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Jun 7, 2012

Booms and Busts, Tulips and Gas

 

There is no doubt that unconventional natural gas resources such as shale gas and tight gas, liberated by horizontal drilling, hydraulic fracturing (fracking) and other technologies, are fundamentally changing the U.S. natural gas supply equation and, over time, maybe that of the rest of the world.

We are in a boom yet spot prices are absurdly low; below costs in many fields with limited associated liquids (which trade based on oil prices). Many firms say they would not be drilling if they had any choice.

So, what’s the deal? Why a boom when the owners of the natural gas supply are not making money (from gas)?

A look back to the Netherlands in the early 1600s offers some lessons. Back then, wealthy merchants liked tulips. They were singularly bright colored decorations for their showy houses, in the generally grey world of water and cloud that is the Netherlands. Tulip bulbs saw a significant price spike, at least in the “spot” or “options” portions of the exchange and side deal markets that were set up at the time. The trade—perhaps it was even betting—was widespread enough to attract lawmakers, attempting to structure the markets, which included many players with no intent of taking delivery.

Analysts now debate whether this was a full-fledged speculative boom—a national frenzy of trading absurd amounts for single, rare bulbs—or a more rational situation, paying high prices for the unusual (diseased, in fact) bulbs that produced multiple colors but were difficult and slow to propagate—pricey breeding stock, as it were.

Fast forward to today, where there are some interesting linkages between tulips and unconventional natural gas. Like the tulip situation, when we look at natural gas it’s important to take into account what is rare—and not rare.

Knowledge of fracking is temporarily rare; learning takes time and effort and is fraught with failures, just like in the early years of propagating a handful of fragile tulip bulbs. But as in the tulip case, as the supply and knowledge spreads, the rarity decreases, even if bid up by foreigners eager to take it home.

When those wanting into the fracking game—by buying companies with leases and expertise under conditions that encourage continued drilling and production even when not economic—dwindle, then the “knowledge and position grab” stage of getting in on the early special “tulips deal” is over.

What happens, then, when next stage, “real” economics take over? For gas, it’s a bit complicated, because many of the shale fields have enough liquids to ensure that, at current high oil prices, the gas can temporarily be treated as an afterthought. The liquids pay for the well.

Flaring, seldom seen onshore, is back in some fields, as many wells are not yet connected to gas gathering systems and liquids are hauled by truck. This will prolong the supply boom a bit, but it's still not “real” economics.

Rather, it’s picking off the richest (wettest) plays first, knowing that paying the piper and figuring out how to make money with fewer or less valuable liquids is still to come. Business plans focusing on this strategy abound, so this phase may continue for a while.

But in due course, the liquids game, like the knowledge grab game, ends too. Real economics will happen. And gas prices will go up. No one knows when and how much—yet another overshoot, or a more steady market due to the large supply (at decent prices).

And fortunately for the gas drillers, the gas demand side also has a say in the matter. Centuries later, the Netherlands is the center of a gigantic world trade in tulips and other flowers, and though they are not generally very expensive plenty of money is made. Whenever gas gets relatively cheap, it becomes very interesting; existing equipment switches to burning it and new gear is built.

Of course, those building the gear are often disappointed because gas prices rise as the super-cheap, non-economic gas disappears and demand drives up price to somewhere comfortably above costs. In the last low-gas price cycle, $100 billion worth of shiny new gear had to be written off.

Over the years, as the Netherlands continued to develop its flower business, the country has had “boom and bust” cycles in other flowers since the famous Tulipmania, just to a lesser degree. It’s much simpler than the high volatility gas game (with many shorter cycles superimposed on longer ones) because gas has weather-dependent demand, fuels switching, the role of evolving regulations in ensuring that operations, land and water are safe; and other complications.

And despite the current boom, gas prices will go up, and activity, down. You can bet on it. As surely as flowers in the springtime.

Highlighted Resources


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How should the U.S. recalibrate itself to take advantage of natural gas reserves?

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U.S. natural gas consumption 2010-2050

In Reinventing Fire, 2050 natural gas consumption is reduced by 36% relative to business-as-usual. Read More

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Showing 1-1 of 1 comments

June 14, 2012

I continue to find it startling that when people--especially people who otherwise focus on the public good- discuss fracking from the perspective of gas availability and pricing, they tend not to mention the effects of fracking on water safety and soil stability.

You might say, "Yes, there are these problems but we are confident they will be solved quite soon" is one possible approach. You might say, "These have the potential of being real bad, but we consider the life cycle of using coal and oil to be even worse" is another.

I firmly believe that some mention of this belongs right in the article. Perhaps you could get by with nothing more than the same offhand mention and WSJ link Lena Hansen provides in her piece. I find it hard to understand its complete omission.

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