EU vs. USA Markets Inflation vs. Deflation (Part 2)

Introduction

That (perceptions that) the stability of the EU is deteriorating is indisputable. Nevertheless, that a breakup of the EU cannot be countenanced is equally indisputable. If the world's banks were forced to crystallise losses from sovereign European bad debts - even it were confined to Greece only - there would be a domino ripple of bankruptcies, starting with the five US banks who dominate the derivatives industry, leading to a collapse of the world's financial system. The following is a recent quote by Angela Merkel: "Germany - and I can say this for the whole country - is prepared to do more on integration but we cannot get involved in things which I am convinced will lead to an even bigger disaster than the situation we are in today," she said. (Source: www.ft.com/intl/cms/s/0/f29cdbf4-b4a8-11e1-aa06-00144feabdc0.html) Further, although Mr Hollande of France is making loud socialist sounding noises, it was reported in the UK Financial Times of June 13th 2012, that: "He is expected to welcome Ms Merkel's calls for closer political and fiscal union and signal his readiness to examine what competences would need to be transferred to Brussels to make the single currency function better, despite strong sensitivity in France to handing over more sovereignty." (Source: www.ft.com/intl/cms/s/0/a732fdbe-b553-11e1-ad93-00144feabdc0.html)

In Part 1 of this series of three articles (www.gold-eagle.com/editorials_12/bloom060712.html) , we examined the logical "disconnect" between what the trading desensitised charts seem to be signalling regarding the gold price and what the fundamentals seem to be saying - as per "conventional wisdom" - particularly in respect of the European Union. Whilst conventional wisdom is anticipating an upward explosion in the gold price, the charts are giving off what some might interpret as potentially bearish signals. When we looked below the surface of those conventional wisdom arguments, to see if we could explain this unexpected behaviour of the gold price, we concluded that rampant printing of money by European countries cannot occur under currently prevailing rules; and we also concluded that a dissolution of the EU - before firewalls are put in place to protect the balance sheets of the banking industry - will likely lead to a collapse of the entire world's financial infrastructure. So, having arrived at a conclusion of what was preferred to "not" happen, this begged the question as to what may be a possible actual outcome. This brings to front and centre the conversation that I had with my gatekeeper friend who spoke to me with (qualitative) optimism about the future.

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Summary and Conclusion

There is evidence to suggest that the pessimism of many commentators regarding the US economy may have been overdone. The natural gas industry within the US seems capable of having some significant positive impact on the US economy within the foreseeable future. In turn, this might serve to drive a (slow) turnaround in the entire world's economy and facilitate the repayment of all sovereign debt within as little as 15 years. The back-of-the-envelope quantified calculations that underpin this latter statement are contained in the body of this article.

Caveat: Understand the assumptions

The assumptions that underlie this conclusion are:

• If any country/ies were to leave the EU, it will be under conditions that do not give rise to default on its/their sovereign debt; with "default" being interpreted in accordance with Generally Accepted Accounting Practice.
• The velocity of money in the world's major economies will not slow significantly further, implying that the world's already lower level GDP will not deteriorate further from its currently depressed levels.
• "Energy" is the engine of the global economy, whilst "money" is merely grease to the economic wheels.
• "Energy Return on Energy Invested" (EROEI), which has been declining across the globe since the early 1980s - and which fact is probably what gave rise, eventually, to the Global Financial Crisis - will stop declining as the world moves to embrace natural gas.

Analysis

If one looks at Map #1 below, one will see that the US has (what financial institutions are interpreting as) vast shale gas resources that are now beginning to come on stream in a big way.

Map #1

(Source: www.energyindustryphotos.com/shale_gas_map_shale_basins.htm)

Before we rush off firing on all cylinders, the word "vast" is open to interpretation. So let's put that word into quantitative context. As at 31st December 2009, the US had 283.9 trillion cubic feet of wet natural gas reserves. (Source:www.eia.gov/pub/oil_gas/natural_gas/data_publications/crude_oil_natural_gas_reserves/current/pdf/arrsummary.pdf)

According to the US Geological Survey, 6,000 cubic feet of natural gas is roughly the equivalent of 1 Barrel of Oil, or 1 "BOE", (source: http://en.wikipedia.org/wiki/Barrel_of_oil_equivalent). This implies that the US gas reserves are around 47 billion BOE - assuming that all the gas can be recovered, and bearing in mind that around 20% of all resources (so far) are shale gas.

Quote: Recovery rates for shale gas in the US so far are around 18% compared with 75% for conventional gas deposits. (Source: www.cges.co.uk/resources/articles/2010/07/22/what-is-shale-gas).

