Natural Gas Extraction May Be More Expensive Than It Seems

The price of natural gas has been a bargain lately when measured by the energy content of gas compared to crude oil. Some attempts have already been made to substitute cheap natural gas for expensive oil. While both commodities have declined significantly from 2008 highs, natural gas prices have been even more depressed due to the discovery of large shale deposits and the belief that extraction technology has improved to the point where explorers will be able to easily exploit the new discoveries. Market participants may be jumping to premature conclusions.

Shale Deposits – The Solution to Dry Holes?

John Dizard, writing for The Financial Times Monday, makes a number of interesting observations regarding the question of how shale deposits will impact pricing for natural gas in the United States. Mr. Dizard believes that promoters have been selling investors on shale deposit exploration by promising more predictable returns compared to the typical experience of exploration which often includes expensive dry holes:

Time and again, with all the three dimensional seismic imaging, reservoir engineering, and so on, people drill wells to 5,000 or 6,000 metres only to get a dry rock collection. Finding oil and gas requires a significant amount of trial and error. Bankers, brokers, and institutional investors do not want to hear this. They want to hear that the businesses they invest in are predictable.

The search for predictable and stable returns combined with the relative ease of finding shale deposits could lead to a fund raising bonanza for exploration firms even though the cost of shale extraction tends to be high:

This is where the technology comes in. Hydraulic fracturing, or “fracking”, is a technique to force liquids through a drill hole at high pressure to create cracks in gas or oil-bearing rock. The gas or oil flows through those artificial cracks to the wellbore. To keep the cracks open, the operator may mix in “proppant”, such as little ceramic spheres. It’s all difficult and ingenious, and requires a lot of expensive equipment and skilled people – including skilled promoters. Someone in Houston came up with the concept of shale gas production as “manufacturing”. The shale rocks are so uniform, you see, that the risk of a dry hole would be almost entirely eliminated.

Wonderful At First, But Potentially More Expensive Later

Despite the high costs of extraction, the uniform and high rates of production initially seem to justify the effort, particularly given the lower risk of dry hole costs. However, Mr. Dizard cites an industry expert who believes that the initial rates of production may end up slowing down as rock formations collapse once significant amounts of gas have been extracted. This would then require more expensive processes in which new fractures are created in the formations to keep gas flowing.

Despite the limitations, there is obviously a price at which natural gas production from shale deposits will make economic sense:

Ben Dell, of Bernstein Research in New York, whose work is respected by both sides in the debate, says: “The average well deteriorates more in quality, and more wells fail, than people believe. Still, I think a rise in prices would make more (shale prospects) economic. Plenty of plays work at $9 per mcf [1,000 cubic feet].” This less-than-expected productivity in the leading gas sector tells Mr Dell that US gas production will decline on the order of 10 per cent next year, leading to $8-$9 gas, or $3 to $4 more than the forward curve anticipates.

Low cost natural gas producers can take some comfort in the strong possibility that shale extraction may end up being much more expensive than people are anticipating, which would require much higher natural gas prices to justify the effort. The idea that cheap natural gas from shale formations will further depress prices from current levels seems hard to believe given what industry experts are saying about the complexity and expense associated with shale extraction.

Disclosure: The author owns shares of a company engaged in the exploration and production of natural gas. No opinion is being provided regarding the near term movement of the price of oil or natural gas. The author does not recommend short term speculation in commodities.

Comments

[learnmoney:]

Most of what you say came from an article in the UK Sunday Times by Danny Fortson.

The article went on to say that Tony Hayward the CEO of BP indicated that the USA ia awash with gas and that the new technology has created a revolution. Shale gas could meet half of America's demand within two decades and turn the country into a net exporter.

On the other hand Cheniere Energy, once a stock market darling, has seen over 90% of its market value disappear. But for most investors who are short term punters its all about PRICE.

Lets watch this space............

Nov 03 09:04 AM

[Ferdinand E...:]

Learnmoney, what else could Mr Hayward say? And yes, smart people will wait before believing that gas is going to create an energy or some other kind of revolution.

Nov 03 09:32 AM

[Ravi Nagarajan:]

Interesting op-ed in the WSJ this morning on the shale topic:

online.wsj.com/article...

