"You Cannot Be Serious!!" by Bill Powers. FSO Editorial 06/08/2010

FSO Editorials

You Cannot Be Serious!!
by Bill Powers
Editor, Powers Energy Investor
June 8, 2010

The above words were shouted on tennis courts all over the world during the decade of the 1980’s by one of the sport’s great players, Mr. John McEnroe. The phrase also aptly describes my reaction while reading a May 10, 2010 Wall Street Journal article by Amy Myers Jaffe entitled, “Shale Gas Will Rock the World.” In the article, Ms. Jaffe describes how shale gas will “defang the energy diplomacy of petro-nations,” and firmly re-assert the West atop the world order among her many projections on how shale gas will shake up energy politics. Ms. Jaffe also suggests shale gas development in China will reduce its need for energy imports and how “domestic shale gas for China may help integrate Beijing into a Pax Americana global system.” I find Ms. Jaffe’s article utterly ridiculous since she fails to cite any credible sources and many of her projections are based on something other than the current reality of shale gas development. I will examine several of Ms. Jaffe claims and provide multiple examples of why Ms. Jaffe’s shale gas-centric future is unlikely to come to fruition.

One of the biggest myths surrounding shale gas, which Ms. Jaffe helps to perpetuate, is its abundance. While I believe shale gas will play an important role in America’s energy future, the estimates Ms. Jaffe provides for shale gas recoveries are quite unrealistic. In her article, Ms. Jaffe had the following to say about the potential of shale gas in the U.S. and Europe:

“By some estimates, there's 1,000 trillion cubic feet recoverable in North America alone—enough to supply the nation's natural gas needs for the next 45 years. Europe may have nearly 200 trillion cubic feet of its own.”

Ms. Jaffe’s comment on the potential for shale gas development in the U.S. and Europe is wildly optimistic based on all historical evidence. Let’s first examine the current state of shale gas development in North America and the potential of its shale gas resources. According to an April 15, 2010 Reuters story, Pemex, Mexico’s state oil company, is planning to drill the country’s first exploratory shale gas well in the northern state of Coahuila later this year. (http://www1.hymarkets.com/html/news/2010/4/15/1271353099nN15197645.html) Given the embryonic state of shale gas development in Mexico, it would be difficult to see how any potential shale gas resources could be assigned to the country at this time.

Although Ms. Jaffe did not cite a source for the potential of U.S. shale gas resources, the widely cited work of the Potential Gas Committee (PGC) is the only source I could find that comes close to justifying the estimate Ms. Jaffe provided for total North American shale gas resources. Before delving into the PGC’s work on the potential of shale gas in the U.S., I believe it is important to get an understanding of the mission of the Potential Gas Committee. Below is a description of the PGC, which was taken from its June 18, 2009 press release announcing the completion of its year-end 2008 U.S. natural gas resource assessment, entitled “Potential Gas Committee Reports Unprecedented Increase in the Magnitude of U.S Natural Gas Resource Base” (Source: http://www.mines.edu/Potential-Gas-Committee-reports-unprecedented-increase-in-magnitude-of-U.S.-natural-gas-resource-base):

“The Potential Gas Committee, an incorporated, nonprofit organization, consists of knowledgeable and highly experienced volunteer members who work in the natural gas exploration, production and transportation industries and in the field and technical services and consulting sectors. The Committee also benefits from the input of respected technical advisors and various observers from federal and state government agencies, academia, and industry and research organizations in both the United States and Canada. Although the PGC functions independently, the Potential Gas Agency at the Colorado School of Mines provides the Committee with guidance, technical assistance, training and administrative support, and assists in member recruitment and outreach. The Potential Gas Agency receives financial support from prominent E&P and gas pipeline companies and distributors, as well as industry trade and research organizations and unaffiliated individuals.” (Italics and bold added.)

Basically, the PGC is an oil and gas industry sponsored organization whose goal is to provide an “independent” assessment of America’s potential natural gas supply. While I am sure the PGC has some very technically capable staff, assessing potential gas supplies is a very subjective and challenging matter.

According to the PGC, year-end 2008 potential U.S. shale gas resources were 616 trillion cubic feet (tcf), 45% above its year-end 2006 assessment. Given that the United States has historically produced relatively small amounts of shale gas (approximately 15 tcf to date), I find the PGC’s estimate to be very optimistic.

