Seeking Alpha
Profile| Send Message| ()  

There is a big controversy in shale well natural gas production.

The supporters say that shale gas brings a cheap and abundant new energy source to America's economy; Opponents say shale gas production is non-economical, as the wells deplete quickly, and the ultimate production volumes are far below original estimates; Environmentalists claim that hydraulic fracturing, called "fracking", causes water pollution.

Aubrey K. McClendon, CEO of Chesapeake Energy (CHK), is one of best-known proponents. Texas geologist Arthur Berman is one of the most outspoken critics of the shale gas revolution.

The controversy is important to not just to the US natural gas sector, but to the coal sector as well. James River Coal Company (JRCC) CEO mentioned shale gas declines in last week's earnings conference even though they produce no shale gas. Is shale gas abundant and cheap to produce? If it is, coal demand is threatened, as cheap and clean-burn natural gas is preferable. If it is not, people buying into the shale gas hype better take their money back and invest in US coal mining shares, as coal remains the old king in energy supply. I will explain the controversy and provide a math model for people to take a stand.

This article is about the shale gas controversy and my take, and how my math model matches against real production data. My model and my take remains my opinion only. The future will be the ultimate judge. I welcome exchanges with readers and industry experts.

The Man the Shale Gas Industry Hates

For a starter on the controversy, please read the latest news article Meet the man the shale gas industry hates, a Rolling Stone article The Big Fracking Bubble, a NYT report Insiders Sound an Alarm Amid a Natural Gas Rush, disclosing hundreds of pages of insider documents and emails. My recent instablog post discussed the subject. Finally, read the blog site of Arthur Berman.

Energy investors want to know who is right to make a smart decision on what to buy. But intrigued by the technicality involved in the dispute, you may have a hard time figuring out what is disputed and how to take a stand.

Is shale gas economical? It boils down to cost and return. The cost part is less disputed. The return depends on natural gas prices and the volume of gas that can be produced from each well, called UER (Ultimate Economical Recovery) by the industry.

How much is the UER is at the center of the controversy

No shale well has gone through a full life cycle yet. So UER must be estimated based on models. A model must match the production data from existing wells. A model is correct if it projects productions that match actual data, vise versa.

Estimating UER of shale gas wells is not trivial due to these reasons:

  1. Shale gas wells have impressive IP (initial daily production rate) which can be different, depending on specific shale plays.
  2. Shale gas production rate decline pretty rapidly over time.
  3. The long term trend of the decline rate is not well known until the production history is long enough to tell.
  4. What is the reasonable production cut off points? Obviously if a well can only be produced for 5 years, the result is very different from a well that is produced for 40 years.

Out of the 4 issues, the IP is the least subject to disputed. Whatever comes out of the well within the first 24 hours tells you the IP. After that, a well's production rate keeps dropping. The least certain, hence most controversy issue is how decline rate evolves over time. Different models are proposed leading to very different estimates of UER.

The shale gas industry projects good UERs of 5 BCF, 10 BCF or even higher. Mr. Arthur Berman believes the typical UER is between 1-2 BCF per well. One BCF is one billion cubic feet. Natural gas is priced in mmBtu (million British Thermal Unit). One mmBtu of natural gas is roughly one thousand cubic feet. Thus, if gas price is $2.00/mmBtu, a UER of 1 BCF can only fetch $2M. But if the UER is 10 BCF, the well can fetch ten times more at $20M. So the shale gas profitability is decided by the UER and gas price.

I use a simple math model to analyze the existing Barnett Shale production data to find out. The shale gas well counts and production volumes are listed in the data table listed further below.

Models of Shale Well Decline Rate

Let me use plain English to describe the UER, the production rate and the decline rate.

UER is the daily production adding up. In math it is calculated by integration of the production rate over the time of a well's lifespan.

The daily production rate is a fraction of IP. The fraction goes from 1.0 initially to near 0 at the end, declining by a certain percentage each day. The percentage decline each day is called decline rate. Given decline rate, you can figure out production rate and the UER.

