Sunday, June 26, 2011

Front Page News! Shale Gas Not Profitable [at $4/MMBtu]

[No joke.]

This morning I was greeted by an above-the-fold front page New York Times headline, "Insiders Sound an Alarm Amid a Natural Gas Rush."  Screaming baby in my arms and no coffee in my tummy.  Awesome way to start my Sunday.

The article is another version of Arthur Berman skepticism but on a much larger stage and with the investigative intrigue of leaked internal documents and emails from various redacted sources.  Being the Times, many of the documents are online and are worth reviewing.  It's a pretty frightening article with phrases tossed around like "bubble," "Ponzi scheme," "Enron" and questioning "whether companies are intentionally, and even illegally, overstating the productivity of their wells."

As if the natural gas industry needed another PR headache, now they have to deal with people at all levels - investors, politics, environmentalists, etc. - questioning the underlying business case of natural gas.  I read the article a couple of times and spent some time thinking about it before posting.

The article seemed pretty well documented, but there was little discussion of the source of the internal documents and emails, but most of the scandalous stuff seemed to come from emails, some of which came from people not involved in shale gas extraction.  It was a strange batch of communiques.  I'd love to know where they came from (outside of Arthur Berman's in box).   

But I think the main point of the article - the profitability of shale gas - was muddled by the fact that there was little mention of the impact of commodity prices.  The difference between a big profit and a non-economic well is the price of gas.  There was little discussion of the fact that many wells are unprofitable because gas is being drilled (irrationally) at low commodity prices to hold leases on a deadline.  Unfortunately, now that rigs are migrating away from the Haynesville Shale, it is unlikely that the supply/demand dynamic will change much because the great hunt for liquids, especially in places like the Eagle Ford Shale, has the collateral damage of producing natural gas a byproduct.  It may not be in the same quantity as the Haynesville, but it is coming to market as a secondary product regardless of gas prices.

If the discussion is history, the point is well taken.  Producers have drilled aggressively in a low price environment.  That is irrational behavior.  But the article seems to damn all shale plays looking forward.  There I have an issue.  You can't look at shale in a $4/MMBtu environment and pass judgement on its viability.  

Perhaps a better question is looking at how the gas story is being "sold" to the public.  The buying public, from everyday utility customers to Dow Chemical love $4/MMBtu gas, but in the long run, gas will not be that price.  To sell the gas story, you need to be talking about a long-term price north of $6/MMBtu.  Sure, the country is awash in shale gas right now, but once the lease holding frenzy is done that portion of supply will decline.  Anyone saying "get used to this ultra-cheap gas" is deceiving the public to sell the story.  

The article points out - possibly supporting the Ponzi/illegal reference - that shale plays let the E&P companies vastly increase their stated reserves, a key metric for investors.  Producers spend money to prove big new reserves, which theoretically leads to greater market value for the company.  At the same, the producers are outspending their cash flow on a regular basis to hold leases and prove reserves.  The company value should increase but it runs out of cash.  From that angle, it doesn't look pretty.  Producers have been in a tough spot for several years now and it doesn't look to be improving any time soon.

There is some discussion of hydraulic fracturing, a big issue in New York, which currently has a drilling moratorium on the Marcellus Shale, but it was more of the requisite acknowledgement than an integral part of the piece.

Arthur Berman's fingerprints are all over the story.  He is positioning himself as the next Harry Markopolos, but I don't think he has discovered the next Bernie Madoff.  I agree that the economics from the producers' perspective are askew, but I don't think it's a bubble.

Don't get me wrong.  I'm a big fan of the New York Times. I like it much more than I actually like New York.    The article makes some valid points, but I think its conclusions are overblown and alarmist.  Unfortunately it probably will find a very receptive audience that will offer little challenge to its conclusions or methodology.  It will be interesting to see if this article becomes another phenomenon or fade into the background.

[If you want the spirited Aubrey McClendon/Chesapeake response, follow this link]


Anonymous said...

Great analysis, Robert. There is such a contradiction in the contention that gas companies are purposely overstating their shale reserves, while recognizing that the gas shale drilling industry is in its infancy, without any history to guide its reserve estimates. I, like you, am a fan of the NYT, but I wish they would examine the benefits of natural gas to our nation rather than nay-saying the industry.

