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Facts & Trends: The U.S. Energy Game Changer

HERE’S A TRUE GAME CHANGER

The most dramatic change to the global oil map is the boom in the United States, with the “light, tight oil” that is now being produced in North Dakota’s Bakken field and Texas’ Permian and Eagle Ford plays. The IEA forecasts that the U.S. will increase its production by 3.3 million barrels per day over the next five years to 11.4 million barrels, a level that exceeds the current output of Saudi Arabia. (Charting the future of crude oil)

There is admittedly a controversy on many aspects of this “revolution”. Doubters claim that projections take little account of declining production at many mature fields and the expected high decline rates in shale wells. Political and environmental issues also add to the hurdles.

Nonetheless, the proof is in the pudding and the fact is that U.S. oil production is actually growing fast, and faster than previously forecast.image_thumb[18]

U.S. crude oil and natural gas liquids (NGL) production rose by 0.6 Mb/d during the 24 months between Q1/09 and Q1/11 and by 1.0 Mb/d in the following 12 months. This sharp acceleration is coming mainly from the shale formations. Here’s a telling chart from RBC Capital:

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When shale gas exploration began to accelerate in 2007-08, there were also many doubts about its sustainability and eventual size. These doubts proved unfounded. We could well be living the same phenomenon with shale oil.

The North American energy picture is improving very rapidly and very significantly.

  • The U.S. oil and NGL production looks set to jump 40% during the next 5 years.
  • The Canadian production could increase 31%.
  • Combined, this 4.4 Mb/d incrementalproduction is nearly 5% of total world production and nearly 14% of OPEC output.
  • This is happening right when the U.S. and world demand is weakening. In this context, can OPEC maintain current high prices for very long?

Imports accounted for 50% of U.S. oil and liquids consumption in 2010. The EIA forecast was for imports to decline to about 40% by 2017 but it now looks like it will be closer to 35%. By itself, this will have a huge impact on the U.S. trade balance.

Consider also the impact of booming natural gas production: the U.S. is expected to be a net exporter of gas in 2022. It imported 4 trillion cubic feet in 2008, 2.6 Tcf in 2010!

In all, in just a few years, the U.S. energy situation has shifted very significantly. A real game changer if there is one!

A December 2011 PwC report concluded that

(…) high shale gas recovery and low prices could impact United States manufacturing industries by adding one million workers, and reduce natural gas expenses by as much as $11.6 billion annually through 2025.

“An underappreciated part of the shale gas story is the substantial cost benefits that could become available to manufacturers based upon estimates of future natural gas prices as more shale gas is recovered,” said Bob McCutcheon, U.S. industrial products leader, PwC. He continued, “In fact, the number of U.S. chemicals, metals and industrial manufacturing companies that disclosed shale gas potential and its impact so far in 2011 easily surpassed that of the last three years combined, indicating this is of growing importance in the outlook of U.S. manufacturers. The significant uptick in shale gas commentary among the manufacturing community reflects the positive influence that shale gas is having from investment, operational and demand standpoints.”

In a March 2012 report, Citigroup, perhaps in typical brokerage fashion, made even rosier forecasts incorporating the indirect impact that the shale oil and gas revolution will have on the economy:

We estimate that the cumulative impact of new production, reduced consumption, and associated activity could increase real GDP by an additional 2% to 3%, creating from 2.7 million to as high as 3.6 million net new jobs by 2020. Furthermore, the current account deficit could shrink by 2.4% of GDP, a 60% reduction in the current deficit, by 2020. This could also cause the dollar to appreciate in real terms by +1.6 to +5.4% by 2020.

Citigroup rooted the recent trends to higher capex:

Starting in 2009 (more than five years following the global surge in upstream capex), new discoveries — excluding extensions and revisions to
existing fields — started to surge, with 2010 being the first year in a quarter of a century when oil discoveries (taking into account NGLs and other liquids, refinery processing gains and biofuels) were greater than oil consumed. Initial data for 2011 is pointing in the same direction.

