I guess this blog is more about quantity rather than quality :) On a blogging roll in the last few days... Anyway...
One of the difficulties for commodity investors—a point often ignored during bullish times—is that the marginal cost of production can decline over time. In fact, this is what tends to happen for most commodities. The vast majority of commodities seem to deflate over time (I need to check this but that's my impression). I want to illustrate this point by referring to what Talisman (TLM), one of Canada's largest oil & gas E&P companies, is saying about natural gas:
Until recently, energy producers have found it too expensive to tap into the huge reserves of natural gas trapped in various shale formations. But as technology has improved, Talisman and several Canadian and U.S. firms have been flocking to the regions.
"The gas price at which our unconventional business remains profitable is coming down all the time. We can see ways to ensure profitability down to $4 gas prices, but we're not going to stop there," Mr. Manzoni [CEO] said.
CEOs are often wildly bullish about future prospects so who knows how correct this will turn out to be. Nevertheless, it is quite remarkable that Talisman thinks it can be profitable at $4/MMBtu with shale gas. Not many would have imagined a few years ago that you can be profitable at $4 with unconventional natgas (for those unfamiliar, unconventional natural gas, such as shale gas, is one of the most expensive sources on the planet.)
This post isn't predicting $4 natgas; rather, the point is that technological advances, efficiency improvements, government incentives, and the like, can bring down the marginal cost of production. If you are betting on a commodity business—by definition, a price-taker and hence only minor control over profitability—you better discount the marginal cost of production to account for technological and other changes. Tags: energy, Talisman Energy (TLM)