Pricing of Gas & Electricity

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Introduction: We talked with Sprott Asset Management Research Analyst Eric Nuttall about the natural gas situation in Canada and the fate of many CBM gas producers and developers. Since our last conversation spot natural gas prices have dropped by 15 percent. Natural gas storage levels are about 2.5 trillion cubic feet, some 423 billion cubic feet higher than a year ago.

Eric Nuttall told us, “Nearly all small-cap natural gas producers have taken it in the teeth this year. The price decreases in their stocks have been absolutely brutal. There are now companies whose stocks are down 40 percent year-to-date, and yet are still strongly growing production on an adjusted share basis.” How will the CBM and natural gas sector pan out through the end of this year? He believes the gas storage surplus will correct itself.

StockInterview: How are the lower natural gas prices impacting Coalbed Methane producers?

Eric Nuttall: For many CBM or shallow gas producers, this means their current drilling program is likely uneconomic, suggesting deferrals in drilling programs until natural gas prices strengthen. It is this very supply response that we need to balance storage levels, so it should not come as a complete surprise.

StockInterview: What, then, should investors do while storage levels are rebalancing?

Eric Nuttall: I would view this period as an opportunity for medium to long-term minded individuals to start building positions in not just unconventional gas producers, but conventional ones as well. The long-term fundamentals are still extremely bullish for natural gas. Many quality names are down 20 to 40 percent year-to-date.

StockInterview: How do you view the long-term fundamentals for gas?

Eric Nuttall: North American natural gas production has been in decline for several years. Most incremental production is coming from smaller, more expensive-to-drill, thinner economic, higher decline pools and reservoirs. Over the past five years first-year decline rates on natural gas wells have doubled to 50 percent. The base decline rate has also doubled to approximately 25 to 30 percent. Pool size has also decreased materially over that time frame. The Western Canadian Sedimentary Basin and much of the US producing basins are mature. Consequently, higher and higher natural gas prices are required to create incentive for producers to drill increasingly marginal wells.

StockInterview: And you expect a continuation of declining natural gas production? And that is that your premise for higher natural gas pricing?

Eric Nuttall: Conventional gas production has been in decline for many years, and the growth areas have largely been unconventional, such as the Piceance Basin (tight gas), the Barnett Shale (shale gas), and the Jonah Field (tight, deep gas). Also, many of the growth assets, such as the Barnett Shale, are already a few years into development, and because the wells have such a steep decline rate in the first few years, it is only adding to the depleting base that we have to make up. It is unlikely that over the next three years, the increase in unconventional gas can offset the decline in conventional, because the depleting base is so much larger. The major natural gas basins in North America are mature. Decline rates are increasing. Pool size is decreasing. Rig count is increasing yet production is at best flat. Until LNG imports increase in a material way, which is not expected for at least four or five more years, I think the case for healthy natural gas prices is intact.

StockInterview: Earlier, you noted drilling was more expensive.

Eric Nuttall: Over the past year, onshore drillings costs are up over 15 percent while operating costs are up over 10 percent. A recent Wall Street Journal article commented on how rig rates for the Gulf of Mexico, on very deep drilling platforms, are as high as $520,000 per day, up from $185,000 a few years ago. And the drilling platforms are still leaving the Gulf of Mexico! Although many are leaving the Gulf of Mexico to go to more prospective areas such as the West African Coast, the current rig situation is still somewhat tight in the Gulf. We have only begun to see signs of moderating rig rate pricing.

StockInterview: How would bad weather, such as a hurricane, impact natural gas prices?

Eric Nuttall: Short term, you would see both natural gas and related stocks surge. If a hurricane strikes the producing area of the Gulf, and we almost need one to – to correct the surplus supply situation. Initially, you’ll have an emotional upward response. Only after assessing the status of production platforms and sub-sea infrastructure would we know the longer-term impact.

StockInterview: Should investors be watching the Weather Channel and ready to phone their stockbrokers?

Eric Nuttall: Timing on any natural gas investment right now is tricky. You need to have a medium- to longer-term focus. We probably have another two months of volatility. There are two camps right now on natural gas. One camp is saying that due to bloated storage levels companies are going to increasingly lay down their drilling rigs, cut production guidance, and stress their balance sheets. Then in the fall, when companies set their 2007 budgets, they will be using low gas prices and presenting moderating production growth profiles to their investors.

