How to profit as the ‘fracking’ energy revolution takes off

In 2003, the then Federal Reserve chairman Alan Greenspan stood before US politicians and warned that America was facing an energy crisis. Local gas production was unable to meet demand. Prices were soaring. The US would have to import shiploads of liquefied natural gas (LNG). Most industry heavyweights agreed with him. By March 2005, 55 new or expanded re-gasification terminals necessary for processing LNG were being planned across the US and Canada.

But the LNG flood never arrived. By 2009 only six new facilities had been built. Why? Because America's energy outlook had been transformed. Gas production had grown by 20% since Greenspan's warning, while the country's reserves had doubled. Indeed, those same LNG facilities are now being adapted to handle exports. The source of this miracle? Unconventional gas. US engineers found a relatively cheap way to access new types of deposits. And while until recently the benefits have been largely restricted to the US, the gas revolution now looks set to shake up the global energy industry.

What is unconventional gas?

Conventional gas forms in concentrated bubbles in highly porous, permeable reservoirs that can be tapped by traditional vertical wells, so it's easy to get out of the ground. By contrast, unconventional gas is widely dispersed in hard or impermeable rocks. We look at some of the different types of gas below, but in short, it requires much more complicated drilling techniques to extract.

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Until the 1970s, America had paid little attention to this hard-to-reach type of gas. But gas shortages encouraged policymakers to deregulate the gas market. By 1989, private companies were free to charge what they wanted for gas. This encouraged them to hunt for ways to exploit America's huge unconventional reserves and invest in alternative drilling techniques. In 2002, Mitchell Energy developed fracking' as a way to extract reserves in the Barnett Shale in north Texas. The method was refined so it would work in other unconventional gas basins too. The resulting boost to gas production meant that, instead of having to import ever more LNG, America began cutting down. International LNG producers such as Qatar, who had boosted export capacity to supply the US, suddenly found demand had dropped. With a glut of locally produced gas competing against foreign producers eager to offload spare production, North American gas prices fell from more than $13 per million British thermal units (Btu) three years ago to $3.63 per million Btu today.

This is even more remarkable given that the price of oil is around $100 a barrel. Gas has always traded at a discount to oil, due to its lower energy content and more restricted uses, but that discount has ballooned. For the last 20 years or so, gas sold for around 1/10th of the price of oil, but now it goes for around 1/20th. Even if you strip out the difference in energy content and compare like for like, gas is still cheaper in other words, you get more bang for your buck than with oil.

Until now the cheap gas glut has been largely confined to America, but that looks set to change. Australia, Argentina, Indonesia, China and India have all made huge finds. Global gas reserves once expected to run out before oil or coal have doubled in the last five years. Shale gas could even have a big impact here in the UK. A recent discovery in Lancashire could hold as much as 200 trillion cubic feet. That's the equivalent of more than 60 years of gas consumption.

Gas goes global

Of course, just because countries have unconventional gas reserves doesn't mean that they will exploit them. The International Energy Agency (IEA) warns that "the complex issues related to unconventional gas production mean that future production projections are subject to a large degree of uncertainty". For example, in France, drilling has been banned amid fears that fracking' chemicals could contaminate water supplies.

Yet some countries will push on regardless. Turner Investments' Robb Parlanti notes that criticisms of unconventional gas "are negligible in comparison with the safety risks posed by nuclear power power-plant meltdowns and the still-unresolved problem of what to do with spent nuclear fuel". This comparison is particularly relevant, he says, because "the world has only two realistic choices for generating massive amounts of clean-burning electricity: nuclear power or natural gas". And after the Fukushima disaster, the "angst-ridden public and political backlash against nuclear power around the world... is likely to lead to slower growth for nuclear power and greater demand for natural gas".

The politics of energy also support unconventional gas development. Before shale gas came along, Venezuela and Iran looked set to corner the gas market, an uncomfortable situation for the West. Now, however, as The Economist notes, if "the shale-gas success is repeated elsewhere, a vital source of energy will become available from an ever more diverse and numerous set of suppliers in increasingly free markets", reducing the political clout of these nations.

China, which recently overtook the US as the world's largest energy consumer, has no wish to be held hostage by its suppliers either. It has the world's largest unconventional gas resources the IEA reckons around 19% of the global total and is trying to gain knowledge in the field by buying specialist American firms. And the US is happy for other countries to copy its techniques. Keen to create a world awash with cheap energy, America has launched the Global Shale Gas Initiative "to help countries seeking to utilise their unconventional natural gas resources". So far China, India, Poland and Jordan have signed up to the deal.