I don't doubt that shale provides real reserves. The question is at what cost natural gas must trade at to make extraction economically viable.

Nov 03 10:07 AM

[koolsool:]

Whether natural gas is $3 or $9 does not matter. The important point that our leaders & policy makers should embrace, is that natural gas is a better fuel for the people of the USA and for world air quality. Better than imported oil or dirty coal (no such thing as clean coal that will actually produce energy on the plus side). They are planning on spending trillions of dollars on clean coal research, that money should be spent on American jobs & American equipment to build natural gas infrastructure, converting vehicles to run on natural gas & converting coal fired electricity utilities to use other forms of energy.

Nov 03 10:09 AM

[blu:]

So some are beginning to see my position on shale reservoirs.
The light gets brighter as more companies end up writing down reserves.

Nov 03 10:27 AM

[Ravi Nagarajan:]

On Nov 03 10:09 AM koolsool wrote:

> Whether natural gas is $3 or $9 does not matter.

Well of course it matters. If the extraction costs for shale deposits are greater than the prevailing price for gas, then the deposits are not economically viable.

Nov 03 10:46 AM

[Mmarrkk:]

The fact that wells decline quickly off their initial rates is no secret. In fact, if you will go through all of the technical and investor presentations, all of the companies accused of "promoting" the shales will readily tell you that first year declines are enormous. Most quote numbers like 70-85% decline in the first year. Yes, that comes from the companies that supposedly "hype" the plays. So, this rapid decline is ALREADY BUILT INTO the economic and production forecasts. Wells that come on at 10 MMCF/day are down to 1.5 MMCF/day by the end of the first year. Who cares? Its all about a) the total reserves produced in the first few years and b) the number of wells lined up in the cue to replace those that are declining. Estimates of total well counts are in the tens of thousands, hence the term manufacturing. By the way, that term was used a long time ago when folks were (and still are) drilling coalbed methane gas wells in San Juan Basin.

The price of gas will probably be driven by the rate at which companies will be able to access these resources, the ability to get experienced rig and frac crews and the overall macro economic conditions. If demand stays low, gas will be plentiful, prices will stay low and drilling will be slow. But if demand picks up, there will be a temporary shortfall that drives prices up. As prices go up, drilling will rapidly increase since the shale developments can be turned "on and off" with somewhat relative ease. As drilling ramps up, supply will outstrip demand and prices will fall a bit. Then drilling will slow down and production will go down, falling below demand, and the whole supply/demand pricing cycle will start over again. Watch for prices bouncing along between $4 and $8 for a while!

Prices can't stay low forever, since new drilling won't occur below $3-4/mcf. That will cause shortfalls, rising prices and, well, you know the cycles!

Nov 03 10:49 AM

[Mark Anthony:]

I am absolutely bullish on natural gas price itself.

But I am now seriously questioning whether UNG is the right instrument to leverage on natural gas price. The fact of the matter is UNG does NOT hold the actual commodity. How could you make money if you do not hold the actual commodity? Who pays for your profit? NG suppier? NY users? The industry suppliers/consumers settle the price gain//loss between them. So if you do not trade and hold the actual commodity, you are not part of the party.

Read more:
seekingalpha.com/autho...

Nov 03 11:14 AM

[tuj:]

Read it from the major skeptic's mouth directly, rather than filtered through 9 other people. Dr. Berman is the one making the big arguments (like at PIRA this year). Read it and decide yourself: petroleumtruthreport.b.../

Nov 03 01:34 PM

[searcher:]

So, the front end costs after the field has been found and 'proved' and demarcated entail drilling individual wells, including radial techniques, compressing water to hydraulically fracture the shale and to use manufactured ceramic spheres to retard the fissures from collapsing. Where does the water come from? Where does it go? Is the gas thus liberated migrate back up the same intrusion? What is done with the other associated petrochemicals (benzene etc.)? Have the true back-end costs been identified and recognized in the economic model for sustained 'production line' development?

Nov 03 01:40 PM

[Mmarrkk:]

Plenty of water for use in most of the areas where the shale gas exists. Fracing uses a fraction of golf course maintenance does.

The water goes down into the ground and the volumes pumped out are put in retention ponds, treated, and re-used for frac'ing future wells.

