"Hubbert's Peak is Finally Here"

We really like Goehring & Rozencwajg's quarterly commentaries on energy and natural resources. Here are a few highlights from their second quarter commentary titled "Hubbert's Peak is Finally Here":

• The most crucial development in global oil markets is depletion in the Permian basin. We first warned about this in 2018, predicting the Permian would peak in 2025. In retrospect, our analysis was too conservative. We now believe the basin could peak within the next twelve months. The implications will be as profound as when United States oil production peaked in 1970, starting a chain of events ultimately sending prices up five-fold over ten years. If we are correct, this could not come at a worse time for oil markets: inventories are tight, production in the rest of the world is declining, and investors are incredibly complacent.
• The trends first outlined in our 1Q22 essay, “The Gas Crisis is Coming to America,” are still all in place; the exceptionally warm weather has simply pushed them out. Even with warm weather, 100% of the storage surplus occurring over the last eight months can be attributed to the fire at the Freeport LNG facility in June last year, which took offline two bcf/d of export capacity. Freeport is again operational, and with the Marcellus gas fields plateauing and six bcf of additional LNG capacity coming on stream in 2024, we believe North American natural gas convergence with international prices could happen much faster than anyone expects.
• Given its “pariah” status, no industry has been more capital starved than coal over the last ten years. As the structural deficit in global natural gas comes to the fore, coal prices should again become price leaders as this decade progresses. We have just started an enormous commodity bull market, similar to the commodity bull markets of 1929-1941, 1968-1980, and 1999-2011. In each of those bull markets, coal equities were the best-performing sector from trough to peak. Given underlying fundamentals, depressed valuations, and a complete lack of institutional interest, we believe coal equities could again become the best-performing equity group when this bull market is over.

Goehring & Rozencwajg manage a mutual fund (GRHIX/GRHAX) with a little over $200 million in assets. The fund owns oil and gas E&Ps (32%), uranium miners (15%), gold miners (13%), copper miners (12%), agricultural companies (12%), coal producers (6%), offshore services (6%), and other oil services (4%). The biggest position is in Range Resources (7%), followed by Cameco (uranium; 4.4%) and Pioneer (E&P; 4%).

If you look at our Shale Treadmill scatterplot, Range Resources is almost all (98%) natural gas and had 39% year-over-year capex growth (Q1 2022 to Q1 2023) resulting in a 3.5% increase in total BOEs produced. Pioneer is evenly split between oil and gas and their y/y capex was down 8% yet BOEs were up 7% - a very favorable result.

It is surprising that G&R do not seem to own any royalty companies (or coal or metals royalties), nor any Canadian oil or deepwater oil producers. They are very bullish on commodities and energy prices but they have a very different approach to constructing their portfolio.

Dorchester Minerals LP Retrospective (2007 vs 2020)

We mentioned Dorchester Minerals in our October 2020 post, "What I Would Buy Instead of Tesla". This is a publicly-traded limited partnership that owns producing and non-producing mineral, royalty, overriding royalty, net profits and leasehold interests in oil and gas. At that point the market cap was $358 million (with no debt) and net income for 1H 2020 had been $10 million vs $28 million for 1H 2019.

The stock is up almost 50% since that post - but oil is up 50% too (currently $60/bbl for WTI). The market cap is now half a billion dollars. They distributed $48.2 million to limited partners in 2020. Their average selling prices of oil were high $40s/bbl and for natural gas a bit below $2/mcf.

I looked at an old research report and saw that Dorchester's revenue in 2006/2007 was ~$75 million and ~$65 million with natural gas @ $7 and crude oil in the $60s/bbl. For 2019 and 2020 it was ~$79 million and ~$47 million. Kurt Wulff had a couple interesting observations in his 2007 report:

Normally we would expect a volume decline of about 11% a year for a reserve life index of 9 years. Instead, DMLP’s decline rate is hardly evident despite distributing all of cash flow to unitholders (see graphic from management presentation). The performance enhances the partnership’s status as the oldest and highest quality oil and gas production Master Limited Partnership (MLP) that we know at a time of renewed interest in the organizational format.

