Riding
the Energy Wave to the Future
By John Mauldin
Aug 14,
2015
“Formula
for success: rise early, work hard, strike oil.”
–
J. Paul Getty
This
week’s yuan devaluation was big news, but it’s really part of a much bigger
saga. Events around the globe are combining to create huge economic change over
the next few years. We are watching giant, multidimensional chess games played
by some master players.
Energy
is the chessboard that connects all the players. What happens when the board
changes shape in the middle of the game? If you don’t know the new energy
landscape, you’ll have a hard time playing to a draw, much less winning.
Today
I’ll tell you about some big shifts in the energy industry. These shifts are
about as positive as can be, unless you need high oil prices to run your
country. In the long run, these changes are bullish for the whole world, which
I think this will surprise many of you. And though we’ve been used to thinking
about energy and technology as two different facets of modern life, today they
are inextricably linked.
When
energy changes, everything else changes, too.
Thoughts
from the Frontline
is now entering its 16th year of continuous weekly publication. I
constantly meet readers who have been with me since the beginning – and even
some who read an earlier print version of my letters. I put TFTF on the
Internet in August 2000 as a free letter, starting with just a few thousand
names, and was amazed at how rapidly it grew. It took just a few years for me
to realize that this new thing called the Internet was the real deal, and I
discontinued my print version. We now push the letter out to almost one million
readers each week, and the letter is posted on dozens of websites.
I
began to archive the letter in January 2001; and every issue – the good, the
bad, and the sometimes very ugly – is still there in the archives, just as I
wrote it. I will admit there are a few paragraphs, and maybe even a whole
letter or two, that I would like to go back and expunge from the record. But I
think it’s better just to let it all be what it is.
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traveling, of course. And now let’s think about energy.
The Cover Pic Indicator
Contrarian
and value investors like to buy assets that are in distress, or at least “out
of favor.” You don’t hear much about those assets at the time. That’s part of
being distressed – everyone ignores you.
So,
following that logic, the last thing you want to buy is a stock or industry
that appears on the cover page of popular financial publications. Commodity and
energy bulls should take note of last weekend’s Barron’s cover.
“COMMODITIES:
TIME TO BUY,” Barron’s
practically screamed at its readers. In case you can’t read the fine print on
the cover, it says,
The
harsh selloff in energy, gold, and other commodities is starting to look like
capitulation. Opportunities in Exxon, Chevron, BHP, Goldcorp. Plus six funds
and six ETFs to help build a position in this oversold sector.
I
presume the photo is supposed to show the sun rising on an oil rig, not setting. The
article quotes some very smart people who are bullish on commodities right now.
Some energy stocks look like real bargains. Barron’s
is simply repeating the market’s conventional wisdom: After a brutal decline,
oil prices are stabilizing and should head higher as the global economy
recovers.
That’s
a perfectly defensible position – but I think it’s wrong.
It’s
wrong because it misses a major shift in the way we produce energy. Many people
think OPEC’s high oil and gas prices led to the US shale energy boom. That’s
not right. The shale boom was born in a time of lower energy prices, and it was
the result of new technologies that make recovering large quantities of oil and
gas less expensive than ever.
I
used to get the occasional letter from James Howard Kunstler, who would tell me
that whatever letter I had just written was completely bass-ackwards, and how
his books explained that we were going to run out of energy and then collapse.
His books (Wikipedia lists about a dozen) and dozens of others warned us of
Peak Oil. (For the record, James, a certain longtime editor on my staff made
sure I got all your letters, reports, and more, as he is firmly in your camp! I
kept smiling and saying that he was (and is) wrong; but Charley is a phenomenal
editor, and you put up with a few quirks for brilliant editing that makes you
look better. Besides, if the world does come to an end, I can wend my way to
his survivalist farm and beg for a job and food, although I’m not exactly sure
I’m ready to milk goats. Just for old time’s sake.)
I
have written for years that Peak Oil is nonsense. Longtime readers know that
I’m a believer in ever-accelerating technological transformation, but I have to
admit I did not see the exponential transformation of the drilling business as
it is currently unfolding. The changes are truly breathtaking and have gone
largely unnoticed.
By
now, you probably know about fracking, the technology where drillers pump
liquids into a well to “fracture” the ground and release oil and gas deposits.
It’s controversial in certain quarters, especially among those who hate
anything carbon-related.
