Shale Gas Companies: All Talk, No Walk?

Natural gas prices and stocks have held up better than I had expected. In trying to find out why, I found a couple analysts now indicating the economics that shale gas companies present in their financial statements is not as strong as what they express in their press releases.

This would actually be bullish for natural gas prices and natural gas stocks.

In other words, these gas companies allegedly talk the talk of cheap profitable gas in press releases but don’t walk the walk in showing it in their financials. Yet.

This newsletter has been part of the chorus that natural gas prices are going through a seismic shift downward because of the improved economics and technology behind horizontal drilling (HD) and multi-stage fracing (MSF).

I believe that the downturn in natural gas prices isn’t just cyclical because of the recession/depression and regular seasonal troughs; rather it’s a systemic issue. HD/MSF increases production per well dramatically, and opens up many new low-cost reservoirs, taking the marginal cost of natural gas down from $7.50/mcf to more like $4-5/mcf.

However, a couple prominent research firms have recently shown some data that could disprove this theory.

Ben Dell is the senior energy analyst at Bernstein Research in New York, one of the top sell-side research firms. In a March 27 research note, he notes “a growing discrepancy between the internal rates of return (IRR) presented in corporate presentations and company reported ROACE (return on average capital employed)... For example, in many plays companies claim to generate IRR’s above 100% at $7.50/mcf gas or claim that their production is economical even at $2-3/mcf gas prices, but at the same time report 6-7% ROACE at a corporate level over the last 3 years, when the average gas price was $7.50/mcf.”

Titled “Why the Haynesville Won’t Work…at $4, $5, or $6/mcf gas”, Dell posits that companies are overstating production, understating costs, or there is a terminology gap at work. For example, a producer could say the IP rate of a well (Initial Production) is 8 mmcf/d (million cubic feet per day). But was that a 30 day average, as is normal, or was it a 12 hour average just after coming online. These HD wells can decline in production so rapidly sometimes that for stock promotion purposes, companies issue figures that may have been correct for a short time, but have no context and are not really “best practises” type numbers.

Dell also questions if the all in costs of a well are being amortized properly into the economics that appear in a company’s press release. If the cash operating cost of a well is $3/mcf, which is the number that appears in a release that does not include the $4-7 million it cost to buy the land and drill the hole - costs that Dell suggests basically doubles the breakeven level of the well to $6/mcf. And to get an acceptable return - even to generate enough cash to drill the next well - would be $8/mcf.

He told his readers how one operator in the Haynesville Shale in northern Louisiana (the most prolific shale play in North America) implied a greater than 100% IRR on a very large 14 mmcf/d well. But once Dell started amortizing in some of his own estimated costs for land and drilling and taxes, that came down to a very pedestrian 14% IRR.

I find that a very harsh set of economics, but his overall thesis could be valid. The cost inflation and land prices in the natural gas industry during the bull years of 2006-2008 meant many companies spent a fortune on a well before any production came out.

A Canadian firm, Peters & Co. out of Calgary, echoed those thoughts this week with a brief commentary “Where is All the Cheap Gas?”

They ran some numbers on costs on companies operating in shale gas plays on both sides of the border - the FD&A, Finding, Development and Acquisition costs, and tried to adjust for currency differences. And what they came up with is that

• Costs in the US are only about $1/boe (barrel of oil equivalent) lower than in Canada
• Costs have actually gone up slightly between the 1-year and 3-year average costs, over their universe of 33 companies.

When I look at the leading gas companies I know - Storm, Celtic, NuVista, Fairborne for example - all of them except Celtic had their costs go up, if only marginally.

What these two reports say is that, regardless of the reasons, the end fact is that as yet, lower cost gas is not showing up in the financial statements of the gas companies.

This would be quite bullish for natural gas prices and stocks. Concludes Peters & Co: “the prediction that natural gas prices will be capped at US$6.00 per Mcf may prove to be a little premature.”

Natural gas stocks would appear to agree.

Disclosure: No positions

Comments

[Eric Fox:]

Was this the Chesapeake Chiggero well?

Apr 08 08:18 AM

[Ferdinand E...:]

I spent a lot of time studying the supply of natural gas a few months ago. I dont remember all of the conclusions I came to, but I definitely remember hesitating to believe that shale gas would solve the problems of those of us on the buy side of the market. The 'natural depreciation rate' of that resource needs some careful examination. Here I recall something that an english economist told me about gas and oil: there are so many lies being told that it is impossible to make an accurate output prediction

Apr 08 09:25 AM

[Houstonoilman:]

These types of wells decline very quickly and produce at marginal rates for a very long time. The economic driver to pay out the capital cost of the well is the price of natural gas during the first year or even first six months of production. The well may produce for 20 years, but if the capital costs are not recovered from adequate commodity prices in the first six months or year, the rate of return will be driven down considerably.

