EQT Corporation (EQT) is the first significant Marcellus-focused operator to release its 2012 results and reserve estimates during this earnings season. Some of the operating metrics and forecasts contained in the report may be of interest to investors following the Marcellus and the natural gas sector in general.
Marcellus growth momentum to continue strong in 2013
EQT's report lends no support to the view that the Marcellus production growth curve will soon begin to saturate in response to lower commodity prices and infrastructure constraints. EQT is projecting its company-wide production to grow by another ~30% in 2013 following 33% year-on-year growth in 2012, driven by the Marcellus. After a significant beat on Q4 '12 production volumes, the first quarter 2013 production is expected to be sequentially flat (but still up more than 35% year-on-year). Rapid growth should resume in the second quarter, with double-digit sequential gains.
Notably, the Marcellus growth is expected to substantially exceed the company-wide growth rate. A graph in EQT's updated investor presentation indicates that the company's Marcellus volumes will exceed 800 MMcf/d by year-end 2013, up more than 250 MMcf/d from the very strong 2012 exit rate of ~550 MMcf/d. This represents a 45+% growth over the next twelve months (the Marcellus volumes grew by 85% in 2012 year-on-year).
"Marcellus profitable at current NYMEX strip," says EQT
EQT will continue to spend aggressively in the Marcellus in 2013, well in excess of its operating cash flow, which likely indicates that the company sees compelling returns in the current commodity price environment. EQT plans to drill 153 wells in 2013 on its 530,000-acre leasehold position in the Marcellus, with projected average drill & complete cost of $6.1 million and EUR of 7.3 Bcfe per well. Almost 90% of the wells will be drilled in the Southwest corner of Pennsylvania and the adjacent area in West Virginia.
The presentation suggests that the economics of the drilling program should remain strong even in a relatively weak natural gas price environment (a very impressive 53% after-tax return at $4.00 NYMEX and still solid ~20%-25% after-tax return at $3.00 NYMEX).
However, a closer analysis of the company's operating costs during the fourth quarter of 2012 reveals that drilling economics in the play are strongly diminished by the very high midstream costs. As a result, competitive returns are predicated on either strong liquids content in the production stream or Tier I dry gas EURs.
Excluding hedges, EQT's company-wide netback in Q4 2012 was $1.89/Mcfe (defined as realized price less cash operating costs), based on $3.40/MMBtu NYMEX. Very notable in the cost structure is the $1.68/Mcfe of Gathering, Transmission and Processing expenses (most of it becomes EQT Midstream's revenue, providing a partial "hedge" against the high midstream costs at EQT corporate level, but still remains a cost for the upstream segment).
(Source: EQT Corporation January 24, 2013 Press Release)
EQT's Marcellus netbacks should be a bit higher than the average for the company, given the play's high productivity per well and significant up-lift from NGLs in wet gas areas. Still, I estimate, using EQT's upstream cost structure as a starting point, that wet gas EUR's of >6.0 Bcfe/well and dry gas EURs of >8 Bcf/well are required for the drilling program to be solidly economic (20%+ returns) at the project level assuming a ~$3.50/MMBtu NYMEX.
EQT provides an EUR map which estimates current productivity of a "standard geometry" well in the Southern and Central part of the Marcellus play. The map suggests that only a small percentage of the Marcellus acreage "works" with high confidence in a sub-$3.50 NYMEX environment. Those areas are essentially limited to the play's two "sweet spots:" the dry gas sweet spot in Northeast Pennsylvania and the sweet spot (both wet gas and dry gas) in Southwest Pennsylvania/Northern West Virginia.
The sweet spots are large enough, however, to provide a massive inventory of drilling locations. According to EQT's estimates, the company's inventory of 9+ Bcf dry gas drilling locations exceeds 1,100 and the inventory of 6.4+ Bcfe wet gas locations exceeds 1,500, assuming 120-acre spacing.
This implies close to 20 Tcf of highly economic gas resource and almost two decades of drilling at the company's current pace. In addition, as well designs and completion techniques continue to improve, the economically competitive drilling inventory should continue to expand. Higher density drilling in the most productive areas should also contribute additional locations (EQT is currently running pilots on double-density spacing).
Clearly, the "drilling location math" is a very stretchable science and some risking is probably in order. It is nonetheless clear that there is no shortage of high-graded drilling inventory in the Marcellus that has a very low all-in cost of supply relative to other fields and can support a very high volume of production for the foreseeable future. Given that natural gas volumes from oil and "combo" plays (which are often "costless" in today's commodity price environment) are not sufficient to fully offset natural declines in dry gas fields, the Marcellus should continue to grow its market share. As a result, essentially irrespective of the natural gas price environment, infrastructure build-out in the Marcellus area will continue at a steady pace and long-haul pipeline operators should be motivated to look for inter-regional trunk-line solutions to the changing direction in natural gas flows.
