Are Unconventional Shale
Natural Gas Wells Economic?

by Joseph Dancy, LSGI Advisors, Inc. | December 1, 2009

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Several energy analysts have recently made presentations claiming wells drilled into unconventional shale reservoirs are most likely uneconomic at current natural gas prices.

They claim the companies developing these reserves will lose money, imply their business strategy is flawed, and that management is in effect wasting company assets thereby threatening shareholder value. Overall, these contrary analysts claim the supply of natural gas in the U.S. market will be lower than expected as unconventional shale wells disappoint.

On the other hand other energy analysts and many exploration companies claim that unconventional shale wells are economic, or will be at natural gas prices slightly higher than current spot prices. The argument has drawn attention lately – and will impact how billions of investment dollars are spent over the next few years.

Real Option Theory - The optimistic analysts argue that marginal wells, and even a dry hole, will yield valuable information that can be used to direct capital expenditures more effectively. Drilling information can be used by management to make decisions to increase the value of a firm’s assets using a decision making strategy that management experts have deemed ‘Real Option’ theory.

Using a Real Option strategy a firm focuses on increasing the value of it’s assets by using a series of discrete investments. Each investment adds to the information a firm possesses with regard to the nature and value of the firm’s asset mix, reducing the risk of development. This information can be used to make better decisions when allocating a firm’s capital.

Even a small working (cost bearing) interest in a well being drilled will generate information allowing a firm to direct capital more effectively. In the worst case will allow a company to cut its’ losses should the project results prove unproductive.

When drilling an unconventional shale well the following information will be obtained:

(1) the depth and nature of the target formation
(2) the depth and nature of ‘up hole’ or ’behind-pipe’ formations
(3) the quality of the formation along the lateral
(4) the most efficient length of lateral and technical issues in drilling
(5) the most efficient number of completion points or stages
(6) the most efficient amount of water and most effective fracture chemicals
(7) the most effective proppants, and amount of proppants to utilize
(8) the chemical nature of any hydrocarbons discovered and formation characteristics
(9) the initial production test volumes and
(10) the decline curve for production from the target formation.

Leasehold Held by Production - A well drilled into an unconventional reservoir will also hold the unit leasehold by production, and allow the company to evaluate the geological nature of the area for trends that might assist the company in its leasing activities or in farming out their acreage to others for development. Uphole zones in areas such as the Haynesville field add to future economic returns from exploration activities. The technological knowledge and developmental expertise is also an asset of the firm that increases the enterprise value, in addition to the physical assets and reserves.

A marginal well in an unconventional reservoir is highly leveraged to the price of natural gas or crude oil. If prices for these commodities increase, the discounted cash flow and hence the value for the assets will also increase. The ‘sensitivity’ of the return to the commodity price is usually quite high for energy properties—the gain in the price of the marginal asset is usually much larger than the increase in the price of the commodity. In a period of rising prices, which we think we face longer term, the returns on marginal properties can surprise shareholders on the upside.

Tudor Pickering Holt - Tudor Pickering Holt, an energy consulting firm, addressed this issue recently. They claim that from an engineering standpoint the analysts claiming unconventional shale wells are uneconomic are incorrect. Tudor Pickering claims that the critics of unconventional reserves are using wrong assumptions regarding decline curves, hence miscalculating the Estimated Ultimate Recovery of the shale wells.

Back testing using existing Barnett shale decline curves Tudor Pickering finds actual production has been much higher than predicted by the curves used by the shale skeptics in their analysis—indicating the critics are too aggressive in their decline assumptions.

We might also note that the natural gas markets are in steep contango—which means that natural gas prices for gas sold in 6 months are much higher than current spot prices. So while front month prices for natural gas are below $5 per thousand cubic feet (mcf), natural gas prices on the futures market for sales six month hence are nearly $6 mcf. If reserves are discovered, and an initial test of the well is positive, a nimble company can ‘sell forward’ its gas at prices much higher than current prices.

Tudor Pickering Holt also notes that the technology is getting better with each well drilled and completed as firms learn how to best recover this low permeability resource. Worst case, should unconventional shale recoveries be as poor as skeptics claim, U.S. onshore production should plummet according to Tudor Pickering—which will substantially increase natural gas prices. The higher price levels would support developmental activity.

Capital Allocation - Keep in mind sophisticated companies with extensive technical expertise are spending billions on shale development—and expect to deliver returns on their investments for both management and shareholders. Not that an investment bubble cannot occur, but considering the risks and rewards the unconventional resource plays appear attractive to many firms.

Next month we will examine the argument that we will see low natural gas prices for years as North America has a permanent natural gas ‘glut’ due to advances in drilling and completion efficiencies – and why this may not be the case.

© 2009 Joseph Dancy

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Joseph Dancy, Adjunct Professor, Oil & Gas Law, SMU School of Law, Advisor, LSGI Market Letter | Joseph Dancy's Book Reviews | E-mail