Geothermal As A Hedge Fund Investment In A Volatile Energy Market

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I founded my company, Inner Earth Energy, based on my instinct that ground source heat pumps pay for themselves because they are 350 - 500 percent more efficient and therefore a better investment than natural gas appliances. Approximately 34% of our natural gas budget is dedicated to residential and commercial heating (Utilis 2006).

My commitment to promoting geothermal or ground source heat pumps as a renewable resource led me to a closer examination of natural gas supply and demand. In the absence of documented support for my belief that natural gas prices will continue to rise, I began to research the market history and future of fossil fuels to better articulate the value to potential clients. I stumbled upon the website Energy Pulse, where I discovered well-researched articles written by retired businessman Murray Duffin. I contacted him and asked how natural gas inflation rates have changed over the past 40 years and what he might project for the future. His response:

"The last 40 years don't matter. We've experienced little increase in prices for about 37 years. People don't pay for the past. It's the future that counts. At present prices, the cost of natural gas has nearly quadrupled in four years, and I anticipate prices to quintuple in five - six years. In calculating the geothermal system payback, consumers need to weigh the investment in the context of realistic projections of $10.00/kcf, with $15.00/kcf being highly likely. Only major demand destruction can prevent such prices, and I don't think that can happen in such a short time."

Statistics from Murray Duffin's article The Energy Challenge 2004 - Natural Gas clearly support his assertions:

• Drilling for natural gas in the five years from 1980 through 1984 was about double the average during the decade of the '90s, but annual average discoveries were slightly less.
• Because of the bad experience with wildcat drilling in the early '80s, drilling in the '90s tended to be concentrated near known large basins, extending their boundaries but not making major new finds.
• 9,000 new gas fields were discovered from 1977-1987, but only 2,500 from 1987-1997.
• With the application of new technology, especially hydraulic fracturing and horizontal drilling, initial production of new fields has been kept nearly constant for two decades, but depletion time has been shrinking rapidly. New wells average 56% depletion in the first year of production. Congressional testimony in 2004 stated that some tight sands wells depleted 50% in less than 6 months.
• Wells drilled in 2000 were 60% above 1999, and early 2001 were about 50% above 2000. Production grew less than 2% in 2000, and less than 1.5% in 2001. After falling off in late 2001 and early 2002, drilling has increased steadily for the last 2 years while production continues to decline.
• New finds are becoming progressively smaller.
• Proved reserves of natural gas in the USA declined from a peak of 290 Tcf in 1967-1970 to 167 Tcf in 1989, and, with some fluctuation, have been flat since, in spite of a major drilling peak in the early 1980s as noted above.
• For 12 years through 2001, discovery just kept pace with production, and consumption growth was served by increasing imports.
• Of 1999 EIA estimated resources of 1,280 Tcf, 890 Tcf were classified as "undiscovered," and 220 Tcf as expected reserve growth. (Most of the discovery in the 1990s was reserve growth. How much can be left?)
• Natural gas production in the USA peaked in 1973.
• Natural gas supply from the Gulf of Mexico (GOM) shelf is in decline.
• Natural gas discovery in the deep Gulf of Mexico is much lower than expected, and NRG Associates in 2001 projected peak supply as 3 Tcf in 2007 versus the National Petroleum Council forecast of 4.5 Tcf in 2010.

Simmons has noted that rig count in the Gulf of Mexico grew 40% from April 1996 to April 2000, and 60% in Texas from January 1996 to October 2000, with production remaining flat.

(Look at the 70-year trend as well as recent natural gas trends at: http://www.oilnergy.com/1gnymex.htm)

In 2007, in an attempt to collaborate with local utility companies, I contacted their business development office and offered up the possibility of sponsoring an Inner Earth Community development project, M.U.S.E, (Minneapolis Urban Sustainable Energy initiative). In our discussion of sustainable energy, I shared my expectation of supply side shortage of natural gas with the director of business development and I asked," Would you not agree that funding geothermal makes sense considering the pending natural gas supply side shortage in North America?" He responded, "I am in agreement that there is a natural gas supply side shortage - you've got that right". He then backtracked in the realization that he may have compromised his company's market position: ""However, our statistical analysis concludes that geothermal has a higher carbon imprint than natural gas"(?). He acknowledged the looming supply side crisis. His statement about carbon imprint, however, is scientifically unfounded and inaccurate. Even with coal-burning power plants delivering the energy, there is a 40% reduction in electric demand for running geothermal which correlates into a direct carbon reduction of 40%. That's impressive in and of it self, let alone adding to that the 100% reduction in use of the fossil fuel natural gas.