To put into perspective how optimistic the PGC’s and Ms. Jaffe’s outlook on the resource potential for shale gas truly is, consider the following. According to the Texas Railroad Commission (the agency tasked with tracking oil and gas production in the State along with other duties), the Barnett shale in the Newark East Field (the largest producing shale gas field in the world), located in the Ft. Worth Basin of Texas, produced approximately 7 tcf of natural gas from January 2000 through January 2010 (Field No: 65280200). [It should be noted that in March 2009, the Newark East field reached its production peak at over 5 billion cubic feet per day (bcf/d) and production has fallen off since.] Assuming the field has another 20 tcf of gas to produce (the US Geological Survey has estimated total recovery of the Barnett to be 26.7 tcf), it is quite clear that dozens of shale gas fields larger than the Barnett will have to be found and exploited if North America is ever to produce the estimate Ms. Jaffe provided of 1,000 tcf of shale gas. Even using aggressive assumptions on the productivity of America’s three largest shale plays outside of the Barnett, the Haynesville shale in northwest Louisiana and east Texas, the Marcellus shale of Pennsylvania and the Fayetteville shale in Arkansas, which combined have produced less than 2 tcf so far, there is simply no historical evidence to support the PGC’s projection of 616 tcf of shale gas potential in the U.S.

Canada has made two very significant shale discoveries in recent years that are poised to play an important role in that country’s future. The Muskwa, Evi and Klua Devonian-age shales found in British Columbia’s Horn River Basin make up Canada’s most recently identified shale gas play. A shale gas primer released by Canada’s National Energy Board (NEB) indicates the Horn River Basin shales contain between 144 and 600 tcf of original gas in place, with an estimated 20% of this gas being recoverable. (Source: http://www.neb.gc.ca/clf-nsi/rnrgynfmtn/nrgyrprt/ntrlgs/prmrndrstndngshlgs2009/prmrndrstndngshlgs2009-eng.html )

Canada’s other shale play is the more mature Montney shale gas play. The NEB’s primer notes that “estimates of natural gas in the Montney are highly variable” and that there is between 80 and 700 tcf of gas in place, of which 20% may be recoverable. The Montney shale currently produces approximately 375 million cubic feet of gas per day. (Source: ibid) Since both the Montney and the Horn River Basin shales have yet to produce 1.5 tcf on a combined basis, it would be difficult to assign Canada, even using aggressive assumptions, more than 100 tcf of recoverable shale gas resources at this time.

As far as Ms. Jaffe’s suggestion that Europe holds potentially 200 tcf of recoverable shale gas, let’s look at some facts. According to a February 2010 presentation on the prospects for unconventional gas in Europe, published by German utility E.ON AG, Europe currently produces virtually no shale gas. (Source: http://www.eon.com/de/downloads/ir/20100205_Unconventional_gas_in_Europe.pdf) The presentation concludes that while Europe has several promising unconventional basins, “European shales are not yet well understood in terms of geology and cost structures” and “Europe is in the early research phase. No real development options in the short run.”

Given that Europe has yet to produce a single molecule of shale gas and does not appear to be in any danger of doing so in the near future, despite significant funds spent on the identification and delineation of potential shale gas fields, I do not see how any shale gas reserves or resources could be assigned to the Continent, let alone 200 tcf.

Even more important than Ms. Jaffe’s over-estimation of North American and European shale gas resources, is her overstatement of the impact shale gas will have on North American and European natural gas deliverability. In her article Ms. Jaffe addresses the deliverability of shale gas with the following passage:

“Prior to the discovery of shale gas, huge declines were expected in domestic production in U.S., Canada and the North Sea.”