So, to be optimistic because more resources are likely to be proven over time, let's run with total recoverable gas resources of 75% of 47 billion barrels, or 35.25 billion recoverable "barrels of oil equivalent".

This must be seen in context of the fact that annual world-wide production of oil is around 83 million barrels of oil a day, which is 30 billion barrels a year which, in turn, implies that the entire proven reserves of wet natural gas in the US would satisfy roughly the equivalent of 1.16 year's global demand for oil. i.e. "Vast" is a relative term.

In this context, when we read statements like: "The amount of natural gas that is extant in this country [the USA] has already been proven to be enough to last us a hundred years" (source: http://www.marketoracle.co.uk/Article35119.html) we need to understand the assumptions that underlie such statements. Presumably, one assumption is very likely to be that "at current rates of consumption" the natural gas resources will last 100 years.

Nevertheless, there are two further pieces of information that are relevant:

• US reserves of natural gas are approximately 2.5% of total world-wide reserves (source:http://en.wikipedia.org/wiki/List_of_countries_by_natural_gas_proven_reserves). This implies that global natural gas reserves would satisfy the equivalent of roughly 40 years of oil substitute requirements assuming that recovery rates were 75%, and assuming that motor vehicle design improvements did not improve fuel efficiency at a faster rate than population growth rate. (Note: This is an unrealistically conservative assumption given the advent of electric hybrid cars and of "range extender" engines.)
• The US consumes roughly 25% of world oil output. This implies that natural gas deposits in the US would allow the US to be energy self sufficient (in its oil requirements) for around 7.6 years. (4.6 years from natural gas plus 3 years from its own oil reserves of 22 billion barrels: Source:www.eia.gov/pub/oil_gas/natural_gas/data_publications/crude_oil_natural_gas_reserves/current/pdf/arrsummary.pdf)

Now, given that the US imported 49% of its oil requirements in 2010, (source: www.reuters.com/article/2011/05/25/us-usa-oil-imports-idUSTRE74O78R20110525) that would allow the US to save a total of (49% X 7.5 billion barrels a year X $80 a barrel) (2010 price) = $294 billion per year of foreign exchange, over a period of 7.5 years and use that money to stimulate domestic industries. This annualised number would represent 62% of the US current account deficit of $473.4 billion for the 2011 year (source: www.bea.gov/newsreleases/international/transactions/transnewsrelease.htm). In short, if the USA can get its act together quickly, natural gas might play an extremely significant role in getting the US domestic economy firing again. How quickly is "quickly"?

To answer this question, have a close look at Map #2 below relative to Map #1. From it you will see that the US gas pipeline infrastructure is already largely in place where it is needed. i.e. "Quickly" means that whatever can be extracted from the shales can be (and is being) delivered to the markets almost immediately.

Map #2

(Source: www.e-education.psu.edu/eme444/node/347 )

My gatekeeper friend also pointed out that the existence of this pipeline network gives the US a tremendous competitive advantage relative to other countries who also have significant shale gas resources but who do not yet have pipeline infrastructures. The numbers on which funds managers are focusing are $2.60 per million btus for natural gas vs. a price of crude oil of around $16 per million btus. (This is 16.25% of, or 83.75% savings on, the recent oil price of $90 a barrel)

The following validates and explains this observation:

The price of natural gas has clearly been falling in the past couple of years as more and more production has come on stream.

Chart # 4 - Market Price per million btu of natural gas (Henry Hub)

(Source: http://205.254.135.7/naturalgas/weekly/)

Compare this with oil: There are approximately 5.6 million btus per barrel of crude oil (source:http://www.physics.uci.edu/~silverma/units.html) and at a recent market price of $90 a barrel, the cost per million btus is $16.07

For the sake of completeness, I also looked at the comparable cost of thermal coal.

As at May 21st 2012, Thermal Coal CAPP price per metric ton was $61.09 - and its historical trend can be seen from the chart below:

Chart #5 : Thermal Coal CAPP Price

As there are approximately 27.8 million btus in a metric ton of coal (source:http://www.convertunits.com/from/Btu/to/tonne+of+coal+equivalent) the cost per million btus of coal is around $2.20, but there are also handling and storage costs associated with coal that, at face value, will be higher than those associated with natural gas under circumstances where a gas pipeline distribution infrastructure already exists. Of relevance, whilst this is the case in the USA, this is not the case, for example, in China - which also has exceptionally large shale gas deposits.