Fracking
technology is moving forward like all other technologies: very fast. Newer
techniques promise to reduce the side effects, at even lower operating costs.
Furthermore, fracking is only the beginning of this revolution. The Manhattan
Institute recently published an excellent (bordering on brilliant) report by
Mark P. Mills, Shale
2.0: Technology and the Coming Big-Data Revolution in America’s Shale Oil
Fields. I highly recommend it.
Mills
outlines the way the new technologies are turning this industry on its head.
Shale production or “unconventional” production is really a completely new
industry. Here is a short quote:
The
price and availability of oil (and natural gas) are determined by three
interlocking variables: politics, money, and technology. Hydrocarbons have existed
in enormous quantities for millennia across the planet. Governments control
land access and business freedoms. Access to capital and the nature of fiscal
policy are also critical determinants of commerce, especially for
capital-intensive industries. But were it not for technology, oil and natural
gas would not flow, and the associated growth that these resources fuel would
not materialize.
While
the conventional and so-called unconventional (i.e., shale) oil industries
display clear similarities in basic mechanics and operations – drills, pipes,
and pumps – most of the conventional equipment, methods, and materials were not
designed or optimized for the new techniques and challenges needed in shale
production. By innovatively applying old and new technologies, shale operators
propelled a stunningly fast gain in the productivity of shale rigs (Figure 4),
with costs per rig stable or declining.
[Look
at the above chart for a few moments; it’s truly staggering. In just seven
years, the amount of oil per well in some shale plays has risen by a factor of
10! That is almost all due to new technologies that are increasingly coming
online.]
Shale
companies now produce more oil with two rigs than they did just a few years ago
with three rigs, sometimes even spending less overall. At $55 per barrel, at
least one of the big players in the Texas Eagle Ford shale reports a 70 percent
financial rate of return. If world prices rise slightly, to $65 per barrel, some
of the more efficient shale oil operators today would enjoy a higher rate of
return than when oil stood at $95 per barrel in 2012.
Read
that last paragraph again. Some shale operators can make good money at $55 a
barrel. At $65, they can make higher
returns than they did three years ago with oil at $95. I have friends here in
Dallas who are raising money for wells that can do better than break even at
$40 per barrel, although they think $60 is where the new normal will settle
out. Texans are nothing if not optimistic.
How
are these new economies possible? Answer: they bent the cost curve downward. It
has fallen fast and – more importantly – it will keep falling.
The
same process that doubles the power of your smartphone every couple of years
without raising its price, is also unfolding in the energy business. That’s why
you see per-well production rising so fast in the Eagle Ford, Bakken, and
Permian Basin fields. It’s not a result of more wells; rig counts have been
falling this year. Rather, the producers are pulling more oil and gas out of
the existing Wells.
How
are they doing this? Many different technologies and techniques are helping.
The Daily Telegraph’s
Ambrose Evans-Pritchard reported
from a Houston energy industry conference earlier this year:
IHS
said an astonishing thing is happening as frackers keep discovering cleverer
ways to extract oil, and switch tactically to better wells. Costs may plummet
by 45pc this year, and by 60pc to 70pc before the end of 2016. “Break-even
prices are going down across the board,” said the group’s Raoul LeBlanc.
Shale
bosses have been lining up at this year’s “Energy Davos” to proclaim the
fracking Gospel. “We have just drilled an 18,000 ft well in 16 days in the
Permian Basis. Last year it took 30 days,” said Scott Sheffield, head of
Pioneer Natural Resources. “We’ve cut spud-to-spud time to 19 days,” said Hess
Corporation’s John Hess, referring to the turnaround time between drilling.
This is half the level in 2012. “We’ve driven down drilling costs by 50pc, and
we can see another 30pc ahead,” he said.
In my
Dec. 10, 2012, Thoughts from
the Frontline, I reported on my trip to see the Bakken shale
fields in North Dakota. My host, Loren Kopseng, showed me some small pipe
sections he called “jewels” because they were stainless steel in contrast to
the dull brown of the pipe. They are to oil wells what microchips are to a
computer.
They are highly complex technology. The first wells drilled in the
Bakken by Marathon Oil used one “jewel.” Five years later, Loren was using 23
in his wells, an exponential leap in production efficiency. At the time, he was
envisioning using 30 or 40 per well by the following year, resulting in a
phenomenal increase in the amount of production per well.