StockInterview: What does the other camp say?

Eric Nuttall: Another camp says that the current natural gas strip already discounts the present and forecasted storage levels. Also, stocks are cheap on a price-to-cash flow and price-to-net asset value ratios, and now is the time to load up on the stocks. I lean towards this viewpoint. But I am also admitting that until the fall, barring a severe hurricane, it is likely that the stocks are going to trade sideways, as opposed to in any clear direction.

StockInterview: One equities strategist, whom we interviewed, suggested some time in August we might start to see the natural gas stocks moving higher.

Eric Nuttall: There is the potential that we might endure another month or two of flat trading in small cap natural gas stocks. By the end of August, it is likely that we will have had both a supply and demand response – worries of massive laying down of rigs, forced well shut-in’s, and overleveraged balance sheets should have subsided. Investors will begin to focus on the natural gas strip rather than spot prices, which currently are around $9.00 for the upcoming winter and $8.00 for next summer.

StockInterview: And until then?

Eric Nuttall: Until that time comes, I think it likely, as a group, the large caps will outperform. They are more weighted towards oil, and have recently been catching a bid on the heel of a huge $22 billion all-cash takeover by Anadarko of Western Gas and Kerr-McGee. Importantly for unconventional gas investors, Anadarko paid around $2.00 for 3P (Possible) Mcf, which is very healthy (Western Gas was predominantly tight gas in Wyoming and coalbed methane in the Powder River Basin). It speaks to Anadarko’s view of strong long-term natural gas fundamentals. These all-cash transactions likely set the bottom in the large caps.

StockInterview: What do you see for the near-term?

Eric Nuttall: Many people have been hoping that warm weather or hurricanes would assist in working off the excess supply, but Mother Nature hasn’t been terribly helpful so far this summer. It appears that we will exit the natural gas injection season at least 10% over last year. Barring any incredible heat waves or significant hurricanes, natural gas prices are likely to remain sub-$6.50 until the fall. Unless we have a serious hot spell or a significant hurricane, it is likely that natural gas stocks will be very volatile without clear direction over the summer into the fall. I would think not until the fall, probably September – October, when people begin to focus not on natural gas spot prices, but on the strip pricing for the winter, which is still over C$10. Until that time comes, I wouldn’t see any clear direction in the stocks. The market is now providing opportunities to buy companies with high quality management for below-average multiples, commonly measured on a price-to-cash flow metric.

StockInterview: Have you given up on the CBM sector or is it coming back?

Eric Nuttall: There is zero doubt in my mind that natural gas is an excellent long-term investment. We’ve peaked in our ability to increase production meaningfully, just as we have with light oil. I think for there to be an increase in long-term natural gas supply, you have to provide incentive to producers to go drill wells that increasingly have lower economic rates of return. And to do that, you need higher natural gas prices. One of the few remaining growth prospects in Canada for natural gas production is coalbed methane. At current gas prices, the economics are very challenging. So to get a supply response from coalbed methane producers, you again need higher gas prices. The current surplus in gas storage will correct itself, and investors should position themselves ahead of natural gas stocks reacting to this inevitability

Energy warms our homes, cooks our food, plays our music, gives us pictures on television, etc. and is an important part of our daily lives.

Energy crisis is a situation in which the nation suffers from a disruption of energy supplies (in our case, oil) accompanied by rapidly increasing energy prices that threaten economic and national security. It may be referred to as an oil crisis, petroleum crisis, energy shortage, electricity shortage or electricity crisis. Electricity is the second most commonly used energy for home heating, after oil. The situation is even more desperate as electricity is the only source of heating throughout the whole country. There are many reasons to believe that, unlike the gas and electricity crises of the 70s, 80s and 90s, the energy troubles we now face will last for decades.

Oil, natural gas, and coal are nonrenewable fuels. Since the industrial revolution, the burning of coal, oil, natural gas or products derived from them has been a socially significant transformation of chemical energy into other forms of energy. Dependency on oil presents real challenge, but as economies grow, until we change our habits, there is going to be more dependency on oil. Every single hour, we spend $41 million on foreign oil. The best way to break the addiction to foreign oil is through new technology. Peak oil problems are immediate and obvious, to deal with it is to find a way to either produce or save more energy. In fact those who control oil and water will control the world. While oil is the world’s primary transportation fuel, coal dominates in our production of electricity.

