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A Surprising Winner From the Natural Gas Boom

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Low natural gas prices have proved to be a major burden for energy companies that derive a substantial portion of their revenue from the out-of-favor commodity. Over the past year or so, most exploration and production companies have curtailed gas drilling and shifted their focus toward oil and natural gas liquids, which are more profitable.

But one subsector within the energy industry has actually benefited handsomely from the depressed state of the natural gas market – the refiners.

America's natural gas boom
Recent advances in drilling technology applied to unconventional shale reservoirs have helped ignite what many have termed a "shale gas revolution." Domestic production has risen steadily, from 19.3 trillion cubic feet (tcf) in 2007, to 20.6 tcf in 2009, to a whopping 22.9 tcf in 2011 – an all-time record. According to recently released data from the U.S. Energy Information Administration, production last year likely surpassed the 2011 record, with some sources estimating year-end production coming in at 24 trillion cubic feet.

Booming production from sources like Pennsylvania's Marcellus Shale and Texas' Barnett Shale has led to a massive oversupply of natural gas, contributing to severely depressed prices over the past couple of years. Last year, for instance, natural gas spent the entire first half of the year under $3 per thousand cubic feet (mcf), though it rose above that level in the latter half of the year.

Since most gas wells are uneconomical at under $3 per mcf gas, energy companies exited gas drilling in droves last year. For instance, EXCO Resources (NYSE: XCO  ) cut its rig count in the Haynesville and Marcellus Shales – both prominent natural gas plays – from 18 and four, respectively, as of year-end 2011 to just five and one as of the third quarter 2012.

Chesapeake Energy (NYSE: CHK  ) , the second-largest natural gas producer in the country, also drastically reduced its gas-directed rig count, which stood at less than 10 as of the third quarter, down from nearly 90 in early 2011.

And LINN Energy (NASDAQOTH: LINEQ  ) pretty much went whole hog on a highly prolific oily play, known as the Hogshooter, where it maintained eight rigs as of the third quarter, with wells posting staggering average initial production rates of around 2,100 barrels per day of oil.

With these and other energy producers turning to liquids drilling, it should come as no surprise that the total number of rigs drilling for natural gas in the U.S. fell precipitously over the course of last year, plunging by almost half. While low prices proved to be a major burden for gas producers, cheap natural gas turned out to be a major boon to refining companies.

Refiners' changing fortunes
Geographically advantaged refining companies were big winners last year, profiting from the wide difference between the price of domestic oil and the price of global oil. Essentially, they were able to purchase cheaper domestic crude oil while selling the refined product at much higher, globally determined prices.

Fourth-quarter earnings among some of the top dogs in the sector were nothing short of spectacular. Valero Energy (NYSE: VLO  ) posted earnings of $1.01 billion, the highest in seven years, and up significantly from just $45 million in the year-ago period. Marathon Petroleum (NYSE: MPC  ) reported earnings of $755 million, a drastic reversal from its $75 million loss in the same quarter last year.

Besides illustrating the highly cyclical nature of the refining business, these results also reinforce some very positive developments for the sector as a whole. First and foremost is the aforementioned wide gap between domestic and global crude oil prices. Another major positive development for U.S.-based refiners has been high demand for refined product, especially from Latin America, which has provided a big boost to exports.

And last, but not least, has been the beneficial effect of low natural gas prices. Now let's take a closer look at this factor.

How low natural gas prices help refining companies
While there are a host of factors impacting refiners' margins, the biggest component of a refiner's variable operating costs is the fuel it uses to produce hydrogen and power its refining facilities. Over recent years, demand for processing ultra-low-sulfur fuels has risen rapidly, which has boosted the demand for fuel and hydrogen.

Obviously, refiners that are more energy-intensive have benefited more than others. For instance, cracking and coking refineries, which convert heavy crude into light petroleum products such as gasoline, jet fuel, and diesel, tend to spend more on energy costs.

And between these two types of refining facilities, coking refineries tend to be the most energy intensive, demanding more than two and a half times the energy to refine a barrel of crude compared to the average cracking refinery. Hence, they have been the biggest beneficiaries of low natural gas prices among refiners.

The massive drop in natural gas prices, from roughly $9 per mcf in 2008 to as low as $2 per mcf in 2011, translated into massive cost savings for both these types of refineries. Over this time period, the average cracking refinery realized savings of $0.55 per barrel in processing costs, while the typical coking refinery realized cost savings of almost $1.50 per barrel.

For San Antonio-based Valero, falling gas prices since 2008 have amounted to savings of $1 billion per year. And as a New York Times article documented, access to cheaper inland oil and lower energy costs have provided Valero's Three Rivers refinery, located near San Antonio, with about $665,000 a day in savings, which has boosted profit by more than 400% since 2008. That's no pocket change.

Final thoughts
Natural gas prices almost certainly will rise over the next few years, which would suggest a gradual erosion of refiners' cost savings. However, even if prices were to rise above $4 per mcf this year and the next, that price level is still significantly below the historical norm. In addition, $4 per mcf natural gas is still substantially cheaper than European and Asian prices and should continue to provide U.S.-based refineries with a major competitive advantage over their foreign peers.

All in all, I think that several American refining companies are still attractive, though I would prefer to wait for a pullback in their share prices, many of which skyrocketed last year. While last year's phenomenal returns are unlikely to be repeated, the sector should continue to prosper due to a host of positive developments that appear structural in nature.

