances in technology).

See Charlie Munger’s 1994 speech on Elementary, Worldly Wisdom.

Midstream

Note: I may be a little biased because I own calls on Kinder Morgan, Richard Kinder’s midstream juggernaut (writeup).

I think that midstream will be a reasonably attractive space for shareholders.  Growth won’t be as high as hot technology companies, online advertising, or other high-growth areas.  However, I think that some midstream stocks will generate good risk/reward for shareholders.  The risk in these stocks is often limited because these companies typically use contracts to get rid of commodity price risk*.  There are a lot of stable, fixed fees.  (*Except for gathering pipelines, whose economics depends heavily on shale companies adding more and more wells onto the network.)

Midstream companies should see strong rates of return on new investments because there is a huge supply/demand imbalance for midstream infrastructure and the companies with the expertise in building new infrastructure.  The shale boom is driving huge demand for gathering pipelines, processing plants, pipelines, LNG export plants, etc. etc.  If shale technology continues to improve, it is likely that the demand for infrastructure will continue to grow.

The other big theme affecting midstream companies is heavy oil production in Canada from tar sands.  Canada does not have (enough) refineries to process heavy oil, so this oil must be transported great distances to the right refineries.  This also drives demand for midstream infrastructure to transport the heavy oil.

Some midstream companies were hurt by the shale boom

In the past, many people thought that the US would be an importer of natural gas rather than an exporter of natural gas.  A lot of midstream infrastructure was built with this purpose in mind.  Cheniere Energy (LNG) originally wanted to be a terminal to import liquefied natural gas.  Then the shale boom happened and natural gas prices plummeted.  Thankfully for LNG shareholders, natural gas prices swung to the other extreme.  LNG is currently pursuing plans to build a terminal to export natural gas.  However, not all midstream players have been so lucky.

Boardwalk Partners (BWP) is a notable example of a company that was hurt by the shale boom.  Some of its infrastructure is geared towards handling natural gas production from the GOM (an area that will likely produce dramatically less natural gas).  Going forward however, there may be value there.  (I haven’t researched BWP enough to say whether or not there is undervaluation worth chasing.)  Boardwalk and other midstream players in similar situations (e.g. EPB) will have opportunities to construct midstream infrastructure relating to LNG exports.  They will have opportunities to deploy large amounts of capital at good rates of return.

Because we are currently in a low interest-rate environment, midstream companies will have access to lots of leverage at attractive terms.  This makes their economics more attractive.

GPs versus LPs

Many midstream companies have a GP/LP structure that is extremely lopsided and extremely favorable for the GP (discussed in my posts on Kinder Morgan and ACMP).  I generally do not want to own the LP.

Why I don’t like exploration and production companies

The underlying problem is that fraud is rampant.

  1. Most companies lie about their reserves (which is essentially a prediction about what will happen in the future).
  2. Most companies lie about their future economics.

They can get away with these lies because there is uncertainty about reserves and future economics.  In a courtroom, it will be very difficult to prove that the insiders and engineers committed fraud and were not overly optimistic and that they didn’t make honest mistakes.  Historically, the charlatans have not gotten into trouble for making rosy projections about the future or for misleading shareholders.  Most of these types of fraud are not illegal.

The reality is that most institutional investors do not ask the right questions.  They don’t take steps to protect themselves against fraud.  Investors should ask for the assumptions used to derive PV10- values (well life, decline curves, allocation of corporate G&A, etc.).  If a shale company is projecting a well life of 40-60 years with a 90% probability of being too conservative… perhaps investors should question management’s integrity.  On a deeper level, predicting the economics of a well is a complex subject that requires engineering expertise and access to technical data.  Institutional investors almost never have the former while the E&Ps almost never provide the latter.

What makes things difficult for the honest E&Ps is that the dishonest E&Ps are raising lots of capital.  Much of this capital is spent on drilling.  This creates an oversupply situation that hurts the honest operators.  The honest operators have to compete against irrational competition.  As well, there is a shortage of honest management teams.  The smart people often give in and play the game of selling overpriced stock like everybody else.

Eventually, there may be a situation where the shale boom turns into a bust.  If that happens, it will be worth looking at the operators with integrity and unusual skill in being the low-cost producer.  The old Contango Oil and Gas was such a company, but its talented CEO passed away.  It may be worth looking at Southwestern, an old joint venture partner of Contango’s.  However, you will need to wait for the day when silly shale stocks implode and end their irrational drilling.

*Disclosure:  I own KMI call options.  No position in Boardwalk / Loews, EPB, MCF, SWN, or LNG.  I am short ACMP as well as other oil and gas stocks.

Links

Beating Wall Street in oil and gas

Value Investors Club / E&P Sector Implosion – This VIC thread manages to name most of my oil and gas shorts.  Presumably I am trading against these investors.  We’ll see who makes money.

Short selling update July 2014 – An old snapshot of my short positions.

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3 thoughts on “Thoughts on oil and gas (Oct 2014)

  1. This is a pretty good overview post in my opinion and I certainly share your concerns over small and mid-cap E&Ps. A few things I’d mention are:

    (a) ethane is a Natural Gas Liquid (NGL). It can be left in the methane stream so long as the burners can handle richer gas (as you point out). But it is also a primary feedstock for the chemicals businesses. Classically – say 5 to 10 years ago, something like ~30% to 50% of the bbls of NGLs production would be ethane and little would stay in the nat gas stream. As relative oversupply dynamics change, the economics of processing and transporting the ethane – i.e. leaving it in the stream or taking it out—change. The same cryogengenic facilities that process natural gas to remove water, butanes, propane, pentanes, etc. also do remove the ethane if that is what makes sense – there aren’t separate facilities for ethane processing to my knowledge. Instead all of the desired NGLs are removed from the methane stream and then later they are fractionated (split apart, something I used to see referred to as frac’d or frac’ing but not so much these days)

    (b) ethane like the other NGLs is a useful feedstock for chemicals companies that run ‘light’. High oil prices (and in turn high naphtha) relative to energy equivalent amounts of methane, have made production of NGLs popular; in turn NGLs ‘trade up’ in value relative to methane. Ethane’s supply:demand dynamics have generally been less favorable than other NGLs.

    (c) I would highly recommend reading Enterprise Products (EPD) earnings call transcripts for anyone on this site or otherwise who is interested in the dynamics of the NGL markets. AJ Teague has consistently had some of the best commentary on the market for many years now.

    (d) I believe EPD and Exxon, among others, are making a big push to export excess ethane. I haven’t followed this market that closely for the past couple of years though so I am less up to date on the specifics. If exporting is successful, you’d expect non-US chemical plants to be happy, and for prices on ethane to go up. Whether it is exported as ethane or ethylene, it is fundamentally a lot more like exporting condensate or gasoline than exporting nat gas (i.e. you don’t need super cooling and regasification infrastructure).

    • Wow, great comments!

      In terms of special facilities, I tried to simplify the overall story. From researching REXX, I noticed that they aren’t using their refrigeration plant presumably because it doesn’t remove enough ethane. Of course you can leave some ethane in the natural gas stream but the huge oversupply of wet gas means that a lot of ethane has to be removed.

      I haven’t quite figured out the ethane consumption side yet. Some of the oil majors are building multi-billion dollar crackers that use ethane as a feedstock (and produce ethylene). However, they aren’t pure plays on ethane. Some of the companies that consume ethylene might be interesting. And chemical companies that consume NGLs might be interesting.

      I will check out EPD, thanks.

  2. Pingback: Energy stock rankings (Oct 2014) | Glenn Chan's Random Notes on Investing

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