Another important observation can be made from the comparative analysis of dry gas and wet gas economics in the Marcellus. Assuming an extended low commodity price environment, wet gas areas have a clear economic and risk-mitigating advantage over dry gas: the NGL component can result in as much as $2/Mcfe pricing uplift (or even higher in super-rich areas) and effectively provides downside protection against extreme weakness in the dry gas price. Under a natural gas pricing scenario similar to 2012, even the super-productive dry gas sweet spot in Northeast Pennsylvania would become marginally economic for new drilling, at the very best, whereas many wet gas wells in the Marcellus would still make economic sense.
As a result, wet gas areas in Southwest Pennsylvania and West Virginia will likely remain the development priority for many Marcellus operators and the wet gas processing and NGL off-take capacity will continue to be the most challenging issue. In that context, it is natural to expect significant value transfer to liquids-focused midstream developers in the area. In the longer term, a local downstream solution for the NGLs volumes (such as Shell's (RDS.A) proposed petrochemical complex in West PA) appears to make compelling economic sense. The closely located and off-take capacity-constrained Point Pleasant/Utica and Collingwood/Utica shales also play well into the thesis.
Marcellus' "1 Bcf/d Club" to see several new members in the next few years
EQT's Marcellus production currently accounts for less than 10 per cent of the play's total and therefore cannot define the trajectory of the field's aggregate production. However, EQT is by no means an exception in terms of expected continued rapid growth. Several other companies have been indicating equally impressive increases in their Marcellus volumes in the next few years:
- Cabot Oil & Gas (COG) announced in December that its operated Marcellus production surpassed the 1 Bcf/d level (gross), which is substantially above the company's 2012 exit rate expectation communicated during the Q3 2012 conference call. Cabot is currently guiding to another 35%-50% company-wide year-on-year production increase in 2013, with the vast majority of the volumes coming from the Susquehanna dry gas area. It will not be surprising to see an upward revision to the guidance given the impressive production results in Q4 and progress in infrastructure de-bottlenecking.
- Southwestern Energy (SWN) may achieve a 2013 operated production exit rate from its Marcellus properties in the 550-600 MMcf/d range, up significantly from the estimated ~300-325 MMcf/d exit rate for 2012; volumes may ramp up to over 1 Bcf/d by 2017 (all volume estimates are by the author based on research of the company's operating results and forecasts).
- Noble Energy (NBL)/Consol Energy (CNX) JV production has more than doubled in 2012 to approximately 280 MMcfe/d and is expected to grow at a 80% year-on-year rate in 2013. The rapid ramp-up rate is expected to be sustained over the next five-year period, with a 55% CAGR projected currently (according to Noble Energy). During the next three years, growth will be driven mostly by wet gas drilling.
- Several more operators will soon be providing their 2013 guidance. Range Resources (RRC) has not released its official 2013 volumes forecast yet but is likely to guide to another year of solid growth, given the company's very strong exposure to the highly economic rich and super-rich gas sweet spots.
Not all areas are equally successful in the Marcellus. In fact, the majority of the play's acreage is uneconomic in today's (and, likely, tomorrow's) price environment and are no different from many other marginal shales that may see little development capital. Several operators have substantially reduced operating activity in the Marcellus's less productive areas:
- Talisman Energy (TLM), who has ~200,000 dry gas acres in Tioga, Bradford and Susquehanna Counties, has reduced its Marcellus capital budget from over $1,100 million in 2011 to less than $300 million in 2013 and is currently running just one rig (which, in fact, may be sufficient to avoid steep declines in its Marcellus volumes). Talisman estimates it needs $3.50-$4.00/Mcf just to break even on its drilling program.
- Ultra Petroleum (UPL) has seen a significant slowdown of drilling activity on its acreage (one part of which is operated by Anadarko and the other by Shell).
- Anadarko Petroleum (APC), with 260,000 net acres in the Marcellus, has been able to achieve very tangible improvements in its drilling economics: average well in its high-graded inventory is expected to deliver a 8 Bcf EUR at a $7 million cost. Still, Anadarko estimates it needs $3.50/MMBtu NYMEX to generate 20%+ before-tax rate of return, which puts its Marcellus drilling program essentially at the bottom of its North American opportunity set.
- EXCO Resources (XCO), with 135,000 net acres in Northeastern and Central PA parts of the play, has reduced its operated rig count in the Marcellus from five rigs in 2011 to just one rig in Q3 2012.
- The majors, including Exxon (XOM) and Chevron (CVX), have been running very conservative rig counts in the Marcellus relative to their massive acreage positions and may let some of their acreage expire undrilled.
However, the massive volumes growth from the sweet spots should be more than sufficient to offset the decline in activity in the less productive areas.
EIA data for "Other States" will likely show continued production growth in November and December
EIA natural gas production data for "Other States" has shown steady growth throughout this year (which is driven primarily by the Marcellus as well as some other fast growing shales such as the Bakken). Given the very strong production ramp up in Q4 by several companies, including Cabot, EQT, Southwestern, and possibly others, it will not be a big surprise to see continued tangible upticks in the Other States volumes in the next two EIA data releases and, as a result, resilient and possibly growing US Lower 48 volumes.
The news would mean little relief for natural gas prices (and the popular equity investment vehicle US Natural Gas fund [UNG]) which, however, seems to adequately reflect the fundamentals at the moment.
Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.