Renewable Fuels: Ready for Prime Time?

The Obama administration's stimulus package contains $56 billion in grants and tax breaks for US clean energy projects over the next 10 years and a budget calling for $15 billion annually for renewable energy programs.

The government dole outs usually do not work. If you need proof, you don't have to look farther than the ethanol boom and bust of the past three years:

• 21% of the US ethanol capacity is currently idle;
• Many ethanol companies are bankrupt: VeraSun, Greater Ohio Ethanol, Gateway Ethanol, Renew Energy, Northwest Biofuels and recently, Aventine Renewable Energy.

For the renewables to take off long term, they must be able to compete with fossil fuels economically without government assistance. We must be realistic about how much renewables could add to the energy mix and within what time frame. Estimates of the potential contribution to the US energy supply of the renewables varies from 10% to 20% in 20 years. Therefore, there is ample time for the investors to jump in. Value investors may have a feast in a few years gorging themselves on these assets for pennies on the dollar when the renewable bust comes.

Gas Pains

Natural gas inventories in the US continue to bloat. IEA has reported that the inventories rose by 20 bcf last week compared to expectations of 14 bcf. Current inventory level is 36% above last year. This data point is the continuation of a very bearish trend whereby supply is trumping demand by about 5 bcf/d.

The supply-demand mismatch is largely due to: (1) demand weakness caused by the recession; (2) improved supply mainly because of the successful exploitation of large shale resources by horizontal drilling methods and (3) increased drilling efficiencies overall.

Production additions per gas rig hit a high of 23 mmcfpd/year in 1999 and recorded a low of 12 mmcfpd/year in 2005. Barclays Capital estimates that this metric jumped to over 14 mcfpd/year in 2008 due to improved drilling efficiencies. The horizontal rig count hit an inflection point of 150-200 rigs in early 2005 hitting a peak of around 650 in September, 2008. Concomitantly, the US onshore production increased 12% in the same period, arresting the decline of US gas production.

With demand down sharply in the rest of the world, LNG cargoes heading to the US are on the increase and pose a serious upwards risk to the supply glut. Slowing global activity as LNG production surges raises the risk that US LNG imports will surge in 2009-2010. Asian demand for spot LNG cargoes has fallen sharply and European spot gas prices have plunged in the past few weeks. US imports are likely to rise 50%+ in the current quarter as more gas will become available as new trains start production.

In response to lower prices, producers have started curtailing drilling activities. These cuts should tip a plateauing US supply profile into sequential decline. The pace and depth of the supply pullback are tied to the depth of the cuts, still in progress. The rig count is likely to fall too low to balance the market, prompting price recovery in 2010. The size of the supply response will also be paced by the rig count.

Given these factors, it is reasonable to expect that the prompt month prices will remain soft throughout 2009 because of the brimming inventories. However, we run the risk that soft prices will cause a sharper fall in rig counts than is warranted resulting in steeper production declines as demand revives in 2010. Therefore, we may enter the second half of 2010 with record low inventories. If this thesis is correct, we should see a steepening of the futures curve with the contango increasing into 2011.