Game Changer? - Nicola Wealth

Game Changer?


TACT 2013-03 Game Changer (header)

There is a revolution going on in America that could make a significant difference in the economic fortunes of that country, and it revolves around the massive increase in the production of oil and gas from shale deposits, which are abundant in the U.S.

In this newsletter, we’ll look at the implications of this as we first consider some observations about the situation, and then a few important questions whose answers will ultimately affect our investment strategy.

SOME FACTS

  • The U.S. will overtake Russia and Saudi Arabia in the next few years as the world’s largest oil producer, according to the International Energy Agency.
  • The U.S. surplus in natural gas gives it even more potential to develop energy independence. New supplies have grown so much that prices for North American gas are far cheaper than they are in Europe or Asia. This gives U.S. manufacturers a significant cost advantage in energy. The following charts show the increase in natural gas from major U.S. shale deposits (Annual Shale Gas Production by Play) and U.S. vs. international gas prices (Cheap Fuel).
  • U.S. oil consumption has dropped from its peak in 2004 and is now less than it was in 2001. This in large part is due to conservation and efficiency as well as the introduction of biofuels (see Oil Consumption chart).

TACT 2013-03 Cheap Fuel

TACT 2013-03 Annual Shale Gas Production

The U.S. is still the world’s largest consumer of oil, but the net effect of conservation and increased production could reduce its dependency by as much as 6 to 7 million barrels per day between 10 and 20 years from now. That, in turn, would reduce the U.S. trade deficit with the rest of the world by almost $250-billion in 2013. That is almost 50% of the deficit.

TACT 2013-03 Oil Consumption

TACT 2013-03 Reductions in Net Oil Imports

Over the last twenty years or more, manufacturing jobs have left the U.S. and gone to China and other low-cost labour countries. However, the massive difference in labour costs is now shrinking. When other factors such as duties, supply chains, transportation costs and logistics of having design and manufacturing so far apart, the overall savings in offshoring are low or minimal for many firms.

TACT 2013-03 Manufacturing Outsourcing

Firms such as Nucor, Apple, Caterpillar, Ford, GE, Whirlpool, Samsung and Toyota are “reshoring” manufacturing to the U.S. In fact, in some important areas, China will have the same total costs of manufacturing as the U.S. by 2015.

A FEW QUESTIONS

  • Is this boom in both oil and gas sustainable or a temporary blip in what has become an increasing energy dependency over time for America?
  • Is the reshoring effect significant enough to change unemployment levels and, perhaps just as importantly, make a dent in the U.S. trade deficit?
  • Will the U.S. be able to continue to reduce its requirements on the demand side (through, for example, conservation and the continued use of electric cars)? Right now about 70% of the oil consumed in the U.S. is used for transportation?
  • Will North American gas prices remain depressed because there is such a glut of product? Will LNG (liquefied natural gas) plants planned to open in the U.S. go ahead and allow gas to be shipped to markets with much higher current prices? If so, what might that do to American net energy dependency? Would it also increase gas prices in North America or would we always have a price advantage because of the lower cost of delivering gas to the end user?
  • What does this do to Canada?We are by far the largest exporter of oil and gas to the U.S. (see map below). However, Canada is expected to increase oil and gas production significantly over the next few years. Who are we going to sell it to if our largest trading partner is having its own boom in oil and gas production?

TACT 2013-03 American Oil Flow

  • When all is said and done, will this be a game changer for the U.S. in terms of its job creation, manufacturing base, trade deficit, and, of course, its fiscal deficit (the royalties on gas and oil could make a big difference to government revenues)?
  • What investment opportunities exist as a result of these changes, if in fact they occur and are sustainable?

OTHER OPINIONS

We’ll look at each of these questions, but first let me share with you three books written by different authors and with different views on energy and its impact on both the U.S. and global economy.

TACT 2013-03 The Quest“The Quest” is written by Daniel Yergin, a world-recognized expert on energy for many years and a winner of the Pulitzer Prize for his earlier book “The Prize.” The book is an exhaustive look at all forms of energy and their histories. Yergin believes fossil fuels will be the major supply of energy for many decades and we will not run out of oil and gas (but it will get more expensive to find and deliver).