And so are the 2012 data which, in fact, are showing an acceleration in shale oil output.

imageThe radical change in the U.S. natural gas market has been well documented.  America’s abundant supply of natural gas is extremely cheap relative to international prices which are regulated and linked to the price of oil. The current high prices for oil and natural gas internationally give America a significant competitive advantage thanks to its domestically traded, deregulated market.

Pimco details the benefits:

But the most momentous change of all looks likely to be in the re-industrialization of America based on dramatically lower cost feedstock than is available anywhere in the world, with the possible exception of Qatar.

Industrial processes are being retooled to use natural gas, instead of oil derivatives, due to gas’s cost advantage. It is this cost advantage in fuel and feedstock supply in North America that is partly contributing to the revival and expansion of the industrial sector.

imageFor industries with large physical plants, such as metals, machinery and  much of the manufacturing sector, natural gas consumption typically exceeds 30% and in some cases 50% of their respective total energy demand. Over the long run, the abundance of natural gas and the just-in-time production would reduce price volatility and place a long-term cap on prices. Fuel substitution, especially with coal and petroleum, and a reduction in the per unit expenditure on gas would lower the overall cost of operation and improve competitiveness.

The agricultural sector would be another beneficiary of the natural gas boom due to its use of fertilizers. Natural gas accounts for the majority of the cost of producing ammonia fertilizer, where gas is used to make ammonia. Higher gas production and lower prices have contributed to the return of activities. Orascom Construction bought and reopened a large ammonia plant in Beaumont, TX. CF Industries also restarted its large Donaldsonville, LA plant and has planned over $1 billion in investments to expand ammonia production capacity over the next four years. Saskatchewan’s Potash Corp is investing in the restart of an ammonia plant shut in 2003.

US ethane-based ethylene producers have moved to the lower end of the global cost curve, after only the Middle East and Canada, and are currently enjoying record margins. By comparison, naphtha-based ethylene producers in Europe and Asia are at a competitive disadvantage.

Cheaper natural gas has also made US methanol production more economical. Consequently, Canadian methanol producer Methanex recently announced plans to relocate an existing methanol plant from Chile to the US Gulf Coast in 2014. Next year Lyondell Basell plans to restart a methanol plant on the Gulf Coast that was idled in 2003 because of high natural gas prices.

Natural gas is an industrial commodity, used by large producers in plants requiring long lead times between planning and actual operations. This is why the real impact of lower natural gas prices on U.S. industrial activity is only beginning to surface.

This chart from RBC Capital illustrates how the U.S. competitive advantage on natural gas will shortly result in a booming ethylene industry. Given the long lead times required, momentum builds slowly but eventually the planned projects emerge. In a matter of 7 years, U.S. ethane production could expand by 50-80%.

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However, the U.S. economy relies far more on oil than natural gas as a percentage of overall energy consumption. The more recent changes in the U.S. oil production profile will therefore have a more significant and immediate impact on America’s industrial and manufacturing sectors.

For starters, even though the U.S. will continue to import oil, its large and increasing domestic supply will no doubt make the U.S. more attractive for international industrial and manufacturing companies. Secondly, U.S. domestic oil prices are currently 20% cheaper than Brent and this spread could widen even more if the U.S. landlocked production grows significantly faster than pipeline capacity. For security reasons, exports of crude oil are not permitted in the U.S. Without the ability to export, U.S. crude oil could become as disconnected from world markets as U.S. natural gas is. On the other hand, a meaningful push to expand pipeline capacity could help narrow the spreads.

Most of U.S. shale oil production is reportedly profitable at a price of oil ranging from $60 to $70 per barrel, thus making the industry sufficiently resilient to a significant downturn of oil prices.

Energy cost and secure availability are cornerstones of all dynamic economies. The U.S. now finds itself in a most advantageous position, enjoying among the lowest energy costs in the world with secure and ample supplies in a most stable geopolitical environment.

