Engineering News

Challenges in Global Energy and Their Potential Impact on Energy Costs
November 28, 2011

Introduction

Pau Morilla-Giner oversees alternative investments at London and Capital and is also the manager of London and Capital's equities and commodities funds. He started his career at JP Morgan Asset Management in Madrid and New York. In 2001 he joined Omega Capital, a multibillion investment company, where he became head of traditional investments and senior hedge fund analyst. From 2005 he was investment manager and head of research at Pragma Wealth Management, a London-based alternative investment company. Pau obtained his BA summa cum laude in economics from Universitat Pompeu Fabra, Barcelona, in 1999, followed by a masters degree in finance from CEMFI (Bank of Spain) in 2001. He has been a visiting professor of finance at the RiskLab School of the Spanish Financial Futures and Options Exchange (MEFF).



Energy has always been both a fundamental issue for nations and an extremely volatile commodity. What are the implications for energy markets of the Japanese earthquake and tsunami and the Libyan war and unrest in the Persian Gulf?

It is already abundantly clear that the Japanese earthquake has created problems for the global nuclear industry. Going forward, industry regulators will pay much more attention at the planning stage to issues such as the location of nuclear plants and how many of them it is sensible to put in the same locality. On older nuclear plants, which is to say plants where the basic design is more than 20 years old, governments are going to have a much more difficult job granting end-of-life extensions. I cannot for a minute think that this will be the end for the nuclear industry, but it does mean that a highly regulated industry is going to become even more intensely regulated, which adds an additional layer of difficulty for potential investors in new nuclear plant.

In Germany, for example, the average age of nuclear plant is 23 years, and Germany has already called a halt to any license extensions while the issue is reconsidered. The United States too is reassessing the way it uses nuclear. The danger for business, in all of this, is that countries could hit periods of brownouts and blackouts if aging nuclear plant is retired on safety grounds before there is adequate alternative generating capacity.

China has given some mixed signals. The ruling State Council suspended all new approval for nuclear plants on March 16, 2011, pending an inspection of existing plants and the issuing of revised safety rules. However, according to an article in the Washington Post of April 2, Xie Zhenhua, vice chairman of the National Development and Reform Commission, told a meeting on climate change in Australia that China's nuclear goals remained unchanged. The article's author was deeply unimpressed by China's current safety planning and noted the absence of real or workable evacuation plans for people living within a mile or two of existing nuclear plant facilities.

However, when all is said and done, nuclear remains one of the most efficient ways of generating a large component of base-load electricity. The "easy" alternative, namely massive coal-fired power plants, is either environmentally unacceptable, or, if clean-burning technologies and carbon capture are introduced, becomes hugely expensive. Which brings us back to the impossibility over the next 30 years of moving away from nuclear.

There will be serious questions around design issues, however. We have not yet seen a great deal of technical information coming out of Japan, but there were clear concerns about the ability of the elderly reactor design to provide unambiguous temperature readings in the core as the crisis developed. This same design technology has been used a great deal in Europe, and if it shows real deficiencies, then that is going to pose some real problems.

By the same token, nuclear power's difficulties smooth the way for other technologies, and one of the fastest and safest replacement technologies available is natural gas. By fast, I do not mean overnight. It takes a lot of time to switch electricity generation capacity from one technology to another.

If we look at the situation in North Africa, it seems clear that the price of oil is destined to be somewhere between US$110 and US$115 or more for some considerable time. This is high enough to bring projects forward that were impossible at sub-US$85 oil. In Canada, the oil tar sand deposits contain huge reserves, but this is very heavy oil and is very expensive to refine. Unit production costs are around US$85 to US$90 a barrel, and the further north in Canada you go, the higher the cost of production. Northern Canada requires US$110 a barrel before companies can break even. Clearly, if we had stable pricing at US$125 a barrel, there would be a real incentive for projects to go forward here.

What this tells us is that the "peak oil" story is not the full picture. There does not have to be less oil available in the world for prices to climb. The determining factor is not just available supply, but how expensive, effectively, oil drilling becomes. Oil, in other words, is expensive not simply because of demand dynamics or inventory dynamics, but because of supply dynamics, which are all about the marginal cost of extracting additional oil from sources that are nontraditional, more expensive to get at, and more expensive to produce and refine.

