By Chris Nelder
Posting in Energy
Energy futurist Chris Nelder explores some serious questions about the economics of shale gas, and wonders if it's really a "game-changer," or a Ponzi scheme, or somewhere in between.
Shale gas is being sold to the American public as a miracle, arriving just in time to save us from peak oil. It's an abundant new fuel supply that will be a "game-changer," we're told. We'll soon be a major exporter of gas to the rest of the world. The economics of fossil fuels have been changed forever, along with our balance of trade.
But what if the business isn't actually profitable? What if it's really based on accounting trickery and overstated claims?
"Fracking" — extracting natural gas by drilling horizontally through dense shale, then fracturing it with high-pressure fluids — has indeed given the U.S. a nice bump in gas production. Production of dry shale gas soared ten-fold from under 0.4 trillion cubic feet (tcf) in 2003, to 4.8 tcf in 2010. Total gas withdrawals, including conventional gas, are up 16 percent since the end of 2005. Shale gas now accounts for about one-quarter of total U.S. dry natural gas production, and about 4 percent of our total primary energy supply.
Our shale gas resources, however, while much ballyhooed in the press, are far less certain. We may now have a 100-year supply of gas in America, as suggested by recent reports. . . or we may not. The U.S. consumes 24 tcf of gas per year. Currently, we only have an 11-year supply on the books: 273 tcf classified as "proved reserves," meaning gas that is commercially producible at a 10 percent discount rate. Beyond that, there are only "probable," "possible," and "speculative" resources, where the gas has not yet actually been discovered, or proved to be economically recoverable. Even where we are sure that the resources exist, we do not know how much of is technically recoverable until we produce it. And as I noted two weeks ago, in the EIA's Low Case shale gas estimate, the U.S. could become a net gas importer by 2035.
There is no doubt that we are producing a lot of gas, for the moment. But it may have come at the cost of profitability.
EBITDA: Earnings Before I Tricked the Dumb Auditor
Houston-based petroleum geologist and energy sector consultant Arthur Berman, along with petroleum engineer Lynn Pittinger, has independently studied the economics of thousands of wells in the three shale gas formations with the longest production histories — the Barnett Shale in Texas, the Fayetteville Shale in Arkansas, and the Haynesville Shale in Louisiana — and found numerous irregularities.
When the true structural costs of shale gas are fully incorporated, he says, including the costs of leasing, restimulating wells where production was flagging, and general operation and administrative overhead, operators need $8 to $9 per thousand cubic feet (mcf) to break even, assuming an 8 percent discount rate. For new development on existing leases, considering just the costs of drilling, completion and operation, operators need $5 to $6/mcf to break even. But the spot price (for immediate delivery) of gas is only $3.11/mcf today, and except for two brief moments in 2010, it has remained below $5 since February 2010. On an averaged annual basis, shale gas has been unprofitable since 2008.
If shale gas production is unprofitable, then why is there still so much drilling activity, and how are producers able to claim otherwise?
One answer to this conundrum is that operators need to keep drilling in order to hold onto their leases. If they don't actively work the land that they spent the last several years acquiring in a buying frenzy, they lose it. The early operators in these gas formations, or "plays," aren't sufficiently well-funded to continue drilling at a loss; they're simply trying to hold onto their leases long enough to flip them to larger companies at a profit. Hence the recent rash of joint ventures with deeper-pocketed players, which give the original leaseholders a way to pay off the leasing and initial drilling costs, but ultimately reduces their net asset values.
A detailed examination of the financial data bears this out. If shale gas is so profitable, then one might expect operators to pay for leasing and drilling costs out of cash flow, and pay down their debt. But quite the opposite appears to be the case. According to analysis by Bernstein Research, capital expenditures on land acquisition and new drilling exceeds cashflow (by as much as 511 percent in the worst example, Carrizo Oil & Gas) for 18 of the top shale gas producers, and they're still heavily laden with debt.
A more direct explanation is that producers are willing to take a big gamble on shale gas in order to support their market valuations. Before the shale boom, reserves of both oil and gas had been in a decades-long trend of decline. Producers were nervous. Cash tomorrow, as represented by reserves, is almost as valuable as cash today from earnings. When production and reserves fall, the stocks of producers fall too and can trigger defaults on loans. Maintaining reserves, even while draining them, is an imperative.
In order to show profitability, shale gas operators have employed complex creative accounting. Instead of the usual "netback" calculations that clearly state the net profit per barrel of oil equivalent (or per mcf of gas) produced, in the 10-K reports filed with the SEC, one finds an intricate set of statements which would only be comprehensible to an expert accountant, not an average investor. Hedging strategies employed after 2008 have counterbalanced some of the losses on production, and major capital costs have been excluded through off-book accounting. Worse, Berman found that some operators have used variable production payment schemes to recognize borrowed cash up front, then failed to account for it as debt and actually claimed it as an asset.