The main tax complication of DMLP is that taxable holders must report distributions as partnership income including the separate items furnished in what is known as a K-1 form. For new purchasers, most or all of income in the early years would be sheltered by cost depletion. For depletion purposes conservative reporting of reserves is an advantage because the implied higher depletion means earlier tax shelter.

The share count has increased by about 25% (acquisitions with stock are how they replace reserves) since 2007, but the share price is currently 38% lower, so the market cap is 25% lower. Revenue/mcap back 15 years ago was about 11% and now it's about 14% with crude oil slightly lower and natural gas way lower. Interestingly, at the time the report was written, DMLP was trading for ~$23 and from 2007-2020 it paid $26 in distributions. Currently trading for $14.

Dorchester's PV-10 of reserves at year-end 2020 was only $137 million. However, the PV-10 is based on the 12 month average oil and gas prices which were depressed in 2020. (Oil was $32.43 and gas was $1.)

Remember the most important quote from the book The Shipping Man:

"[H]e who is the most bullish on the market, or has the lowest cost of capital, or has some other personal motivation for doing a deal, or ideally all three, wins the ship. Everyone else does nothing but talk about the very good and rational reasons they have for not doing deals. The simple fact is that you must take a view on the market."

Dorchester is at a big premium to a reserve value - at much lower hydrocarbon prices. To buy it, I think you have to have the view that, while electric vehicle sales may continue to slowly grow, the worldwide ICE vehicle fleet is going to keep growing too. Plus petroleum is irreplaceable for diesel and kerosene prime movers. 

The result if you believe those premises is that oil (and many other commodities) will need a bull market here in order to recruit commodity investors to expand production again. 

Remember that U.S. explorers and producers lost an incredible amount of money over the past decade. They burned their debt and equity investors, and discipline will be restored by investors who force them to "accept life in a declining industry, slash costs and ramp up returns of capital to shareholders".

NOAA Says Warmer January

Bearish.

Cooler Temperatures For the Next Two Weeks

Natural Gas Withdrawal Season Has Started

Great storage report this week,

"The EIA reported a 38 Bcf net withdrawal from storage last week, bringing the level of working gas in storage to 3.873 Tcf. The weekly withdrawal compared favorably to benchmarks, being 47 Bcf lower than last year (+9 Bcf) and 41 Bcf lower than the five year average (+3 Bcf). The current storage level is 0.6% above last year (3.849 Tcf) and 4.5% above the five year average (3.705 Tcf)."

Wow, so an early start to withdrawal season! Read this article too,

"'38 bcf is a game changer,' [...] 'That is stronger than weather patterns would have suggested...'"

And here's a great chart showing how much better the withdrawals are year-over-year. If serious production declines have begun, and this isn't just from colder weather, then natural gas has entered a new part of the cycle. February 2013 gas is back above $4/mcf, and is clearly in a powerful rally.

The 3-month NOAA climate outlook is for slightly warmer winter temperatures in the SW (not big gas heating consumers) and normal to slighly cooler temperatures in the important midwestern and NE states.

We may have seen the last time that the CHK preferred trades below $75...

"Natural Gas Prices Could Return To The Traditional Oil To Gas Conversion Ratio In 2013"

From a Seeking Alpha article,

"EIA Weekly Storage Report reported a draw of 18 Bcf for the week ended Nov. 9, 2012. Based on the weather forecasts, there won't be any more injections into storage this fall. Storage peaked with last week's report at 3,929 Bcf, which is well below current storage capacity estimated by the EIA to be over 4.2 Bcf. [...] The biggest determinant of natural gas usage is always weather. Last winter's fourth-warmest temperature on record, combined with excessive drilling because of past hedges and efforts to hold acreage by production, is what created the huge storage glut. But now, according to the EIA, storage is only 71 Bcf higher than last year and within 100 Bcf of the last three mid-November reports. This means the storage glut is basically gone and natural gas prices will be driven by weather and 2013 production."