He is a supporter of alternative energy and the use of electric vehicles. (Interestingly, he did note that one of Henry Ford’s first automobiles ran on batteries and could go 60 miles without a recharge; car companies are still trying to jump that hurdle 100 years later.) Finally, he sees a bright future for natural gas as a replacement for coal and, eventually, for oil in some transportation areas (such as trucking and bus fleets).

TACT 2013-03 Why Your World“Why Your World is About to Get a Whole Lot Smaller” is by Jeff Rubin. Rubin is a Canadian economist who is also a believer in peak oil (as in cheap oil is gone and the price of oil will rise to $200 / barrel and higher because the supply will not be able to keep up with the demand).

The impact of this will be a huge increase in the cost of imported goods (both manufactured and foodstuffs) because of massive increases in transportation costs. The higher oil prices will act as a new tax on consumers, at best creating a long-term recession and, at worst, a depression until a replacement for oil can be found. Needless to say, he and Yergin are not on the same page, but both books are well written and offer an interesting way to read opposing views.

TACT 2013-03 Energy ObesityThe last book is also written by a Canadian. “The End of Energy Obesity” was penned by Peter Tertzakian, an oil and gas analyst for ARC Resources in Calgary. His previous book was also well received (“1000 Barrels Per Second”). Tertzakian is closer to Yergin in his overall views, but feels more strongly about the role that conservation has to play to make energy work effectively.

 

 

 

LOOKING FOR ANSWERS

Having read these books, let me outline how I see them answering some of the questions we asked earlier.

  • I lean towards both the analysis and conclusions of Yergin and Tertzakian. We are not running out of oil as has been shown by both deep sea exploration and shale deposits, but both are far more expensive than Saudi Oil. A combination of North American supply chain for energy and conservation would continue to reduce dependence on OPEC and bring back many jobs, to the U.S. in particular.
  • If America was able to develop the political will to increase taxes, it would double taxes on fossil fuels. This would not only reduce demand, but that money could be used to subsidize technology development in long-term sustainable alternatives such as, wind, solar, and nuclear. (I doubt they have the will to do this, so my hopes are modest.)
  • Nevertheless, for the next twenty years it would appear that the U.S. will annually increase its total fossil fuel output and reduce its overall demand at the same time. That means both the trade and fiscal deficits should drop significantly based on just this factor alone.
  • The U.S. spends far more on energy exploration than other country at $138-billion per year (compared to $35-billion in China and $5-billion in Saudi Arabia).
  • The U.S. and Canada will develop LNG plants that will ship gas overseas and take advantage of the huge price differences that exist for gas around the world and not for oil (which is considered fungible). Eventually, this will lift gas prices to some equilibrium between those world prices and the current depressed prices. How quickly this occurs depends on regulatory approvals.
  • Another key factor with gas prices will be the increase in the use of gas because of companies such as Nucor reshoring production back to the U.S. The speed with which that occurs could materially affect prices, yet still leave them competitive vs. the rest of the world.
  • Reshoring of some manufacturing jobs is also occurring because of the shrinking wage differentials between low-cost producers and rich world economies. This can be significant if labour is a small portion of the production costs (as it is in the case of an iPad) or when there is a benefit in bringing manufacturing closer to the R&D of a company.

SOME CONCLUSIONS

There are two themes I take away for all of this:

  • The U.S. has the ability to dramatically change both its energy dependency and shrinking manufacturing base at the same time. I think this will happen and have a positive effect on the trade and fiscal deficits, as well as unemployment. I see this as relatively bullish for the U.S. (I also acknowledge that unless there are long-term solutions to both the U.S. debt and deficits created between the White House and Congress, this potential windfall could easily dissipate. I remain optimistic that some reasonable compromise will be reached.)
  • If there is a victim in this story it is natural gas, whose price in North America has been depressed for some time because of the glut of gas stuck on the North American continent. Right now gas sells for 1/6th the price in Asia and about 1/3rd the price in Europe. On an energy basis, it sells for about 25% of the price of oil in North America. Our belief is that some of this price difference will be arbitraged away by a combination of the LNG plant development noted earlier and a higher increase in the uses for gas to provide core energy needs. We believe a long-term hold in natural gas will create some very attractive returns over time.

