The Seventh Fold

Fellow Folders,

In April I wrote a quick post on the (un)economics of the much-hyped shale gas ‘revolution’. That post was inspired by comments made by long-time oil industry analyst Henry Groppe which were published in the Globe and Mail. In that post, I leaned on the insights of petroleum geologist and industry consultant Art Berman, who had been arguing eloquently and persistently that shale gas reserves are greatly overstated. The point that Art argued in his 2009 presentation at the annual ASPO-USA conference (.pdf), is that the production rates for conventional gas fields and shale gas fields are significantly different. Shale gas produces high volumes for short periods while conventional fields produce at relatively low rates but do so over a long period of time. The problem with the shale gas reserve estimate methodology is that the models which accurately predict conventional production rates are being applied to unconventional plays in order to forecast future production and estimate total reserves. As a consequence, high initial flows are forecasted to decline at much slower rates than a growing body of empirical evidence suggests will be the case. This misapplication of models has resulted in a situation where the “volume of commercially recoverable [natural gas] has probably been greatly over-estimated.”

In October, I attended the annual ASPO-USA conference where I had the opportunity to talk with Art and take in another of his excellent presentations on the subject of the Marcellus shale play. For the more technically inclined, you can download the presentation from here (.pdf).

According to Art Berman the economics of shale gas production have not improved and the conclusions he drew from other shale plays apply to the Marcellus. He makes numerous forceful points:

• Shale plays have “consistently contracted to a core that represents 10-20% of the resource that was initially claimed.” The problem is that shale gas deposits are not homogenous. Wells drilled into the same formation using the same technologies will produce gas at wildly different rates. Art empirically shows that over time, core areas have emerged within the various shale plays. The Haynesville shale play provides a telling case study. Four years ago, Louisiana’s Haynesville shale play was promoted as the fourth largest gas field in the world. Today the core area which has emerged represents only about 10% of the play.
• Reserves have been greatly overstated. In addition to the flawed methodology he pointed out in 2009, Art argues that reserve estimations are further overstated because producers assume that the high rates of production from some wells on a formation are indicative of production rates that should be expected throughout the formations. He then empirically shows that these formations are highly heterogenous and that production rates in core areas are not indicative of the play as a whole (see previous point).
• According to SEC 10-K filings, the marginal cost of production for most companies is $7.50 per Mcf. There is a common misperception that the low natural gas prices that have prevailed over the last few years are sustainable – that we’ll have a cheap and abundant source of natural gas for a hundred years or more. The problem, of course, is that the SEC filings of shale gas producing companies show they are essentially operating at a loss. While this may sound unbelievable, there are a couple of countervailing forces that have allowed the market price to consistently remain far below the production costs of most companies: 1) the constant influx of dollars from mislead investors is pumping the books as investor cash is sunk into new wells, and 2) the value of the ‘land’ increases when these new wells are drilled because doing so allows companies to declare ever-higher proved reserves.
• Shareholder equity has been consistently destroyed. Given the argument above, this statement needs no further explanation.

Regarding the Marcellus play more specifically, Art Berman argues that development will disappoint expectations because there are a number of infrastructure limitations including: limited pipeline capacity, insufficient plants to strip the natural gas liquids (NGLs) that are produced along with the natural gas, and the natural gas pipeline expansion from the Rockies has minimized the local gas price differentials that made the Marcellus attractive (in other words Marcellus shale gas will have to compete against cheaper conventional gas).

In addition, Art argued in his October presentation that “environmental issues will not go away. Hydraulic fracturing has contaminated aquifers in some areas, [and] proximity to urban areas and high population density means heightened sensitivity, [which means it is] also more difficult to put deals together and get permits to drill.” To this list of difficulties, we can now add that on December 23, the New York Dept. of Environmental Protection called for the prohibition of shale gas production anywhere in the watershed which supplies NYC with its water. Yep, I guess that makes the Marcellus even that much more challenging to produce!

Thanks for reading.

DA