The US energy sector is undergoing a rapid change. It’s no exaggeration to describe it as a revolution.
The nation’s ability to get at once-inaccessible shale oil and gas has sent energy production soaring.
The US Energy Information Administration expects oil production to rise by 25% this year. And in less than a decade, America could overtake Saudi Arabia as the world’s top oil producer.
This could have a major impact on everything from US industry to the strength of the dollar. It’s all very exciting.
But it’s easy to get a little too carried away, particularly now that everyone knows about the ‘shale gas revolution’. Those expecting a future of cheap energy and collapsing oil prices are heading for a disappointment.
Here’s why - and what it means for your money.
Saudi Arabia now wants to put a floor under the oil price
Natural gas prices in the US (if not elsewhere) have collapsed as production of shale gas has surged.
With all these predictions of soaring US oil shale production, you might have expected oil prices to have dropped significantly by now.
So why haven’t they?
For a start, it’s worth remembering that oil is a global market, unlike natural gas, which is still split into distinct regional markets. Rising production in one area can be offset by falling production elsewhere.
So one culprit for the firm oil price is Saudi Arabia. Up until very recently, it has been trying to keep a lid on oil prices. In the longer term, the Saudis understand only too well that if oil becomes too expensive, it only boosts efforts to find new sources of energy.
And in the shorter term, fears over a conflict in Iran last year saw Saudi Arabia acting as a safety valve - keeping production high and capping prices at around $100 a barrel. This also had the useful side effect (for the Saudis) of damaging their rivals in Iran.
But this has now started to change. The latest figures show that Saudi production in December fell to its lowest level since early 2011.
There are various reasons for this. With immediate concerns over Iran dying down, now that the US election has passed without an Israeli attack, there are concerns that there is already too much oil on the market.
That’s not good news for Saudi Arabia. It might not want prices to go too high, but it can’t have them fall too far either. The country needs increasing amounts of money to bribe its population with bread and circuses to buy off growing pressure for reform.
But there are also physical limits to the amount of oil that Saudi Arabia can produce. As I already pointed out, much of the recent production boost was driven by bringing old wells back online. Clearly, this is not sustainable.
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Don’t get carried away by reports of soaring US oil production
So even as US production is growing, we can’t necessarily expect the same from the rest of the world.
It’s also important not to get too carried away by the hype over US production. Even if the Energy Information Administration is right to forecast a jump in production over the next two years, output in 2014 will still be below that of 1988, and nearly a fifth below the peak in 1970.
And America is not yet properly equipped for the business of being the world’s great oil power. As Capital Economics points out, the domestic infrastructure is poor. There aren’t enough pipelines. And existing refineries work best with light imported crude, rather than the heavier oil found in Oklahoma, North Dakota and Texas.
More importantly - at least as far as energy prices go - investment in drilling and exploration has started to fall, even as more oil and gas is pumped. That’s because the plunge in natural gas prices has made many fields - which produce both oil and gas - unprofitable to run.
You can see the impact this has had by looking at the number of rigs being used to drill for oil and gas. Oilfield services company Baker Hughes estimates that the number of oil rigs has fallen by just under 8% from August last year.
The drop in gas rigs has been even bigger. There are just 434 operating at the moment, compared with 1,606 at the peak just before the financial crash. Along with strong demand for consumption, this has helped to reduce the glut of gas, which had been pushing prices down. While natural gas prices remain low, they have recovered somewhat from their lowest levels over the past year or so.
One way to play the rising gas price
So what does this mean in practical terms? The price of crude oil still looks more likely to fall than to rise. But we wouldn’t bet on a crash - and we certainly wouldn’t bet on petrol prices for your average British driver falling significantly this year.
Meanwhile, the price of natural gas is likely to rise, as demand continues to increase while production drops off. This should be good news for companies that are involved in shale gas production.
One interesting - if risky play - is Chesapeake Oil (NYSE: CHK). While continued low gas prices meant that it made a loss this year, the company has taken the bold decision to double down on the price of gas going up. It has increased its reserves and decided not to hedge its exposure to gas prices.
Having been the target of regulators over a dubious loan, Chesapeake’s maverick chairman Aubrey McClendon has made his peace with shareholders, forgoing his annual bonus and agreeing to cut the company’s debt levels. This should help investor confidence and ensure that his attention is focused on maximising revenue.
If that sounds a little too speculative for your liking, my colleague David Stevenson at the Fleet Street Letter has other ideas on how to play the natural gas boom - including tips to play the UK’s own ‘shale gas revolution’. Find out more about the Fleet Street Letter here.
• This article is taken from the free investment email Money Morning.
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