Update on the Shale Gas Revolution, Part 1


"While it may be cheaper to build gas liquifaction and re-gassification plants, their economics will not overcome the huge price differential of products versus raw gas quickly. This could mean that new LNG plants may not be built, in favor of GTL plants."

Since I last wrote about the Shale Gas Revolution and its implications late in 2011, there have been many more important developments, as well as some new trends.

New Shell GTL Plant in Louisiana
The most important, and most recent, news is that Royal Dutch Shell (RDS.A - Analyst Report) is apparently in the preliminary stages of feasibility and design work on a potentially huge, $10 billion, 2 million gallon per day (approximately 50,000 barrels per day) Gas-to-Liquids (GTL) facility in Louisiana, using abundant natural gas feedstock.

This development is important for several reasons:

Validation of Future Gas Abundance
First, it validates the long-range forecast of persistently high volumes of economical natural gas. Since the plant would not enter production until 2014 at the earliest, a gigantic, experienced GTL and gas producer must be confident that natural gas prices will remain a relative bargain, and that this will continue for a long time into the life of the plant.

GTL Remains Attractive
Second, despite being burned by the cost-overruns at its large Pearl GTL plant in Qatar, Shell still sees attractive returns in such a plant. This is an important demonstration for other market participants, some of whom may decide to emulate Shell. Indeed, Sasol (SSL - Analyst Report) of South Africa already indicated a few months ago that it would build a large GTL plant in Louisiana.

Export Capability
Third, the plant is in good export position—it will not be located inland to take advantage of the very cheapest natural gas prices in the heart of major shale gas plays, but close to tidewater for easy shipping of diesel and other liquids to Latin America and Europe.

GTL More Attractive than LNG
Fourth, it is very telling that Shell did not decide to work on building a Liquified Natural Gas (LNG) facility to export gas from its own shale or offshore production. While natural gas prices in Europe and elsewhere in the world are much higher than those in North America, the energy-equivalent prices of diesel and other petroleum products are at even more of a premium versus raw natural gas.

While it may be cheaper to build gas liquifaction and re-gassification plants, their economics may not be able to overcome the huge price differential of products versus raw gas for a long time to come. This could mean that new LNG plants for Kitimat, British Columbia, and Valdez or Anchorage, Alaska, and, more fancifully, Halifax, Nova Scotia, may not be built—in favor of GTL plants.

The implications of that last point are potentially profound. The more natural gas that gets converted to liquids for export in North America—rather than exported to East Asia, Europe, and elsewhere—means natural gas that will not be sent into the world markets to reduce natural gas prices in those markets.

Hence, relatively high prices may persist there, maintaining the already major incentives to drill for gas and associated liquids in other propitious shale formations. In the U.K., Poland, and Ukraine, drilling is active, and showing some impressive results, although not much actual production thus far.

Also, as Europe is densely populated, there are industrial and environmental issues that can delay full and rapid exploitation such as has occurred in North America.

EU Nations Wish to Avoid Dependence on Russia
There is a big strategic and also commercial reason that European nations will likely become more enthusiastic drillers: the wish to reduce an unhealthy reliance on one major supplier: Russia. The Ukraine and other European countries have had more than one cutoff of supply from pricing and payment disputes, and in mid-winter, too. No customer is comfortable in having only one supplier, and Russia also has a record of being a difficult and untrustworthy trading and investment partner, as BP (BP - Analyst Report) and Chevron (CVX - Analyst Report) can attest.

Environmental Trends Favor Gas Over Coal, Nuclear
Another reason that shale gas exploration will likely receive a warmer reception in Europe in the future is their longer-term environmental goals, which have not been—and in practice cannot be—satisfied by renewable energy initiatives and incentives. The governments of Germany, France, the U.K., and other European nations wish to downplay or eventually eliminate electricity production from coal plants, and from nuclear generators, too. The only rapid, cheap and readily available other sort of energy will be shale gas, unless they wish to become further dependent on Russia, Central Asia or the Middle East.

Pipelines and Drilling In Europe to Expand
While the new pipeline in the Baltic that bypasses Ukraine—and another one from the Caspian that bypasses both Ukraine and Russia en route to Europe—ameliorate some of those dependency problems, the long-term outlook for shale gas and liquids in Europe remains rosy. While it may not make much difference to the major oil companies’ stock performance, it will help those of the oil and gas service companies, especially the hydraulic fracturing, "fracking," specialists. These companies will also benefit from new exploration in China.

China Active in Shale, Abroad and Domestically
China has made investments in North American oil and gas producers, in an effort to acquire expertise in shale formation exploration and exploitation. Apparently, their state-controlled companies have begun some drilling in their own country, but the true extent of their success is not known. It seems likely that it will take several years to increase production to a level where they can substitute gas for coal in power stations. Coal has been the source of terrible air pollution in China and is a major health risk.

The Chinese government is changing its energy policy to emphasize gas exploration and development to reduce its reliance on coal. There should be opportunities for North American companies, but the probability for technology leakage is great. What it could mean over the longer term is that the potential for very large exports of LNG to China may be muted, as they may produce much of what they consume.

However, some Chinese companies—or the government—could decide that they wish to go the GTL route; substitution of imports of crude by local production of diesel could do a lot to reduce unfavorable trade and funds flows, and make more business sense, too—again, given the differential between the cost of GTL products versus those refined from crude oil. China no longer has a significant trade surplus, other than with the U.S.

There are a couple of other wild cards, but they will take some years to play out:

Japan Important in LNG, General Global Gas Demand
The first is Japan. While the Fukushima nuclear reactor disaster seems to have set the populace and the government on a path against the atom, some sober second thoughts might prevail when the costs of changing to gas for electricity generation are re-examined. The sunk costs of existing nuclear generators make the marginal cash costs seem compelling against the large capital costs entirely new generating facilities will require.

Russia Could Take Much of Japanese Market
Assuming that they will continue on the LNG road, Japan may find itself in a complicated situation. As European gas production increases, Russian Far East production may get backed up and bottlenecked, in the way that Canadian and Bakken gas production is currently. Russia is already proposing to China new pipelines to bring their excess gas to northeastern cities.

Russia has not yet advanced any pipeline proposals to Japan, but it could make a lot of sense to both parties. If that occurs, then there could be substantial gas-on-gas competition that will benefit the customer—and be unpleasant for North American LNG exporters, increasing the attractiveness of building GTL plants versus LNG ones on the West Coast.

(Part Two of this article can be found here.)

Ian Madson

Zacks Investment Research

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