New investment post on Encana

28 Sep 2014 by Jim Fickett.

Encana: Exchanging value for income

US natural gas prices still too low to support adequate production

31 Aug 2014 by Jim Fickett.

Experienced US exploration and development companies are still reducing natural gas production in favor of liquids. And the natural gas in storage is at a 12-year low. Nothing is certain, but the price is likely to continue its two-year uptrend.

For several years the production of natural gas from US shale has been more of a Ponzi scheme than a business, with continual infusion of new capital required to keep the drills operating. However a recent study from the Financial Times suggests this period is over, and cash flow from operations is now sufficient to cover new investment; i.e. free cash flow is finally positive.

Cash earned from operations by 25 leading North American [oil and gas] exploration and production companies is expected in aggregate to exceed their capital spending next year for the first time since 2008, according to an analysis by Factset for the Financial Times. …

As production has grown … the industry has been reliant on sustained inflows of capital to finance its drilling programmes – through borrowing, equity issuance and asset sales.

Some critics have described the industry as a “Ponzi scheme”, relying on the excitement over the shale boom to attract new investment, and warned that it could collapse when companies ran out of financing to drill more wells. However, shale companies’ finances have improved rapidly as a result of a shift by many away from natural gas towards more lucrative oil production and a pick-up in natural gas prices after they fell to 10-year lows in 2012.

Analysts’ consensus forecasts now indicate that the leading shale companies’ operating cash flows in 2015 will show an excess of about $2.4bn over their capital spending – compared with a shortfall of about $32.2bn in 2012, and $8.8bn last year.

In 2012, only two of the 25 leading companies could cover their capital spending from their operating cash flows, and this year that number is expected to rise to 10.

The main reasons cash flow has improved are:

  1. Increasing efficiency through incremental technological advances
  2. A gradual migration away from natural gas production to oil and natural gas liquids
  3. A two-year trend of gradually rising natural gas prices

So, given that production costs have gone down and gas prices are up, is the market in balance? Not yet.

Although every producer's quarterly reports brags on profitability and low costs of production, actions speak louder than words, and almost all experienced producers are still shifting their production away from gas and towards liquids (see, for example, the company websites of Chesapeake, Devon, Encana, Exxon, Shell). That strongly suggests that the price still needs to rise to even maintain production.

As companies have decreased production, the amount of gas in storage, measured as smoothed months of supply, has dropped to an unusually low level.

This suggests, again, that the incentive to produce sufficient gas has not been adequate – i.e., the price has been too low.

There is one other point which supports higher prices in the future – planned exports. LNG export terminals will start to operate in late 2015, and exports may take approximately 3-4% of production by 2017.

Demand is very likely to be high. For example, Japan still has not restarted any nuclear reactors, and is a major gas importer. The price of shipborne liquefied natural gas in Japan is currently $16.75/mmbtu, more than $10 above the US Henry Hub price, while liquefaction, shipping, and re-expansion costs $2 to $3/mmbtu.

Some have predicted that the rest of the world will join the US soon in producing large amounts of shale gas. This is not happening yet. Two of the countries that have pushed hardest to develop shale gas resources have very little to show for it so far. In Poland,

Both domestic and foreign operators have drilled 65 exploration wells since mid-2010.

However, the geology has proved more difficult than originally predicted and none has yet flowed gas at a commercial rate.

And in China,

With more than 30 trillion cubic metres of recoverable shale gas, China has the largest reserves in the world, almost 70% more than in America, home of the shale-gas revolution. [actually, this comparison is for technically recoverable resources, not reserves]…

American shale seams are mostly found in easily accessible areas at quite shallow depths, and formed of rock that is easy to fracture. China’s are mostly deeper, often in inhospitable areas, and made up of rock that resists American fracking techniques. Worse, some of the biggest reserves are in regions, such as Sichuan province, that have been convulsed by seismic activity or are short of water, making fracking even tougher.

China’s two biggest state oil companies, Sinopec and China National Petroleum, have been fracking furiously, but so far only Sinopec has a commercially significant shale-gas project up and running, in Sichuan’s Fuling district. It claims the field will yield 5 billion cubic metres next year, compared with just 200m cubic metres of shale gas produced nationally in 2013. Few other large shale fields are set to come online, while other natural-gas projects have missed their production targets.