I find the above passage very confusing for a number of reasons. First, I am not aware of any shale gas production coming from the North Sea or anywhere else in Europe. North Sea gas production has been falling for several years and is likely to continue to do so for the foreseeable future, due in large part to the steep production declines in the U.K. North Sea. (Source: http://tonto.eia.doe.gov/cfapps/ipdbproject/IEDIndex3.cfm?tid=3&pid=3&aid=1 ) Second, despite Canada’s two very large shale discoveries, the country is experiencing declining natural gas production. After reaching peak production of approximately 17 bcf/d in 2001, Canadian natural gas production fell to 14.4 bcf/d by the end of 2009, a 15% decline. (Source: NEB, Natural Resources Canada). Canadian natural gas production is on pace for further declines in 2010. (Source: Natural Resources Canada) With Canadian shale gas accounting for less than 5% of the country’s total gas production, Canada’s shale gas production will have to grow substantially (which it may well do) before the country will be able to reverse its production slide.

While Ms. Jaffe correctly states that shale gas discoveries have helped to reverse the decline in U.S. natural gas production, she fails to discuss how the high-decline rates that shale gas wells experience in their early productive lives will significantly limit U.S. shale gas production growth. In researching production statistics for a book I am writing on America’s upcoming natural gas deliverability crisis, I have found that U.S. shale gas production is unlikely to materially grow from its current level of 8 bcf/d (13% of total U.S. production). Let me explain why. First, as previously mentioned, the Barnett shale, which accounts for 60% of all U.S. shale gas production, is in terminal decline. Though the Barnett may have produced less than a third of its reserves and may be productive for another 20 years, the high declines of the early years of shale wells have created a production treadmill that would require operators to drill an increasing number of shale wells each year just to keep production flat.

Second, we are currently seeing many shale gas operators drill woefully uneconomic shale gas wells simply to keep high-priced leases from expiring. The drilling of fringe acreage to hold leases during times of low natural gas prices has pulled forward substantial production that would otherwise have waited for better prices. I believe that drilling to hold acreage will be ending shortly since several shale gas operators have re-directed their capital spending towards projects that are prospective for oil and have de-emphasized gas drilling.

Another area where I believe Ms. Jaffe’s article is off base is on the direction of costs associated with shale gas extraction. Ms. Jaffe noted the following on the potential for cost improvements in shale gas development:

“Take costs first. Over the past decade, new techniques have been developed that drastically cut the price tag of production. The Haynesville shale, which extends from Texas into Louisiana, is seeing costs as low as $3 per million British thermal units, down from $5 or more in the Barnett shale in the 1990s. And more cost-cutting developments are likely on the way as major oil companies get into the game. If they need to do shale for $2, I am willing to bet they can, in the next five years.”

While there certainly have been reductions in the development costs of shale gas over the past decade, there is growing evidence that costs for shale gas development are rising, not falling. For example, the leading operator in the Haynesville shale in Louisiana, Petrohawk Energy Corp (NYSE:HK), reported its 2009 proved developed producing (PDP) finding costs were approximately $2.80 per thousand cubic feet (mcf). However, the company is likely to experience substantially higher cost over the next couple of years for two very important reasons. First, due to the weakness in the natural gas directed rig count during 2009 (there were about 200 fewer rigs drilling for natural gas at this time last year), drilling expenses and fracture stimulation (frac) costs were lower than current levels. More importantly, Petrohawk is likely to see higher development costs in 2010 since it has likely drilled its best areas of the play. Based largely on the geophysical work that was performed during the development of the Barnett, shale gas developers can now easily recognize the core areas of shale plays and exploit those before moving on to lesser quality areas.

Lesser quality reservoir means lower productivity and higher costs per unit. The highly economic core areas of shale plays such as the Haynesville are far smaller than most realize and costs outside of these core areas are much higher than currently recognized. Late entrants into the Barnett drilled acreage well outside the core areas and were met with poor well results. This indicates that even when using advanced drilling and completion techniques such horizontal drilling and multi-stage fracturing, reservoir quality is still the biggest determinant in drilling an economically successful well. This fact has not been lost on Aubrey McClendon, CEO of Chesapeake Energy (NYSE:CHK), whose company is one of the most active shale gas drillers in the country. Mr. McClendon said the following about the size of the core area of the Barnett Shale during an interview with Bloomberg News on October 14, 2009:

“There was a time when you all were told that any of the 17 counties in the Barnett Shale play would be as good as any other county. We found out that there are about two and a half counties where you really want to be.”

