Energy Self-Sufficiency through Shale Gas Changes the Game for the United States

by Angelos Damaskos

Introduction
Angelos Damaskos is founder and CEO of Sector Investment Managers (SIM), an FSA-authorized and regulated investment advisory company, and portfolio manager for SIMs Junior Oils Trust. Junior Oils Trust, launched in October 2004, focuses its investments in smaller oil and gas equities and grew from a launch net asset value size of 3.7 million to in excess of 67 million by February 2011. In 2009 Damaskos and SIM launched Junior Gold, an FSA-authorized and regulated open-ended investment company concentrating on gold and other precious metals mining equities. Damaskos graduated in 1985 from the University of Glasgow with a degree in mechanical engineering and in 1989 obtained a MBA from the University of Sheffield. He has more than 14 years investment banking experience with major banks in London, concentrating on natural resources. Most recently he worked with the European Bank for Reconstruction and Development with responsibility for some of the banks equity investments in Russia.

The radiation leaks at Japans Fukushima reactors following the earthquake and tsunami in March 2011 appear to be causing several countries to rethink their attitude to nuclear power. How do you view the potential impact on industry, which needs reliable power generation?
The possibility of a reactor meltdown has always been the worst nightmare of everyone in the nuclear industry and, indeed, outside it. We have to understand, though, that the Fukushima reactors were an old design, one that has been in operation since the 1970s. This design requires electrical pumps to drive the coolant water, and when power was lost after the tsunami took out the backup diesel generators, coolant could not be pumped and the reactors began to overheat. In the modern design you have a passive cooling system that works on the basis of conduction and by recirculating the water within the reactor using latent heat. Germany has suspended operations at six nuclear reactors and is going to tighten up heavily on safety requirements, which may well delay the construction of new reactors. China is building 45 reactors of the passive cooling type. However, it has now announced that it wants to shift some of its future generation capacity away from nuclear, as a direct reaction to the Japanese crisis. Instead it will look to renewable generation, primarily wind, to make up the difference. But nuclear continues to be a significant part of their generation plans, so this is certainly not the end for nuclear power. The point, however, is that nuclear power plants are hugely expensive, costing anything between US$4 and 5 billion to build, and they take up to eight years to complete. And by the time they are completed, whatever design they are based on will have been to an extent superseded by newer technology. So old is not necessarily the same as bad. What is clear is that modern economies need electricity and power if they are going to thrive, and if we want to reduce carbon emission, nuclear power looks like a very big part of the equation. For fast-growing economies like China there is no alternative other than to incorporate nuclear into the mix, or their carbon emissions will grow at a frightening pace. The Japanese situation was unprecedented. We now know that, because of the contours of the land, the tsunami was 14.5 m high when it struck the plant, and not just 7.6 m, as it was when it hit the coast. Who could have envisaged such a wave swamping and devastating the Fukushima pumping system? From the perspective of the oil and gas industry, the positive thing to emerge from this disaster is that there will be an increased demand for gas-fired electricity generation. We can expect Japanese imports of liquefied natural gas (LNG) to go up as a result, and that demand in other Asian countries will grow too. There are very big LNG export facilities in the Middle East, and Australia is building some massive LNG terminals to
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meet demand from China. These should come onstream in the next few years. Whether the United States, with its vast shale gas reserves, will move into LNG export is very difficult to predict. Some licenses have already been granted, but building new plant to liquefy natural gas is hugely expensive. However, if the US production of shale gas ramps up massively, the economics might justify export. At the same time, given the revolutions that are spreading through the Arab worldrocking even such an autocratic and despotic regime as Syria and disturbing Saudi Arabiait seems clear that a generation of internet-aware citizens in that part of the world is much less inclined to accept arguments appealing to religion and tradition to explain their exclusion from the decision-making process. Over time the whole of the Persian Gulf area is likely to get caught up in this process of change. One result is that oil companies with reserves in safe political regions will attract an increasing premium as the turmoil in the Middle East grows. One obvious strategy for investors, and certainly one that we have been following, is to invest in such companies while holding significant reserves of cash to enable one to buy in to such weaknesses as might appear. Oil company bonds with a low risk of default are another way of generating reliable returns, with aggregate yields of 12.5% very achievable, along with lower volatility than one would get from an equity portfolio.