Hardly surprising, then, that in May China signed a $400-billion deal with Russia’s Gazprom to import 38 billion cubic metres of natural gas a year over the next three decades.

All in all, it will be several more years before exports influence the US market significantly, but exports will probably provide a small upward force on prices beginning in perhaps a year and a half.

Most episodes of deflation have been benign

19 Jul 2014 by Jim Fickett.

The recent annual report from the Bank for International Settlements, a bank for central banks, contains an excellent myth-busting analysis of deflation.

Current economic policy commentary often suggests that deflation is extremely dangerous and must be avoided at all costs. The two scary examples often given are Japan's lost decades and the Great Depression. Both examples mislead. Japan actually has quite healthy growth per working person, and the slow overall growth is entirely explained by demographics (Japan's slow growth needs no explanation beyond demographics and Deflation is not the problem). In the Great Depression, the really scary phenomenon was the debt and asset price collapse, and it was out of this collapse that deflation came.

There have been many other examples of deflationary periods, and the BIS explains that the historical record shows deflation is not usually a problem:

it is essential to discuss the risks and costs of falling prices in a dispassionate way. The word “deflation” is extraordinarily charged: it immediately raises the spectre of the Great Depression. In fact, the Great Depression was the exception rather than the rule, in the intensity of both its price declines and the associated output losses … Historically, periods of falling prices have often coincided with sustained output growth. And the experience of more recent decades is no exception. Moreover, conditions have changed substantially since the 1930s, not least with regard to downward wage flexibility. …

Deflations are not all alike. Owing to the prevalence of price declines in the 19th and early 20th centuries as well as since the 1990s, the historical record can reveal important features of deflation dynamics. Four stand out.

First, the record is replete with examples of “good”, or at least “benign”, deflations in the sense that they coincided with output either rising along trend or undergoing only a modest and temporary setback. …

The second important feature of deflation dynamics revealed by the historical record is the general absence of an inherent deflation spiral risk – only the Great Depression episode featured a deflation spiral in the form of a strong and persistent decline in the price level; the other episodes did not. During the pre-World War I episodes, price drops were persistent but not large, with an average cumulative decline in the consumer price index of about 7%. More recently, deflation episodes have been very short-lived, with the price level falling mildly; the notable exception is Japan, where price levels fell cumulatively by roughly 4% from the late 1990s until very recently. The evidence, especially in recent decades, argues against the notion that deflations lead to vicious deflation spirals. In addition, the fact that wages are less flexible today than they were in the distant past reduces the likelihood of a self-reinforcing downward spiral of wages and prices.

Third, it is asset price deflations rather than general deflations that have consistently and significantly harmed macroeconomic performance. Indeed, both the Great Depression in the United States and the Japanese deflation of the 1990s were preceded by a major collapse in equity prices and, especially, property prices. These observations suggest that the chain of causality runs primarily from asset price deflation to real economic downturn, and then to deflation, rather than from general deflation to economic activity. …

Fourth, recent deflation episodes have often gone hand in hand with rising asset prices, credit expansion and strong output performance. Examples include episodes in the 1990s and 2000s in countries as distinct as China and Norway.

Why does all this matter? Because the real danger is not the mild deflation the Fed is working so hard to avoid, but rather the asset bubbles the Fed is blowing, and their likely eventual collapse:

There is a risk that easy monetary policy in response to good deflations, aiming to bring inflation closer to target, could inadvertently accommodate the build-up of financial imbalances. Such resistance to “good” deflations can, over time, lead to “bad” deflations if the imbalances eventually unwind in a disruptive manner.

Unsustainable state and local government budgets continue to slowly compound risk

26 May 2014 by Jim Fickett.

The US National Income and Product Accounts (NIPA) now show results for state and local government budgets through 2013. Income and expenditures remain more or less flat, with expenditures significantly exceeding income (although most states require balanced budgets in theory, this does not happen in practice):

Some economists, Krugman of the fake Nobel for instance, like to point out that moderate amounts of borrowing can be sustained for the long term. This might be true. The problem is that small amounts of borrowing are for politicians what small amounts of heroin are to addicts. Unsustainable state and local budgets will quite likely lead eventually to a federal rescue, which is most likely to be resolved with inflation.