The decline rate itself varies over time, going from a high initial value towards a low terminal value smoothly. How it moves from the initial decline rate towards the terminal value is the difference between different decline models. I propose that decline rate goes from initial value Ri to terminal value Rf as following:

(click to enlarge)

The formula gives Ri at zero time, and Rf at infinite time. It suggests that the decline rate approaches the final value in a decay fashion: First it drops fast, then it slows down towards a terminal value.

This is a reasonably generic one size fits all model. By picking different values of Ri, Rf and beta it can describe the decline all shale wells.

I ran the computer model against Barnett Shale production data to find the right set of parameters that project the productions that match the real data with minimum discrepancy (Sigma). The best matching values of three parameters are given under the formula shown above.

The Model Matches Existing Production Data

With the best fitting parameters found, I plotted out the Barnett Shale decline chart as below:

(click to enlarge)

The UER for Barnett Shale is thus calculated to be 2.415 BCF in 20 years based on actual production data. The vindication is my projected annual production matches the actual numbers nicely as shown below:

(click to enlarge)

Note that for year 2007 and 2008, the production match was less ideal. I notice that the actual productions for those two years look inconsistent with well count so that two numbers could be reported wrong off. My projection seems to be more consistent with the well count. The data used is summarized in the table below:

The Big Answer - What is the UER?

I discovered the Barnett Shale UER to be roughly 2.415 BCF per well. This amount of gas at $2.00/mmBtu price is worth only $4.83M! Sorry to disappoint folks in the shale gas industry!

Could the UER be much higher? Not likely:

  • The model is generic and can match any real data precisely by tweaking the parameters. The chart shows a perfect match.
  • Even if my fit parameters could be wrong. I tried some radically different parameters. They may give poor matches but yet they all predict a low UER, around or below 2 BCF. See below.
  • The Barnett Shale has 20+ years history and 15870 shale wells now. The cumulative production is 10,800 BCF, averaging to only 0.68 BCF per well. It is reasonable to say that the well yield is not getting any better. About 1 to 2 BCF per well is the volume of gas we can expect to get.

I tried radically different parameters for the calculation. Some of them give poor matches of real data. But they all end up with an UER around 2 BCF or below, never much higher.

My model matches Arthur Berman's empirical decline chart created from actual shale well data. When I showed him the chart, he said he was not surprised it would match:

(click to enlarge)

Please refer to my instablog post where I can make updates to elaborate more. Let me talk about what it means for investors here.

Dark Future Looms for Shale Gas Players

The lifetime cost of producing a shale gas well, based on my estimate is roughly $15M (the cost is more than drilling a well). I think producers needs to bring in $20M to cover the cost, pay salaries and provide a moderate profit. The UER I calculated, 2.415 BCF, assuming 20 years of production. If the well lifespan is shorter, the UER could be less.

For $15M investment, 2.415 BCF is not a lot of natural gas to get. Roughly $8/mmBtu gas is needed to bring in $20M for a reasonable profitability. Can such natural gas price be achievable? Is it sustainable for end users? Will some users back away from such high gas price?

Disappointed by Barnett Shale, the industry turned their attention to other shale plays like Haynesville and most recently Utica in eastern Ohio. McClendon pitched Utica to Jim Cramer on Mad Money last year.

What happened since then? The best Utica well, Buell 8H, dropped from 3010 BOE a day on Sep. 28 of 2011 to only 1040 BOE by the end of Q1 2012, a drop of 65% in just six months! (1 BOE = 5800 cubic feet of gas) CHK still believes the well can produce 13 BCF. Will the decline rate slow down as CHK hoped for? Berman pointed out that with short well history, it is hard to forecast the long term decline pattern. So far Berman thinks that Haynesville or Utica is not much better than Barnett in long term.