INVESTMENT STRATEGY IMPACT

How will this affect our investment strategy?

  • An increase in our overall exposure to the U.S. economy through some of its best run companies.
  • We already own positions in natural gas companies. In the U.S., we own Master Limited Partnerships to acquire exposure to energy, because of their tax efficiency and higher yields.
  • In Canada, we have assets in royalty companies such as Caledonian and Range Royalty. These are both private equity and not liquid, but generate a reasonable cash flow in the form of distributions.
  • We will consider investing in infrastructure. Because of both capital and liquidity issues, it is likely we would do this through other pools, created for large institutions, to diversify and reduce risk.
  • Pipeline companies and shipping companies that have long-term contracts to deliver gas (such as Teekay).

Overall, this is good news for America and, ultimately, good news for Canada; but perhaps not right now. We are currently going through some pain with depressed prices for both oil and gas.

That will not change until we have developed the ability to sell both on world markets – not just to the U.S. – and that will require pipelines. There is much resistance from both environmentalists and native bands with respect to the building of pipelines. That creates more risk in Canada until these issues are resolved.

My guess is that we will agree to allow the development of LNG and the supporting pipelines that are required and eventually that will support higher gas prices. The political and environmental issues with oil, and the fact that almost all new production comes from the oil sands, will prove to be considerably more difficult to resolve.

If the shale oil and gas developments in North America are sustainable, then North Americans (U.S. residents in particular) will be significant beneficiaries with a more secure supply of energy, price advantages for what might be decades with gas, more manufacturing jobs, and large infrastructure spending.

Certainly, oil and gas can be an important part of most anyone’s portfolio, and it is an asset class we are watching closely as part of our investment strategy.

The Other Side of the Coin:
The Argument for Peak Oil and Gas

This newsletter takes a widely POSITIVE view of the potential for American energy independence, but as with everything, there is always another side to the story. So what is the argument for Peak Oil and a scarcity of U.S. energy resources?

TACT 2013-03 Cold HungryIn Game Changer?, we spoke of Jeff Rubin’s view that peak oil (and to a lesser degree gas) means resources are limited and prices will rise considerably over the next few years.

He is not the only one who does not see an explosion of shale oil and gas production in America.

Two U.S. experts, Bill Powers and Arthur Berman, have been writing and speaking about issues regarding the entire shale industry for years, and in May of 2013 Powers’ new book will come out with a foreword from Berman.

In brief, here are their concerns:

  • Decline rates in shale oil and gas fields are as much as 50% in the first year and require a lot of expensive drilling to maintain production in a given area.
  • The 100 years of gas supply for the U.S. is more likely five to seven years, and the nation can ill afford to ship gas overseas as LNG (Liquified Natural Gas).
  • All of this means higher gas and oil prices over the next few years and leaves the U.S. dependent on others for energy.

For a more detailed summary of Powers’ reasoning, go to this link for his interview with “The Energy Report” (http://www.theenergyreport.com/pub/na/14705).

So, is the boom in shale oil and gas an energy Ponzi scheme or the real deal?

As with most things, the truth likely lies somewhere in between. Critics of Powers and Berman point out that shale gas production has risen 1200% in the last ten years, and that other major institutions (such as MIT) disagree with their analysis.

My own thoughts are that technology over time does make a difference and makes certain types of resources that were impossible to recover, viable. A number of major parties (including pipeline companies, oil and gas companies, LNG plants, and governments) are making some big investments based on their belief that they can extract the gas and oil for many decades to come.

In the end, I believe the price of energy will outpace inflation for the foreseeable future and that having a part of one’s capital invested in energy is logical, since, by itself, it drives the global economy.

Because gas is currently the depressed poor cousin, to me it makes sense to have a greater focus here. Ironically, if Powers, Rubin, Berman et al are right, then investing in gas will be even better since prices will rise more rapidly due to lower production.

This document is not intended to provide legal, accounting, tax or specific investment advice. Information contained in this document was obtained from sources believed to be reliable; however Nicola Wealth Management does not assume any responsibility for losses, whether direct, special or consequential, that arise out of the use of this information. Please speak to your advisor for personalized advice based on your unique circumstances.