While researching petroleum engineering websites, I readily found discussion groups addressing the supply side shortage caused by high demand on natural gas for energy generation (electric), the Polyethylene (plastics derived from NG) supply chain. See: (http://www.americanchemistry.com/s_acc/bin.asp?CID=311&DID=1710&DOC=FILE.PDF ).

In their 2007 article titled "What Drives Natural Gas Prices?" Brown and Yucel state in their abstract:

"Natural gas market analyses generally emphasize weather and inventories as the drivers of natural gas prices, using an error corrected model, we show that when these and other additional factors are taken into account, movements in crude oil prices have a prominent role in shaping natural gas prices."

Oil has been hovering around an historic high of $100.00/barrel of West Texas Intermediate Crude (WTIC) mid-January 2008.

I expect we will see no drop in petroleum prices any time soon. Even Halliburton announced the end of the Natural gas boom in March of this year. (http://online.wsj.com/article_email/SB117441904130043121-lMyQjAxMDE3NzI0MTQyMTE5Wj.html)

Obstacles to Moderating Natural Gas Prices

According to the American Gas Foundation's February 2005 study, if current policies continue, natural gas prices will nearly double in the next 15 years. As detailed earlier, the Nation has experienced widespread economic dislocation resulting from current high natural gas prices. It is critical that Congress act today to keep natural gas demand destruction from snowballing into economy-wide destruction. As discussed earlier in the preceding section, U.S. environmental policies, principally the regulation of air emissions, increased demand for natural gas.

Obviously, this paper (above) was written to help grease the supply side wheel for oil exploration on currently off-limits land. The American Natural Gas Foundation reiterates the supply side shortage. Even if we were to open up wilderness areas to exploration, we have yet to witness major field discoveries, but rather, only recovery in currently known well fields.

European natural gas supply and demand are following similar trends. OECD European gas production looks set to peak in 2008. After that, falling production combined with rising demand will see OECD European gas imports rising from current 197 BCM per annum to 442 BCM per annum by 2020. Where will this gas come from, and how will rising European imports affect North America and the rest of the world? (http://europe.theoildrum.com/node/3283)

Our local and global demand is higher than and growing exponentially faster than our recovery rate. Deregulation is highly unlikely for a number of reasons, the primary one being the public's perception of global warming. From a sustainability point of view, we may witness a bump down on the graph of natural gas supply and demand, but it amounts to a temporary fix for a long term rise in natural gas cost and in overall declines in North American and global supply. I encourage you to follow natural gas commodities at http://www.oilnergy.com/1gnymex.htm#since30 where you can see daily, weekly, monthly and 70-year trends.

Many pundits suggest that liquid petroleum (LP) or Liquid Natural Gas (LNG) supplies are abundant overseas. What about imports of LP or LNG? Supply of LNG overseas is increasing, but re-gasification facilities being built are lagging behind in capacity. Understandably, many people do not want LNG facilities in their back yards as the process is extremely volatile. The rate at which we build new facilities cannot possibly keep up with the rate at which the supply is diminishing. From Murray Duffin's article:

"The world LNG tanker fleet in Q1 2004 was 156 vessels, with 62 more on order for delivery through 2008. World shipbuilding capacity for LNG tankers is 20 ships/yr. If this capacity is booked full, another 50 or so vessels can be delivered by the end of 2008. All of the existing fleet is already under long-term contract, and not more than 18 of the vessels under order are available for shipments to the USA. Most of the incremental USA supply will have to come from the Middle East, which means only about 10 deliveries per ship per year. One modern ship has a capacity of about 2.6-2.8 Bcf of regasified NG, but because of losses during transport, could only deliver about 2.3 Bcf per trip from Qatar to the USA. At 10 trips per year we would need an incremental 100 ships by end 2009 to meet 2010 demand equal to 2004 consumption, or 160 to meet 2002 consumption. Even if shipbuilding capacity is doubled by the end of 2006, (and the order book right now is not large enough to get that process started), and all of the incremental capacity went to serve USA demand, we would still be 50 ships short of minimum 2010 needs."

