Shale Gas (Part II): Tooth Fairy Economics

In my last post, I noted how a whole host of reports have been trumpeting shale gas as the ultimate ‘get out of jail free’ card from any kind of energy constraint and, indeed, the need to invest in renewables to protect the planet from climate change. Here is Mortimer Zuckerman talking of a shale gas ‘revolution’ in the Wall Street Journal.

America’s soaring natural-gas production has already helped cut our share of oil consumption met by imports to 47% last year from 60% in 2005, according to the Energy Information Administration. The shale-gas revolution, with proper safety practices, can be expected to continue this trend while addressing three longstanding concerns of the energy business: energy scarcity, energy security, and environmental risks. In a word, we have a chance to remake our energy future.

Note that an awful lot is being asked of shale gas if it going to help solve scarcity, security and environmental risks all at once. We are in effect asking it to do three things: 1) allow total energy consumption from all energy sources to grow in order to solve the problem of scarcity, 2) enable us to switch away from coal in the generation of electricity in order to blunt (but not stop) CO2 emission growth and so ameliorate environmental risks, and 3) facilitate a transport revolution that allows us to stop importing oil from geopolitical hotspots.

If shale gas is to achieve all this, then it does indeed deserve the moniker ‘game changer’ or, indeed, ‘revolution’. But where is the proof? Well it is usually couched in terms of reserves. In other words, we have X amount of reserves, therefore we can satisfy Y years of consumption. Unfortunately, such analysis generally makes no mention of cost and price (and the impact price has on demand and economic growth). This is somewhat ironic, since the most evangelical advocates of shale gas see it as a prime example of the redemptive power of the market. Moreover, the years of production are usually calculated by taking current gas consumption rather than the quantities of consumption that will be needed to produce the revolution.

The key question then is whether shale gas can be made available at the right price and within the right time frame and in the right amount to make the challenges of peak oil and anthropogenic climate change redundant (or at least give us a bridge to a new generation of non-carbon fuel technologies).

To put some hard numbers on what is needed, the starting point must be the US Energy Information Agency (EIA) data, since their consumption numbers will allow as to, in effect, calibrate the scale of shale gas roll-out needed to truly transform the US energy landscape. Fortunately, the EIA has just published the early release of its Annual Energy Outlook 2012 with lots of fresh data on shale gas; you can find it here. And this is the consumption outlook:

What strikes me about this chart is that a revolution in gas is nowhere to be seen. Natural gas accounts for 25% of energy consumption in 2010 and, wait for it, 25% of consumption in 2035! Coal has hardly budged, so we haven’t managed to secure an environmental dividend from gas; and any decrease in oil dependency in the economy has come through renewables and liquid biofuels.

How could this possibly be? Are the EIA bureaucrats totally unaware of the shale gas revolution that is promoted so breathlessly in the op-ed columns of the world’s financial press? Well actually the EIA are all over the shale gas story as the chart below shows:

The critical point here is that, as with every other fossil fuel, you need to run just to stand still. Yes, shale gas production has exploded, and is expected to keep growing rapidly, but a large portion of this growth is needed just to replace the fall-off in conventional gas production. Furthermore, if we believe in the EIA’s ‘business as usual’ annual average GDP growth forecast of 2.6% through the forecast period, then aggregate gas production (conventional and unconventional) has to grow just to maintain the same share of the energy cake.

Moreover, all this is premised on a very rosy EIA forecast of a continued improvement in GDP energy intensity.

Energy use per 2005 dollar of GDP declines by 42 percent from 2010 to 2035 in AEO2012 as the result of a continued shift from manufacturing to services (and, even within manufacturing, to less energy-intensive industries), rising energy prices, and the adoption of policies that promote energy efficiency.

To date, much of the energy intensity improvement has been achieved through the US outsourcing its energy heavy industries to China. Whether this can continue 25 years into the future is highly contentious. If the energy intensity gains are not forthcoming then either a) we must find more energy or b) growth will be forced to match the energy available through the mechanism of a rising price.

The EIA has also held down oil consumption in its central scenario through seeing a continued steep increase in the price of oil (WTI), to $145 per barrel in real 2010 dollars ($230 per barrel in nominal, non-inflation adjusted terms). Gas prices, meanwhile, are reasonably well-behaved up until 2023 at less than $5 per thousand cubic feet in real terms, but then start rising to around $6.50 as cheaper, conventional sources of gas fall out of the mix.

I am reminded again of the observation by Michael Cembalest, the CIO of JP Morgan, that unconventional is a euphemism for expensive. Technology may dull the pain of the transition to unconventional, but it does not eliminate it. You can get a better idea of the cost dynamics (original data from a Deutsche Bank report) if you look at the chart below taken from a quite bullish presentation by Jean-Marie Bourdaire, the Director of  Studies at the World Energy Council here.