It is also worth pointing out that state and local transfers to persons (of which the biggest portion is Medicaid) do continue to rise, while investment has been falling now for several years. This will become a problem for infrastructure. Note I am not advocating that those down on their luck should be tossed aside; just pointing out one additional way in which budgets are unsustainable.

(See the Reference page NIPA state and local budgets for sources and past commentary.)

US natural gas market has probably normalized

10 May 2014 by Jim Fickett.

Demand for US natural gas has been high enough for the last two years that gas in storage, measured in 12-month-average months-of-supply, has dropped pretty steadily:

The statistics (from the Energy Information Administration of the Department of Energy) are slow to come out, so the graph above only goes through February. However weekly spot prices have continued a noisy but fairly clear two-year uptrend through April:

Recent reports from exploration and development companies have been somewhat more positive, and stock prices are up. This is partly because most companies have been concentrating on liquids-rich plays. However it is also the case that the gas price is finally at a level to cover expenses, and many companies are now reporting an operating profit from gas.

US construction spending continues to grow at a steady pace

30 Mar 2014 by Jim Fickett.

The value of construction put in place in the US, as measured by the Census Bureau, continued to grow at a steady and fairly normal pace through January:

Given that construction, heavily dependent on the cost of financing, is booming, while jobs, dependent on solid, healthy growth, are barely growing, it seems fairly clear that the economy is artificially supported by the Fed's low interest policy, which cannot continue forever. Yes, we are still in a recovery. No, it is not a very healthy one.

Risky corporate debt continues to grow rapidly

16 Mar 2014 by Jim Fickett.

There is more risky corporate debt outstanding now than before the last crisis, and the total continues to expand rapidly. The highest growth rate is in variable-rate loans, which could provide a trigger for defaults as rates rise.

Fitch Ratings recently released an interesting report on junk bonds and leveraged loans in the US, titled, Fitch U.S. Leveraged Loan Default Insight. As the title indicates, the report includes an in-depth study on loan defaults over the financial cycle. Here I will only mention a few simple facts on the growth of risky debt.

Here is the key result:

Note that although junk bonds outstanding exceed institutional (i.e. sold to money managers rather than to banks) leveraged loans outstanding, the loans are growing much more rapidly. This is because most loans are variable rate and, now that the Fed has started to taper, people are beginning to acknowledge that rates won't stay low forever. As Fitch says,

The institutional loan market expanded at a substantially faster clip than the high yield bond market in 2013 ― up 26% year over year (to $725 billion) versus 12% for high yield ($1.265 trillion). Momentum has continued into 2014 with outstanding volume reaching $755 billion in February. …

In 2013, the prospect of rising interest rates heightened retail and institutional demand for loans as a floating-rate yield alternative.

Note also that leveraged loans outstanding are approximately where they were before the last crisis, but junk debt outstanding is much higher. And both continue to grow rapidly.

These two categories of risky debt combined reached about $2 trillion at the end of 2013. To get a sense of scale, subprime mortgages outstanding, at the center of the last crisis, also stood at about $2 trillion in 2007 (Comparing subprime corporate and subprime mortgages).

Many commentators point to low current default rates as assurance that nothing dangerous is afoot. But default rates in 2007 were also very low; default rates are a lagging indicator, not a leading one. Low default rates in 2007 were a primary reason why few understood at the beginning of the crisis that something really serious was happening. Do not make that mistake in the next crisis.

Since the highest growth rate is now in variable-rate loans, as rates rise companies already on the edge will be subject to more strain. And the strain will be contagious to the junk bond market, since many companies have issued both kinds of debt:

Approximately 40% of institutional loan volume is associated with companies that have both loans and high yield bonds in their capital structure. … Since 2007, 56% of defaulted leveraged loan volume of $138.7 billion has come from these joint issuers.

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