Coal provides more than half of the Nation’s electricity supply, and America has enough coal to last more than 200 years. Coal may be cheap, but building the apparatus for turning it into electricity is not. Higher Electricity Prices forces the utility companies to continue investing in conventional coal plants despite the fact that governments are moving to restrict the heat-trapping carbon dioxide emissions from such plants. We spend approximately $130 billion a year on electricity. In the average home, 25% of the electricity used to power home electronics is consumed while the products are turned off. Energy efficient technology can save electricity and money. But that won’t happen as long as the country’s electricity demand keeps growing as it is on pace to do, 1 to 2 percent each year.

Landscaping your home for energy efficiency can reduce your heating and cooling bills, the largest component of your home’s energy use. While our dependence on energy is not likely to decrease, there will continue to be an increase of new innovations in energy technologies with a larger focus on energy conservation and efficiency.

In an era of escalating concern about climate change, boosting energy efficiency in the buildings and homes will not only lower carbon emissions but can also provide substantial financial return to people who implement ‘green designs and technology’ to their environment. By reducing the electricity we will also be helping to decrease greenhouse gas emissions.

While several key government agencies and industry sources have rejected the notion that a global energy crisis is imminent, others in the field believe the crisis is already upon us. The energy crisis is real, it’s not going away, and the federal government needs to do its part to help our communities by providing tax credits and/or rate reduction rebates to consumers who actually reduce their aggregate power usage by more than 10 percent of previous year’s electricity. It is clear electricity consumers need comprehensive and integrated planning to prevent future crises and problems. No matter how cheap heat and electricity become, using less is cheaper still.

Energy saving devices designed to provide significant reductions in electricity usage and monthly electricity bills, increase the life of electrical motors through heat reduction and provide surge protection for your entire Home or business. This can yield an improved payback period relative to the use of an energy saving device. Individuals that purchase this device will find that it reduces energy costs 8%-25%.

They work by reducing the power drawn from the utility by storing in its capacitors otherwise lost electricity caused by the inductive motors in the home. Some examples of inductive motors are air conditioners, refrigerators, freezers, washers, dryers, dishwashers, pool pumps, vacuum cleaners, furnace blower motors, fans etc.

They supply the stored electricity back to inductive loads, thus causing decreased demand from the utility, thereby using less electricity. The process is called power factor optimization.

Power Factor is the percentage of electricity delivered to a house and used effectively, compared to what is wasted. A 1.0 power factor means that all the electricity is being used effectively for its purpose. However, most homes in America today have a .77 power factor or less. This means that 77% of the electricity that is coming through the meter (home or business) is being used effectively. The other 23% is being wasted by your inductive load. With a low power factor, the utility has to deliver more electricity to do the same work.

By increasing that power factor in most cases to .97 or .98, thus increasing the effective use of the electricity and lowering usage.

The best electricity saving devices are ones that provides Spike/Surge Suppression, a feature that protects appliances and electronics (TV’s, stereos, computers, DVR’s, security systems, wireless phones, fluorescent lamps and other equipment) from voltage spikes. Voltage spikes can come from many different sources such as noisy equipment (like motors), power fluctuations, static electricity, and lightning.

The most common form of Spike/Surge suppression are MOV’s (Metal Oxide Varistors) or simply Varistors. MOV’s are arranged in parallel with the circuit being protected. Typical residential and light commercial power sources allow literally hundreds of spikes and surges per day to reach valuable and oftentimes sensitive electricity equipment. MOV’s can suppress these spikes and surges and still remain operational. In the event of a massive surge or spike, the kind created by a direct lightning strike, the MOV sacrifices itself and fails open.

Electrical Noise Filtration 
Homes, businesses, and factories are filled with electrical devices that generate “noise.” What is ironic is this noise is harmful to the very appliances that create it. The offending “noisemakers” include TVs, computers, compact fluorescent bulbs, fluorescent lamps, stereos, and even major appliances that now have electricity interface and control. The “electricity noise” created by these devices breaks down the switching power supplies, causing premature failure.