The most important principle that emerges from this information is that the US is well placed to become energy independent in general in the very near future (for a period of at least several years); and, in particular, independent of oil imports. There are three reasons for this:

• By and large, the oil companies are just as interested in shale oil as in shale gas at the present time. The fracking process allows shale oil to be extracted as well as shale gas. i.e. The US economy gets a double whammy energy benefit.
• The cost of the shale gas is so low relative to oil that the cost of liquefying it can be easily absorbed and still result in the price of LPG (liquefied petroleum gas) or CNG (compressed natural gas) being far below the pump price of gasoline or diesel. By way of illustration, as a consequence of my search of the internet to validate the potential impact on costs and the time when these benefits can be expected to kick in, I discovered four relevant quotes:
  • "…With natural gas selling for about $1.50 less than diesel per gallon, the potential savings for a truck using 10,000 gallons a year is around $15,000 in fuel costs." (Source:www.afdc.energy.gov/afdc/progs/fleet_exp_fuel.php/NG) (Author note: At the time of this quote - September 2011 - the retail price of diesel was approximately $3.80 per gallon. This implies a 39% saving. As time passes and more shale gas production comes on stream, the savings might be expected to grow.)
  • "..between 12-15% of all public transit buses throughout the U.S. now run on Natural gas. Nearly one in every five new buses ordered today are slated to run on natural gas. That number will increase significantly over the coming years." (source: www.naturalgas-vehicles.com/natural-gas-trucks.html)
  • "..most trucking fleets replace their trucks about every seven years. If a majority of trucking firms were to switch to natural gas trucks, it could happen on a big scale within five to ten years. 2012 trucks running on natural gas are a great alternative to diesel trucks. (Source: ibid)
  • "Maintenance costs has also been an extremely pleasant surprise, says Ciofalo [of Choice Environmental Services]."We have compared apples to apples, comparing the latest diesel emissions technology with the CNG trucks and found there is significantly less maintenance required on CNG trucks than on our comparable diesel trucks." (Source: www.afdc.energy.gov/afdc/progs/fleet_exp_fuel.php/NG)
• Coal fired power stations are typically configured with what is known as Integrated Combined Cycle Gasification technology (ICCG) which involves converting the coal to hydrocarbon gas and burning the gas. If Natural Gas can be piped to the coal fired power stations, these plants can be converted to use natural gas which, in addition to reducing the US's reliance on coal imports, will also burn more cleanly and, because of reduced transport, handling and storage costs, will put downward pressure on raw material costs. (Notes:
  • Texaco has been a dominant player for decades in this gasification technology space. Oil companies have a good understanding of both natural gas and coal gasification, and the oil industry is moving to take control of the gas fracking industry.
  • The above is a mite simplistic because a given volume of natural gas does not burn as hot as the same volume of coal or oil. E.g. Liquid natural gas contains 75,000 btu per gallon, which is 65% of the 114,000 btu contained in a gallon of gasoline. (source: http://en.wikipedia.org/wiki/Gasoline_gallon_equivalent) Therefore there will be technical problems to solve. Nevertheless, if we are comparing on a "per million btu" basis, the above reasoning is indicative of "potential" outcome.)

The net effects of all of the above will be fourfold:

• The US's current account deficit seems likely to shrink dramatically in the foreseeable future, and the amount saved on imports can be redirected to stimulate the US economy.
• The energy cost structure of the US is about to come under significant downward pressure - which will render its manufacturing and transport industries significantly more cost effective relative to those in low-wage, emerging economies with higher energy costs.
• The US will be able to shift its foreign policy focus from the Middle East to Asia - which would explain why Saudi Arabia is very concerned about high oil prices (see www.telegraph.co.uk/finance/oilprices/9154820/Saudi-Arabia-sends-tankers-to-US-with-pledge-to-bring-down-oil-price.html), when "conventional wisdom" would argue that the Saudis should be rejoicing. It would also explain why China is unhappy with Australia's continuing alliance with the US. The following is a quote from a recent media article: "AUSTRALIA must find a ''godfather'' to protect it and cannot juggle its relationships with the US and China indefinitely, according to a prominent Chinese defence strategist."(Source: http://www.smh.com.au/world/canberra-must-pick-strategic-godfather-20120515-1yp43.html). In the above context, this statement is pure brinkmanship.
• The oil companies will retain their influence over political decision making.

The following is a quote from a recent article on the subject of natural gas and its impact on the US economy: "Natural gas is a feedstock for much of our chemical production. Natural gas has been an absolute shot in the arm to our steel industry; the piping and the new drilling equipment that is being used and produced. It has created, in places like North Dakota where you also have shale oil as well as shale gas, a boom." (Source: www.marketoracle.co.uk/Article35119.html)

In context of all of the above, the US economy may be reaching for a bottom over the next year or two, and Europe (and the massive sovereign debts of the industrialised nations) aside, this is likely to have a significant impact on the global economy given that the US still accounts for something like 25% of global GDP. It should also be remembered that the UK had the foresight to avoid joining the Euro currency bloc and so the Anglo-American alliance remains intact.