The production of associated natural gas liquids, which generally command about half the price of oil, further complicates the economics. (At the 2011 average of $95 a barrel for oil in the U.S., gas sells at an enormous discount to oil, at $3.29 per million BTU, versus $16.39 for oil.) Natural gas liquids produced along with the "dry" gas have certainly helped generate revenues, but to what degree, we don't know, since they are not separately reported to regulators. Berman estimates they might add $1/mcf after processing. Operators commingle the revenues from "dry" gas with those from associated natural gas liquids, masking the true profitability of the gas production.
Does it matter if some operators are able to drill profitably due to the natural gas liquids, but not the gas itself? Well yes, it does. If the wells are shut down after their liquids play out, it could leave a lot of gas effectively stranded, and a significant chunk of the anticipated reserves would never be produced.
We do know that many shale gas operators have been refocusing their operations on liquids-rich areas of the plays in the last few years, in order to capture the liquids premium. As fund manager Jim Hansen of Seattle-based Ravenna Capital Management pointed out to me, a slide in a November 2010 investor presentation by major shale gas producer Chesapeake Energy confirmed that it was "aggressively shifting capital to liquids-rich plays," and reducing drilling to the level required to retain its leases and court joint venture partners, until natural gas prices rise above $6/mcf. This comports to Berman's profitability analysis. Chesapeake's stated strategy was to acquire large leaseholdings in liquids-rich plays, then sell a minority interest in them within one year, in order to recover the cost of the lease.
Hansen also observes that the rig count in shale operations is now down more than 50 percent from its 2008 high, casting further doubt on the idea that additional drilling is currently profitable.
In the oldest and most productive of the shale gas plays, the Barnett Shale in Texas, wells decline at an annualized rate of 44 percent, according to Berman's research, with a steep decline rate of 65 percent in the first year and 53 percent in the next, falling gradually thereafter to around 20 percent per year. Shale gas wells typically pay out over half their total lifetime production in the first year. So operators must keep drilling continuously to maintain a flat rate of overall production. However, operators and the industry press tend to only report the high, initial flow rates of gas wells, giving investors a mistaken impression of how productive they really are. Indeed, Berman's analysis suggests that the claimed lifetime productivity of the wells—and by extension, the reserves that operators are claiming in their SEC filings—may be overstated by over 100 percent.
Nobody expects the shale gas inquisition
As more data about these relatively young operations becomes available, it is tending more toward the more lower estimates of the skeptics than the initial estimates of the operators. For example, Berman's analysis of wells in the Haynesville Shale suggested that they would produce about 3 billion cubic feet of gas on average, not the 6 to 10 bcf claimed by the operators — estimates which were based on the high initial productivity of the wells, without taking their lower, later output properly into account. Objective third-party research from Louisiana State University has just confirmed Berman's estimate.
Berman, Pittinger, and Hansen are not alone in their skepticism about the profitability of shale gas. Writing in The New York Times back in June, Ian Urbina referenced numerous emails and internal documents from industry insiders who were skeptical about the claims made by operators. Industry defenders countered that the skeptics are outsiders, and dismissed their findings out of hand (with, I will note, some fairly specious arguments). But new scrutiny is now being applied to the claims of producers. New York Attorney General Eric Schneiderman is now investigating Marcellus Shale operators, including Range Resources, Cabot Oil & Gas Corp, and Goodrich Petroleum, specifically to see if they have overstated the productivity of their wells. And the SEC has issued dozens of EDGAR filings to shale gas companies to shale gas companies, questioning their methodology on reserves calculations, accounting of development expenses, and other formal disclosures.
If all of this is beginning to sound a bit Ponzilicious, it should, particularly if the anticipated future production and profitability don't materialize. But that doesn't mean it's a fraud, and Berman is quick to point out that all of the accounting employed by shale gas producers is perfectly legal. On the other hand, so were the mortgage-backed securities, the credit default swaps leveraged on those securities, and other financial weapons of mass destruction that would have brought down the global financial system in 2008, if the Fed and the Treasury hadn't intervened by debasing the U.S. dollar.
Now, it's certainly possible that the story of shale gas will unfold in an orderly, totally legal manner. Some of the wildcatters could make out nicely on their debt-fueled land grab, while others go bankrupt. The bigger players who later acquire the leases could produce gas at a loss for years before gas prices rise again and put them in the black on their bets. That's just capitalism.
But it's also possible that early players simply took advantage of the uncertainty about a new resource and sold their operations like pigs in a poke, and that we'll find ourselves holding a fleet of shiny new CNG trucks and gas-fired power plants just as the shale gas phenomenon flares out.
