A Shale Gas Bubble?

Last weekend the New York Times published a front-page article raising serious questions about the true scale and economics of the production of natural gas from shale, invoking the specter of another asset bubble. To say that this created a buzz would be an understatement. Yet while the article addressed important concerns, it mischaracterized the overall situation by conflating the fortunes and prospects of individual companies with the long-term viability of exploiting the underlying resource. Even if some prominent shale-focused companies were to fail, that wouldn't alter the quantity of shale gas in the ground. It also wouldn't change the fact that shale gas accounted for more than 15% of domestic US natural gas production in 2009 and is expected to supply at least 25% by 2035, even in the most pessimistic shale gas scenario included in the Department of Energy's 2011 Annual Energy Outlook. Comparisons to Enron or the Dot-Com bubble make little sense when the shale gas bonanza has shifted the fundamentals of physical supply and demand, irrespective of its effect on the equity values of companies in this sector.

I understand why the Times' assessment might resonate just now. In the aftermath of a series of asset bubbles and the economic contractions they helped trigger, skepticism about claims such as the game-changing potential of shale gas comes naturally, particularly when it appears that some industry and government insiders don't share the consensus enthusiasm for shale gas. There's nothing wrong with asking some tough questions, particularly given the scale of the opportunity and what it could mean for long-term electricity prices and the displacement of higher-emitting fuels. I have made a career of asking tough questions, myself. However, I also hope that these government officials asked questions at least that tough before issuing billions of dollars in cash grants, loans and loan guarantees to renewable energy developers and electric vehicle start-ups with shorter track records than most shale drillers, and facing greater uncertainties.

That's not as much of a non sequitur as it might seem, because of the prominent placement of the article and its context within the series of probing articles the Times has done on shale gas and its main enabling technology, hydraulic fracturing or "fracking." I wouldn't be surprised to learn that that the paper's editors, like many in environmental circles, find the development of this resource to be an unwelcome diversion on the path to a lower-carbon future. After all, while natural gas emits much less greenhouse gas than coal over its lifecycle, particularly for electricity generation, it certainly emits much more than wind, solar and geothermal power. Many renewable energy projects have struggled to compete with the low cost of gas-fired power generation that shale gas helped bring about. Ultimately, the price of natural gas lies at the heart of both the concerns raised in Sunday's story and the worries of many environmentalists that cheap gas could delay the shift to renewables by many years--although I would remind them that gas-fired power also looks very helpful for enabling the grid to accommodate more renewables.

If I thought that natural gas prices were likely to remain at their current level of roughly $4 per million BTUs indefinitely, I might share some of those concerns. I'd also be even more vocal than I have been in highlighting the opportunity for gas to displace imported oil at an energy equivalent of under $25 per barrel. However, there are good reasons to believe that today's prices aren't just the result of abundant shale gas, but also of a weak US economy. It's no coincidence that they fell precipitously as the recession was starting to bite in the second half of 2008, in tandem with oil prices. Stronger growth is likely to bring more demand from existing users, along with new demand of the type I highlighted in Monday's posting. If the futures market reflects the current consensus on prices in the future, then that consensus expects a fairly steady increase in gas prices in the next few years, reaching $6/MMBTU by late 2015.

By itself that would resolve many of the concerns of environmentalists about competition between gas and renewables, as long as renewables like wind and solar continue on their recent cost-reduction trajectories. It would also negate many of the notions in Sunday's article, because at $6 the project economics of most of the shale plays the Times considered would be cash-positive or at least cash-neutral. That means a driller could finance development without having to bootstrap into it by selling reserves, a practice that appears to have inspired the Times' references to shale gas as a form of Ponzi scheme.

Meanwhile, at an average of $6 per MMBTU the price of natural gas would still be lower--and possibly less volatile--than in the boom years of the last decade, while remaining cheap enough to eventually displace a lot of imported oil. The resulting $35 per oil-equivalent barrel would have looked expensive as recently as 2003, but it would be a bargain in today's world.

In its larger context Sunday's article, by making a case that the future output of shale gas could be much lower than has been assumed, lays the groundwork for opponents of shale development to claim that it is both too risky and not material enough to be worth the risks they attribute to it. After studying this issue carefully, I am convinced that neither aspect of that proposition is correct. Shale can be developed safely, particularly when following guidelines such as the Operating Principles for shale and tight gas that Shell just put out. And shale certainly looks big enough to make a significant difference in the energy balances of entire countries, including both the US and China. Not every company producing shale gas will be financially successful, but that's been true in the oil patch since Col. Drake drilled his first well in 1859. In the unlikely event that shale gas turned out to be a bubble, it wouldn't be the first one in the history of oil and gas exploration. However, if it were a bubble, like previous ones it would leave behind a large number of wells that will be producing vitally important energy for many years to come, whatever the fate of the companies that originally drilled them.