In regard to the waning influence of the Arab oil countries, it also appears that Israel's recent natural (pooled) gas finds has the capacity, at the margin, to shift the balance of power within the Middle East and, therefore, the political landscape of the entire planet might be expected to experience a positive structural shift from the perspective of the oil and banking dominated Anglo-American alliance.

All this would explain the recent "buy" signal on the dollar index chart below (chart courtesy DecisionPoint.com)

Chart #6

Conceivably, in terms of this chart, the dollar might rise by a further 5% before hitting resistance, and there are other technical signs that the index may even penetrate above the downward pointing trend line. Again, "conventional wisdom" has it that the dollar is rising because there is a flight from the Euro. Whilst this might be true, it also seems relevant that - with the energy picture within the US changing so dramatically - the dollar is rising not only because the US economy is less weak than the European economies, but because investment is flowing into the US, in turn, because investing there makes sense in its own right. If that is indeed the case, then two unassailable facts might be explained:

• The perplexingly stubborn behaviour of the gold price (refusing to break up to new highs despite the EU crisis) might be a function of a genuinely strengthening US dollar.
• The US equity market may not fall as far as conventional wisdom would have us believe; which is the message being sent by the charts.

Conclusion

From the perspective of the US economy, the worst may be almost over; albeit that the full benefits of the "natural gas era" may take upwards of 10 to 15 years to fully impact. Whilst it may not yet be appropriate to become optimistic, the rationale that justifies pessimism may be waning.

Author Comment

Before we sign off, let's focus for a minute or two on the roughly $45 trillion sovereign debt that is outstanding and subtract from this amount the $15 trillion owing by the US (round numbers). This leaves $30 trillion that "conventional wisdom" says cannot possibly be repaid.

Now, assuming that an improving US economy will enable the economy of the rest of the world to tread water, let's now look at the "savings" that can flow to the entire rest-of-world's GDP if the remaining 75% of 83 million barrels of oil a day were to be replaced by natural gas at an 83.75% cost saving per year.

Assuming a base price of $90 a barrel, the annual saving (at wholesale price) would be:

Savings = 83 million barrels per day X 75% (R.O.W.) X 365 days X $90 /barrel x 83.75%

= $1.7 TRILLION a year.

i.e. Once the world has switched to natural gas, it will take the indebted countries outside the USA approximately 17.6 years to pay off their debts assuming interest rates can be kept low and paid out of income. In my recently published novel, The Last Finesse, I suggest how the $30 trillion can be reduced to approximately $25 trillion by means of equity:debt swaps.

Assuming this is possible, the debt can be repaid in 25/1.7 = 15 years, out of cost savings flowing from a reduction in the price of liquid fuel. It should be noted that the price of oil has already started to fall and that falling demand may not be a function, purely, of slowing economic conditions.

But there will be more than just savings involved because the savings will be augmented by the economic multiplier effect flowing from investment (by the US oil industry and others) in gas mining and pipeline infrastructure outside the USA and in industries such as hybrid/gas driven cars with range extender engines.

In closing, there are also two sobering thoughts that need to be communicated:

• Clearly the above is highly simplified. Nevertheless, we should temper our scepticism by the fact that any time delays in generating the anticipated cost savings may be (partially) offset by profit growth flowing from the multiplier effect as applied to new long term infrastructure investment. The general principle is that the $30 trillion sovereign debt is likely to be capable of being restructured and repaid over time. That general principle remains credible, assuming the fear associated with an EU break-up abates and this gives rise to downward pressure on interest rates. (Note: When one cuts through the posturing, it becomes clear that both Mrs Merkel and Mr Hollande understand the importance of maintaining both investor and consumer confidence).
• Unfortunately, there are still some very significant issues that are not addressed by the above scenario, which will be discussed in article #3 in this series. The EU "battle", if it is won, will unmask the need to win a far larger war that still needs to be waged.

Brian Bloom

Author, Beyond Neanderthal and The Last Finesse

www.beyondneanderthal.com

Beyond Neanderthal and The Last Finesse are now available to purchase in e-book format, at under US$10 a copy, via almost 60 web based book retailers across the globe. In addition to Kindle, the entertaining, easy-to-read fact based adventure novels may also be downloaded on Kindle for PC, iPhone, iPod Touch, Blackberry, Nook, iPad and Adobe Digital Editions. Together, these two books offer a holistic right brain/left brain view of the current human condition, and possibilities for a more positive future for humanity.