In addition to cheap natural gas and a Brent-WTI spread that is likely to remain above historical norms, refined product exports should continue to boost refiners' profits. While U.S. gasoline demand peaked in 2005 and will probably continue to fall, the demand for refined product should continue to grow in the developed world, particularly in Latin America.

There are many different ways to play the energy sector, and our analysts have uncovered an under-the-radar company that's dominating its industry. This company is a leading provider of equipment and components used in drilling and production operations, and poised to profit in a big way from it. To get the name and detailed analysis of this company that will prosper for years to come, check out our special free report: "The Only Energy Stock You'll Ever Need." Don't miss out on this limited-time offer and your opportunity to discover this under-the-radar company before the market does. Click here to access your report -- it's totally free.

Read/Post Comments (2) | Recommend This Article (9)

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  • Report this Comment On February 08, 2013, at 11:10 AM, gasblogger wrote:

    Very interesting! I had not thought of this. Too bad we cannot convert all engines to natural gas, and just use reineries for other needed products. My goal is to make natural gas the preferred, cleaner, and cheaper fuel. One that will defeat coal, nuclear, gasoline and diesel as the preferred fuel.

    Natural gas is the future of energy. It is replacing dirty old coal plants, and dangerous expensive nuclear plants. It will fuel cars, trucks, vans, buses, locomotives, aircraft, ships, tractors, engines of all kinds. It costs far less. It will help keep us out of more useless wars, where we shed our blood and money. It is used to make many products. It lowers CO2 emissions, and pollution. Over 4,700 select natural gas story links on my free blog. An annotated and illustrated bibliography of live links, updated daily. The worldwide picture of natural gas. Read in 67 nations. ronwagnersrants . blogspot . com

  • Report this Comment On February 08, 2013, at 12:23 PM, MarkOfBeast wrote:

    Arjun Sreekumar:

    Surprise! Bakken Shale Wells decline even faster than Arthur Berman calculated. The more recent wells even decline faster than old ones.

    Arthur Berman is not the only shale gas skeptism. I am probably the most outspoken critic Shale Gas among all people who wrote on Seeking Alpha. They have now imposed worse censorship on me because I spoke out on the truth of shale gas. Not only they banned me from writting any article or instablog on Seeking Alpha. They banned me from making any comment or even communicate privately with any Seeking Alpha readers. In communist countries at least people are free to communicate privately.

    This tells you that they feared people to hear the truth on shale gas. I intend to complaint to SEC about Seeking Alpha's blatant market manipulation by supressing truthful information. Some vested interest group played a dirty hand in getting me, Mark Anthony, completely banned on Seeking Alpha. My previous articles are still there. But I bet they will ultimately remove all traces of them eventually.

    Now, Arthur Berman first got my attention to the potential scam in the US shale gas industry. But unlike most people, I do not take Arthur Berman's words on face value. I dig out data myself and do my own data analysis.

    Here is what I find out by studying data from several thousand Bakken wells. Bakken is a good study candicate thanks for excellent public data release by North Dakota Department of Mineral Resources. They have month by month production statistics of ALL Bakken shale wells. So you can track each well and see how the production declines.

    My study shows that Bakken well declines MUCH FASTER than even Arthur Berman claimed. For example I summed up production from 3062 Bakken wells that has been continuously producing in all the months from May to Nov 2012, including 128 wells that only started in May 2012. That's the entirety of all wells I can find that has been producing continuously, but excluding a few that produced for a while and then shut down.

    In May 2012, those existing wells produced at average of 506869 Barrels per day (BOE), with gas and oil production lumped together as Barrel of Oil Equivalence (BOE).

    In Nov 2012, only six months later, these same 3062 wells produced at 353040 BOE/day. That's a drop of -30.35% in merely six months. That's averaging at -0.2% drop per day, or -5.9% drop per month, or -51.5% drop per year.

    That's how fast the collective group of existing wells drop, with newest and oldest wells all included. That's losing slightly more than half of production rate in a year.

    Identifying only the newest 128 wells which only started in May 2012. These 128 wells dropped from 62067.67 BOE/day to 27950.77 BOE/day, or losing -55.0% in six months. That's a -0.436% drop per day, or -12.5% loss per month, or losing 80% in a year. Here are just some of the well numbers in this group:




    Now looking at the oldest wells within this group. There are 1244 Bakken wells that has been producing continuously since Dec., 2009. These wells produced at 111911 BOE/day in Dec. 2009. They dropped to 54539 BOE/day in May 2012 and further dropped to 50234 BOE/day in Nov 2012. So these vintage wells more than three years old were dropping at -7.9% every half year, or losing -15.2% per year. These wells show that even after more than three years, the well decline is still very steep.

    Singling out wells first started in Jan. 2010, no early and no later. There are 31 of them:





    These wells that started in Jan 2010 produced at 8052.68 BOE/day in that month, dropped to 2433.77 BOE in May 2012 and then to 2007.77 in Dec. 2012. So these three year old wells dropped at losing -17.5% in half a year, or losing -32% per year, or losing 0.1% per day.

    At such steep decline, even Bakken shale, perceived as most profitable due to its high content of oil and high oil price, is NOT profitable currently. They need $20 or $30/barrel higher oil price to break even.

    Follow my blog at

    stockology . blogspot . com

    (remove the spaces)

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