Marcellus Shale

Where Is That Natural Gas Treadmill?

Dr. Scott Cline
PhD, Petroleum Engineering

Part II in a series entitled “Mother of All Spin” about Deborah Rogers’ New York speaking tour.

I addressed some of Deborah Rogers “resource economics” in my last post entitled “Natural Gas Critic Refuses to See What’s Before Her Eyes,” but that was just the beginning, as she next turned to shale gas micro-economics with the theme that, even if the resource potential is enormous, the wells must be uneconomical.  She argues continued exploration and development of natural gas from shale is just a scam to defraud investors by keep production artificially high enough to service debt while individual wells are “falling on their face.”

Really? Well, no that’s just not correct.

One Gas Well Is Not an Industry

Rogers begins this particular argument by claiming that, Dr. John Lee, a legendary petroleum engineer now at the University of Houston, told her in an email exchange that only 20% of shale gas wells will be economic and the other 80% are uneconomic. And she says her “friend” Arthur Berman, a peak oil theory geologist, says it’s more like 90%. Now, what does that really mean?

What Dr. Lee is more likely trying to say, and Ms. Rogers is misinterpreting through inexperience, is that there is considerable variation in the quality of natural gas shale wells, as is also the case with conventional wells, especially when you add in the large “dry hole” risk in conventional well drilling that is not present in shale gas drilling.

With natural gas from shale we do find that a certain percentage, that varies by play, can be very prolific and would probably be economic at almost any natural gas price. Some Marcellus wells are so prolific, in fact, they “payout” in less than a year even at low gas prices.

To know the ultimate economics of the remaining percent (she says 80%, an oversimplified estimate that, in reality, varies by area and time) would require knowledge of when each well was drilled, the product price over time for each unit of production sold, the operating cost structure, the lease cost, the operator’s royalty burden, the actual well cost and many other factors that are often operator specific.  Just labeling individual wells uneconomic because somebody has extrapolated a decline curve, slapped an assumed gas price on the production, assumed a general operating cost profile and royalty rate is not sufficient.

And, indeed, the more relevant measure is whether or not a play or portfolio of oil and gas properties has value in excess of its costs. So, let’s look at some actual transactions between buyers and sellers of shale gas properties to better measure the value and economics. The IRS definition of fair market value:

“ fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”

Petrohawk Growth Profile from Investor Perspective

Significant transactions have confirmed enormous reserve and economic potential. Just a few examples include last month’s sale of PetroHawk to BHP Billiton for $12.1 billion or a 61% premium to its pre-sale announcement share price and an all time high.

Apparently, PetroHawk, who Ms. Rogers portrayed as a poster child of reserve inflation, wasn’t viewed that way by other experienced natural gas investors.

In fact BHP, a sophisticated company, uses among others, the third party independent professional engineering Netherland Sewall to do its due diligence. Netherland Sewall was one of the companies that Ms. Rogers claimed were skeptical of shale gas reserve estimates!

Other recent transactions worth noting include ExxonMobil’s purchase of XTO for a 25% premium (more on this later), Chevron’s acquisition of Atlas for a 37% premium over market value, and other transactions such as Shell’s purchase of East Resources (whose owner, incidentally, went on to buy the Buffalo Sabers hockey team). These significant premiums cannot be explained by synergies and SEC rule changes alone.

Clearly, large oil and gas companies have been interested in buying shale assets because they perceive the resource to be vast, profitable in the long run and very likely to exhibit reserve increases over time with continued technology advances. Development and exploration activity and economics will ebb and flow with costs and product prices, but transactions will show the actual value. Simply looking at individual well economics as a snapshot in time does not!

Isn’t “Putting Money Where Your Mouth Is” a Good Thing?

Ms. Rogers then opines that industry simply hypes the initial potentials (IP) in order to fool investors into believing this translates into higher reserves. She says “friends” (perhaps Chip Northrup who makes similar arguments and describes her as “a great speaker and accomplished analyst of fracking”) colloquially call this the “Drilling for High IP Releases” phenomenon.

Again, this is ridiculous. No knowledgeable banker, engineer or company would blindly invest in a project simply because of high initial potential news releases. There is sometimes correlation between IP and ultimate reserves in shale gas development, but nobody would use this metric alone for major investments.

Bankers and investors making decisions either use their own engineers or hire third party engineers to make independent judgments during any loan process based on all data including well logs, production history, pressure data, reservoir simulation, fracture architecture studies and many other types of data. And, it’s doubtful individual stock investors would react to this kind of news either given that it has not been shown to move stock prices over any reasonable period of time.