I understand Apple and the high yield crap selling off post-election. I don't understand why natural gas equities and especially royalty trusts like CHKR are falling. The commodity is doing fine. Interest rates fell after the election. Maybe just falling in sympathy? I wish I had bought more Conrad, which had been falling in sympathy. Results are out tonight and they blew the doors off. Maybe that will happen with the natural gas names too.

Barron's: "Expect a Near-Term Pause in Gas Prices"

From a Barron's piece,

While there remains upside optionality to gas prices over the next 18 to 24 months, absent an extremely cold winter, we highlight five reasons why a near-term pause in pricing is likely: 1) Stronger-than-forecast Haynesville production; 2) Drilling efficiencies in dry gas basins are temporarily mitigating the collapse in gas-drilling activity; 3) A near-term surge is likely in Marcellus production from infrastructure projects; 4) Continued ethane rejection in the Rockies and Mid-Continent, which is boosting gas supply; 5) Market-share losses to coal as switching economics no longer favor gas in all regions.

I do worry about this. The natural gas supply situation has benefited a lot from coal to gas switching, however what was once a floor now acts as a ceiling on the way up. A cold winter would be bullish, but another really warm winter could be ruinous. This is a very interesting test of belief in global warming. If you think the warm 2011 winter was because of the effect of the Arctic oscillation on the jet stream, you wouldn't necessarily expect it to repeat itself (and have an ultra warm winter with NG price crash).

All the same, do you want to have to take a position on winter 2012 weather? No thanks.

"Dominion closing nuclear plant due to low natgas prices"

"After claiming hundreds of coal-fired plants, the boom in U.S. shale gas output is now starting to grind down the nuclear industry, with smaller older plants like the 566-megawatt (MW) Kewaunee plant first to be affected.
[...]
Kewaunee's power purchase agreements are ending at a time of projected low wholesale electricity prices in the region"

As much is this is bullish for natural gas, I don't think it is sound for the country to become so dependent on natural gas for generating electricity.

Natural Gas Rally ($CHK, $CHKDG, $PTEQP)

The breakout in natural gas prices continues - almost the entire curve is now above $4, with the front month contracts at their highest prices since December 2011.

The CHKDG (Chesapeake preferred) is stuck around 82 - I think par would be a fair price at this point, which would be 22% higher. I'm happy to collect the 6.1% yield until that point. Similar story with the PTQEP pref.

Natural Gas Prices are Difficult to Predict!

"Three times in the past 15 years, huge investments—such as $100-odd billion worth of mistimed combined-cycle gas turbine generators bought in the late ’90s—were painfully stranded or misdirected when gas price forecasts shifted abruptly."

Look at the chart of how EIA natural gas forecasts turned out.

Nuclear Fracking

Maybe this is what GMXR needs to open up those tight formations? In "Project Gasbuggy", a 29kt nuclear explosion allowed a sandstone formation to produce natural gas. Unfortunately, the "gas proved to be too radioactive to be commercially viable."

Natural Gas Reacts Poorly to Storage Report

"The U.S. Energy Information Administration said natural gas stockpiles rose by 28 billion cubic feet in the week ended July 27, topping the 23-bcf build forecast in a Dow Jones Newswires survey of analysts and traders."

"EIA: 27 Gigawatts of Coal-Fired Capacity to Retire Over Next Five Years"

Just about every day there's more good news for natural gas:

"The coal-fired capacity expected to be retired over the next five years is more than four times greater than retirements performed during the preceding five-year period (6.5 gigawatts). Moreover, based on EIA data, the approximate 9 gigawatts of coal-fired capacity retirements expected to occur in 2012 will likely be the largest one-year amount in the nation's history. The record is, however, expected to be short-lived, as almost 10 gigawatts of coal-fired capacity are expected to retire in 2015."