A
company here in Dallas called EKU
Power Drives is developing eco-friendly alternatives to the big
diesel-driven pump units that power most fracking wells. Their units can
actually run on the natural gas the well produces – effectively letting the
well generate its own power. This innovation greatly reduces the need for
carbon-belching tractors, not to mention the need for tanker trucks to
constantly deliver fuel to remote wells.
Another
friend is promoting a new technology that exponentially reduces the number of
moving parts in a pump. Essentially, the moving part of the pump is a new
material that expands and contracts because of an electric charge. While this
technological advance will have wide application in a number of industries, one
of the big expenses of oil wells is the continual replacement of valves and
pumps. If you can make a pump cheaper and longer-lasting, you bring down the
cost of recovering oil.
That’s
not all. “Walking rigs” can move around a pad, drilling multiple wells (in some
cases dozens) in a small area. That ready mobility means less time and expense
relocating equipment. Intelligent drill bits in those wells can maneuver
themselves around obstacles underground, raising each shaft’s success rate.
The
biggest breakthroughs are just now beginning. “Big-data analytics” will make
production even more efficient and reduce costs further. Companies gather
massive amounts of data in the active shale fields. Computers can analyze that
data and pick out optimal spots to drill more wells.
Some
of that data, incidentally, belongs to overleveraged explorers and drillers who
are right now on the road to bankruptcy. Their data, like the bankrupt
companies’ other assets, will eventually be sold to pay off creditors.
Companies are already lining up to bid.
Right
now, some US shale operators can break even at $10/barrel. Costs for the
“expensive” ones run around $55 per barrel but are falling fast. With massive
quantities of oil and gas still in the ground, there is no economic reason
these companies can’t make big money even if energy prices stay in the $40s.
The
Peak Oil proponents weren’t just wrong; they were exponentially wrong. We’re not going to run
out of oil, and it is not getting too expensive to produce. Quite the opposite
on both counts.
Last
year, while Americans celebrated Thanksgiving, the OPEC oil cartel, led by
Saudi Arabia, decided not to reduce oil production. Their apparent goal was to
drive prices lower and keep them low long enough to decapitate those annoying
American shale producers.
For
a while, it looked like the gamble was working. Energy stocks plummeted as
crude oil sank into the $40s. Producers slashed their capital expenditures,
forcing layoffs at some top energy-service firms. The number of oil rigs in
production plunged.
Now,
in hindsight, it looks as though the Saudis miscalculated badly. Ambrose
Evans-Pritchard is on
the case:
The
Saudis took a huge gamble last November when they stopped supporting prices and
opted instead to flood the market and drive out rivals, boosting their own
output to 10.6m barrels a day (b/d) into the teeth of the downturn. Bank of
America says OPEC is now “effectively dissolved”. The cartel might as well shut
down its offices in Vienna to save money.
If
the aim was to choke the US shale industry, the Saudis have misjudged badly,
just as they misjudged the growing shale threat at every stage for eight years.
“It is becoming apparent that non-OPEC producers are not as responsive to low
oil prices as had been thought, at least in the short-run,” said the Saudi
central bank in its latest stability report.
“The
main impact has been to cut back on developmental drilling of new oil wells,
rather than slowing the flow of oil from existing wells. This requires more
patience,” it said.
One
Saudi expert was blunter. “The policy hasn’t worked and it will never work,” he
said.
The
technologies described above are reducing US production costs faster than the
Saudi plan is reducing oil prices. OPEC’s pumping is mainly hurting its own
members. That’s why Ambrose says the cartel might as well shut down.
Saudi
Arabia is trapped. If prices go up, US shale producers will uncap some wells
and produce more. And if it isn’t the US, it will be Australia, Canada, or even
China’s growing shale industry. Argentina has potentially massive shale oil
plays. Ditto Mexico. There is oil and natural gas all over Eastern Europe.
Oil-producing
nations (and not just OPEC members) are losing the ability to subsidize their
government spending with oil revenues. Look at this table of the oil price they
need in order to balance their budgets.
The
Saudis have a big cushion, but it won’t last forever. That may be why this week
the Saudi finance ministry sold government bonds for the first time since 2007.
