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Shale Gas Reality Begins to Dawn

It has long been our position at The Automatic Earth that North America is collectively dreaming with regard to unconventional natural gas. While gas is undeniably there, the Energy Returned On Energy Invested (EROEI) is dramatically lower than for conventional supplies. The critical nature of EROEI has been widely ignored, but will ultimately determine what is and is not an energy source, and shale gas is going to fail the test.

As we pointed out in Get Ready for the North American Gas Shock in July 2011, the natural gas situation is not what it seems at all:

The shale gas bubble is a perfect example of the irrationality of markets, the power of perverse short-term incentives, the driving force of momentum-chasing, the dominance of perception over reality in determining prices, and the determination for a herd to stampede over a cliff all at once.

The perception of a gas glut has driven prices so low that none of the participants are making money (at least not by producing gas) or creating value. We see a familiar story of excessive debt, and the hollowing out of productive companies dead set on pursuing a mirage.

Many industry insiders know perfectly well that the prospects for recovering substantial amounts of gas are poor, and that the industry is structured as a ponzi scheme. Still, there has been money to be made in the short term by flipping land leases and building infrastructure to handle gas.

The hype is so extreme that those who fall for it contemplate, in all seriousness, North America becoming a natural gas exporting powerhouse, and a threat to Australian LNG producers, or to Russia’s Gazprom.

This concept, constructed from a mixture of greed and desperation (at the lack of conventional gas prospects), is entirely divorced from reality. (See here for Dimitri Orlov’s excellent piece on why Gazprom has nothing to worry about.)

Nevertheless, euphoric hype is extremely catching. Given that prices are driven by perception, not by reality, hype has the power to change the dynamics of an industry, exaggerating boom and bust cycles in practice. The hype has resulted in the perception of glut – that North America is drowning in natural gas. The inconvenient fact that this perception is completely wrong does not alter its power in relation to prices.

Natural gas companies gambling on shale gas have been facing prices so low – far below the cost of production – that all of them have been producing gas unprofitably. The financial risk has been increasing dramatically as the companies have been drowning in debt trying to ride out the rock bottom prices that have been the result of people believing the fantasy. Finally, casualties of the financial shenanigans involved are emerging. It is very likely that there will be many more, as companies that have tried to ride out the low prices go under.

Wolf Richter:

Natural Gas: Where Endless Money Went To Die

Alas, thanks to the Feds zero-interest-rate policy and the trillions it has handed over to its cronies since late 2008, the sweeps of creative destruction have broken down. Instead, boundless sums of money have been searching for a place to go, and they’re chasing yield when there is none, and so they’re taking risks, any kind of risks, in their vain battle to come out ahead.

The result is a stunning misallocation of capital to the tune of tens of billions of dollars to an economic activity drilling for dry natural gas that has been highly unprofitable for years. It’s where money has gone to die. What’s left is debt, and wells that will never produce enough to make their investors whole.

But the money has dried up. And drilling for natural gas is collapsing. Last week, there were only 562 rigs drilling for dry natural gas, the lowest number since September 1999…

…At $2.53 per million Btu at the Henry Hub, the price of natural gas is up 33% from the April low of $1.90 per million Btu, a number not seen in a decade.

.But even if it doubled, it would still be below the cost of production. And if it tripled, it might still be below the cost of production for most producers. That’s how mis-priced the commodity has become.

More from Wolf Richter:

Dirt Cheap Natural Gas Is Tearing Up The Very Industry That’s Producing It

The economics of fracking are horrid. All wells have decline rates where production drops over time. But instead of decades for traditional wells, decline rates in horizontal fracking are measured in weeks and months: production falls off a cliff from day one and continues for a year or so until it levels out at about 10% of initial production. To be in the black over its life under these circumstances, a well in the Barnett Shale would have to sell its production for about $8 per million Btu, pricing models have shown.

…Drilling is destroying capital at an astonishing rate, and drillers are left with a mountain of debt just when decline rates are starting to wreak their havoc. To keep the decline rates from mucking up income statements, companies had to drill more and more, with new wells making up for the declining production of old wells. Alas, the scheme hit a wall, namely reality…

…The natural gas business is brutal. The peak in drilling occurred in September 2008 with 1,606 rigs. Then the financial crisis threw it into a vertigo-inducing plunge. After last years mini-peak, the plunge continued…

…Production lags behind rig count, and while rig count for gas wells has been setting new decade lows, production has been rising month after month to new record highs. But lagging doesn’t mean decoupled. And someday…. Oops, it already happened. It has started. Production has turned the corner, and not just in one field, but across the US.