The economic dividends of such competitive advantage are very meaningful and long lasting. They tend to build up slowly before they become visible to everybody and add up to a significant economic stimulus. Their impact has already begun but most of it has been masked by the lingering economic and financial crisis.

For example, employment in the oil and gas extraction sector has improved in recent years but it has the potential to substantially exceed its 1982 peak.

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Employment in oil and gas support activities, a prime beneficiary of the shale gas boom, has grown nicely since 2010 but it has yet to feel the impact of the more recent shale oil boom.

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Together, these two sectors now employ some 470,000 people when they barely employed 245,000 people back in 2004, well before the financial crisis. IHS Global Insight predicts that direct, indirect and induced employment in shale gas onlyis estimated to grow to 869,684 employees in 2015 from 601,348 employees in 2010.

The U.S. manufacturing sector is enjoying a renaissance on its own but energy will provide additional momentum in coming years. The Boston Consulting Group’s 2011 report Made in America, Again, Why Manufacturing Will Return to the U.S listed a number of reasons for America’s improved competitiveness (e.g. relative wages, productivity, transportation logistics) but made little mention of the energy cost gap developing between the U.S. and its main competitors in the world.

In a more recent analysis, PwC makes energy a more explicit and significant reason for “reshoring”.

The United States manufacturing sector is experiencing a cyclical recovery. However, structural—and likely sustained— changes in some of these areas could extend the recovery beyond what might be expected in a typical economic upturn. Even if an increase in the relative competitiveness of United States labor costs were to unfold, that seems unlikely to be sufficient to result, in itself, in a domestic manufacturing resurgence.

Instead, a host of other factors— particularly transportation and energy costs, and currency fluctuations—are more likely the most salient reason United States manufacturers will choose to produce closer to their major customer bases.

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Manufacturing employment has been relatively strong since 2010 amid a very difficult economy. Yet, its nearly 500,000 new jobs are but a fraction of the more than 5 million jobs lost since 2001.

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Here are a few examples of this new “reshoring” trend:

  • “We’ve been able to reshore about 15 to 20 percent of our volume back to the U.S. from China over the last year,” said Bill Lovell, OtterBox’s global director of supply chain.
  • General Electric opened a $38 million manufacturing plant in Louisville, Ky., and said it plans to invest $1 billion in its appliances businessand create 1,300 American jobs by 2014.
  • Chinese electronics giant Lenovo, which acquired IBM’s personal- computer division in 2005, announced this month that it plans to open its first PC plant in the U.S. in North Carolina early next year, a move that will add 115 manufacturing jobs.
  • Colorado Flexible Heaters, an independent maker of heaters for roofs, moved the production of its systems from China to Glenwood Springs last year. The company opened a local manufacturing plant in May 2011 and found that it could make the heaters about 25 percent cheaper, said founder Dave McKenna.
  • When Sleek Audio got off the ground in 2005, they first found that U.S. manufacturers were quoting prices of $19 or $20 for one particular component that the Chinese were offering to make for $2. But when the Krywkos decided to quit China last year and asked around again about making the part in the U.S., this time the answer was $8. A box that used to be quoted for $4 to $5 in the U.S. before was quoted at $3 now.
  • “We just kind of got kicked right in the teeth dealing with China. It wasn’t any fun by any means. But it helped us learn to bring stuff back to the United States,” said Calibur11 owner Coy Christmas. The company, which makes cases for consoles such as the Xbox 360, will add a few employees in Duluth and more in Chicago, where it plans to hire contractors to handle molding, assembling and packaging.
  • “We found a Wisconsin company to make the blades. And without the shipping, testing and reject costs, they actually beat the price in China,” said Darlene Miller, owner of Permac Industries, a high-precision machine shop.
  • 3M Co. said it consolidated production of its Littmann stethoscope from 14 domestic and foreign contractors to just one factory in Columbia, Mo., a move that will improve efficiency.
  • Charles Bunch, chairman and CEO of PPG Industries, told CNBC’s Jim Cramer that the cost of energy within China also is much higher. “The China cost advantage in many energy-intensive industries is diminishing,” he told Cramer. “Now, the U.S. is going to be  much more competitive on the global scene in terms of manufacturing costs.”