That said, the debt-to-GDP ratio in Saudi is essentially negligible; and when I
sent Ambrose’s rather negative Saudi outlook to some of my friends in Saudi,
they were all quick to respond about the potential for the Saudi government to
make cuts and deal with lower-priced oil, just as they have in the past.
Venezuela? They are essentially screwed.
OPEC
countries have no one to blame but themselves. Those years when they kept
prices at $90 and higher gave the fracking industry, as well as solar and other
alternatives, time to develop. They can’t put that genie back in the bottle.
For
the time being, the US is now the “swing producer” for both oil and gas.
Production costs in the Bakken and Eagle Ford will be the top of the range
going forward – and that cost is a lot lower than most OPEC members currently
need to sustain their governments. Over time this is going to mean a
significant readjustment in the spending of most Middle Eastern governments.
I
expect that the increase in the production of oil will actually slacken
somewhat over the next year, as rig count is down, a pattern we have seen in
the past. But production is not going to fall as much as oil pessimists think.
Further, US production is likely to rise over time, even at $50–$60 oil.
We
should note that not all oil rigs are equal, so you cannot simply equate the
number of rigs in use with oil production. There are multiple generations of
oil rigs, and the ones that are going idle are older-generation rigs that cost
more to operate. (One can see the same dynamic happening in the shipping
business as the big cargo carriers built before the middle of the last decade
are being priced out of the market. New-technology ships rule.)
Does
cheap shale mean solar, wind, and other alternative energy sources will lose
momentum? I don’t think so. Governments around the world still want to reduce
carbon emissions. For that matter, so do I. I prefer not to see the air I am
breathing, thank you very much.
The
newer shale oil production techniques are better on the environmental front,
but they still produce significant emissions. And while costs are dropping for
drilling oil and natural gas, the cost of solar energy is dropping even faster.
In fact, the real revolution is in the dramatic fall in the cost of producing a
kilowatt of power using solar energy.
What
I think will happen is that shale, and particularly shale gas, will be the
world’s “bridge” to cleaner energy sources. Solar is already more
cost-effective than fossil fuels in some tropical countries. It will keep
growing in those places, even if the developed world loses interest.
To
get an idea of how the cost of solar energy has fallen in the last few decades,
check out this
article by Ramez Naam. His first chart shows the prices agreed to for solar
power purchase agreements in the last eight years. The cost of solar power is
clearly coming down and is now almost half what it was less than 10 years ago.
Every
doubling of solar power production reduces the cost of new power purchase
agreements by about 16% because of lower module costs, lower “soft” costs,
lower overhead management costs, and higher capacity factors. Moore’s Law is
alive and well in the solar industry.
Where
is the cost of solar going? It will not be long before solar is competitive
with natural gas.
Yes,
coal will still be cheaper for another decade or so, but at the current pace of
progress – and there seems to be no technological reason that progress won’t
continue – solar will be cheaper than even coal. And it is certainly much
cleaner.
We
also have to distinguish between electricity and transport fuels. With
apologies to Elon Musk and Tesla, the electric cars aren’t quite ready for
prime time yet in terms of cost, although the quality of a Tesla is amazing.
Meanwhile, fuel cell technology is progressing rapidly. We may see fuel-cell
cars move ahead of rechargeable electric ones in the coming years.
I
don’t have any preference between the two – nor should you. Let them compete,
and we’ll see what works best. Consumers will win either way.
In
fact, this revolution will have many winners.
Shale
oil and gas producers who have aggressively implemented the new technologies
and staked out prime deposits should perform very well, even at today’s low
prices. The US chemical industry, which uses huge quantities of fuel, is
already starting to build new facilities near the shale production zones. This
will give them a leg up on foreign competitors whose fuel supply is more
expensive.
Energy-importing
nations like China, Japan, and parts of Europe will be able to buy fuel at
bargain prices from reliable US producers. Note that just today the Obama
administration agreed to allow US oil to be sold to Mexico. Even if Congress
doesn’t go along this year, there is a developing consensus that we should be
selling oil and natural gas from the US. That will increase our drilling here
and create jobs while helping to reduce our trade deficit. There is no reason
to bottle up resources when we have plenty to share with the world.
I
hope energy exports will happen soon, but I see a bright future even if they
don’t. Energy costs have long acted as a “tax” on economic development. Now we
are on the way to a world where energy is either very inexpensive or downright
free. Think of solar energy as digital energy. Just as the cost of data storage
has come down, the cost of energy is going to come down as well. This trend
will spur economic growth in ways we can only imagine now.