Apr 08 09:40 AM

[Augustus:]

The decline rates on some of these shale wells has been very, very dramatic. First year declines on the order of 75% are not uncommon. Some production can continue for a long time, but the volumes are no where near the IP numbers. These folks may have really screwed up the deal when they paid the monsterous prices for the leases. I expect the drilling and development costs are returned fairly soon, particularly at the projected $10 gas sale price. Outrageous land investments are going to kill the companies for a long time. How much cash does it take to develop all of that lease inventory?

Apr 08 09:54 AM

[Mmarrkk:]

I find the quoted cash operating cost of $3/mcf extremely high. I think it is more like $1/mcf. Throw in $0.50/mcf basin differentials to HH and again that much for overhead and transport, you get to maybe $2.

Looking at some of the reported monthly production numbers for Haynesville wells, there are several that are averaging well over 10 MMCF/day for the first few months, not hours.

Plus, many of these shale players have gas hedged at $8-9/mcf through the middle of 2010. At the rate the wells produce, they can get the drilling costs payed out during this period of high hedged prices and when the go unhedged, they are only incurring the operating costs.

I think the shale model CAN work if folks get their costs down and avoid escalation in drilling costs.

Apr 08 10:46 AM

[searcher:]

Current production that is hedged out beyond the productive sweet spot is not all that valuable. Reserves acquired at distress values by strong developers with efficient gathering and marketing resources will prosper. Those dependent on 'enthusiasm' for equity or equity sweetened debt will always represent spurious margins.

Apr 08 12:18 PM

[Eric Fox:]

Mmarrkk...a recent sell side report I saw had cash operating costs for 2008 as follows:

CHK - $2.22 per Mcfe
EOG $2.04
XTO - $2.93

The lowest was UPL at $1.92 and SWN at $1.58

Apr 10 11:47 AM

[HandsomeMan:]

wait a minute... i guess i'm not understanding the author when he says he's bullish on natgas prices and natgas stocks

is he saying that these natgas producers can actually produce gas at much lower costs.... so this benefits their bottom line? i would think that this means they actually keep producing more natgas at exactly the wrong time, when natgas prices are plummeting and folks need to restrain production

and if natgas production costs are indeed below $2 / mcfe, then i wouldn't be surprised if natgas goes to $1.50 in this kind of environment... not bullish for natgas prices or stocks... especially if these guys incurred huge amounts of debt to buy land that they now need more money to drill...

Apr 10 04:48 PM

[growser7:]

The article and some of the comments remind me of Mark Twain's definition of a mine as "a hole in the ground with a liar on top,"

Handsome, I think the author is arguing that shale gas is a lot more expensive to extract than the investing public has been lead to believe. I have some friends in the oilpatch who confirm that opinion, along with the high intial decline rates (i.e over the first 12 months). The same holds true for the Bakken shale oil play---expensive drilling with 30+% decline at twelve months.

Countering that of course is the fact that leasing costs will fall, as will rig and pipe costs etc.

A BIG fly in the ointment will be the tax treatment of drilling. I understand that the new administration is looking to eliminate the tax credits for intangible drilling expenses, with legislation to take effect later this year. That will dampen future drilling even if the commodites are hedged---the dry hole costs of some of these wells are in the millions. So--we might have constrained supply in the future for entirely different reasons, with the breakeven points of all of these projects pushed to the right.

Apr 15 02:47 AM

[RJB 1077:]

Great article, and well put.

Press releases are always written with the best foot forward, and are crafted to lead you to the conclusion we the writer wants you to believe.

I can add to the conversation by saying this:

Royalty rates in the US shale plays are increasing, a cost which doesn't show on the operating line in a balance sheet. It's generally a separate line, and many companies use a blended (i.e. total corporate) royalty rate to show lower op costs on their higher royalty plays.

For example. If you were the first to the table in the Barnett shale play in 2004/2005 you could negotiate a 1/8th royalty lease or a 12.5% royalty lease. Turns out that landowners can read, and can find each other in coffee shops or down the road... subsequently in the land rush to acquire acreage companies were forced to offer not only higher bonus payments (as high as $3000 to $5000 per acre, enough to add $1MM to the cost of a shale well) they also offered royalties as high as 35% of gross revenue.

At $4 gas, and $2/mcf operating cost (which is as low as can reasonably expected.) a 35% royalty only allows $0.60 per mcf to pay out capital and make a return. On a 2 BCF shale well that's only $1.2MM worth of return at a flat $4 gas price. We barely paid for the land in our example let alone paying out the well, the pipeline, the compressor station... (I'd say we just lost about $8MM actually.)

The shale plays will make money for some at $6... but not for all, and they will provide a reasonable level of new production at $7 to $8, but remember... we always drill the best wells in our inventory first, and the shale wells we drill in 2010 & 2011 are not going to be as productive as the wells in the sweet spots... the wells we drilled in 2006 thru 2008.

Keep thinking critically, and I'll leave you with an anecdote. Other commodities have had these sorts of supply gluts in the past. People talk about an unlimited supply, and that the price will never rise above X again. We've just spent 7 years running to stand still in terms of North American gas production, and with the downturn we've decimated company cashflows and with it the ability to re-invest to put on 2010's gas...

Where do you think gas prices are going?

Aug 06 02:48 PM