Beyond these few real world examples of both small and large companies reshoring (or “onshoring”), a sea wave of change seems to be making its way toward American shores. The NY Post:

According to a survey by the Boston Consulting Group of executives at 106 manufacturing companies with $1 billion or more in sales, 37 percent said they are planning or “actively considering” onshoring. Among large firms with $10 billion in sales or better, almost half (48 percent) say they’re planning to move, or already have moved, their production facilities back to the States.

They include Master Lock, which recently returned to its original home base in Milwaukee, and NCR, which set up its ATM manufacturing division in Georgia. Appliance Park in Louisville is filling up again, as GE moves manufacturing divisions back home from China. Michelin is breaking ground on a new tire plant in South Carolina; Volkswagen has new facilities in Chatanooga, Tenn., and Airbus is building a $600 million plant in Mobile, Ala. Samsung plans to invest more than $20 billion in various US manufacturing enterprises.

Bob McCutcheon, PwC’s U.S. Industrial Products leader says that

Beyond the cyclical rebound, however, a host of structural changes is emerging that may lead to the U.S. becoming an important location for basing production and R&D facilities for several industries.  In addition to trends in labor costs, other factors include the need to reduce transportation and energy costs; the emergence of the U.S. as a more attractive exporter and the relative attractiveness of the U.S. markets.

The U.S. is obviously going through a soft economic patch due to ongoing weakness around the world. In spite of this and of its own home-made challenges, the U.S. economy has been surprisingly resilient, mainly because of a relatively vibrant export sector. Given the present state of most of America’s trading partners, the resiliency of American exports is noteworthy. Obviously, much is happening below the surface.

Amid all the doom and gloom, both at home and abroad, the U.S. is getting ready to take full advantage of its growing competitiveness. Citigroup’s conclusion may seem preposterous at this time but it reflects the potential rewards that energy portends:

At this point, it may be useful to step back and consider the sheer scale of the potential economic consequences in perspective: We are contemplating hundreds of billions of dollars of new output, three or four million new jobs, a current account deficit slashed by half or more, and a strengthened dollar firmly reasserted as the reserve currency of choice.

Not to mention the potential strengthening of U.S. federal and state government finances, the national security implications of improved energy independence, a resurgence of the nation’s technological and
manufacturing competitiveness, the social implications of new wealth and job creation, and many other silver linings.

Investors should therefore not let themselves sink into extreme pessimism. Hopefully, politicians will dig very deep within their selves and avoid impeding the emerging American industrial renaissance.

Equity markets are very cheap for many valid reasons (see P/Es, QEs & SAUDIS). The world is a mess with little visibility for a turnaround mainly because normal market forces are ineffectual, being relentlessly overruled by political and/or technocratic interventions. The hope for the world is that central bankers’ bets succeed and growth reappears without higher inflation.

Investors should nevertheless realize that the U.S. is staging a stealth recovery lead by energy, manufacturing and housing. So far, it has been masked by still weak employment growth and other mainly foreign problems as well as by the inability of politicians to effectively address the looming American fiscal cliff.

Yet, barring endless and fruitless political bickering, the American economy could soon surprise almost everybody and display strong and sustained growth in capital investments, construction and employment, irrespectively and independently of what might then be going on in Europe or in China. That would no doubt help narrow the current deep undervaluation in U.S. equity markets.

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BUT, WHO’S THE PIPER?

It has become an almost universal theme: It’s now time to pay the piper!

The Icelanders heard it first, back in 2008, then the Irish, and recently the Greeks, the Portuguese, the Spaniards, the Italians. The English people are also hearing it, the French aussi. The American people, unlike its political class, are starting to get the message as well.

