Natural Gas (UNG): From "Ponzi Scheme" to Huge Writedowns
A little over a year ago The New York Times published a very controversial article detailing what might be a potential Ponzi scheme or at the very least an industry-wide fleecing of investors in the natural gas industry.
In this article, NYT printed a variety of emails from corporate insiders casting doubt on the wells in shale formations in Barnett, Marcellus, and Fayettesville. These same insiders questioned the economic viability of these wells and whether or not the total potential output was even close to what management was telling investors.
Around the same time, Arthur Berman issued an eye opening report on the overly optimistic estimates that the natural gas industry is using for shale gas reserves. According to Berman:
Type curves that are commonly used to support strong hyperbolic flattening are misleading because they incorporate survivorship bias and rate increases from re-stimulations that require additional capital investment. Comparison of individual and group decline-curve analysis indicates that group or type-curve methods substantially over-estimate recoverable reserves.
Berman goes on to state,
Our analysis of shale gas well decline trends indicates that the estimated ultimate recovery (EUR) per well is approximately one-half of the values commonly presented by operators. The average EUR per well for the most active operators is 1.3 Bcf in the Barnett, 1.1 Bcf in the Fayetteville, and 3.0 Bcf in the Haynesville shale gas plays.
The primary difference between our analysis and the typical well profile proposed by operators is that we observe predominantly exponential (weak to moderate hyperbolic) decline in most of the individual well decline trends, rather than steadily flattening hyperbolic decline. For the Barnett and Fayetteville shale plays, we identify a two-stage exponential decline based on decline curve analysis (DCA) of individual wells; for the Haynesville Shale we observe predominantly exponential decline for individual wells.
What does this mean? Well, in a nutshell, the natural gas companies' estimates are using the assumption that after an initial decline, the remaining estimated reserves will be reduced in a "hyperbolic profile with resulting hyperbolic curvature, or "b", exponents of more than 1.0 (Exhibit 2). This invariably results in a much higher EUR and longer well life because the decline rate progressively flattens beyond production history to very low terminal decline rates of a few percent." Berman asserts that based on actual data over the past 10 years from existing wells, the decline in production is actually exponential and therefore liable to run out much faster than estimated. Additionally, he shows that the actual reserve amounts are far lower than estimates and the costs of extracting the shale gas is far greater than gas companies are stating in their prepared remarks to investors.
In many ways, this is no different than the mortgage backed securities banks were peddling to investors in the first half of the 2000's. The estimated life of the mortgage products was projected to be 30 years because the average house was expected to rise 2 to 3 percent per year ad infinitum (offsetting any potential credit risk from subprime borrowers). In the same way, natural gas companies are assuming that the reserves will last 100 years because the decline rates are linear rather than exponential.
Berman concludes "Our work on the three most mature shale plays has profound implications. Facts indicate that most wells are not commercial at current gas prices and require prices at least in the range of $8.00 to $9.00/mcf to break even on full-cycle prices, and $5.00 to $6.00/mcf on point-forward prices. Our price forecasts ($4.00-4.55/mcf average through 2012) are below $8.00/mcf for the next 18 months. It is, therefore, possible that some producers will be unable to maintain present drilling levels from cash flow, joint ventures, asset sales and stock offerings.
Decline rates indicate that a decrease in drilling by any of the major producers in the shale gas plays would reveal the insecurity of supply. This is especially true in the case of the Haynesville Shale play where initial rates are about three times higher than in the Barnett or Fayetteville. Already, rig rates are dropping in the Haynesville as operators shift emphasis to more liquid-prone objectives that have even lower gas rates. This might create doubt about the paradigm of cheap and abundant shale gas supply and have a cascading effect on confidence and capital availability."
After Berman issued this report, he was naturally attacked as lacking credibility by Chesapeake (CHK) and other publicly traded natural gas companies. Back in March 2012 The Rolling Stone also issued a scathing article on what appears to be a massive scam surrounding shale gas, which quoted Mr. Berman and also saw some backlash from the natural gas companies. You can read all of the back and forth here:
One Year Later:
So now that we're a year removed from the above referenced New York Times article and the Berman report, what has changed? Well, Berman was estimating that with $4 to $4.50 natural gas, the shale gas plays would see huge economic losses in 2012. However, the price of natural gas has averaged around $2.50 for much of 2012, making these even less economical than Berman estimated.
We have seen several publicly traded companies write down the value of their shale gas assets tremendously. Here are links to several companies that have written-down assets: BHP (BHP); BG Group (OTCQX:BRGYY); Apache (APA); Pengrowth (PGH); Encana (ECA); Ultra Petroleum (UPL).
It remains to be seen if the entire shale gas industry is a Ponzi scheme. More likely is the possibility that it is overhyped by Wall Street and Natural Gas firms, who bought up large plots of land and issued optimistic projections to suck other companies and investors into buying that same land from them at higher prices.
It is looking highly likely that once again the public will get the short end of the stick in a few years as the supply of gas from these shale formations runs out much faster than estimates, leaving the public with a large glut of natural gas fueled cars and trucks and natural gas fueling stations, all of which were built on the promise of 100+ years of supply at cheap prices and the dream of energy independence. As this surplus demand infrastructure is built out and as supplies run out quicker than expected, prices will naturally rise dramatically.
The production levels drop dramatically after the first 20 months on the majority of shale wells and a huge amount of wells have been drilled over the past 5 years so the ability to find high producing wells will diminish quickly and the ones that have already been drilled will be producing far lower supplies. The natural gas market should begin to feel this constraint over the next three to 12 months. Consumers will be stuck with natural gas cars that cost more to fuel than cars that take unleaded gas and they will be left with home heating bills that will be skyrocketing. Add to this the potential reduction in supplies from exporting liquid natural gas to foreign markets by 2015 and we could see a massive bull market in natural gas.
We can thank CHK and others now for what will be yet another popped bubble. In 5 years Congress will shamefully trot out the executives of these companies, putting on a show for the public as they publicly condemn them for what turned out to be a giant investment scam. However, none of them will be willing to admit they were warned when ahead of time by the likes of Arthur Berman, The New York Times, The Rolling Stone, and other sources. It will all play out just like every other scandal we have seen over the past 13 years, from the dot com bubble to the housing boom to the Madoff Ponzi Scheme, etc.
Given all of the bubbles we have been through over the past 13 years, we all know to be cautious when we hear the words "This time is different." Well, the natural gas industry would like the public to believe that this time is different, that we can gain energy independence on the back of an unlimited supply of natural gas that can be drilled at dirt cheap prices.
Does the average person believe those words yet again?