If we could possibly implement re-gasification facilities and multi-billion dollar offshore terminals, and additional ships to bring in the very expensive to make and ship and store LP, our US demand pressures on the manufacturing supply side will continue or are continuing to outstrip the supply. Ships are on order, but we cannot overlook the fact that demand is draining the tank faster than filling it. Public safety concerns may be an issue as well. One LP tanker, if detonated, will produce a fireball one mile across, qualifying it as a weapon of mass destruction.

The simplest prediction is set forth in the paper by Brown and Yucel, "What Drives Natural Gas Prices?" They speak of the rise in cost, riding on the public's perception that natural gas should rise along with crude oil.

The commodities are mutually exclusive of one another; yet the public accepts the parallel cost increase between the two. Even though the natural gas prices came down and flattened in 1985 - 1995, the overall trend since the 1930's shows an overall trend of significant increase.

I recently contacted the director of the Minnesota Department of Commerce Energy Division to inquire about financial assistance available for businesses trying to implement Minnesota Governor Pawlenty's 20% decrease in fossil fuels by 2025. I shared the findings of my natural gas research with the Director who stated:

"I am curious about your statement that "Natural Gas [is] on schedule to quintuple in cost at the wellhead over the next 6 to 10 years. Our staff follows natural gas futures and reports that wellhead prices (in constant dollars) are actually predicted to drop over the next 6 - 10 years. Their source is the Federal Energy Information Administration. If you have other information, we would be interested to know that source."

In a 2007 article in the Minneapolis Star Tribune titled "Oil Forecasting off Target", Mike Meyers wrote:" Since 1985, federal government forecasters on oil prices have missed the mark on average from 6 to 116 percent. "'I've done 120 short-term energy outlooks, and I've probably gotten two of them right" said Mark Rodekohr, a veteran Department of Energy (DOE) economist. "We've long been embarrassed by our mistakes "he said. Private forecasters have done little better (to be fair). 2007 will be the ninth year in a row that the "market consensus" guessed low on how high oil prices would go. According to a recent analysis by Deutsche Bank, on average, forecasters have undershot the market by 31 percent each year. In the last five years, the price of a barrel of oil has tripled. The fact is that few experts saw it coming.

I am placing my faith in the aforementioned sources that predict natural gas increases, no different than Mike Myers pointing out that oil forecasters consistently get it wrong. The facts speak for themselves - look at the past trend to date. Oil has reached $100.00 a barrel, and per usual, natural gas is following. The intermediate short-sided ups and downs due to inclement weather and supply side surpluses and shortages have not stopped the long-term exponential upward trend of both oil and natural gas.

I assume that you are aware of the amount of natural gas it takes to produce ethanol fuel (1.2/1). On a nationwide basis, how many new plants are in the workings? In our state alone, how many new natural gas electric generators are being built? ? If you are curious to see how many manufacturing processes use natural gas, Google "Higher Natural Gas Prices Impact Manufacturing".

The so-called "experts" offer up a multitude of opinions and contradictions, the unfortunate result of this ongoing debate to be a focus on natural gas supply and demand, We need to generate solutions centered on alleviating pressure on the demand which will effectively reduce demand while at the same time bringing up the supply side. Thirty eight percent (38%) of our entire national petroleum budget is allocated to heating residential and commercial buildings.

I am of the opinion that we could see prices moderate if we were able to increase LP imports, but there are not enough reserves, gas basins, well fields, shale oil, shale gas or other carboniferous deposits in North America to bring prices down in a manner which is sustainable for any amount of time. Given increasing public awareness of the economic benefits of geoheat pumps, it stands to reason that pursuing low return (shale oil) petroleum based sources is not economically sound.

As to China and India as emerging markets, I foresee no decline in demand for either crude oil or natural gas. China is competing with us directly for Canada's petroleum resources in that they are paying Canada to build a gasoline pipeline from their Oil Sand Fields in Alberta to the Pacific cost.