Initially, the message to the Icelanders came from almost everywhere on the planet. As new crisis emerged, the messengers became fewer as more of them realized they were also deserving. Presently, we hear it mainly in German, Dutch and other quieter voices like Finish, all people proud to proclaim their frugality, their discipline but also their unwilling capability to bail the sinners out.

But even Germans are not without dues to the piper. The largest German banks are some $350B short in capital and the smaller landerbanks, where most Germans stock up their hard earned savings, are big lenders to the very countries Germans wish their government let go belly up. According to the Bank for International Settlements, Germany lent almost $1.5 trillion in total to PIIGS countries.

In effect, the proud, disciplined and laborious Germans are also on the hook. Bailing out the Club Meds, where they happily spend their hard earned vacations, would cost them dearly. Letting them sink, just as much, if not more, if only because even smart merchants suffer when their main clients can no longer afford their wares. Ask the Swiss about that.

In truth, it seems that most everybody is guilty of some (or SOME) excesses and needs to remit one way or the other. Ordinary citizens are guilty of over spending, under working or under declaring; bankers are faulty of over lending and under reserving; politicians are faulty of …being politicians. Who can rightly claim to be sinless here?

This looks like the economic and financial Last Judgment and everybody seems about to go to hell!

It’s easy and fashionable to blame the Clubmedders not to work much,  overspend and retire early on generous pensions. The reality is that politicians allowed their people, even incited them, to “sin”, buying votes the easy way, promising the undeliverable, delivering the unaffordable, on their voters’ own dwindling credit. Power-hungry politicians lure voters with short term goodies to be paid for during their successors’ terms; the latters, knowing the game all too well, need simply to kick the can further down the road.

For many, the road is ending, the can is hitting the wall.

Political fiscal irresponsibility is almost universal nowadays. Yet, US politicians have brought it to another level with some 279 congressman and senators having formally pledgednot to raise any taxes under any conditions. Politic being the art of compromising, how can we expect these stubborn one-sided caretakers to effectively solve a serious crisis if their feet are deep into ideological concrete?

An even lower level has been reached in Italy, the perennial home of the commedia del arte. Can we expect the Italian people to be fiscally responsible when Berlusconi and more than 10% of Italy’s elected representatives are investigated or accused of fiscal frauds? And what about the French Affaire Chirac?

What about bankers, investment bankers and investment managers? Forget these hedge fund rogues who cost billions to unbelievably careless banks only happy to collect their 2/20 to feed their management with obscenely indecent pay packages. Forget the Madoffs of this world, deserving but accountable scapegoats to the more subtle elite, many also truly deserving but rarely accountable. The financial elite has lost its marbles, fear having easily given way to greed at the square.

In truth, the financial elite is greatly responsible for the world economic mess. They have lent irresponsibly, invested irresponsibly, managed irresponsibly. They are at the root of the US housing debacle and at the root of the European sovereign debt debacle.

If Americans bought increasingly overpriced homes with oversized mortgages, it could only happen because greedy and unaccountable bankers were willing, often begging, to lend them. If funding was available for such loans, it was because greedy and unaccountable investment bankers packaged zillions of toxic products that greedy and unaccountable investment managers gobbled to maximize their investment returns.

Thorough risk analysis and disclosure, as well as prudent, common sense, investing have disappeared as the race to “churn to earn” gained momentum during the last two decades. More and more elite professionals were driven by the better-than-thy-neighbor life provided by oversized bonuses, tacitly paid for by investors, large and small, who believed that these well dressed, well spoken, well connected seemingly important people had “the truth”, to use a hedge fund ridiculous expression. The only truth is that too big to fail worked as probably anticipated by the empire building elite!