More Natural Gas Consumption Coming

From the Exxon Mobil earnings call:

"Exxon Mobil Chemical filed permit applications to progress plans for a world scale, petrochemical expansion that our integrated Baytown, Texas complex. The project includes a new ethane cracker with up to 1.5 million tons per annum on ethylene capacity, which will see two new 650,000 tons per year premium polyethylene lines situated at the nearby Mont Belvieu plastics plant. The proposed expansion capitalizes on the abundant and growing supply of North America natural gas liquids to economically supply the rapidly growing global demand for high performance polyethylene products. These metallocene based premium resins deliver sustainability benefits such as lighter packaging weight, lower energy consumption, and reduced emissions. Required government reviews and approvals are expected to take about a year after which Exxon Mobil will make a final investment decision. If progressed, a 2016 start-up would be anticipated."

"Heat Sends U.S. Nuclear Power Production to 9-Year Low"

This is a pleasant surprise.

"Nuclear-power production in the U.S. is at the lowest seasonal levels in nine years as drought and heat force reactors from Ohio to Vermont to slow output.
[...]
Nuclear plants require sufficient water to cool during operation, and rivers or lakes may get overheated or fall in times of high temperatures and drought..."

Nuclear generating capacity actually decreases somewhat as a function of heat.

Three Month Temperature Outlook

Uncoupling of Natural Gas

"Natural-gas futures on Monday finished at the highest level this year, up 1.2% on the day at $3.117 a million British thermal units, even as most major financial markets tumbled on renewed worries about Europe's debt crisis. Because the gas market is isolated to the U.S.—export volumes are insignificant—the commodity has remained largely unaffected by the latest resurgence of fears on the global economy..."

Good stuff. That's the dynamic you would expect when buying a commodity that is deeply and unsustainably underpriced.

Plant Shutdowns Bullish for Natural Gas

"[U]nexpected outages at four U.S. East Coast nuclear power plants on Wednesday helped drive the gains. The outages, totaling about 3,500 megawatts, could add as much as 700 million cubic feet, or more than 1 percent, to daily gas demand.
[...]
A Reuters poll of industry traders and analysts on Wednesday showed most expected stocks to have gained 34 billion cubic feet last week, a build that would again sharply cut the inventory surplus to last year and the five-year average. Stocks rose an adjusted 67 bcf during the same week last year."

Bearish Natural Gas Writeup in Barron's

Posted today:

"We acknowledge the limitations of three bearish data points over the last eight days, but we believe they point to the continued uncertainty about when a decrease in gas-focused drilling might manifest itself in lower production. We also point to the EIA's Monthly Gas Production Report, which reported April 2012 gross domestic production figures in late June. According to the EIA, Lower 48 gross production increased by almost 1% in April to 72.5 Bcf per day, near all-time-high production levels established in November 2011 and January 2012."

Another way to look at it would be that it is impressive that natural gas has rallied this much without production declining yet.

If you think about the decline rate of the existing stock of natural gas wells, it is sizable. For the conventional share of production, you probably have something in the single digits. For the unconventional production, well north of a 1/3 decline rate annually.

So, in order to maintain gas production, we need to move quickly to a gas price that actually incentivizes drilling wells. 

"Will Natural Gas Power Demand Keep The Lid on Storage?"

Good post:

The natural gas storage story this year is all about increased power burn demand for natural gas. This untypical source of demand for gas has kept storage injection under control in the face of record levels of gas production. This has prevented historically high gas storage levels from hitting the wall. The CDD data tells us that during the last part of June and early July the high natural gas power burn was almost certainly caused by the unseasonably high temperatures seen across the US. Natural gas is therefore being burned for generation in addition to coal rather than in its place.

[...E]ach week that goes by seems to reduce the likelihood that natural gas storage balances will hit the wall in September or October at the end of the storage season. It looks like the industry has dodged the storage bullet one more time – thanks to hot weather.