Of
course, these developments have large geopolitical ramifications, but that’s a
topic for another letter.
The subject
does, however, bring up an interesting thought about how we measure GDP. In
another 10 years we are going to see a wave of home solar installations,
especially in the southern tier of the United States as the cost of
installation falls and battery technology improves. Let’s look at that from the
standpoint of measuring GDP.
For
simplicity sake, let’s say you buy $10,000 worth of electricity a year from
your local utility. That is $10,000 of GDP. Now let’s say you spend $40,000 to
put in a solar system that allows you to get off the grid. That is a one-time
boost to GDP of $40,000. But now you no longer pay $10,000 a year to the
utility, so as long as you are on the solar system, you are no longer
contributing to GDP. Further, if you buy an electric car and charge it, you are
no longer buying gas, and thus the portion of your money previously spent on
fuel is no longer contributing to GDP.
Yes,
your money is available to be spent elsewhere, but you could also save it or
invest it. You will be using the same amount of electricity, so your lifestyle
will be the same, but it will not be measured in GDP. There is a growing debate
among economists, especially those around Silicon Valley, as to how we should
be measuring GDP.
back to New York
I
finish this letter back in Dallas, where I will be for a few days before I go
to New York in the middle of next week for business (even in August) and then
head up to the Hampshires to spend the weekend with my friend Jack Rivkin of
Altegris. We may visit Doug Kass, who is in the area; and with Jack who knows
what else we may run into? He seems to know everybody. Then on Monday we’ll
take the ferry over to Connecticut and drive up to Gloucester to stay with my
friend Dr. Woody Brock at one of the most interesting summer homes in
Massachusetts. The Guggenheim actually did an entire book on his art collection
and furniture (a lot of serious Napoleon-era furniture). It is quite the museum
tour, but the part that I really love are the grounds around his home, which
are home to an amazing assortment of obelisks, pyramids, temple replicas, and
massive sculpture, all in a park-like setting with a fabulous quarry lake. At
night the lighting is amazing. In addition to admiring the art and relaxing,
Woody and I will spend a great deal of time talking through all things
economic, with an emphasis on where the world is going over the next 20 years.
After
a few days we will drive back down to Boston, where we will stay with Steve
Cucchiaro, who has a new catamaran and has promised me smooth waters to sail
upon (I suffer motion sickness all too easily). Of course, when you have the
founder of Windhaven (now retired), you have to talk portfolio design and
investing.
Then
it’s back down to New York for a few days for some meetings, and maybe we’ll
catch a play or two. I’ll be back in Dallas by the middle of the week, and my
September looks surprisingly void of travel. This is good, as I need the time
to work on my book. Deadlines wait for no man.
I
spent the last few days in the mountains in Whistler, British Columbia, with my
good friend Louis Gave. Louis has a vacation home at the top of one of the
mountains (quite the different venue from Hong Kong). He was rounding out his
summer, so he required us to go along with a few of his friends to do this
thing called the Sasquatch. It turned out to be a 1.4-mile-long zip line
stretched hundreds of feet over and across the Whistler Valley. The initial
drop is several hundred feet, and you quickly accelerate to more than 80 miles
an hour. I truly had no idea what I was in for as I stood at the edge of the
platform and looked over, and quite frankly I almost panicked. It seemed like
we were at the tippy top of the world. It’s one thing to know in your mind that
it’s perfectly safe and another thing to step off the edge of a perfectly good
platform. I took comfort in the fact that one of Louis’s friends – a longtime
member of the French Foreign Legion and a serious risk taker on mountain bikes
and skydiving – also expressed a little nervousness. But it was small comfort.
Only the potential embarrassment of having to walk back down the mountain by
myself made me actually go through with it. It was not as terrible an
experience as a vicious bear market, but only because it was over quicker. I
would prefer not to experience either again. I must say, however, that Louis,
who is a bit of an adrenaline junkie, seemed to end the adventure with his
heart pumping almost as fast as mine.
Have yourself a great week. I intend
to do nothing more adventurous this weekend than watch a movie and read a
science fiction novel. I’ve decided that I prefer to have my adrenaline rushes
vicariously.
Your
wondering if the future will come that fast analyst,
John Mauldin
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