Jeff said...

Well, anything is profitable at the right price, when chesapeake broke the haynesville secret to the world natgas was at 10-11 bucks, its not news when hedges rolled off that 4 dollar gas made this unprofitable. I do question shale players practice of slapping a more attractive B factor on these well that are choked back. making them appear to have more reserves than they actually have, didn't you post something about chesapeakes shifting type curve leading to higher EURs recently? THAT really is fudging the numbers and misleading investors. I'm not a lawyer so i can't comment on legality. Berman has been a pariah to industry leaders for 3 years now, is it surprising the shalers are now eating crow? Does David eventually slay Goliath(s)?

Robert Hutchinson said...

One of the points I didn't get to fully was the motivation behind the extreme irrationality to drill uneconomic wells. As Jeff mentions, when CHK broke the Haynesville, gas prices were high and the lease bonuses (which quickly inflated, largely because of aggressive leasing practices of CHK) may have made sense in the $10/Mcf economic model. But when gas prices crashed, that model was no longer valid. Unfortunately, the bonuses were the one variable that couldn't be controlled when prices crashed since they were already paid and the clock was ticking. As a result, all of the other producers that partook in the leasing frenzy followed CHK down a very expensive rabbit hole.

I think that point is being lost in the reaction to the article. A person reading it without the historical context might conclude that shale is a bubble or a boondoggle. That is not true. The gas is there. It can be extracted. The question is what is the price at which it can be done so that capital is not destroyed in the process? It damn sure ain't $4/Mcf.

The article also talks about doubts of shale wells' long-term productivity. Since there is very little history, the boosters and the critics are both combining science and faith. Can you imagine the intense pressure on the independent reserve consultants hired by producers to quantify/validate these reserves?

Barron said...

I can't help but see the silver lining if the public perception of the shale companies is that they're drilling the next big bubble. It certainly couldn't hurt passage of the Pickens Plan as well as squash those proposals to eliminate the industry's ever-important tax provisions. The mark to market accounting principles ala Enron make for compelling reading, but the comparisons are baseless in that E&P's are drilling in new waters, so to speak, and I'm dubious of any malicious attempts to mislead investors. Lastly, I couldn't agree with you more, Robert in that the article virtually ignores the impact of a change in the price of natural gas! If, as one of the quoted emails asserts, most companies are either making a little or losing a little on their wells, then it stands to reason that they have positioned themselves adequately to reap huge dividends when the price of natural gas inevitably rises. So I say keep the bubble talk going, b/c the more the industry seems to be in peril, the more help it will receive in the form of favorable legislation, which is the biggest ally in elevating the price of NAT gas, not good ole supply/demand.

Anonymous said...

"The question is what is the price at which it can be done so that capital is not destroyed in the process? It damn sure ain't $4/Mcf."

What would be your opinion on what price it could be done, and how long do you envision before it gets there? thanks

Robert Hutchinson said...

Regarding the price question - that's the billion dollar question. If you believe past statements from people like Aubrey McClendon of Chesapeake, that number would be $6/MMBtu or higher. Not being privy to the inside numbers, I really don't know. One of the big arguments made by critics like Arthur Berman is that the full costs of a well, including intangibles and lease costs, are not included in the calculations.

There are many ways to filet that fish. The bottom line is that well costs are about the same for each good operator, +/- 10%, but it's the lease costs (and overhead/burden) that can vary significantly. You can play around a lot with accounting and say that you can make money at $4.50/MMBtu or something like that, but I don't see that number being below $6. Some analysts suggest the number is closer to $8/MMBtu. I'm not sure about that. Ultimately it will have more to do with the long-term productivity of the wells (another thing questioned in the NYT article).

Regarding timing of returning to those prices, it may be a few years. Even if you lay down all of the rigs in the Haynesville Shale, you still have new gas from the other shale plays to consider. Until there is a fundamental demand driver (i.e. an improved economy), the prices will continue to suck wind. Most analysts and the EIA see $6 natgas as more than a couple of years off based on current conditions.