Jens Zimmermann is an equity analyst and upstream oil and gas industry specialist at ABN AMRO.
At a recent conference of US mid-cap exploration & production companies, the main focus was on so-called “shale gas” reservoirs in the US. Over the past two years, new horizontal drilling techniques have made the development of these vast “unconventional” gas reservoirs possible at lower unit costs; thereby achieving attractive returns even at USD 3-5 natgas prices. For that reason, European Oil majors (BP, Eni, BG Group and StatoilHydro) have also bought into the US shale gas industry via minority stakes. The prospective shale gas supply coming to the market in the next 2- 3 years is one reason for the current weakness in natgas prices. This note gives an introduction to the shale gas theme and identifies several companies that are already well-positioned to benefit from attractive shale gas economics.
Shale Gas Economics 101
Due to the ultra-low permeability, shale rock formations typically provide the sealing around hydrocarbon fields of producing oil & natural gas reservoirs. Shale gas is natural gas that is trapped in these shale rock formations that seal the existing reservoirs; therefore, shale rock can be both the source of and reservoir for natural gas. Due to the low permeability and difficult access of shale formations, only technological advancements in horizontal drilling and hydraulic fracturing techniques have made the development of shale gas reservoirs commercially viable.
Shale gas reservoirs are characterized by very steep initial decline rates (typically 65-75% in the first year), which then flatten out by the third or fourth year, after which shale wells can produce at relatively low rates for decades (although most of a reserve’s estimated ultimate recovery (EUR) is depleted during the first five years). However, high EUR rates of the original gas in place (OGIP) drive down the unit costs per Btu (British thermal unit) due to significant scale efficiencies.
The Five Most Promising Shale Gas Reservoirs
Shale gas has a huge growth potential for US natgas production. Of an estimated total 1,836 Trillion cubic feet of potential natgas reserves in the US, about a third comes from shale gas reservoirs (616 Tcf). Currently, shales account for about 10% of total US natgas production, but this portion could double over the next three years and might reach 50% by 2020.
In addition to the Barnett Shale in Texas, which scored the first commercial success with the introduction of horizontal drilling in 2005, the Fayetteville (Arkansas) and Woodford (Oklahoma) are already established and commercially producing reservoirs. The two emerging shale gas fields that currently get the most attention are the Haynesville (Northwest Louisiana/East Texas) and Marcellus (Pennsylvania) shales, which are both progressing rapidly towards commerciality. There are about ten more exploratory shale reservoirs, for which initial testing is underway (see Figure 1).
Break-Even Prices
It was frequently emphasised at the conference that “not all shales are equal”, meaning that the combination of geological factors like permeability, thickness, pore pressure, depth, and gas in place determine the ultimate attractiveness of a specific shale gas reservoir. In addition to these shale-specific geological factors, it is also important for the producing companies that the explored natural gas can be brought at reasonable costs to large consumer markets (like the populated US northeast, a great advantage for the Marcellus shale). In this context, gathering and processing facilities as well as a pipeline network with sufficient transport capacity are key criteria.
The break-even natgas price for each shale gas reservoir simply relates to the costs of getting the gas out of the ground, while they do not include the additional transportation costs to consumer markets.
Thus, the break-even prices reflect each reservoir’s geological constellation and determine the price threshold, below which the exploration would become loss-making and the company has an incentive to halt its natgas drilling. Compared to the break-even prices from conventional reservoirs (which are in the USD 6- 7/mln Btu range), shale gas can achieve much lower break-even prices due to the huge economic scaling effect that these large reservoirs provide.
Implication For NatGas Prices
Natural gas prices have recently fallen through the USD 3/mln Btu threshold to the lowest level in seven years due to an unfavourable combination of several factors. First, US demand for natural gas remains weak as we have not seen a material pick up industrial activity despite the recent economic “green shoots”; Secondly, weak natgas demand is met by a wall of supply as evidenced by record inventory levels. Finally, there is a perception that the supply glut could last due to increasing LNG supply and abundant discoveries of huge shale gas reservoirs (as described in this report).
This unfavourable combination of supply and demand factors explains investors’ bearishness towards natural gas and the diverting price performance between crude oil (driven by global economic growth expectations) and natgas (weak US demand conditions). However, we believe that investors are currently too focused on record inventory levels and that remaining storage will soon run out of capacity, which will lead to involuntary production curtailments. Storage levels are projected to peak in September/October this year before they should start to fall seasonally with the
beginning of the colder winter heating season.
Furthermore, the 55% plunge in the natgas rig count will lead to production cuts that will inevitably bite into production growth and natgas supply towards the end of 2009/beginning of 2010, at a time when demand could realistically start to improve again. Therefore, this self-correcting supply mechanism could lead to a cyclical natgas price rally towards the end of the year. Instead of focusing on short-term storage worries, investors should rather keep an eye on a likely cyclical natgas price recovery towards the end of 2009 and in 2010 (the consensus forecast is looking for USD 5.13/mln Btu in Q4 2009 and USD 6.50/mln Btu in 2010).
Shale Gas Pioneers
While the already well-known Barnett, Fayetteville and Woodford shales are mainly dominated by established large-cap companies, investors’ focus is increasingly shifting to the emerging Haynesville and Marcellus reservoirs, in which also smaller companies have bought drilling acreage (see Figure 4, yellow box indicates exposure to that shale gas reservoir).
The relative shale gas exposure for these smaller E&P companies is much greater on a per share basis than for internationally diversified large-cap stocks like Devon Energy and Anadarko Petroleum, which also have a higher earnings exposure to crude oil. In contrast, smaller E&P companies have an almost 100% earnings exposure to the natgas price. In order to capture the upside potential from several shale gas plays along the whole market cap spectrum and to increase the natgas price correlation of smaller companies, it would make sense to invest into a basket of shale gas companies to diversify the company specific risk associated with smaller players.
About the author:
Jens Zimmerman is an equity analyst and upstream oil and gas industry specialist at ABN AMRO
