US energy evolution

Robin Wehbé, The Boston Company Asset Management

In the late 1970s, US President Jimmy Carter set the country’s sights on energy self-sufficiency. In 2014, 33 years after Carter left office, the US has yet to achieve it. Despite this, the ‘shale revolution’ looks to be the dominant US investment theme over the next decade.

The unconventional extraction boom in the US oil and gas sector, a result of technological improvements, has transformed the global energy picture. The days of peak oil are over. Global oil and gas supply has turned a corner, and the US stands to enjoy this energy advantage over the rest of the world.

Further compounding the appeal of US domestic production is the current geopolitical climate. Better-than-expected US production growth came just in time to soften the multiple blows of Iranian sanctions, the ongoing conflict in Libya and various Latin American political agendas (Venezuela, Mexico, Brazil and Argentina have all disappointed for assorted reasons). The US provides a stable and attractive global energy solution amid a world of frequent chaos.

The recent Russia/Ukraine tensions have further amplified this trend of using energy supplies as non-military tools to apply political pressure. Since 2006, the Russian government has twice cut supplies during disputes with neighbouring Ukraine, and Russia’s gas exporter hinted in the most recent conflict that it may reconsider favorable pricing terms extended by the prior government. Such fears of supply disruption underscore the demand for reliable US natural gas.

The benefits of this favourable backdrop are likely to be felt across corporate America in the years to come.

Spend, spend, spend

America’s energy drive goes beyond cheaper fuel in the cars of the US consumer; it manifests itself in the form of huge direct investment within the oil and gas sector. America is trying to spend its way to global energy dominance and, in turn, self-sufficiency. Capital expenditures for oil and gas projects in the US are likely to rise more than 5% in 2014 to roughly US$338 billion1, more than three times what was spent in 2000. The US now makes up half of global upstream (operations stages that involve exploration and production) capital spend; world spend is predicted to total US$723bn for 20142.

US infrastructure spend is being centred on three main areas: oil and natural gas in Texas and North Dakota and natural gas in the Mid-Atlantic area. Texas has already benefited from pre-existing oil infrastructure while the boom in unconventional natural gas extraction has opened up new areas such as North Dakota and the mid-Atlantic. These new methods are more complicated and expensive as they involve tapping non-traditional sources, such as shale rock, through horizontal drilling and hydraulic fracturing (fracking). Completely new manufacturing hubs are being created.

As far as transport spend is concerned, rail is the big winner so far. Once a victim of falling coal demand, the US rail system is being invigorated by the energy bounce. Oil and gas companies are taking control of train cars and sub-leasing to others. With pipelines a permanent, inflexible and expensive alternative, rail is no longer seen as the temporary solution. We are seeing the second coming of the US railways. According to the Association of American Railroads, trains transported 407,642 carloads of crude oil in 2013. That’s a 74% increase from 20123 and a jump of more than 4,000% from the 9,500 carloads transported in 20084. This trend is set to continue into 2015.

Greasing the wheels

How does the US monetise its position as one of the world’s oil and gas ‘big boys’ and build for the long-term future? America’s lawmakers have a role to play in changing the US export and cabotage (coastal shipping) laws that still reflect the country’s historic energy scarcity and present stumbling blocks to monetisation. The Export Administration Act of 1979 prohibits the sale of US crude oil abroad, with the exception of Canada and Mexico, while the Merchant Marine Act of 1920 requires all goods transported by water between US ports to be carried by US ships, constructed in the US, owned by US citizens and crewed by US citizens and permanent US residents. With US energy law and regulation rooted in the protectionist era of the 1970s; the seismic shift in supply needs to be recognised on Capitol Hill.

While the prospects for US shale gas, which is cheaper to extract than ‘unconventional’ crude, look positive, with Asian buyers willing to lock in for the long term at liquefied natural gas prices that far exceed the cost of extraction, the challenges in the ‘unconventional’ crude space are sizeable. The cost of ‘unconventional’ crude remains at the top of the cost curve; indeed, it can cost around US$90 to produce a US$100 barrel of oil. The US sector is achieving 10% efficiency gains on an annual basis but how much more efficiency can be achieved? This is no quick win.

Making pipe-dreams reality

With its long history of conventional oil and gas production, the US is leading the ‘unconventional revolution’. Benefiting from the existence of source rock in areas already producing conventional oil and gas, many of the exploration risks are reduced. However, at different points in this secular story, today’s winners will be tomorrow’s losers. This evolution will bring with it both opportunities and risks. Energy self-sufficiency it is not but the ‘shale revolution’ looks set to be a vital investment story not just in 2014 but over the coming decade.

1. Oil & Gas journal, March 2014
2. Barclays, December 2013
3. Association of American railroads, March 2014
4. Association of American railroads, December 2013

This is not investment advice. Regulatory Disclosure