31min read
PREVIOUS ARTICLE . NEXT ARTICLE Live Account vs. Demo Account

As the global economic outlook remains uncertain and the purveyors of doom reign supreme, more people are taking their money out of equities and putting it into gold, bonds, term deposits, and perhaps even under the mattress or buried safely in the garden. 

Yet investing history seems to tell us equities win out in the long run.  American finance professor at the famed Wharton School of Business Jeremy Siegel points out since 1871 the three decades with the highest negative returns were followed by a decade of positive returns of 8%, 13%, and 9%.

Assuming the Mayans were wrong and the civilization as we know will not end at the close of 2012, there are opportunities in equities right now that future generations of investors may look back upon as having been too good to be true. 

Right here in Australia we are at the centre of what could prove to be the next big thing; the opportunity is the gas revolution. 

Natural gas in all its forms could be the next big thing.  Yet right now fear appears to be trumping greed for the next big thing as investors are not exactly breaking down the doors to put money into our big gas players like Woodside and Santos.  Why should they when some equities markets endured a decade of negative to mediocre returns and almost two years in the current decade shows little sign of improvement?

You may have read various experts proclaiming we are at the dawn of the golden age of gas.  While there is a darker side to that pronouncement, there are signs of a coming together of forces that could be thought of as a “perfect storm” for a major boom in natural gas.

With record setting weather calamities of all types occurring all over the world, climate change adocates may yet have their day.  Already the world’s reinsurance industry is warning of continuing losses in the multi-billions due to global warming.  Whether you are a believer or a doubter, more countries are looking for cleaner sources of energy.

Renewables have yet to prove they can be cost-effective enough to be a major source and nuclear power is coming under intense scrutiny following the disaster at the Japanese Fukishima facility. 

Emerging market countries like China and India will have potentially exponential growth in energy demand given the size of their populations.

Finally two technological stgelopments have put natural gas center stage.  While neither is new, both are now cost effective enough to propel the growth in natural gas.  The first is the ability to liquefy natural gas (LNG) to allow international transport.  The second is hydraulic fracturing and horizontal drilling which allows the mining of previously unreachable unconventional sources of natural gas trapped in coal seam formations and shale rock formations.

The demand outlook is real and positive.  American energy giant ExxonMobil recently published a comprehensive “Outlook for Energy: A View to 2040.”  Here is a chart from Exxon breaking down global energy demand by fuel type in the year 2040:

Although ExxonMobil expects oil to remain the world’s number one fuel, the percentage growth of natural gas from 2010 to 2040 is higher.  Note they expect natural gas to overtake coal as the number 2 fuel, with coal actually showing a decline.  The United States Energy Information Agency (EIA) agreed with that assessment in their 2012 Annual Energy Outlook.

For further evidence you have only to look at the more than $200 billion major global energy and utility companies are investing in the future of LNG in Australia.  The gas revolution spearheaded by the LNG boom is not without its problems, especially the huge capital expenditures with stgeloping LNG facilities and infrastructure.

Another potential  problem that has yet to rear its ugly head is insufficient supply of natural gas – called feedstock – for the LNG plants.  With all the hype around us it is easy to forget that LNG is not some unique gas.  It is natural gas in a liquid state and those LNG processing facilities popping up around Australia’s coastlines are going to need natural gas to liquefy and lots of it.  Right now experts tell us our conventional sources of natural gas won’t be able to keep up with the demand so expect an increase in exploration and production of unconventional gas resources.

Think of a conventional gas resource as a large pocket of gas trapped by a porous geological formation, usually sandstone or limestone.  To get the gas a vertical well is drilled and once a hole is pierced at the top of the formation the pressure of the trapped gas forces it up the well pipe for recovery.

Geologists have long known gas also exists trapped in tight or non-porous formations around coal seams and shale rock, but it was both technologically and economically unfeasible to extract it.  Today there are two types of unconventional gas that have the potential to jump start a golden age of gas in Australia – coal seam gas and shale gas.

Coal seam gas is already being extracted in Australia, not without controversy.  From Geosciences Australia the following map shows us where conventional gas and unconventional CSG (Coal Seam Gas) drilling and exploration is taking place in Australia:

Coal Seam Gas production in eastern Australia has exploded over the last 15 years, in part due to diminishing reserves of conventional gas and in part to the Queensland government’s energy and greenhouse gas reduction policies.  Thirteen percent of grid connected power generation in the State must be gas-fired. 

