"Colorado’s Gas Pains" by Bill Powers. FSO Editorial 05/17/2010

FSO Editorials Colorado’s Gas Pains
by Bill Powers
Editor, Powers Energy Investor
May 17, 2010

Like many western states, Colorado has experienced both the good and the bad from the rapid development of its unconventional gas over the last five years. The recent drilling boom has made Colorado America’s fifth largest natural gas producing state, based on 2008 data. The State plays host to the northern portions of two of the largest coal bed methane (CBM) basins in the country, the San Juan Basin and the Raton Basin. It is also home to one of the country’s largest unconventional tight gas plays, the Piceance Basin, centered around Garfield County. From 2003 until the natural gas price spike in 2008, Colorado was seen by many in the exploration and production (E&P) industry as home to significant growth. The State possessed large tracts of prospective under-developed acreage and expanding pipeline capacity that reduced the wellhead price differentials Rocky Mountain producers had to overcome to turn a profit. However, the tremendous optimism over the future of natural gas in Colorado has turned into despair. Not only is the State experiencing a large drop off in natural gas production due to reduced drilling activity and the rapid maturation of its producing basins, but several counties have experienced significant environmental problems related to natural gas drilling. In this issue, I will provide an overview of natural gas development in Colorado and how its recent difficulties provide some insight into what can be expected from other states.

The below graphic was taken from the Colorado Oil and Gas Commission’s website from a 2007 study on the Raton Basin and identifies three of the most important producing areas in the State:
Picture 1.png

Colorado’s portion of the prolific San Juan CBM play has been a steady source of increasing natural gas production. The San Juan Basin, the largest CBM field in North America, first went into commercial development in the mid-1980s. While the Colorado portion of the San Juan Basin had been known to contain natural gas as far back as the early 1920’s, the first CBM wells were not drilled into the Menefee/Fruitland formations until the late 1940’s. Commercial CBM production started in the mid-1980’s due in large part to Section 29 tax credits that were part of the Crude Oil Windfall Profits Tax of 1980. Section 29 credits gave developers large tax breaks to invest in unconventional resources that would otherwise have been uneconomical. The Section 29 credit program expired in 2002.

Over the past three decades, the San Juan basin has been a gold mine for its developers. With a combination of both conventional natural gas production and unconventional resources, the San Juan basin currently contributes approximately 2.5 billion cubic feet per day (bcf/d) to the nation’s gas supply. Though a larger portion of the basin sits in northern New Mexico, La Plata Colorado has become a major center for gas production as evidenced by the below table:

La Plata County NG Production

Year	Production (bcf)*
2005	458.3
2006	440.3
2007	417.0
2008	421.2
2009	421.4

Source: CO Oil and Gas Conserv. Comm.
*bcf=billion cubic feet

While the San Juan basin is certain to remain a major producing basin for years to come, there is strong evidence that years of in-fill drilling and aggressive production techniques have put the basin into a terminal and irreversible decline.

Colorado’s other major CBM field is the northern portion of the Raton Basin located in Las Animas, County. The Raton field, similar to the San Juan basin, straddles the border of New Mexico and Colorado and is considerably smaller than its western neighbor. The Raton Basin was originally developed for its significant coal resources beginning in 1873 when the first coal mines opened. CBM development began in the Raton Basin in the early 1980’s. (Source: http://en.wikipedia.org/wiki/Raton_Basin )

The Colorado portion of the Raton CBM field has also been significantly development. Prior to the collapse in natural gas prices in mid-2008, operators rapidly grew CBM production in the Basin. The following table displays the past few years of natural gas production in Las Animas County:

Las Animas County NG Production

Year	Production (bcf)
2005	89.4
2006	102.5
2007	115.9
2008	129.3
2009	126.5

Source: CO Oil and Gas Conserv. Comm.

While CBM production does not have anywhere close to the production declines of shale gas, both La Plata and Las Animas counties are headed for declines in natural gas output in 2010 due to a major decline in the natural gas directed drilling.

Far and away the largest natural gas producing basin in the State of Colorado is the Piceance Basin in Garfield County. While Piceance is a combination of both a CBM play and a tight sands play, the high-decline rate tight sands formations make up the majority of production in the basin. The development and optimization of large, multi-zone fracture stimulations of vertical wells ignited a drilling boom in the County. The below table displays the huge jump in natural gas production in Garfield County prior to its drop off in 2009:

Garfield County NG Production

Year	Production (bcf)
2005	270.1
2006	350.2
2007	436.9
2008	542.7
2009	527.7

Source: CO. Oil and Gas Conserv. Comm.

Since Piceance Basin tight sands wells have first year decline rates of up to 90%, the recent slow- down in drilling is likely to cause a large fall off in Garfield County production in 2010.

Garfield County is not only Colorado’s largest producer of natural gas; it is also the epicenter of a pitched battle between the oil and gas industry and residents. The drilling boom that unfolded in the County not only caused a fair amount of inconvenience to its residents, it also caused significant environmental damage that has not only re-shaped the State’s oil and gas industry but has influenced the development of unconventional natural gas nationwide. Due to the large backlash from residents of Garfield County, the Colorado Oil and Gas Conservation Committee (COGCC) has taken a very tough approach on enforcing its environmental regulations. In April 2010, the COGCC levied its largest fine in its history of $390,000 against Occidental Petroleum (NYSE:OXY) for contamination caused from a leaky drilling pit. In 2007, Oxy built an unpermitted drilling pit without a liner that leaked drilling fluids into the drinking water for surrounding area. Needless to say, the community was furious. (Source: http://www.gjsentinel.com/news/articles/oxy_faces_record_fine_for_tain) The COGCC has several other cases pending that involve leaking drilling pits due to torn or faulty liners.

Other states have taken notice of the environmental problems gas drilling has caused in the State of Colorado. Given that Halliburton and BJ Services have admitted to violations of exemptions to the Clean Drinking Water Act that were part of the 2005 Energy Bill by using diesel in fracturing jobs, I expect other states such as New York to take a very cautious approach to the development of unconventional natural gas. (Source: http://www.nytimes.com/gwire/2010/02/19/19greenwire-two-oil-field-companies-acknowledge-fracking-w-90863.html?pagewanted=1)

With a natural gas directed rig count that has recently turned down again, rapidly maturing natural gas basins and increased costs for environmental regulatory compliance, I see natural gas prices increasing substantially in the next few months. I discuss in my newsletter my favorite ways to capitalize on the coming increase in natural gas prices. My methods include employing specific options, ETFs and quality-run gas-weighted, producers, several of which are included in my Model Portfolio.

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