If politicians lost any remaining fiscal responsibility, it is because financial markets, driven by the elite “professionals” did not perform the usual checks and balances through thorough analysis and normal interest rate mechanisms. In Europe, too many people, i.e. bankers, investment bankers and managers, for similar reasons, blindly or conveniently believed that the new Eurozone would effectively diffuse irresponsibility. They kept lending and investing even as “the math” got uglier and uglier. Now that the damage has been done, the bonus checks cashed, the same professionals are advising politicians on the ways and means by which to solve the mess while lobbying to avoid “excessive” re-regulations which, they claim, would slow growth and cost millions of jobs. Think about that!

Central bankers have also sinned as evidenced by the Greenspan and Bernanke puts, superficial and overly optimistic economic analysis and the desperate frenetic pumping of oxygen into punctured economic balloons. Jean-Claude Trichet, who tries to speak as germanly as possible, may say he’s been “impeccable” all he wants, in reality he has zealously and stubbornly sucked fresh air off Europeans just when they, and the rest of the world, badly needed it. His mistaken interest rate hikes of 2011, like those of 2008, need to be reversed quickly but his ego cannot so readily admit it. Rates have yet to be cut even though all economic stats are negative and inflation is but an illusive threat by his own recent admission.

So many of these elites have committed major sins, yet remain in function, “advising” law makers not to regulate banks and hedge funds, even though they failed to regulate themselves as Alan Greenspan foolishly expected. These greedy and totally irresponsible elite have overbuilt and undermanaged to such an extreme that they have nearly bankrupted world economies.

They should also, eventually, pay the piper.

But, who’s the piper, if just about everybody is guilty and needs to repent and remit? It just seems that nobody will really gain from the major sins of the last decade. Quite the opposite, in fact. We are probably going through a massive loss of global wealth through significant, long lasting, tax and fee increases in most developed countries and for most people and companies.

The Greek people are shocked by the austerity measures imposed on them by lenders but they are only the first to suffer. In effect, Greece will live the dismantling of a middle-class welfare state in real time. To wit:

  • Government salaries were cut 25-35%. Many private employers have imposed severe cuts as well.
  • A “solidarity tax” of 1-4% on income of all workers.
  • The VAT has increased from 13% to 23%.
  • A property tax ranging from 900 to 1,500 euros per year.

These harsh measures ensued because Greece lenders have agreed to a 21% hit on their loans. Yes, 21%! That’s the bailout package “negotiated” for the banks by a former banker(!) In all fairness, banks should take at least twice that hit, allowing the Greeks to pay the piper over several years rather than strangling them in such a way that the whole continent might suffer just as much, eventually requiring another 20-30% haircut by banks.

Wolfgang Schauble, the no-nonsense German finmin concurs that bankers should share the blame and the cost for their bad lending decisions:

Without a substantial contribution from financial institutions, the legitimacy of our Westernized capitalized system will suffer.

In the US, as, if and when politicians come to their senses, crude choices will need to be made. Thomas Friedman summarized it simply:

It becomes clearer every week that the United States faces a big choice: We Americans can either have a hard decade or a bad century.

We can either roll up our sleeves and do what’s needed to overcome our post-war excesses and adapt to the demands of the 21st century or we can just keep limping into the future.

(…) My fading hope is that this is Obama’s opening bid and enough Republicans will come to their senses and engage him again in a Grand Bargain. My fear is that both parties have just started their 2012 campaigns. In which case, the rest of us will just sit here, hostages to fortune, orphans of a political system gone mad, hunkering down for a bad century.

In another column, Friedman threw his arms up:

The more I read the papers the more I’m convinced that “we the people” are having an economic crisis and “you the politicians” are having an election- and there is frighteningly little overlap between the two.

This looks like the economic, financial and political Last Judgment and everybody seems about to go to hell!

Who can afford a piper nowadays?

What should investors do when myopic and egocentric politicians are responsible for saving us from economic and financial Armageddon?

Bargain hunting is tempting especially since crises have a way of focusing minds. Still, given the long lasting damage inflicted to world economies, the very poor visibility and the dire consequences if policy makers “miss”, caution remains the golden word.

Contact: edgeandodds [at] gmail.com