"How’s That Shale Thing Working Out For Ya Tony?" by Bill Powers. FSO Editorial 02/09/2010

FSO Editorials

How’s That Shale Thing Working Out For Ya Tony?
by Bill Powers
Editor, Powers Energy Investor
February 9, 2010

While there was plenty of nonsense that came from the recent World Economic Forum in Davos, Switzerland, there was one comment that stood out for its tremendous absurdity. According to a January 28, 2010 article in Reuters, the CEO of BP, Tony Hayward, had the following to say about shale gas while at a meeting of fellow energy CEO’s during the conference:

"(It's) a complete game-changer in the U.S. It probably transforms the U.S. energy outlook for the next 100 years," said Hayward.

I am not sure where Mr. Hayward gets his numbers, however, according to the US Geological Survey, the US has approximately 10 years of natural gas reserves at its current rate of production of 24 trillion cubic feet per year. While there are undoubtedly speculative resources that can be moved into reserves, I find it misleading and disingenuous to make a statement indicating that the US will be able to produce natural gas at a rate anywhere close to its current level, even 10 years from now.

Taking a closer look at BP’s involvement in two of the largest shale plays under development, it is clear that while Mr. Haywood espouses shale as a “game changer”, his firm has experienced challenges in achieving economic returns on its investment and growing its shale gas production.

In July 2008, at the height of the shale gas frenzy, BP made a big splash in the energy world by purchasing Chesapeake Energy’s Arkoma Basin Woodford Shale assets for $1.75 billion. The purchase included 90,000 net acres of leaseholds and 50 million cubic feet of production per day (mmcf/d). Using an 80-acre spacing unit, which is the standard spacing unit for the Arkoma Woodford, BP paid approximately $1.5 million in land costs per each potential well (assuming all of the acreage is viable, which it will not be) or $19,400 per acre. According to the January 2010 investor presentation from Newfield Exploration, the leading driller in the Arkoma Woodford, each well costs $6.25 million to drill and complete without factoring in the cost of the land. Therefore, to drill and complete a well in the Arkoma Woodford, BP’s all-in costs are a whopping $7.75 million. Based on current well-cost estimates and today’s gas prices, BP has little chance of generating more than marginal returns on its Woodford investment.

The weak economics of BP’s Woodford Shale assets should give BP’s shareholders pause. Will they eventually share the CEO’s vision that shale gas from the Woodford and other shale plays will “transform” the energy landscape in the US? Maybe BP has had better luck in its other major shale play, the Fayetteville Shale? Let’s have a look.

In September 2008, BP announced that it paid $1.9 billion to Chesapeake Energy for a 25% stake in its 540,000 net acres in the company’s Fayetteville Shale play. The purchase, which was $1.1 billion in cash and $800 million in drilling carries that were paid out by the end of 2009, also included a 25% stake in the 180 mmcf/d in production (45 mmcf/d net). In other words, for BP’s 135,000 net acres in the Fayetteville, the company paid approximately $14,000 an acre or $1.1 million per 80-acre drilling location. As part of the agreement, CHK will act as operator on all jointly owned lands.

A look at CHK’s February 2010 investor presentation provides a great deal of insight into the economics BP is achieving on its investment in the Fayetteville. According to the presentation, CHK achieves a 31% internal rate of return (IRR) on each of its $3 million Fayetteville wells, assuming $7.00 per thousand cubic feet (mcf) gas prices. Given that today’s average gas price is approximately $5.35 per mcf, it is likely CHK is achieving an IRR in the low teens. Therefore, using a higher land price for BP, it would be virtually impossible for the company to have achieved a meaningful return on its investment in the Fayetteville Shale. Maybe the company has at least seen significant production growth since the time of its investment? While CHK has grown the joint venture’s production from 180 mmcf/d in September 2008 to 290 mmcf/d by year-end 2009, CHK estimates its Fayetteville joint venture production to be 330 mmcf/d by year-end 2011. Without significant production growth from its Fayetteville assets beyond what is currently predicted by its JV partner or a massive rebound in gas prices, it is difficult for to see how BP will ever achieve a double-digit rate of return on its investment in the Fayetteville.

[Note: Given that CHK is the second most active driller in the Fayetteville behind Southwestern Energy, we can infer the production rates from the play over the next couple of years. Based on CHK’s prediction of 330 mmcf/d in Fayetteville production by year-end 2011 and Southwestern Energy’s drilling plans to drill approximately 500 wells this year in the Fayetteville to grow their current production of 1.3 bcf/d, the Fayetteville Shale will probably experience peak production of between 2.5 bcf/d and 3 bcf/d before the end of 2012.]

While I believe that shale gas will continue to play an important role in America’s energy future, I cannot see how shale transforms our country’s energy future for the next 100 years. Certainly if Mr. Hayward had been following his own firm’s activities in US shale plays, he would not have made such a misleading comment regarding the importance of shale gas.

Successful investors are skeptical of prevailing opinion and look for ways to profit from disconnects between conventional wisdom and reality. I believe there is a significant disconnect between the general market’s understanding of the potential impact of shale gas and what will likely occur based on information available from state regulators and the largest firms leveraged to these plays. When such a large disconnect exists, there are often great opportunities for investment.

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