Harmonic Filtration as designed into Pe3 is based upon 100-year old science and power engineering principles. What is new is how this technology-typically only used in industrial settings-is now available to residential customers, offices, schools, and light commercial customers. Harmonic Filtration has been extensively applied for decades by industrial users and the electric utility industry itself.

Pe3 is designed to filter harmonics and other high frequency current (trash) from the electricity environment, thereby reducing the potential for leakage into the human environment and creating additional trash in non-liner loads (TVs, computers, variable frequency drives, energy efficient lighting, etc.). Let’s face it; the use of electronics within the American home has been growing at exponential rates and the need for filtering out the “noise” created by these numerous non-linear loads has never been greater. At 60 Hz the filters act as capacitors and normally marginally improve the power factor of the customer load, which are normally slightly inductive.

HARMONIC Noise – The Problem… 
(1) Malfunctioning and failure in computer equipment 
(2) Overheating of neutral conductors 
(3) Low efficiency and overheating of UPS, transformers and cables of the installation 
(4) Tripping of protections without apparent reason 
(5) Interferences in communication networks 
(6) Incremented power consumption

HARMONIC Noise – The Result… 
(1) Low quality electricity energy. Elevated harmonic voltage distortion 
(2) Elevated neutral – earth voltage 
(3) High harmonic distortion in the current 
(4) Excessive levels of 3rd and 9th harmonics in the neutral conductor 
(5) Elevated true RMS current in the phases 
(6) Low power factor due to harmonics 
(7) Elevated losses in the electricity installation

Vehicle to Grid applications have a number of benefits for all sorts of businesses and stakeholders. Vehicle to Grid (V2G): 

  • Empowers the home consumer to make sensible choices about when they use their electricity through smart metering
  • saves the consumer money in the long run through effective electricity management
  • is green! Every time you supply the grid with electricity during the yearly peak energy demand, you are reducing the need to upgrade the electricity network with more transmission lines and generators
  • You are helping to bring electric vehicles (EV’s) onto the market
  • You are reducing your carbon footprint! This is a big ones these days
  • The electricity company can save money and reduce their unit electricity prices, or reduce the need to increase them
  • reduce the amount of electricity transmission line needed. I.e. the car transports the electricity to where it is needed.
  • Cuts down on the amount of fuel stations required
  • Reduces our addiction to foreign oil through the accelerated introduction of electric vehicles and ability to replace fossil fuel generation with renewable energy generation.
  • Allows more sustainable energy and renewable energy to be introduced onto the electricity grid, as electric vehicle batteries can now act as a buffer to intermittent generation.

The last point is an important one. Traditional transmission networks are struggling to cope with large percentages of intermittent renewable and sustainable energy generation, as electricity generation from these sources is largely dependent on the elements. Therefore to have the ability to store electricity somewhere is important. In many countries power utilities are approaching this by pumping water up a hill and regenerating during peak times (~60% efficiency) or storing hydrogen formed by electrolysis underground ready for re generation (~40% efficiency). Storing electricity in batteries is a much higher efficiency (60% – 90%) however is a little costly.

Japan uses large battery sheds to store small amounts of energy, however vehicle to grid systems also work very well as storage mechanisms and are likely to play this role in the future as more electric vehicles hit the market. How soon we will see such networks will largely rely on the countries commitment to renewable and sustainable energy sources, as well as the abundance of wind, sun and wave energy. Although many companies claim to have a green lining, short term economics of such projects still remains the number one driver for the introduction of such technology.

The advantage to the end consumer who is running a vehicle to grid system is the savings in electricity for essentially hiring out the storage space in their electric car battery. So as we can see, it is a win win for many as it not only reduces the stress on our electricity transmission and generation networks, allows more sustainable energy to be placed on the system with lower carbon emissions, but also saves the end user money whilst making electric vehicles more affordable. It also weans us off our foreign oil addiction through the cost effective introduction of electric vehicles, a topical issue as we approach peak oil status around the world. For more information you may want to consult your electricity network to find out about their smart metering tariffs. You will also want to look into the purchase of an electric vehicle, or an electric vehicle conversion in able to make use of the vehicle-2-grid (V2G) technology. I guess we can all look forward to a cleaner, greener, cheaper carbon restrained future, and V2G is going to help us get there in a big way

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