There is a huge amount of oil still in the ground, but the technology to get at it is fiercely expensive, so for this reason, once these technologies begin to be deployed in any scale, you will not see much retrenchment of oil prices below the breakeven costs for these nontraditional reserves. On the same theme, there is a huge amount of oil in offshore Brazil, but this is deep-water drilling and the cost of extraction is very high. You would not see breakeven with oil at $110, which, again, points to oil moving higher in the near future.

On top of all this, if you add instability in the Middle East into the equation, the problems are compounded. Bahrain is looking difficult, but without doubt the last barrier holding back the oil price from going beyond $120 a barrel is Saudi Arabia. Today, Saudi Arabia can absorb any dislocation to world supplies coming from disruption to Libyan oil production. Libya produces less than 2% of world oil and replacing it absorbs about 12% of Saudi surplus capacity. So it is not a problem for them. But this means too that they are not in a position to absorb further shocks to production from the Middle East. If another major country in the Persian Gulf reduced supply, or if there were to be a problem which impacted the passage of oil tankers through the Suez Canal, that would be a huge event for global oil prices.

The key point to grasp here is that as we near the end of March 2011, [it's now July] we are seeing unusually high, cyclically high, inventories in oil stocks coinciding with the oil price at very high levels above $100 a barrel. If there were no instability in the Middle East, at current inventory levels oil would not be above $85 a barrel.

The Bahrain situation is not that big an issue purely from the standpoint of the country's oil reserves. But it is a highly dangerous issue from another standpoint, and in fact is far more dangerous than either Libya or Egypt. The issue with Bahrain is not a population that is revolting against a leader. It is the fact that it is a minority Sunni ruling elite being confronted by a majority Shiah population that is being stirred up by Iran. The big fear in the market is that this will lead to a direct confrontation between Sunni Saudi Arabia, which is committed to defending the Sunni regime in Bahrain, and Shiah Iran. That would be catastrophic for the oil and gas sector. Bahrain itself is not the issue. It is the fact that it could create a domino effect, drawing more and more parties reluctantly into a conflict that no one country wants to precipitate.



Both oil and natural gas are hugely important fuels for industry. If we look at the relationship between the price of oil and the price of natural gas, that relationship varies dramatically from one region to the next. What are the implications for natural gas pricing in the medium term?

The place to start any analysis of the relationship between the price of oil and natural gas is to look at their energy equivalence. A barrel of crude oil is equivalent to about 5.8 thousand cubic feet of gas in energy terms. So the price of gas per 1,000 cubic feet should logically be about one-sixth the price of a barrel of oil. If you owned an oil-fired generation plant and a gas-fired plant, you would arbitrage any price differential between the two fuel types. So when the spread widens between the logical price and the actual price, what is happening is that you are looking at real difficulties for particular markets in arbitraging away that energy/price equivalence. I make this point for illustrative purposes, but it is important to realize that in many instances there is no arbitrage possibility because the two fuels are not equivalent in their use. Natural gas is primarily used in heating and power generation, and oil is very important for transport. Of course, the further the price ratio between the two tips out of balance, the more pressure there is to explore direct equivalences, such as the use of compressed natural gas for transport, or as a feed to hydrogen fuel cell-driven vehicles.

Now let us look regionally. In Europe, Russian gas is hugely important and the Russians have pegged the price of gas very solidly to the price of oil. I see nothing to change this in the medium term. In Asia there is a shortage of natural gas for power generation, so there is a very big global business shipping liquefied natural gas (LNG) to Asia. Demand outstrips supply, so this maintains the price of gas at high levels.

Then you have the third region, North America. Here you have exactly the reverse set of conditions. The United States has seen a massive ramp-up in the production of shale gas, or the extraction of gas from hydrocarbon-bearing shale, of which the it has huge deposits, running to more than 1 trillion cubic feet. Advanced extraction techniques in the United States based on hydrofracturing of the shale and a combination of deep vertical drilling and horizontal drilling out from the bottom of the well have considerably extended production capacity from shale.

