How to profit as the shale gas revolution disappoints

Shale is being hailed as the solution to the West's energy problems. The ability to drill gas and oil trapped in shale rock more cheaply could make the US "energy independent" by 2030, reckons BP.

It's a seductive idea. The prospect of becoming less reliant on foreign powers is very appealing. Americans don't like enriching Saudi Arabia and other Middle Eastern countries while Europeans hate the leverage that Russia's gas gives them.

While there are other alternative energy sources, they all have their own problems: coal is too dirty, solar power is too expensive, and nuclear energy is- rightly or wrongly - seen as too risky.

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There is no doubt that shale will lead to cheaper energy - already gas prices in the US (though not elsewhere) are at record lows - but it's not a miracle cure. It has problems of its own; and that means there's a good chance that shale will disappoint some of its more enthusiastic fans, as well as consumers hoping for permanently lower energy prices.

However, that could be good news for investors. We'll look at why and how you can profit from the sector in a moment.

But first, what are the downsides about shale?

Shale gas is dirtier than you might think

Shale gas fans claim that it emits 50% less carbon than coal. And if you are just talking about its end use, then they might be right. However other experts point out that it could be up to twice as dirty as coal, due to its byproducts - as well as producing greenhouse gases, shale gas may also pollute vital water supplies.

'Fracking', the process of blasting open shale formations to get at the gas, has been blamed for spoiling farmland and rivers with methane and chemicals. In some cases the radioactive gas radon has been released. It has even been linked to earthquakes around the world. Because of all this, it has been banned in many parts of the US, Canada and Europe, and faces stiff opposition elsewhere.

Searching for shale gas also requires a lot of land, making it unsuited to urban areas.

It may not be as abundant as the optimists think

Because shale gas has only been tapped relatively recently, there is great uncertainty about reserves. Initial reports suggested that the US alone might have enough shale gas to last 100 years. However, as more wells have been sunk and more data becomes available, the estimates have started to fall. The US Energy Information Agency slashed forecast reserves by 41% last month. And so far, proven reserves only cover a decade's worth of gas.

Several high-profile drilling efforts in Europe have failed too: Exxon couldn't find viable reserves in either Hungary or Poland, while Shell also drew a blank in Sweden. Progress outside the EU and US is even slower. PFC Energy believes that even by 2020, Argentina and China, two hotly tipped areas, will only produce small amounts of shale gas.

There may be other significant reserves of shale gas in areas such as Ukraine, Libya and Algeria but that again leaves us with the problem of relying on politically unstable areas for energy supplies.

Low prices for natural gas won't last

We've already mentioned shale's role in lowering US natural gas prices. However, much of this comes down to how the natural gas industry operates.

Shale gas firms buy land-use options. These options require companies to drill for gas even if prices are low. Firms also need to recoup large capital costs quickly. This leads to a situation where a large number of firms are desperate to sell as much gas as possible purely to generate cash flow, even if it would be more logical to wait until gas prices rise.

This pushes down prices and makes it appear that energy is cheaper than it really is. However, once prices fall far enough, firms start letting leases expire and cutting production. Production falls until higher prices make fresh drilling economic again.

And this now seems to be happening. US shale gas production may already have peaked, with the number of rigs falling by 18% compared with last year. Andrew Liveris, the head of Dow Chemicals, believes that the price of natural gas a key input for the chemicals industry - will soar in the future. As a result, he is considering hedging the company's exposure.

Get ready for rising gas prices

What does this all mean? Shale gas can only push prices down so far. So consumers hoping for ever-lower gas prices look set to be disappointed. And perhaps hopes for self-sufficiency by 2030 are overdone (for more on this, see the feature in this week's issue of MoneyWeek magazine: Does the US still need the Middle East?).

However, rising gas prices are great news for the firms producing the shale gas. A particularly attractive option is Chesapeake Energy (US: CHK). The company, which is run by Aubrey McClendon, a veteran wildcatter, has been ahead of the curve. It has already stopped expanding its shale gas portfolio, has cut deals with bigger companies, and is now reducing output and closing wells and rigs.

This will help the company to repay some of its debt and increase cash, putting it on a much stronger footing compared to other firms. It also means that it will be able to expand production and profits - again when prices increase.

Meanwhile, Chesapeake's focus on Texas, and other areas in the US, means that it should benefit if there continues to be problems with drilling in Europe, especially if regulations are reduced further in America following this year's US presidential election (you can find out more here on how a Republican victory could be good for oil stocks: What this year's US election could mean for stocks).