Ms. Rogers correctly noted Chesapeake Energy, and others, had announced they would reduce rigs drilling for natural gas and shut in natural gas production in an effort to raise prices.  Nevertheless, Rogers says this is somehow a lie, the actual game plan being only to shut in wells that are poor performers to mask the bad exploration results, while continuing to develop and produce because they have to service debt, thus putting them on a development treadmill. In this way, she surmises, their loans won’t appear in default. She says many of those wells will never be put in production because they are so poor, the land is trashed and the mineral owners will be left with no money and the environmental consequences.

Wow, that’s quite an accusation. The rig count for natural gas development has dropped and production has been curtailed but it certainly hasn’t dropped off the chart as Ms. Rogers seems to suggest. Maybe she isn’t satisfied the natural gas development rig count hasn’t gone down fast enough, but that has more to do with long term contract commitments, expiring lease protections and commitments to development partners than it does with debt service. And, besides, do any consumers care if prices remain low as a result of abundance?  I don’t think so.

Ms. Rogers simultaneously says gas companies continue to develop new wells simply to service debt payments and, yet, the Fayetteville, Haynesville and Barnett shale plays are already “exhausted” and in decline after only 5-7 years. It can hardly be that both are true.  Even Art Berman, the almost solitary geologist and shale gas reserve skeptic, who Rogers is always happy to quote, said in a June, 2011, New York Times article:

“the data suggest that  if the wells’ production continues to decline in the current manner, many will become financially unviable within 10 to 15 years.”

Hmm, that’s already twice what Ms. Rogers said in her presentations and even then who would be able to predict the gas price, or operating costs, that far out to confidently predict the economic life? Even so, does this mean a given well was not economic over its life?  No, of course not!

Barnett Production vs. Rig Counts

Barnett Shale Production vs. Rig Counts (Source: Barnett Shale Energy Education Council)

And, even if a natural gas play is in production decline it does not necessarily mean the play is “over” as Ms. Rogers keeps suggesting. It simply means the well development rate is not keeping up with the current production decline. Contrary to what Ms. Rogers says, the gas-directed rig count slid this month to 652, its lowest since May, 2002, when there were 640 gas rigs operating. So where is that treadmill?

Moreover, reduced development activity level is not only related to price but to the fact companies are able to increase reserves and production per well through better development, completion and production methods over time. Ms. Rogers is skeptical of this idea, but it is a fact. I confronted her with an article in the February, 2012, issue of “World Oil” stating the Barnett rig count dropped to a 7-year low with only 50 rigs running (1/4 that of 2008), yet 2011 was a record production year and has continued to increase for two years, which was in stark contrast to her spin. The article attributes this primarily to increasingly better exploration and development practices and I agree.

Ms. Rogers, however, clumsily excuses her bad prediction by saying the record production is simply from delayed pipeline connections of wells drilled in the past. But, all one has to do is look at the evidence I showed in Part I of this series, where the ultimate recoveries of wells are increasing each year through better technology and production management, to see the truth she is intent on denying.

This isn’t all, however.  There’s much more, so stay tuned …

If you missed Part I, entitled “Natural Gas Critic Refuses to See What’s Before Her Eyes,” check it out here.

Dr. Cline holds s a BS in geological science from Penn State, and both MS and PhD in petroleum engineering from University of Oklahoma and an MBA. He began his career in 1976 for Gulf Oil Corporation (now Chevron) and later worked as geophysicist, geologist, petroleum engineer, and senior manager for several other oil and gas companies based in Houston and Oklahoma City. He currently lives in the Finger Lakes region of NY and consults to the oil and gas industry. He also teaches corporate finance and is an accredited business valuation specialist. He was involved in the early study and implementation of horizontal drilling , published on a wide range of oil and gas topics and his research interests include horizontal drilling in fractured reservoirs, well construction and design, reservoir simulation, fluid flow in porous media, oil and gas valuation, reserve and resource estimation, and unitization matters. His PhD dissertation was on decline curve analysis of horizontal and vertical wells in fractured reservoirs. He has recently served as subject matter expert at the US EPA technical sessions on well construction and hydraulic fracturing in Arlington, VA, the Quebec’s Office of Public Hearings on the Environment (BAPE) in regard to formulating oil and gas regulation in Quebec and testified before the NY State Assembly Energy and Environmental Committees on hydraulic fracturing. 

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