It is important to realize that shale gas is a complete game-changer for the United States. It takes the country in one bound, as it were, from being a massive importer of oil and gas to being energy self-sufficient for potentially the whole of the next [this?] century-a time frame that is more than sufficient for other sources of energy generation, such as nuclear fission from deuterium and tritium (hydrogen isotopes found in seawater and common right across the planet) to become mainstream, commonplace technologies. Nuclear fission is probably three to four decades away from being a commercial reality and it has the potential, again, to be a complete game-changer, making energy self-sufficiency much easier for countries to acquire.



I take it that the United States is not unique in having shale gas reserves. What are the implications for other regions?

The reserves in the United States are on a different scale to those elsewhere. Russia has some shale gas reserves, and there are some in the Middle East, in Iran, and off the coast of Venezuela. But the key point is that shale gas in the United States and Canada can really change the balance of power among energy producers. Today we have OPEC as a cartel dictating oil pricing to some extent to the world. The United States could have an impact on this pricing. Another important factor is that natural gas is a very clean fuel. It will make it much easier for the United States to lower its carbon footprint and get closer to the Kyoto Protocol.



There are issues with the hydrofracturing, or hydrofracking, techniques used, with claims that the chemicals in the hydrofracking mix are environmentally damaging. Will that become a major stumbling block to the development of shale gas?

The background to the hydrofracking controversy was fully aired in a series of articles in the New York Times recently. There are two major issues. One concerns the additives mixed in with the water and sand that are pumped down the well. The additives are only a very small component, typically around 0.5%, but the charge is that they contain toxic elements which, if they escape to the surface, will pollute and poison the soil and the environment. This is very difficult to establish since the production companies take a very proprietary attitude to their formulae for the additives, claiming that the right mix conveys a competitive advantage, so they should not be forced to disclose it to their competitors. The other problem is that a percentage of the water that is pumped down the well to fracture the rock flows back out again. In the Marcellus Shale area, which is both the second largest shale gas reservoir in the world and is located in and near densely populated areas, these controversies will run and run and they look certain to impose some kind of additional regulatory cost on the industry. It seems unlikely though, that the protests will stop gas shale from being produced.

Another key point to grasp about US shale gas is that it confers a tremendous competitive advantage to US industry at a time when the US deficit is a serious cause for concern. US companies that are heavy energy users can save considerably on their production and manufacturing costs by switching from oil at US$120 or more a barrel to natural gas at US$4-$5 per 1,000 cubic feet instead of US$20, which would be the logical price if the gas price had not decoupled from oil. Although shale gas prices will go up over the next few years, gas futures pricing even going out 20 years is still very low.

However, there is an issue with distribution. The United States is poorly served as far as coast-to-coast and state-to-state distribution pipelines are concerned, and there are huge planning and permission obstacles in the way of private companies wanting to build new pipelines. No town or city wants a pipeline running near it or through any scenic spot. So it is hard to retrofit a national gas distribution network on to the country. The other point is that baseload electricity generation in the United States is very solidly predicated on coal-fired power stations. Gas-fired generation plants are there in plenty, but they are used to meet peak demand, since they can be powered up very quickly. Switching from coal- to gas-fired stations designed to run 100% of the time is going to be a challenge. On the plus side, in a speech at the end of March 2011 President Obama announced a number of new energy policy goals, including making much more use of shale gas and using compressed natural gas to drive bus fleets and heavy transport fleets. That will be a very positive boost for natural gas. It will also help the United States to go some way toward meeting its carbon reduction obligations under the Kyoto Agreement.



More Info

Books:Cassidy, John. How Markets Fail: The Logic of Economic Calamities. New York: Farrar, Straus and Giroux, 2009.Sorkin, Andrew Ross. Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System-and Themselves. New York: Viking/Penguin, 2009.Ward, Nick, with Sinéad O'Brien. Left for Dead: The 1979 Fastnet Race-One Man's Epic Story of Survival. London, UK: A&C Black, 2010.

Article:Richburg, K. B. "China expanding nuclear power but lacks emergency planning." Washington Post (April 2, 2011). Online at: tinyurl.com/3t8blf5

Source: Pau Morilla-Giner QFinance

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