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A Wind Bubble?

New US wind turbine installations have slowed significantly this year, compared to 2009, and the decline is having consequences. Among other fallout, Suzlon is mothballing a four-year-old wind turbine factory in Minnesota and laying off the remaining 110 workers, due to a lack of new orders. While the industry pins most of the blame for the slowdown on insufficiently aggressive federal energy policies, it suddenly occurred to me to wonder whether wind power, like housing, might have been caught up in an investment bubble that has finally popped, somewhat belatedly.

The idea of a wind bubble goes against all conventional wisdom, including the importance of expanding electricity generation from low-emission sources in order to mitigate climate change; the desire to build a vibrant "new energy" economy in the US for energy security and competitive reasons; and the persistent mantra of the green jobs that are supposed to turn the economy around. Yet every bubble must have a compelling, plausible narrative, or it would never take off.

When you examine the charts of annual and quarterly US wind turbine installations on pages 2 and 3 of the "Third Quarter 2010 Market Report" from the American Wind Energy Association, there are at least two ways to look at them. The customary perspective would attribute the dramatic increase in wind installations beginning in 2006, which set records in each of the next three years, to the rapid scaling up of an industry that many envision supplying 20% of US electricity generation within two decades, up from its current level of around 2%. This growth has been supported by a variety of incentives and mandates, including the federal renewable production tax credit (PTC), the stimulus grants, and state renewable portfolio standards. But in this scenario it's hard to explain why installations would have fallen off so much this year, when all of these benefits are still in place, other than the imminent expiration of eligibility for the stimulus grants--which in another year might have been expected to trigger a mad rush for projects to get in under the wire, as we saw in 2008 when the PTC was due to expire at year end. How can we attribute this year's drop in installations to the absence of a policy--either a national renewable electricity standard or a comprehensive climate bill--that we've never had?

So turn this picture around and ask why wind might have been in a bubble, and why that bubble might have only popped now, roughly two years after the other bubbles for stocks, housing and possibly oil prices. Aside from the policies promoting wind and other renewables, which have not changed, wind power developers would have looked at two other indicators: credit and demand. Wind projects are capital intensive, and in the run-up to the financial crisis they benefited from the same kind of cheap and readily available credit as other businesses and homeowners did. At the same time, between 2000 and 2007 US demand for electricity was growing at about 1.3% per year. That might not seem like much, but at the scale of the US power sector, that translated into the need to add around 7,000 MW of new generating capacity each year. If all of that was from wind turbines, the required nameplate capacity would approach 20,000 MW, because of wind's lower average output per MW. Wind was also becoming a preferred technology, despite its intermittency, because coal was falling out of favor for environmental reasons and the price of natural gas, the fuel for the dominant incremental generation technology for the last 20 years, had spiked and become very volatile.

If wind was indeed being carried along either by its own bubble or by the froth from the other bubbles fueling the economy in the middle of the decade, why has it only now run out of steam, rather than popping in 2008 or 2009? After all, electricity demand growth evaporated when the financial crisis and recession hit, and demand has not yet recovered to its 2007 peak. For 2008, perhaps the dash to complete projects before the expected expiration of the PTC--it wasn't extended until October of that year--provides sufficient explanation. As for 2009, the charts show that installations did fall dramatically until the implementation of the Treasury stimulus grant program, which injected $1.7 B into wind projects last year and another $2.9 B this year. Moreover, the stimulus grants were more valuable to wind developers than the PTC they formerly received. That isn't just because developers got the money up front, rather than having to wait until a project started up and produced electricity, but also because the grants were based on the 30% investment tax credit (ITC). Using NREL's simplified calculator for the levelized cost of electricity, at a typical cost of around $2,200/kW of capacity the ITC could be worth at least 20% more than the 2.2¢/kWh PTC. In other words, just as the wind market was collapsing last year, the government increased its incentives and accelerated them into up-front cash. That might have been enough to keep a bubble going for a while longer.

Of course there's no way to know whether this scenario is more accurate than the standard explanation for what has happened to the US wind market this year. Nor does it doom wind power to the doldrums even after the economy resumes growing and creating jobs at a healthier rate, and electricity demand picks up. However, if there is a grain of truth in this view, then it might alter our perspective on providing more aggressive support for the wind industry based on the notion that installations should still be running at 10,000 MW per year or more, as they were in 2009, rather than at the lower rate of around 5,000 MW we see today.

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