The uncomfortable truth is that, at this point, we simply don't know how big our shale gas resources are, how much of the gas can be technically or economically produced, or how profitable producing the gas actually is. And that should give us pause. Apart from the rancorous debate over the environmental impact of shale gas fracking, we would do well to consider how much faith we're placing in the questionable economics of shale gas, and how much of our future we're betting on it.
Photo: "American Gasland," artwork by River Side (marcellusprotest/Flickr)
Dec 13, 2011
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I appreciate your wise and honest reflections on the "favored status" that's been mantled on shale gas. I'm not against shale gas, but argue that we consumers must honestly assess the environmental risks along w/ the true economic costs vs. benefits into the whole picture. The impact of fracking on releasing more earthquakes and contaminating ground water MUST be openly and honestly determined. Once those things are known and reported, the panacea of shale gas may be far less glamorous, and possibly even rejected. In my personal opinion, I think environmentally and socially favorable, and economically viable, alternative energy sources like biofuels from cellulosic and algae feedstock are much better and should receive our dedicated national focus.
I am still not convinced by all the conspiracy theories (and I was a fan of the X Files). The assumptions about why lease holders insist on holding on to the leases are so simplistic that they approach the ridiculous. Also, those of us in the energy industry have all heard of the USGS geologist who had predicted that by 1970 we would have completely ran out of oil. One thing that geologists and engineers always forget is the effect of simple economics in the production and consumption equation. I have seen so many horribly wrong forecasts prepared by engineers and geologists that at this point in my life I tend to dismiss them instantaneously. The question I have of Mr. Berman et al is who gets to benefit (or in the alternative who really gets harmed). So, let's argue for a moment that they are correct. How do E&Ps benefti from "cooking their books"? The article tried to answer the question but I believe it failed. What is the motive? Come on I am sure you have an answer. A_D_T
Chris, I don't get why "thousand cubic feet" is abbreviated mcf. I would have thought that would be for "million cubic feet". Can you explain?
We are seeing more and more articles about frac'ing and I have noticed an interesting trend. Those opposed to the practice always spell frac with a "k". Frac, is short for fracturing, and those in the industry have consistantly spelled it "frac". I don't believe it is an accident that those opposed to frac'ing choose to spell it with a "k" to ensure the association with another word that starts with an f and ends with a k, and add to the negative perception. The fracturing of zones containing hydrocarbon (either oil or gas) has been around for several decades, with tens of thousands of wells being frac'd in the US. If contamination of ground water had been a serious problem with frac'ing, then it should be easy to find numerous cases where this has happened, which simply is not the case.
Good post Chris! I first read your writing a couple of weeks back with your "Why energy journalism is so bad" post. I started out a half a year ago reading about the petroleum industry and energy economics and was very confused. took me a long time to get my head around the spin and outright BS. I wish I'd had your post on energy journalism available when I first started my reading! Anyway I very much agree with your summary of the economics of the shale gas play. A couple of articles I've come across that should add to the discussion and complement your post. Wood Mackenzie on shale gas play break-evens. http://www.ogfj.com/articles/2011/08/playing-a-smart-shale.html And a Rigzone "Musings from the oil patch" opinion. http://www.rigzone.com/news/article.asp?a_id=113141 If this shakes out as badly as I think it might I can imagine that a lot of investment will never come back to the shale gas plays. And that is probably for the best! Thanks, Andrew
Pennsylvania has more than 1,600 Marcellus wells. Gas drillers are promising 10,000 new wells in the next few years, and they???re eager to frack the Delaware River Basin. Drilling activity has more than doubled, yet the PA DEP budget was cut by $165 million. Surely enforcement represents an ever expanding task? Meanwhile, gas drillers are storing gas and flaring wells more frequently while they wait for higher gas prices, and 25,000 miles of new high-pressure gathering pipelines to be slapped down to ship LNG to China. I gather it's too late to put this genie back in the bottle, but no one in Harrisburg has any vision for all this gas. And, given all that we do know about fracking, shouldn't watersheds be off limits?
In order to keep a lease, you don't have to do massive drilling. It only takes one well. You don't even have to run it all the time. Yet we now get 25% (I've actually read 40% just the other day) of our gas from shale. All the talk of accounting tricks is silly. On the scale of production that's going on, if at the end of the day if you don't have money in your pocket, you just don't do it. Accounting tricks are only useful to hide profits. For example, there are all kinds of ways to shift profit so you reduce taxes. But if there is no profit, then no accounting trick will ever conjure one up. Neider needs to stop thinking that oil companies will spend tens of billions in unprofitable enterprises just to mess with his mind. He might also consider taking an Accounting 101 course.