Ms. Jaffe also seems to have an inflated view of the potential of shale gas in China. Below is another excerpt from her article about the potential impact shale gas development will have in China:

“Shale-gas development could also mean big changes for China. The need for energy imports has taken China to problematic nations such as Iran, Sudan and Burma, making it harder for the West to forge global policies to address the problems those countries create. But with newly accessible natural gas available at home, China could well turn away from imports—and the hot spots that produce them.”

Once again, Ms. Jaffe seems to be putting the cart before the horse. While Chinese oil and gas companies along with a handful of Western partners have identified a number of regions where shale gas potential exists, China currently produces no shale gas. Similar to her projections on Europe’s shale gas potential, I believe Ms. Jaffe underestimates the difficulty involved in the development of commercial of unconventional gas resources. Since 1980, China, home to massive coal resources, has been trying to establish commercial coal bed methane (CBM) production and currently has only one commercial CBM project to show for all its efforts. According to a paper by Guanghau Liu presented at the International Geological Congress meeting in August 2008 entitled “CBM Development in China”, China’s lack of CBM success is a result of the following:

“(1) poor understanding of local geology and coal reservoir characteristics, (2) inadequate techniques of well completion, stimulation and production, (3) improper application of equipment, and (4) lack of commercial operation experiences.”

Source: http://www.cprm.gov.br/33IGC/1315413.html

Given that China is just now starting to delineate its shale gas potential, I do not see any circumstances under which China will have meaningful shale gas production online within the next five years.

Another area where I believe Ms. Jaffe is overstating the role of shale gas is its potential for limiting Russia’s influence over the natural gas supplies of Europe. From Ms. Jaffe’s article:

“Europe, for instance, receives 25% of its natural-gas supply via pipelines from Russia, with some consumers almost completely dependent on the big supplier. In the wake of Russia's strong-arming of the Ukraine, Europe has been actively diversifying its supply, and shale gas will make that task cheaper and easier.

Shale-gas resources are believed to extend into countries such as Poland, Romania, Sweden, Austria, Germany—and Ukraine. Once European shale gas comes, the Kremlin will be hard-pressed to use its energy exports as a political lever.”

While Europe is smartly attempting to limit its dependence on Russia for its gas supplies, the maturity of Europe’s fields and Russia’s sheer size (according to the 2009 BP Statistical Review, the country is the world’s largest producer of natural gas) will make any diversification efforts difficult. Additionally, Ms. Jaffe fails to recognize that outside of Norway, every European country has past its peak of natural gas production and are increasingly turning to imported natural gas to meet internal demand (Source: EIA).

Consider the dilemma facing Germany, one of Europe’s largest consumers of natural gas and the country with the most dependence on Russia gas imports. According to the US Energy Information Agency, natural gas production in Germany fell from 836 billion cubic feet (bcf) of gas in 2000 to only 578 bcf in 2008 (nearly a 31% drop) while consumption in the country rose from 3.098 tcf in 2000 to 3.383 in 2008 (a 9% increase).

While the economic downturn in Europe and elsewhere has destroyed demand for natural gas as well as natural gas imports, I see this trend reversing at some point. Due to a rebound in economic activity and/or declining domestic supplies, Europe will likely become even more reliant, not less as Ms. Jaffe suggests, on Russia for natural gas supplies. I believe the Russian gas bear is not dead, only hibernating.

In conclusion, Ms. Jaffe rightly points out that shale gas is going to be an important part of America’s energy future. However, she and many others who have been vocal supporters of shale gas development have been wildly overstating its impact on America’s future gas supply and its potential in countries overseas. Unrealistic expectations for potential of shale gas have led U.S. policymakers to encourage an over-reliance on natural gas as a feedstock for electricity generation and to provide tax subsidies for the development of natural gas vehicles at a time when America’s natural gas deliverability is headed for a decline. If America’s policymakers do not quickly realize the limits of shale gas and stop the encouragement of increased consumption, we will soon find ourselves on the precipice of a natural gas deliverability crisis that will very damaging to our economy.

Investors who can go against the grain in these uncertain times, those who can ignore the nonsense about an unending supply of shale gas and are willing to take a contrarian approach, will benefit greatly from the coming rebound in natural gas prices. I share some of my favorite ways to participate in the coming rise in natural gas prices in my Model Portfolio, which is published each month in my newsletter.

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