Its still just a little notch in the curve. But its a sign that the collapse in rig count is translating into lower production numbers. And when the steep decline rates are beginning to overlap the drop in rig count, production will head south in a dizzying trajectory.

Money has been thrown at the industry, but the notion is dawning that the game is up and that returns will never materialise. The ponzi scheme has reached its natural limit, and investors are waking up to the realisation that they have been chasing a fantasy.

Ironically, just as the washout begins, natural gas prices may have bottomed. Conventional natural gas in North America peaked in 2001. Coal bed methane and now shale gas have been revealed to be massively overblown as an energy source. Producers are reaping the consequences of mal-investment and will be going out of business. Demand has been building with the transition from coal to natural gas for power generation. This is an ideal set up for a supply collapse and subsequent price spike.

North America is poised for a huge natural gas shock. Far from being an exporter, North America is going to experience a natural gas supply crunch. Prices will be rising at the same time as peoples purchasing power falls precipitously, thanks to deflation. The structural dependency on natural gas that has been cemented in recent years is going to guarantee maximum pain as prices reconnect with reality.

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Capital Flight, Capital Controls, Capital Fear

The ending of extend-and-pretend is ushering in a new era of fear and uncertainty which is rapidly evolving into the next phase of the on-going credit crunch.

It is becoming clearer to many that the problems run much deeper than they had perceived, and more people all the time are realising the systemic nature of the risks we are facing. Fear leads to knee-jerk reactions. In financial markets, it leads to volatility and self-fulfilling prophecies to the downside. It leads to capital flight, and then to capital controls. Continue reading “Capital Flight, Capital Controls, Capital Fear”

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Then and Now: Sunshine and Eclipse

The video Sunshine and Eclipse is a must see for anyone interested in economic history, and in the psychology of economics in the real world (as opposed to the ivory tower of modern neo-classical economics). The documentary is describing Canada in the period between 1927 and 1934, in other words, in the euphoric phase of the Roaring Twenties bubble and the credit implosion of the 1930s.

It is of far broader interest than Canada, however. It is fascinating to look at the insatiable optimism of the Twenties, the commodity boom, the expansion of trade and the sense that human beings had overcome adversity and created ever-lasting prosperity. In fact, the Roaring Twenties were simply a rediscovery of leverage, as are all credit bubbles. Continue reading “Then and Now: Sunshine and Eclipse”

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How to Build a Lifeboat

 

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National Photo Co. Mack Sennett Girl 1919. Actress Marvel Rea, one of film producer Mack Sennett’s well-rounded “bathing girls”

 

Yesterday we talked about why we are facing deflation and today I wanted to review and explain the suggestions we have made previously for dealing with a deflationary scenario. In short, this is the list we have run periodically since we started TAE (with one addition at the end):

1) Hold no debt (for most people this means renting)

2) Hold cash and cash equivalents (short term treasuries) under your own control

3) Don’t trust the banking system, deposit insurance or no deposit insurance

4) Sell equities, real estate, most bonds, commodities, collectibles (or short if you can afford to gamble)

5) Gain some control over the necessities of your own existence if you can afford it

6) Be prepared to work with others as that will give you far greater scope for resilience and security

7) If you have done all that and still have spare resources, consider precious metals as an insurance policy

8) Be worth more to your employer than he is paying you

9) Look after your health! Continue reading “How to Build a Lifeboat”

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40 ways to lose your future

People have been asking how we see the future unfold. In case you wonder what we stand for, much of our view of what’s to come can be found in the primers on the right-hand side bar. Here is an additional brief summary (in no particular order and not meant to be exhaustive) of the ground we have consistently covered here at TAE over the last year and a half, and before that elsewhere. Continue reading “40 ways to lose your future”

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The Storm Surge of Decentralisation

One of our consistent themes at TAE has been not expecting solutions to come from the top down. Existing centralised systems depend on dwindling tax revenues, which will dry up to a tremendous extent over the next few years as economic activity falls off a cliff and property prices plummet.