In Europe the gas price is quite tightly coupled to the price of oil. What would more gas generation plant being installed as older nuclear plants are retired do to the price of gas?
There is no one global price for gas. The gas futures industry draws its pricing from the Henry Hub futures exchange in the United States. In June 2008, when we saw oil at US$147 per barrel, gas prices were at a high of US$13.00 per 1,000 cubic feet. They have been declining ever since, to an all-time low of US$2.4 in August 2009. However, this is a purely North American phenomenon, and the low gas pricessomewhere around US $4 in March 2011are a function of too much supply. Gas and a range of oil companies, including the majors such as Exxon, are competing for prime position in the US shale gas market, and acquiring shale gas acreage is now a big part of the game. In Europe and the United Kingdom, natural gas is the fuel of choice for power generation as well as for residential and industrial heating, so we see gas prices remaining firm there for the foreseeable future. Russia has huge supplies of natural gas, so supply is not an issue for Europe, other than the political risk. However, the United Kingdom, which is now a net importer of natural gas, is presently constrained by the capacity of the pipelines that bring gas into the country. There have been several initiatives to develop temporary gas storage capacity to offset this, primarily underground in depleted oil fields, to help cope with peak demand. There may also be projects coming forward for more permanent gas storage terminals. The point about gas, versus oil, is that it is a very easy fuel to handle and is easy to distribute to many consumer points. Moreover, unlike oil, it does not have to go through an expensive refining process. However, you need big infrastructure changes before it can be used as a fuel for transport.

To what extent do you see renewables playing a major role in US power production through the next decade or so?
There is strong support right now for solar power in the United States and we are seeing some quite extensive new installations for solar generation. Clearly this has all the advantages of a home-grown industry and acts to reduce energy imports, which is positive for the US balance of trade, although currently not in a hugely significant way. But we see the cost of solar panels dropping significantly over the next year or two. This will make it much more economically viable for industrial premises and residential estates to do a lot more local power generation. What goes for the United States goes for many other parts of the world too, so we see solar power becoming increasingly important. We think that wind power, while important, is probably limited in terms of its share of global power generation since it is expensive and more difficult than solar power both to push through planning and to install. Without quite high subsidies, much of the currently installed base of wind farms around the world does not make economic sense. This is not true of solar power, and as the cost of solar panels falls it will be even less so. The United States already has massive
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fields of solar panels, and you get a direct and immediate input into the local grid. If the power is consumed by local industry and population centers, it makes excellent economic sense, particularly in states with plenty of sun like Texas.

On shale gas, how do you see this being played as an investment proposition?
One way of taking a position would be to invest in the oil majors, most of which are involved in and very committed to shale gas extraction. However, we do not particularly like investing in oil majors for the simple reason that much of their balance sheet is invested in the associated infrastructure that goes with oil and gas production. This infrastructure is completely unresponsive to upward movements in the oil price, which means that a large chunk of their balance sheets does not respond to increased oil prices. That acts as a drag on returns from an investors perspective. For this reason we prefer to invest in oil companies that are at a much earlier stage in their development, with less infrastructure on their balance sheets, such as Talisman Energy. We have exposure to that type of company. There has been a great deal of corporate activity across the United States buying or leasing land that has potential for shale gas production, and that too provides investment opportunity. However, one has to be aware that the market is very much at a positioning stage right now. Analysis shows that from a production perspective the marginal profitability of shale gas is US$56 per 1,000 cubic feet, so, considered purely from a present-day standpoint, shale gas is not profitable. In order to invest in this sector you have to take a long-term view and wait for the gas price to recover. For those companies that want to be big players in shale gas there is no option. They have to invest right now and take an early position or they simply will not be able to get into the game. So they are looking to their operations in a few years time to subsidize their current production and asset acquisition phase. However, with a positive view of gas prices over the next few years, they can continue to accelerate their production and their shale reserves. So we look to hold companies that have a large acreage in shale gas plays, knowing that this acreage will make them very attractive as acquisition targets for the majors over the next few years. We have seen transactions done in areas neighboring these companies holdings at high multiples, so we are very optimistic.