BTW, many of the shale plays use plain old sand, not ceramic proppant.

The chemicals used in fracing make up less than 1 % and most are found in your home right now. Look at the contents in a bottle of Formula 409 or Windex!

Look at the "back-end" costs for building a freaking Toyota Prius. Those batteries contain some pretty nasty crud too, you know. As does the plastices/fiberglass that makes up the body. And did you know that NATURAL GAS is used as a raw material for making many of those parts? Get a grip you NIMBY!

Nov 03 03:05 PM

[koolsool:]

You missed my my point. Whether nat gas is $3 or $9, the USA should not waste trillions of dollars on clean coal research. It should be used to harvest and use American natural gas. New technology for drilling already has made the cost of drilling come way down. Multiple wells can be drilled from one rig now, which is why the rig count has come down so low, while we are still increasing our supply with way fewer rigs.

Nov 03 04:22 PM

[Jeep:]

You are of course correct that cost matters and that when cost is above the gas price the wells are uneconomic, but keep in mind that the "industrial type" operation (or as MMarrkk said above "manufacturing") involved in shale gas and other tight sands drilling tends to allow both economies of scale and reduced costs as the E&P companies move up the learning curve in any given play. The first well is expensive, but unlike drilling in, say, the GOM where every well is different, each well thereafter gets cheaper.

I have real doubts about whether drilling for gas makes economic sense these days (unless it has a high ratio of condensate), but shale gas is going to be a permanent part of the drilling picture in the US and is going to be increasingly tried elsewhere.


On Nov 03 10:07 AM Ravi Nagarajan wrote:

> Interesting op-ed in the WSJ this morning on the shale topic:
>
> online.wsj.com/article...
>
>
> I don't doubt that shale provides real reserves. The question is
> at what cost natural gas must trade at to make extraction economically
> viable.

Nov 03 09:41 PM

[Spicer:]

Not familiar with meaning of the term reserve? If it ain't economically viable with today's commodity market prices it ain't a reserve just a resource.


On Nov 03 10:07 AM Ravi Nagarajan wrote:

> Interesting op-ed in the WSJ this morning on the shale topic:
>
> online.wsj.com/article...
>
>
> I don't doubt that shale provides real reserves. The question is
> at what cost natural gas must trade at to make extraction economically
> viable.

Nov 04 06:25 AM

[mwfall:]

Aint familiar with the concept of attending grammar class rather than staying home to watch tv?


On Nov 04 06:25 AM Spicer wrote:

> Not familiar with meaning of the term reserve? If it ain't economically
> viable with today's commodity market prices it ain't a reserve just
> a resource.

Nov 06 03:57 AM

[Taymere:]

Right on! We seriously polluted the environment trying to maintain our source of Arab oil shooting tons of radioactive DU munitions into Kuwait and Iraq in the 1st Gulf War. The cancer rate for Iraqis skyrocketed in 90's and it is still sky high. But at least we learned our lesson about the environmental costs of war...Oh wait!

How would these NIMBY's feel if Arabs cam to the USA and killed our friends and family to ensure their supply of black gold? Oh sorry, I meant came to "liberate us." Natural gas is domestic and nobody has to die to extract it. We know how to purify drinking water if hydraulic fracturing makes it come to that, but it's much harder to wash clean the trauma of war from the minds of our young soldiers. A little bit of war is way too much NIMBYS.

On Nov 03 03:05 PM Mmarrkk wrote:

> Plenty of water for use in most of the areas where the shale gas
> exists. Fracing uses a fraction of golf course maintenance does.
>
>
> The water goes down into the ground and the volumes pumped out are
> put in retention ponds, treated, and re-used for frac'ing future
> wells.
>
> BTW, many of the shale plays use plain old sand, not ceramic proppant.
>
>
> The chemicals used in fracing make up less than 1 % and most are
> found in your home right now. Look at the contents in a bottle of
> Formula 409 or Windex!
>
> Look at the "back-end" costs for building a freaking Toyota Prius.
> Those batteries contain some pretty nasty crud too, you know. As
> does the plastices/fiberglass that makes up the body. And did you
> know that NATURAL GAS is used as a raw material for making many of
> those parts? Get a grip you NIMBY!

Nov 11 04:26 AM