The golden age of gas

The IEA reckons we are now entering a "golden age of gas". It predicts that gas use will grow by 62% between 2008 and 2035, replacing coal as the second-most used fuel after oil. Unconventional gas will play a huge part in this, with its contribution to overall gas production rising from 12% to 24% over the period. But finding the gas is only half the challenge. A key element in the success of US unconventional gas was the deregulated market. If gas is to overtake coal it needs to be relatively cheap and internationally available. For that to happen the gas market must evolve into an international commodity market. Unlike oil, the gas market is still largely regional: low prices in the Americas don't translate to low prices in Asia and Europe. For example, Asian LNG currently trades at around $11 per million BTU while the UK price is hovering at $8.

The main reason for this is that the European and Asian gas markets are dominated by long-term contracts linked to the price of oil. Historically these contracts were needed to justify heavy spending on pipelines, which prevented a more flexible spot market from developing. Another reason for the difference is transport. Pipelines make sense for intra-regional trade, but ships are needed to create a global market.

The answer? LNG. Export terminals turn the gas into a chilled, compressed liquid. LNG takes up 1/600th of the volume of normal gas, making it much easier to transport. It then needs to be re-gasified at a specialist import terminal when it arrives in a country. The good news is that in the last decade the cost of such terminals has fallen. This has allowed more countries to access LNG imports, creating a bigger LNG market and an incentive for producers to build export facilities. Between 2006 and 2010 volumes of traded LNG doubled: now more than 40 countries export and import the stuff. LNG now accounts for 20% of all gas traded internationally. "The structure of the LNG trade is evolving," says the president of the International Gas Union, Dr Abdul Rahim Hashim. "While long-term contracts will continue to underpin new investments, they are being increasingly supplemented by a growing short-term and spot trade, made possible in part by destination flexibility in LNG contracts. More than a fifth of the world's LNG trade in 2010 was in the short-term market, and the volume is expected to grow further in the next few years." Meanwhile, a new type of floating LNG facility should help producers bring gas from smaller reservoirs to market. Until now one of the major problems with LNG was that it was only economically viable to build liquefaction plants next to large deposits. Now floating facilities will be able to export all the gas from a small deposit before sailing to the next country.

Exciting stuff but none of it will come cheap. The IEA reckons that $8trn will be spent on natural-gas-related infrastructure between now and 2035 as countries and companies expand production, transportation and storage facilities. We look at some of the best ways to profit below.

A blow for Malthus

Despite advances in renewable and nuclear energy, fossil fuels still account for more than 80% of global energy consumption. Given that supplies are finite, it's understandable that scientists spend a lot of time worrying about when they might run out. The Malthusian argument that rapid population growth is using up the earth's resources too quickly for comfort has been gaining ground recently, while stalling global oil production there has been no significant growth in crude oil production since 2005 has seen the notion of peak oil' turn from near-conspiracy theory into widely accepted mainstream argument.

So does unconventional gas change all that? US energy analyst Gregor Macdonald doesn't think so. "North America not just the US but Canada as well looks to have massive natural gas resources." But he warns that the boom is not what it seems. "It's taking more wells across North America to produce this natural gas from shale." Moreover, attempts to "scale up this production [are] going to run into water and contamination issues". The environmental issue ultimately boils down to politics, so it may not seem a sticking point in the face of global energy shortages. But it's not the only hurdle to gas's golden age'. Gas may be able to replace coal in power stations, but it will have a much harder time replacing oil in fuel tanks. Sales of gas-powered cars are rising fast, but from a tiny base. For gas to truly have an impact on the oil market, "the market for transportation fuels must be breached by natural gas or gas-derived fuels", says Donald Hertzmark on energy blog MasterResource.

But the impact of the boom in gas reserves will not be confined to the energy market. Gas is also a key feedstock for fertiliser, plastics and many chemicals. Until recently many believed that rising gas prices would push up the cost of thousands of day-to-day items a forecast that now looks unlikely to come true. So while it's not necessarily a magic bullet, the success of unconventional gas is a victory for human ingenuity against the Malthusians, says The Economist, that "should make the world a cleaner, safer place".

(Source: Cedigaz)

The best stocks to buy now

One way to play the growing trade in LNG is to invest in firms that transport the stuff. Last November last year we tipped Golar LNG (NYSE: GLNG), one of the world's independent owners and operators of LNG carriers. Since then, shares in the Norwegian shipping firm have jumped by more than 150%. On a forward p/e of 20, the stock now looks quite pricey. However, if you have already bought in, we'd keep hold of it, as it is well placed to benefit from increased LNG trade.