Yes maybe fracking won't yield nearly as much gas as people hope. And maybe fracking will indeed cause significant problems with fresh water supplies and so will have to be severely curtailed. But (as Chris Nelder is honest enough to point out) maybe not. The point is that we just won't know until we try. The important thing is not to rely on any particular new technology until its place in the energy mix has been proven. So taking a responsible attitude towards planning our energy future means deploying a lineup of different tecchnologies in descending order of feasibility and availability and recognising that the order may change several times over the years ahead. That logic means that we must inevitably start with fossil fuels (oil, coal, gas and nuclear) because they are the proven technologies that are actually working right now. Of these only nuclear has a low carbon footprint. So for those alarmists (not me) who are obsessed with fears of dangerous man-induced climate change, the logic should be to reduce dependency on oil, coal and gas by increasing nuclear capability. Then, as the various renewable energy sources do become more mature and available over time, the nuclear capability can be reduced proportionately. But, if the renewables don't perform quite as well as we all hope, or take longer to do so than we plan, we will not be left high and dry with an energy shortage. What I am saying is that nuclear is currently the least worst option and we would be crazy not to exercise that option while carrying out the development of renewable energy alternatives. To rely today on the imminent arrival of new unproven technologies (including shale gas) for our energy future would be very foolhardy indeed. The problem is that the same people who want to get rid of the CO2-generating fuels are also neurotic about nuclear. Why this should be so is not clear since nuclear is a carbon-minimal form of power generation which also has an incredibly safe track record. So they are left trying to persuade the rest of us that the renewable alternatives are more proven and advanced than they actually are. This wishful thinking is in danger of destroying the West as the Chinese and other emerging nations march cheerfully on towards a safe, clean and predominantly nuclear future.
The water problem is critical, and with the tight economics of shale gas production (costs $8 per mcf but market price only $3) and the primitive water treatment technology being offered, it doesn't look like the water problem will be solved soon. If you're losing money on drilling but just are doing it so you can hold on to your leases in hopes of unloading them onto some bigger fool, then that doesn't look like any kind of answer to our energy needs, and it's not something to be proud of. The only way it makes sense is if the price of gas triples, which was not what the country is expecting out of this supposed boom. This is also bad news for wind and solar, which need natural gas backup.
Chris, If that is your coinage, it is deliciously brilliant. With conning going bat poop in our national life such cautionary, researched articles are worth their weight in spam as per Roubini's recent tweets to the question, "What do you think of gold?" Roubini responds, "No views on that Barbarous Relic. I would rather buy Spam. (take that, Ron Paul, you reactionary idiot-my addition) Can you eat Gold? No. You can eat & barter Spam. Can you sell spam back to your bank? No Banks can take back your Gold." It's strategic to be cautioned about the possibility that no banks will take on your frack at some future time, because you've been conning the Hell out of everyone.
Shale gas may indeed be over-promised. But it is one more energy option to explore. Drilling techniques will be refined, extraction science improved, and there will be plenty of time to determine how much supply is extractable. I agree that at present, the promise seems a bit tenuous. I don't agree that fracking is a serious threat to the water supply of 100 million people.
Excellent article. Well researched, written and informative. Quite revealing in fact. Fracking threatens the water supply of over 100 million Americans. It is a pending disaster that will make the recent Gulf spill look like a hiccup. It could ruin the ground water across large swaths of America - a disaster that would be permanent on a human scale. The frackers claim that their wells are much deeper than the aquifer, but all it takes is a problem with the casing going down into the well, or a problem with their catchment pond, their waste disposal methods, etc. for their poisons and natural gas to leach into the environment, and especially the water table. They can't promise that it won't happen, and it's almost guaranteed that it will, over and over again, as it already has happened many times. It's just the proverbial "salt in the wound" that it's likely also just another scam, like the so-called "derivatives" of the recent housing market debacle.
mcf is thousand cubic feet That's just the way it always was is what I was told! mmcf is a million cubic feet (I think) bcf, more sensibly is a billion cubic feet
Good luck with that http://www.google.com/trends?q=frac%27ing%2C+fracking
Thanks for highlighting those excellent pieces, Andrew. I wish I'd found them in my research for this article!
@cosserat: so there's this country on the other side of the world, it's called Japan, and it's having all sorts of fun with nuclear energy. Perhaps you'd like to get in on what will likely be firesale prices on the land. Of course, you won't be able to use the land for any reason. But as you cheerfully point out, China and other emerging nations are cheerfully incorporating nuclear energy into their portfolio. Never mind that the countries with far greater experience in nuclear energy are moving away from it. You wouldn't want to do anything stupid like learn from others experiences.
Thanks for posting. http://www.nsserials.com/
I agree with you that a large portion of water is at risk due to the now popular method of fracking. What I find weird is that the risk to the water supply for gas production that, as MR. Nelder says, is not a profitable venture. The idea of drill, baby, drill seems to miss the practical aspects of balancing cost of exploration with actual production results. It is disconcerting to find out that energy producers are taking on riskier methods to keep oil and gas flowing.
Just remembered... it's the roman numeral M http://en.wikipedia.org/wiki/Roman_numerals