We have already seen cuts to services and increases in taxes and user fees, and we can expect a great deal more of that dynamic as central authorities emulate hypothermic bodies. In other words, they will cut off the circulation to the fingers and toes in order to preserve the body temperature of the core. This is, of course, a survival strategy, from the point of view of the core. But it does nothing good for the prospects of ordinary people, who represent the fingers and toes. Continue reading “The Storm Surge of Decentralisation”

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Look Back, Look Forward and Look Down. Way Down

This is the 1000th post at The Automatic Earth, so it seems appropriate to review our message and update our projections – to look back and then look forward. Since the beginning of TAE in January 2008, and before that at The Oil Drum Canada, our purpose has consistently been to warn people that a decades-long credit expansion is ending, and that, as a consequence, we are in the grip of a very serious financial crisis.

The first leg down (October 2007- March 2009) was just a foretaste of what credit crunch really means, and the long sucker rally has been enough to put people back to sleep again, secure in the mistaken belief that supposedly omnipotent central bankers could postpone any kind of reckoning indefinitely.

Financial bubbles are not a new phenomenon, but are in fact quite common in the historical record. Every few decades, a new generation rediscovers the magic of leverage, igniting a rapid expansion of credit, and therefore debt. Every time humanity experiences a bubble, it fails to recognise the pattern.

The lessons of the past are sadly never learned. Each time the optimism is highly contagious. In the larger episodes, it crescendos into euphoria, leading societies into a period of collective madness where risk is embraced and caution is thrown to the wind. Sky-high valuations are readily rationalised – it’s different here, it’s different this time.

We come to believe that just this once there might be a free lunch, that we can have something for nothing. We throw ourselves into ponzi finance, chasing the mirage of speculative gains, often through highly questionable and outright fraudulent practices. Enron, Lehman Brothers, and recently MF Global, are but a few egregious examples of what has become an endemic phenomenon.

The increasing focus on chasing speculative profits parasitizes the real economy to a greater and greater extent over time. After all, why work hard for small profits in the real world, when profits on money chasing its own tail are so much greater for so little effort?

Who even notices the hollowing out of the real economy, or the conversion of large amounts of capital into waste, or the often pointless depletion of non-renewable resources, or the growing structural dependency trap, when there is so much short term material prosperity to pursue? Continue reading “Look Back, Look Forward and Look Down. Way Down”

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October 3 2011: Commodities and Deflation: A Response to Chris Martenson

Chris Martenson recently posted a rebuttal to the deflationist take on commodities – Commodities Look Set to Rocket Higher. In contrast, our deflationary view here at The Automatic Earth, written at the end of August, is encapsulated in Et tu, Commodities?. To recap, our position is that commodity prices are coming off the top of a major speculative episode and consequently have a very long way to fall.

That is how speculative periods always resolve themselves. We argue, however, that this does not mean commodities will be cheap, even at much lower prices than today, given that the implosion of the wider credit bubble will cause purchasing power to fall faster than price. This means affordability worsening even as prices fall. Continue reading “October 3 2011: Commodities and Deflation: A Response to Chris Martenson”

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Et tu, Commodities?

Our most consistent theme here at The Automatic Earth has been the developing deflationary environment and the knock-on effects that will follow as a result. Now that the rally from March 2009 appears to be well and truly over, it is time to revisit aspects of the bigger picture, in order for people to prepare for a full-blown liquidity crunch. October 2007-March 2009 was merely a taster.

As we have explained before, inflation and deflation are monetary phenomena – respectively an increase and decrease in the supply of money plus credit relative to available goods and services – and are major drivers of price movements. They are not the only price drivers, to be sure, but they are usually the most significant. People generally focus on nominal prices, when understanding price drivers is far more important. A focus merely on nominal price also obscures what is happening to affordability – the comparison between price and purchasing power.

We have lived through some 30 years of inflationary times, since the financial liberalization of the early 1980s under Reagan and Thatcher initiated the era of globalization. Money freed from capital controls was free to look for opportunities worldwide, and the resulting global economic boom greatly increased trade, resource consumption, financial interconnectedness and the multiplier effect for monetary expansion. Continue reading “Et tu, Commodities?”

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Over the Edge Lies Fear

The nature of markets has long been a major focus here at The Automatic Earth. Whereas most commentators treat markets as being driven in some kind of rational fashion by external events, we have concentrated on the irrational endogenous dynamics and the role of sentiment in creating the perceptions that drive positive feedback loops – either virtuous or vicious circles. Sentiment, and therefore perception, can change very abruptly, with far-reaching effects. The events of this past week or so have been a prime example. Continue reading “Over the Edge Lies Fear”

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