Then there's the question of infrastructure. Once gas has been extracted, it needs to be processed, shipped and stored. That means an awful lot of infrastructure will need to be built as gas use jumps over the next 25 years. One firm that is well positioned to benefit from this is US engineer and manufacturer Chart Industries (Nasdaq: GTLS). The firm's energy and chemicals division makes a range of products for storing, cooling and transporting gas, and its equipment is used in LNG liquefaction and re-gasification terminals. Chart also produces smaller products that should benefit from the growth in small and mid-scale LNG projects. Chart's distribution and storage arm serves industrial users. For example, its compressed gas solutions allow customers who are far from any pipelines to transport natural gas by road. Indeed, Chart recently expanded its manufacturing facilities to meet growing industrial demand.

All told, these segments contribute 75% to group sales with the remainder made up by gas-based medical devices. Chart has recently bolstered its presence in China Asia now accounts for 21% of sales. On a forward p/e of 16.8, the firm isn't cheap, but earnings should see an upside as a string of new LNG projects are developed. Of the seven analysts covering the stock, six rate it as a buy with a consensus target price of $66.

Woodside Petroleum's (ASX: WPL) name is something of a misnomer. Australia's largest energy company has long produced more gas than oil. The firm has 6,450 billion cubic feet (bcf) of proved gas reserves, and an estimated 1,550 bcf of probable reserves. Woodside turns this gas into LNG, which it ships to Asia. Indeed, Woodside's location is one of its chief advantages. Its proximity to rapidly growing Asian nations means it can ship LNG to those customers more economically than suppliers in other places in the world.

Recently, the share price has taken a beating. That's partly due to delays and increased costs to the company's latest mega-LNG project, Pluto. Disputes with East Timor about how best to exploit the gas field, which straddles Australian and East Timorese waters, haven't helped either. Meanwhile, Shell's decision to sell a stake in the company have stoked fears of a stock overhang. But the bad news is already in the price, says Huw Williams at Religare Capital Markets. The firm benefits from "a range of sales contracts into North Asia" while its "plans for new LNG capacity will keep it in top place". Woodside is a long-term way to play rising Asian gas demand while its control over production and liquefaction let it enjoy more of the margins than a standard gas producer.

For broader exposure to the sector you can invest in the First Trust ISE-REVERE Natural Gas Index Fund (NYSE: FCG). This exchange-traded fund (ETF) tracks the ISE-REVERE, an American index of natural gas-producing firms. We tipped it in November and it's gone up 2% since. However, a more interesting option may be Van Eck's Unconventional Oil & Gas ETF. The new ETF hasn't yet been approved, but judging from the filing it will track the Market Vectors Unconventional Oil & Gas Index. Approval is expected later this year, so we'll be watching out for it.

The map above shows the current state of play when it comes to global gas reserves. China has the world's largest unconventional reserves with 36 trillion cubic metres (tcm).

However, the International Energy Agency still expects it to be a major importer over the next 25 years as its energy needs grow. In the short term, unconventional gas isn't good news for Russia: if shale reserves were fully exploited, Russia's share of the western European gas market might fall from 27% in 2009 to 13% by 2040. However, many analysts suspect Russia could have huge unconventional gas potential, although with conventional reserves of 47.5 tcm, so far it hasn't felt the need to look for unconventional gas.

Argentina was South America's first nation to strike oil. Yet in the last decade, it had begun to import energy as reserves dwindled. A recent 21.9 tcm gas discovery should give the economy a timely boost. South Africa has Africa's largest unconventional gas haul, at 13.7 tcm.

What types of unconventional gas are there? Shale gas is the most common form: the IEA believes it will account for around 50% of unconventional production by 2035. It is locked in highly impermeable shale rock. Operators use complicated horizontal drilling to gain access to the shale. Then comes the hydraulic fracturing (fracking'). A mixture of water, sand and chemicals is pumped in to crack open the shale. Typically gas rushes out of the well in the first year before declining markedly.

Coal bed methane (CBM) is natural gas trapped within coal seams the second most commonly exploited unconventional gas. China, Canada, America and Australia have major CBM resources. Tight gas is stuck in a very tight formation underground, trapped in impermeable and non-porous rock, sandstone or limestone. This makes it harder for the gas to travel through the rock, so operators need to drill more wells. They also have to drill horizontal or slanted wells to expose more of the gas. Another method is acidising, ie, pumping the well with acids to dissolve some of the rocks to ease the passage of the gas.

This article was originally published in MoneyWeek magazine issue number 561 on 28 October 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.