I covered the Shell plan to build a gas to liquids (GTL) plant in Louisiana just recently (link, link), pointing out my view that achieving continued growth in global liquid fuels production can only be achieved in the long-run through converting other hydrocarbons such as natural gas into liquid fuel. I also pointed out that the future of US natural gas may not be what people currently expect based on the euphoria surrounding the potential of hydraulic fracturing; therefore, there is a danger of this particular plan not being currently viable in the US. Now, with Shell canceling its planned project, it seems my skepticism was justified. Shell cited uncertainty about the future of oil and gas prices as the reason to abandon the project.
The EIA thinks that for such projects to be viable, price of natural gas needs to be below $6 per million BTUs. In the absence of being able to secure long-term natural gas supplies under this price threshold, the price of oil would have to rise significantly. That seems to be something that we would be foolish to expect to happen for a sustained period, because demand destruction causing an economic slowdown seems to be occurring soon after the WTI oil price crosses the $110-120 per barrel threshold.
Note: The drop in oil consumption in the OECD economies in the spring of 2011 may not be entirely attributed to the spike in oil prices, but it corresponds with the spike in oil prices and as we can see, it is a significant consumer demand drop.
The Shell decision cannot be based on the belief that oil prices are headed much lower either, because it is a well-known fact that projects ranging from deep water, shale oil, oil sands, and scavenging old conventional fields in order to squeeze out some more oil are all dependent on oil prices staying at current levels. Oil prices going bellow $80-90 a barrel will lead to significant supply destruction.
The most likely reason left for it to abandon the plan, which up to recently was obviously thought to have much potential given that Shell even picked a site and secured subsidies and concessions totaling over $120 million from local authorities, can only be because it now sees US natural gas prices going up significantly.
Perhaps Shell is looking at the recent EIA data on tight hydrocarbons, which may have opened its eyes and frankly should be a revelation for us as well. The fact that a few shale gas fields such as the Fayetteville, Barnett and Haynesville already peaked only half a decade into the great fracking revolution was often credited to the low price of gas, ironically caused by the fracking boom. In other words, the shale gas drillers became the victims of their own success. Simple logic dictates therefore that in a few years when the market tightens a little bit, taking the price of natural gas to perhaps $6, the declining trend in these fields can be reversed and we will see a return to sustained growing production for perhaps decades to come.
Looking at EIA data on Haynesville more closely, we have reason to believe this to be a false premise.
As the chart shows, the field's monthly legacy production decline, in other words the volume of new production that would have had to be brought on line each month just to keep production going reached its peak of 600 million cubic feet/day soon after drilling activity reached a peak. Since then, drilling activity slowed down fivefold and legacy production decline was cut by half as a result.
So, what will really happen if drilling activity is ramped up again as a result of higher gas prices? Initially, there would be an increase in production, given that current legacy decline rate is not as high as it was a few years back. Monthly legacy decline rate will, however, pick up again as drilling activity picks up and unlike when production first started and legacy decline rates were essentially zero, now the decline rate will start from around the current rate of 300 million cubic feet/day. If drilling activity were to reach the old peak again, it would most likely mean that a new peak in legacy decline rate would follow shortly after. So, we can only conclude that any ramp-up in drilling activity has a slim chance of ever restoring this field or any other declining field to its previous production peak and maintain that rate for a sustained period. Soon after this bump up in production would be achieved, it would be followed by a decline, which will likely be even steeper given that at this point many of these fields have actually yielded a large portion of the extractable reserves in place.
America's largest shale gas field, the Marcellus is still in its relatively early production ramp-up phase and will likely continue to increase production perhaps for the rest of the decade. The question is what then? With many other major shale gas fields already in decline as well as conventional onshore and offshore production, the most likely point of decline in total US natural gas production will come about a decade from now, soon after Marcellus peaks. Newer fields such as the Utica will not be enough to make up for lost production elsewhere. Neither will price and technology make a huge impact, as I pointed out through our example with the Haynesville field, where we now finally have enough production history and data to be able to extrapolate future field behavior including under various price movement assumptions.
The Shell GTL plant in Louisiana was to be completed around the year 2020, right when we might expect these issues to influence the natural gas situation on the continent. It is therefore understandable why Shell perceived oil and gas prices to be a threat to their project's viability. It is of note, however, that South Africa's Sasol has a similar project in the pipeline in Louisiana as well and it has no plans of abandoning it at this time. Sasol claims that as long as the oil price per barrel ratio to natural gas per million BTUs ratio is over 16/1, it considers it a viable operation. In other words, Sasol expects the spot price of gas at around $6 and oil at around $100 in the long-run.
My personal take on this is that in the absence of significant capital investment (sunk cost) efficiency gains, or concessions for the GTL product, such as tax exemptions based on its cleaner burning properties, which as I pointed out before might make it an especially attractive transport fuel in large urban areas, where we face smog issues, GTL in the US is a very risky proposition at this point. It was a plan based on views influenced by too much hype surrounding the fracking revolution and not enough cool-headed analysis. The Shell oil decision might be perhaps the first indication that we are starting to sober up.
As for the overall future of GTL, I believe it is still likely to become a major source of liquid fuel supply in the decades to come. It will likely happen in places like Iran if and when conditions will be normalized. Russia with its vast gas reserves might be tempted to make a special deal locking in the price of gas at under $6 per million BTUs in exchange for potentially economically beneficial investments yielding good quality jobs. There is currently much opposition to Russia's pipeline plans towards the European Union, with the EC declaring Gazprom's deals with transiting countries within the EU for the proposed South Stream project in breach of EU regulations. Perhaps Russia could be tempted into selling its gas in GTL diesel form to the world's largest diesel fuel market, instead of attempting to continue with the complicated business of pipeline politics in the region, which is proving to become a headache.
There is no doubt that future global demand for GTL will be robust and it is in fact a necessary path if we are to avoid severe global economic hardship in the future. The future of GTL may not be in the United States, but it will have a major role to play in allowing us to continue along current global economic path. For the United States perhaps coal to liquids will prove to be a better fit than GTL, because it seems the first signs that just recently established consensus on cheap abundant natural gas supplies for decades to come is wrong, is starting to surface already, despite the fact that we are still only a few years into the fracking revolution.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.