I see a dark future looming for the shale gas industry. They may need unsustainably high natural gas prices to be profitable.

Natural gas is recovering to go much higher. But until the natural gas industry is ready to face the reality and admit they were wrong in their rosy projections, I see no good reason to buy natural gas stocks. You are better off buying deeply discounted coal-mining stocks. Political fear mongering does not trump over the free market. Old king coal remains the cheapest energy source for many more decades, both in USA and overseas.

Invest In US Coal Instead of Natural Gas

So shale gas plays have low UERs and high cost per mmBtu, what do you do as an investor?

Natural gas and coal price will go up. Abundant and cheap natural gas is an illusion.

The shale gas industry has been telling a beautiful fairy tale. They have yet to acknowledge that they were wrong on Barnett so far. There must be a day of reckoning for the industry to face the reality. Until that day comes and the industry takes its consequences and suffers the casualties, stay away from this sector!

While the shale gas boom bursts, coal is still America's cheapest and most reliable energy source. Free market forces must trump over the political rhetoric. The US coal sector is unfairly punished and trading at deep discounts. This is a big investment opportunity.

Looking at prices of shares like James River Coal Company or Patriot Coal Corp. (PCX), you would think that coal price must be so low they are giving out the black gold for free. The truth is Appalachian coal is trading at $58 per ton, higher than a few years back. Current Coal price is still marginally profitable for at least some coal companies. Peabody Energy Corp (BTU) recently reported a profit.

I wonder why no such deep discount of shares occurs in the natural gas sector, in names like Chesapeake Energy and EnCana (ECA)? EnCana produces 3.3 BCF of natural gas per day and booked $1.8B revenue for the quarter, but they have a tiny $12M of profit? How did they amortize the costs?

Thus, you should be skeptical to ETFs like United Stated Natural Gas (UNG), ProShares Ultra DJ-UBS Natural Gas (BOIL), ProShares UltraShort DJ-UBS Natural Gas (KOLD).

You should be skeptical to these US oil and natural gas players:

Chesapeake Energy Corp. {CHK}, Constellation Energy (CEP), Cabot Oil & Gas Corp. (COG), ConocoPhillips (COP), Anadarko Petroleum Corp. (APC), EOG Resources Inc (EOG), Devon Energy Corp. (DVN), Baker Hughes Inc. (BHI), Southwestern Energy Co. (SWN), Sand Ridge Energy (SD), Pioneer Natural Resources (PXD), Magnum Hunter Resources (MHR), Kinder Morgan Energy Partners (KMP), Enerplus Resource Fund (ERF), Carrizo Oil & Gas (CRZO), Callon Petroleum (CPE), Enterprise Products Partners LP (EPD), Goodrich Petroleum (GDP), GMX Resources (GMXR), IDT Corp (IDT), Lucas Energy (LEI), Rex Energy (REXX), Approach Resources (AREX), Natural Gas Services Group (NGS), Breitburn Energy Partners (BBEP), National Fuel Gas (NFG), Range Energy Resources (RRC), Petroquest Energy (PQ), Unit Corp. (UNT), Transocean Ltd. (RIG), BP plc. (BP) and Exxon Mobil (XOM).

I recommend that you load up on US coal mining companies:

James River Coal Co. {JRCC}, Patriot Coal Corp. {PCX}, Arch Coal Inc. (ACI), Alpha Natural Resources Inc. (ANR), Alliance Resource Partners LP (ARLP), Cloud Peak Energy Inc. (CLD), Cliffs Natural Resources Inc. (CLF), Consol Energy Corp. (CNX), Natural Resource Partners (NRP), Penn Virginia Resource Partners LP (PVR) and last but not least, Walter Energy Inc. (WLT).

I own JRCC and PCX and others, I will not dwell onto the good and the bad of specific stocks. I am bullish on the US coal sector. All coal stocks are good buys. I will let the readers pick their own favorites.

Source: Controversy On Shale Gas Boom And Burst Explained