The key point is that every time you try to force another 5 million cubic feet of gas per day into the market you push the price of gas up substantially. But because price is set at the margin, all consumers must pay the market clearing price (although this will take time, as much supply is on long-term contracts that will only get repriced when they expire).

For this reason, gas it not able to drive coal out of the energy equation. Look at it another way, in 2010 coal provided 20.8 quadrillion Btu of energy consumption in the US, or 21% of the total. Coal currently costs somewhat less than $2 per million Btu and the EIA sees it rising modestly (presuming no carbon tax) to $2.51 by 2035 (real 2010 dollars). Let’s turn to gas. We have a pretty active market for natural gas, both spot and futures, and if you write op-eds in the Wall Street Journal then this is something you can relate to. So let’s take a look at natural gas prices at the CME here. We find that natural gas is currently trading at around $2.5 per million Btu. But wait a minute, as we look at the longer contracts a few years out we find that gas is trading over $4 dollars per million Btu. If you are a techno-optimist, this is not right: technology is supposed to inexorably drive the cost curve down. The critical point here is that the market is saying that the emperor (technology) has no clothes and coal is not about to be driven into oblivion. (If you think the market is a fool, then you can sell long-dated natural gas contracts and make an absolute killing.)

So if natural gas is not about to deliver us from anthropogenic climate change through displacing coal, will it lead us to the salvation of energy security? Well, the media is abuzz with the idea that the US will become a natural gas exporter. But what does that actually mean in overall energy terms?

Let’s start with how much natural gas was actually imported into the US in 2010. It came to 2.7 quadrillion Btu, which is equivalent to 2.7% of total energy consumption in that year. How will things look according to the EIU in 2035? In that year, they see the US exporting 1.4 quadrillion Btu, whch will then be equal to 1.3% of total consumption. Keeping in mind that over this period there will have been no radical changes in coal and oil in the energy mix, does this amount to a ‘revolution’ or ‘game changer’? Furthemore, in the natural gas arena, who is the US actually becoming independent of? In truth, it is those dangerous Mad Mullahs of Ottawa. True, under the EIA projections, overall oil dependency is declining over the next 20 years, but shale gas is irrelevant to this trend.

The story moves from being purely silly to sureal when we see that such a high-profile academic as Dieter Helm (who has the ear of governments across Europe) claiming that US shale gas will not only transform the US but Western Europe as well (here).

The implications for prices are already being felt: the US is, in effect, ceasing to be a gas importer, so that LNG capacity built with US demand in mind is now effectively redundant. The excess LNG capacity that results at the global level, therefore, has to find other markets—including Europe. Europe no longer faces US competition.

And

Given that there is no physical shortage of fossil fuels, peak-oilers have to rely on demands for energy which rely overwhelmingly on oil. For practical purposes, that means transport. Peak-oilers assume that oil is essential to transport, and will not be substituted by other fossil fuels (or indeed other non-fossil fuels). The prospect of the electrification of transport undermines this claim. The electricity can be produced by abundant gas (and coal), and shale gas pushes aside any serious notion of ‘peak gas’.

When I look at these statements, I don’t know whether to laugh or cry. Shale gas in the US will add roughly 10 quadrillion Btu of energy potential over the next 20 or so years while at the same time conventional gas sources will decline by around half that amount and overall demand linked to GDP will keep growing. Five quadrillion Btu of energy is not to be sneezed at but it not an energy ‘revolution’. Liquid fuels in the US give us currently 37 quadrillion Btu of energy for transportation. The bottom line is that to electrify transportation in the US alone we are talking about tens of quadrillions of Btu to make a transformational difference.

Do the promoters of a shale gas revolution believe that the EIA is tens of quadrillion of Btu short of potential? To answer this question, I searched to see if I could find any backer of shale who attached energy production (as opposed to reserve numbers) to their forecasts. Frankly, I came up with a blank (please comment if you beg to differ).

There are  shrills for shale gas but they don’t contain any hard production numbers. For example, this by the Global Warming Policy Foundation (authored by Matt Riddley with a foreword by Freeman Dyson). The Global Warming Policy Foundation is chocked full of the great and the good of the English aristocracy. The board of trustees boasts five Lords, one Baroness, a Knight and a Bishop. I feel as if I have time wharped back to Downton Abbey. But if you read the report you will find no actual firm numbers. Only statements such as this:

Shale gas is proving to be an abundant new source of energy in the United States. Because it is globally ubiquitous and can probably be produced both cheaply and close to major markets, it promises to stabilise and lower gas prices relative to oil prices. This could happen even if, in investment terms, a speculative bubble may have formed in the rush to drill for shale gas in North America. Abundant and low-cost shale gas probably will – where politics allows – cause gas to take or defend market share from coal, nuclear and renewables in the electricity generating market, and from oil in the transport market, over coming decades.

Well what do we mean by ‘probably be produced both cheaply and close to markets’? How much shale gas will take what share and over what time from coal and oil, both in the US and globally? These are the questions we want answered. Anything less is mere tooth fairy economics.