While CSG producers are heavily regulated, environmental concerns about the impact of CSG exploration and drilling on water supplies remains.  Despite the fact no water aquifer contamination has yet to happen, a graphical depiction of the drilling process highlights the concern.  In the belief a picture is worth a thousand words, here is a simple illustration from the Australian Geographic of how CSG is extracted from the earth:

First, you can see the well pipe passes directly through an aquifer which serves as a water supply for the local folks.  Second, the process involves injecting a lot of water mixed with sand and chemicals under high pressure, causing fractures in the seam and allowing the gas to escape.  But it escapes into the water which is pumped to the surface where the gas and water are separated.  The water is stored in on-site ponds where it can be treated and recycled.  In some cases the water is allowed to evaporate in the ponds, leaving a salt/chemical revenue the industry claims is not harmful.  Farmers and environmentalists are unconvinced and the controversy over the huge amount of water required and the possibility of chemical leak into the aquifer rages on.  In addition, the process of pumping the water and gas mixture out of the well leads to a depressurisation of the surrounding layers with the possibility of a lowering of the aquifer.

It is interesting to note that approximately 50% of CSG wells do not need hydraulic fracturing as the seam is permeable enough for the gas to flow without the pressurised water, sand, and chemical cocktail.  Considering the need to reduce greenhouse gas emissions and the billions of dollars involved, it is likely the controversy will only lead to better safeguards, not a cessation of CSG production.

While CSG is booming, the other unconventional gas source – shale gas – has yet to stir organised voices in protest because drilling for that source is barely beyond the embryonic stage.  Look back at the map above and you will see no sites with shale gas reserves listed.  At this point, we have little more than estimates and one proven well from producer Beach Energy.  But the shale gas is there and it may be there in enough abundance to provide the feedstock (natural gas) needed for quell the insatiable appetites of the mammoth LNG projects underway.

The estimated reserves are substantial.  In the early stages of searching for potential sources, international oil and gas engineering consulting firm AWT International did their own study and produced the following map identifying locations targeted as having high potential for shale gas exploration:

From an investor’s point of view, the most important feature of the map is not the play extent of each basin, but the little red lines representing existing gas pipe lines.  When evaluating potential shale gas plays, the proximity of an existing pipeline means lower capital expenditures.  This early study highlights the potential of shale gas and as of May of 2012 federal agency Geoscience Australia is now estimating shale gas could double Australia’s natural gas reserves, from 400 to 800 trillion cubic feet of recoverable gas.

There are those who say shale has the potential to replace CSG as the principal supplier of LNG facilities and others who cite the higher production costs of shale gas as evidence it could be at least a decade before shale gas begins to have an impact. 

While it is true it costs more to produce shale gas, there are other factors that bode well for the future of this unconventional gas source.  The first is the higher volume of gas per well, resulting in fewer wells.  The controversy over CSG in eastern Australia is fueled in part by the fact literally thousands of wells will be popping up over the next decade. 

Another factor is the remote location of our most promising source for shale gas production – the Cooper Basin out in the middle of nowhere. 

A third factor is the depth of each well, far lower than a CSG well and therefore less likely to threaten surrounding aquifers.

A fourth factor is again the remote location, minimising, but not eliminating, the problem of what to do with the waste water.

To highlight some of these factors, let’s look at another diagram, this one depicting the shale gas extraction process.  The graphic appeared on the Propublica website and is based on wells in the US Marcellus shale:

First note the well depth of 7,000 Feet, or 2127 metres, is significantly deeper than the average CSG well which ranges from 100 metres to 1500 metres.  The well fracturing occurs far below the water table.  Note that shale gas extraction always involves fracturing and most often drilling a horizontal shaft as well.  While wastewater from shale gas drilling is also stored in wastewater pits, again the remote location mitigates the severity of the problem until technology comes up with a better solution.

Finally, the Cooper Basin has been in use for more than 40 years and well over 700 conventional wells have been fracked since 1969 because of the tightness of the geological formations there, minimising the possibility of water contamination through depressurization.

In summary, you could make a strong case that shale gas drilling is safer than CSG drilling. 

Right now the big energy players like Total, BP, Royal Dutch Shell, and BHP are combing Australia looking for both oil and shale gas prospects, but the initial exploration and test drilling has been done by the Junior explorers like Beach Petroleum.  The prospect of takeovers from the majors is another reason to get excited about investing in an existing shale gas play.  The following map shows the companies now in search of shale in each of the major resource basins:

Cooper Basin has the best existing pipeline infrastructure and also the first proven reserves of shale gas in the country through Beach Petroleum, so we are going to look at the five companies working there.  This is not to suggest any of the other shale gas explorers would not make a good investment; nor should it suggest avoiding CSG producers.  CSG is booming now and a producer there could be a good investment, as could any of the shale gas explorers from the other basins.  It just seems investing in a Cooper Basin exploring company could be a better investment over the longer term.  Here are the five stocks by market cap with price history:

Company

Code

Market Cap

Share Price

52 Wk Hi

52 Wk Lo

P/E

(FYE)

P/EG

(5 Yr E)

Debt to Equity

(mrq)