Environmentally, shale gas production is attracting considerable controversy, with allegations that it pollutes the water table, the rivers, and the local environment. Could that be a show stopper going forward?
If we start from the basics, shale gas is held in dense, relatively impermeable rock formations, so the gas is trapped in the rock and unable to flow to the surface. Many of the biggest reserves of shale gas in the United States, such as the belt running from Louisiana through to Texas, are typically far away from residential areas. However, the Marcellus Shale in New York State, on which much of the controversy over shale gas production centers, is different. Much of the production there is very close to residential areas and protests were inevitable. The controversy centers on the production technique, known as hydrofracturing, or hydrofracking. This involves drilling a deep vertical well, then drilling a long horizontal hole through the shale at the bottom of the vertical drop. Water is then pumped at high pressure down the well into the horizontal hole, where it fractures the shale. The water contains a filler, sand, which stops the cracks in the shale from resealing and allows the gas to flow from the shale. However, it also contains additives, and the shale gas production companies do not like to reveal their individual formulae for the fluids that are pumped down the well. They claim that this protects their competitive advantage and that the formulations are their intellectual property, much as CocaCola claims that its recipe for Coke is its unique property. The protestors claim that the formulae used in hydrofracking are hazardous to health and to the soil. In our view, however, it is clear that extensive studies on the potential dangers from hydrofracking have provided no conclusive evidence of damage to health or the environment. Indeed, since the vertical wells go way down below the porous rock layers into the dense

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shale, the only possibility of, say, methane, one of the most potent of the greenhouse gases, escaping is if the upper few hundred feet of the well is poorly cemented in. Given industry best practice, we do not see substantive issuesand given that, thanks to the sheer scale of the countrys shale gas reserves, we are talking here about energy self-sufficiency for the United States for the next 100 years, we cannot see protests proving a serious block to production. As Talisman points out in its account of hydrofracking, the additives typically amount to 0.5% of the total fluid used and are there to prevent bacteria building up, to lubricate the fracking process, and to prevent scale deposits that could otherwise build up on piping and equipment. A portion of the water used in hydrofracking flows back to the surface and there have been protests, particularly in the Marcellus Shale area, around sites that have allowed runoff of this water into the Delaware River. However, best practice is to capture the emerging water and to remix and reuse it to cut down on the total water requirements involved in hydrofracking. So a good part of what we will probably see going forward will be regulations to enforce codes of best practice on producers. That may raise costs slightly, but we do not see it being a show stopper. One of the difficulties for producers is that shale lease licenses typically have a use it or lose it clause, since the owner of the land, who is also the owner of the mineral rights, naturally wants to see the earliest possible returns from granting the license. However, a reasonably high percentage of the gas from a shale gas well is extracted within the first year or two, with subsequent annualized flows tailing down to a steady, but much lower, percentage. This creates a dilemma when gas prices are as low as at present, since producers from new wells are faced with having to take a significant percentage of their production to market at a time when prices are depressed, thereby contributing to the very gas glut that is depressing prices! So they are truly between a rock and a hard place at the moment, and there are going to be many producers that will not make it through gas prices that are below production costs to a period where they can expect US $78 per 1,000 cubic feet. The reverse of this is that the United States has a once-in-a-lifetime year or two of extremely cheap energy prices at a time when the price of oil looks set to go much higher than US$120 a barrel in the near future and prices of US$150 a barrel are possible if Saudi Arabian production is threatened by a spread of the unrest in North Africa. The next few years are going to be very interesting for energy analysts and for businesses that are large consumers of energy.

More Info
Books:
Collins, Jim. Good to Great: Why Some Companies Make the Leap And Others Dont. New York: HarperCollins, 2001. Fisher, Ken, with Jennifer Chou and Lara Hoffmans. The Only Three Questions That Count: Investing by Knowing What Others Dont. Hoboken, NJ: Wiley, 2007. Rogers, Jim. Adventure Capitalist: The Ultimate Road Trip. New York: Random House, 2003. Rogers, Jim. Hot Commodities: How Anyone Can Invest Profitably in the Worlds Best Market. New York: Random House, 2004. Yergin, Daniel. The Prize: The Epic Quest for Oil, Money & Power. New York: Free Press, 2008.

See Also
Viewpoints Why the World Needs a Green New Deal Industry Profile Energy Oil and Gas

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