Tuesday, February 23, 2010

Energy/Natural Gas Update

I just attended an analyst lunch for Total, the large French integrated oil company. I thought would summarize a few of their thoughts in the context of what has been going on in the energy sector, especially natural gas.

Replacing oil reserves is becoming much harder. Total used to have one of the highest replacement rates among the majors (around +7% growth per annum) but now they expect production growth will, at best, be around +2% until 2015.

They're not alone - all of the majors are going to more expensive parts of the world, dealing with unsavory and corrupt governments, to try to secure more oil, but with limited success. Even in places like Iraq - which is trying to ramp production up to 12 million barrels per day from their current 1 million barrel (Total, by the way, doubts that they will be able to accomplish this) - is only offering the majors $1.50 per barrel as their cut of the oil price for their help in drilling.

(When you ask Total: Why bother for $1.50 per barrel? They respond that they have no choice - either they participate now, or they will be excluded in the future).

So all seem to be moving towards natural gas. Unlike oil, natural gas is currently in plentiful supply. However, as the majors look towards the future, they believe that gas supply will gradually tighten, especially if oil prices remain $60 per barrel or higher.

Over the weekend Schlumberger announced the purchase of Smith International, which was their move towards more natural gas exposure. Exxon bought XTO a few weeks ago, and will be the largest natural gas producer in the world once the deal closes. And Total announced a major joint venture with Chesapeake towards the end of last year.

The risk to all of this, of course, is if the demand for natural gas doesn't materialize. There have been several occasions over the last 20 years when the promise of natural gas seemed limitless, only to have prices crash. This time, however, the majors obviously don't believe this is the case.

From an investment standpoint, this seems to offer some support to those companies with either natural gas exposure or have significant existing oil reserves (e.g. Chevron, Occidental, Devon).

For more perspective, here's an article in yesterday's New York Times blog :

Behind Schlumberger’s Smith Deal: A Big Gas Bet

February 22, 2010, 12:24 pm

Schlumberger’s $11 billion takover of a smaller rival, Smith Industries, seems to be a big bet on unconventional natural gas production in the United States.

In making the deal, Schlumberger is apparently hoping that Smith’s reputation and extensive domestic network will help position it as the top player in an increasingly hot sector of the oil patch, fending off the likes of Baker Hughes.

“There is I don’t think any doubt that long-term shale gas is going to be one of the big new energy sources both in the U.S. and overseas,” Andrew Gould, Schlumberger’s chief executive, said in a conference call with analysts on Monday. “Smith’s capacity to serve that market in North America is of great interest to me.”

With big oil companies like Exxon Mobil and Total, as well as a handful of private equity firms, spending billions to buy up unconventional leases around the country, the demand for more drilling is obvious. But the flood of new natural gas on the market could squeeze margins to unprofitable levels, making Schlumberger’s 18 percent premium for Smith look a bit rich.

“It may not be the best financial return in the oilfield at this point in time,” Mr. Gould said, “but long term, what we can learn in that market is extremely interesting”

A deal between Schlumberger and Smith had been rumored since last summer, when Baker Hughes acquired BJ Services for $5.5 billion. BJ derived about 81 percent of its 2008 revenue from an oil service technique known as pressure pumping, used in unconventional natural gas wells.

Both BJ and Smith also make use of a technique known as fracturing to obtain unconventional reservoirs, including “tight” or low-permeability sandstones, coal-bed methane and gas-bearing shale. Much of that production is focused in the United States in natural gas reservoirs in Texas, North Dakota and the Rocky Mountains.

Smith is a leader in drill bit technology needed to burrow down into shale, which could be highly valuable to Schlumberger.

“Schlumberger’s claims that Smith gives it greater exposure to the U.S. shale does make sense, at least to some degree,” Doug Sheridan of EnergyPoint Research, which conducts customer satisfaction surveys for oil field service companies, told DealBook. “Through its leadership position in bits and bits related technologies, Smith has considerable knowledge of what works and does not work when drilling shale wells.”

It seems like every other week there is another major shale field discovered which could bring billions of cubic feet of gas to the market. High natural gas prices first spurred this rush into shale earlier this decade and it has continued even as prices have dropped significantly, on the hopes that increased natural gas demand will justify more and more drilling.

But the expensive and crude fracturing technique is expensive and time-consuming. While it is still profitable to drill for unconventional gas at current prices of around $5 per one million British thermal units, there isn’t much room for error. Even a slight drop in gas prices would make shale fields unprofitable.

“I don’t think that the actual optimum technology set for producing shale gas has yet been defined — at the moment, we are doing it by brute force and ignorance.” Mr. Gould said. “As we get better at identifying the sweet spots in shale reservoirs, drilling will systematically become more important.”

The United States is expected to rely more on natural gas for its power needs, as it is cleaner than coal. But carbon-cap legislation has yet to take effect, raising questions about whether the anticipated rise in natural gas demand will materialize. Many producers that depend heavily on natural gas left the country after prices spiked in the middle part of the last decade, meaning that the new demand needs to come from the more fickle residential and commercial sectors.

Cyrus Sanati