I believe that sustainable and renewable energy such as geothermal heat pumps play a vital role in the multiple working hypotheses to arrive at solutions yet to be developed in our National Energy Policy. Geothermal heat pumps represent a viable solution in terms of sustaining our economic growth and attaining our environmental objectives. As I mentioned earlier, geothermal systems pay for themselves by virtue of being 300+% efficient, creating positive cash flow for whatever public institution or private individual enlists their use. The added bonus is the resultant reduction in greenhouse gases (Economic, Efficient and Environmentally sound). The money that we divert from fossil fuel imports stays in our local economy, generating economic stability as well as opportunity. John Farrell of the Institute for Self-Reliance in Minneapolis said in his article in the Star-Tribune (August 15, 2007): "The overall local and regional economic impact of locally owned (wind) turbines (or other renewable energy resources) is 25 to 300 percent greater than that of a corporately owned one".

The money we currently pay to natural gas companies flows out of our local economy. Geothermal heat pumps pay for themselves, have 50% longer life cycles than standard systems, produce no on -site emissions, and produce positive cash flow to individuals, local municipalities and the State.. For every operating dollar you put into a heat pump, you get $3.50 - $5.50 returned in heat energy which calculates into savings of thousands of dollars per household per year; imagine an infusion of this capital into local economies. An inventor in Oregon recently engineered a geoheat pump which is 1000% efficient which is equivalent to $10.00 returned for each $1.00 invested (June 2007 GeoOutlook).I strongly believe that geothermal heat pumps, in both residential and commercial applications, could put a dent in the pending NG shortage. Through planned execution, installations in both the new construction or retrofit markets can take up the slack in currently volatile energy markets. Even factoring in the variability of installation cost and payback per individual case, one can conclude that a geothermal system guarantees a return on investment greater than or equal to30- year treasury bond, currently around 4.3 to 4.6%. The geothermal return on investment will continue to be predicated on comparisons with both natural gas and fuel oil, the prices of which are not going down in the long run. Over time, your initial investment in geothermal will balloon in tandem with the increasing cost of natural gas. We can anticipate the cost to be driven even higher by virtue of the growing demand and shrinking supply and the parallel trend it follows rising along side WTIC. Your system payback can be calculated by quantifying your past energy output and loss, and projecting future energy cost based on a conservative estimate of 4% inflation. In design calculations, given variability in system cost and payback scenarios, I conservatively estimate a 30-year return ranging from 6 to 19 percent. For these reasons, I assert that personal investment in geothermal energy systems is a hedge fund in these volatile energy markets. And who on Wall Street wouldn't kill for a guaranteed return of 6 to 19 percent over 30 years?

The oil price hovered at $90 a barrel in the last three months of 2007. After spiking this month and briefly breaking through the $100 level, it is trading at about $90.66. (This was written the end of January 2008, March 11th , 2008 oil was trading at 111.00 dollars per barrel.) A Shell spokesman declined to comment ahead of the results. But the company has previously defended its profits, arguing that the lion's share is re-invested - capital expenditure in 2007 was forecast to be in the range of $22bn-$23bn.

Production is getting more expensive as easily accessible resources become more difficult to find. The industry reckons that the cost of production has gone up from $5 a barrel in 2000 to $14 in 2006 and many analysts believe that oil company profits may have peaked.

Jeroen van der Veer, Shell's chief executive, warned last week that by 2015, supplies of easy-to-access oil and gas would no longer keep up with demand. Governments are also demanding higher cuts from new oil fields" (http://www.guardian.co.uk/business/2008/jan/28/royaldutchshell.oil).

Here is what van der Veer writes about the two new future energy scenarios that have been developed by the quintessential business-scenario writers at Shell:

"We are experiencing a step-change in the growth rate of energy demand due to rising population and economic development. After 2015, easily accessible supplies of oil and gas probably will no longer keep up with demand."

The future, according to Shell, will be either a "scramble" for resources or a cautious, well planned ride into a changing future. (http://www.usnews.com/blogs/beyond-the-barrel/2008/1/25/shell-admits-cheap-oil-is-running-out.html, http://business.timesonline.co.uk/tol/business/economics/wef/article3248484.ece)