Santos Ltd

STO

$10,195M

$10.70

$14.63

$10.11

16.3

1.03

36.38

Beach Petroleum

BPT

$1,205M

$0.96

$1.76

$0.81

11.33

0.36

0.19

Senex Energy

SXY

$743M

$0.72

$1.19

$0..31

0.0

Drill Search Energy

DLS

$346M

$1.02

$1.58

$0.42

8.04

 

0.0

Icon Energy

ICN

$84M

$0.18

$0.32

$0.12

11.35

 

None of these companies could be considered a shale gas pure play as shale gas exploration is in its infancy, but Beach Energy comes closest.  Like all the other companies here Beach has operations in oil and CSG but they have shifted their gas operational efforts to shale, partnering out their CSG interests.  You should know the industry term for this is farming in or farming out.  A company with license or tenement interest can farm in a partner who puts up operational capital in exchange for a percentage interest in the license.  Farm in arrangements allow tiny exploration companies to operate without borrowing or public equity offerings.

Although we used forward looking numbers for valuation in the table, these are not stocks one can easily judge from the numbers.  The one thing we can say is that none are encumbered by sufficient debt so as to make ongoing exploration without additional borrowing an issue.  Remember most have partnership arrangements with financial backing.  Even leader of the pack Beach Energy has an arrangement with industry giant Santos.

Perhaps the safest investment here would by Santos, which qualifies as a “triple play” opportunity.  With Santos you get exposure to LNG production through their interest in the mammoth GLNG (Gladstone LNG) project as well as to their CSG assets in eastern Australia.  Although they are actively exploring shale gas potential in the Cooper Basin, Santos management is in the camp of those who believe it will be a decade before actual shale gas production of significant size will come on line.

Supporting their view is international energy consulting firm Woods Mackenzie who recently stated at an industry conference that substantial production of shale gas (100 million cubic feet per day) will not happen until the next decade.  However, the race is on as the major players have upped their exploration investments and Beach Energy claims their successful shale gas start-up well will be selling gas in a year’s time.  Beach’s executive director Reginald Nelson has boldly proclaimed “I am going to love proving them wrong.”

In June of 2011 energy analysts at Morgan Stanley said there was about $500 million in planned shale gas exploration ongoing.  One year later they doubled their estimate to $1 Billion.  Morgan Stanley analyst went on to say: “the three or four LNG plants being built at Gladstone would require more gas over their life spans than had been identified in eastern Australia, providing potential markets – as well as price signals – for shale-gas stgelopment.”

Beach Energy is clearly the leader in shale gas stgelopment, but last year’s darling of the ASX has been tossed on the trading trash heap in 2012.  Here is their one year share price chart, compared to Santos:

This year two of the stocks from our table have vaulted into the spotlight as investors eagerly take each for a spin around the dance floor.  Drill Search Energy (DLS) is up an astounding 153% year over year, and Senex Energy (SXY) is up an impressive 97.2%. 

Of the two, SXY has the most promising shale gas prospects with an extensive hydraulic fracture stimulation program on one its wells already producing some flowback of gas to surface.  The company claims this testing has proven the presence of a “massive gas resource.”  SXY has over the year engaged in a series of capital raising equity offerings and options conversions, without taking a hit in the share price.  DLS has also issued shares but it should be noted these two companies are attracting interest more from their oil operations than from shale gas exploration.  Here is a one year share price movement chart for the two:

Finally there is tiny Icon Energy (ICN) whose only claim to shale gas fame is their 40% partnership with Beach Energy.  The company has oil interests with solid financial backing and its share price has held up somewhat, remaining positive year over year.  Here is their one year price chart:

While we have focused exclusively on the Cooper Basin plays, investing opportunities elsewhere remain attractive.  The top gainer on the ASX this year is Buru Energy (BRU), up 373% largely due to the discovery of a conventional oil source in the Canning Basin, but they have shale gas assets there as well.

While some in Australia tout the coming of the golden age of gas and anticipate a shale gas revolution here such as was seen in the United States, the issue is still in doubt.  History tells us that some events that later prove to be game-changing were initially met with a high degree of scepticism.  Four decades ago tech giant IBM scoffed at the notion the desktop personal computer could ever threaten its main frame dominance.  And the rest, as they say, is history.

Now we have two sides here with conflicting views.  You can find some experts who claim there are too many CSG wells opening up in eastern Australia and others who claim not enough.  You have some who claim the Americans will be arriving in Asian ports with their own LNG before our facilities are fully operational and others who cite distance and the time involved in bringing an LNG facility online as evidence proving the competition claim is less problematic.

Investing in the gas revolution is not without risk and focusing on shale gas plays could easily be considered speculative.  As the story unfolds, the tell tale signs will emerge as our LNG processing plants begin to go online over the next several years.  An abundance of feedstock for the plants, or a lack or sufficient quantities, will tell us what we need to know. 

>> Click here to read other articles from this week’s newsletter

 

Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au.You should seek professional advice before making any investment decisions.