I have written several articles on shale gas. I believe that natural gas (as NG) producers over-estimate EUR (Estimated Ultimate Recovery) from shale wells using models that have not been shown to match the long term declines of shale wells. Moreover, most of new well drillings merely make up for the production drop of existing wells.
Let me use some data to illustrate the points. The Q2 2012 result released by Southwestern Energy Co. (NYSE:SWN) contained the data I need to analyze how gas wells in the Fayetteville Shale decline over time. I want to find out the realistic EUR and the real cost of production in that shale play.
Southwestern Energy Q2 2012 Results
- The company reported total gas/oil/liquid production of 137.4 BCFE for Q2, with 121.0 BCF from Fayetteville, up from 116 BCF in Q1.
- The company brought 131 new Fayetteville wells into production, with average IP (initial production) 3.50 mmCF/day. Average drilling cost was $2.8M/well.
- The company spent $635M in capital expenditure in Fayetteville.
- The production rate at Fayetteville was 1.877 BCF/day at the end of the quarter, up from 1.775 BCF/day a year ago.
These numbers alarmed me. At 3.50mmCF/day each, 131 wells would add 458.5mmCF/day production rate. The quarterly production would have increased by 41.7 BCF had there been no well declines. But the production was up by only 5.0 BCF. So the bulk of new production merely served to counter the declines.
Analyzing the Fayetteville Well Declines
SWN released a table listing wells drilled in each quarter and their IPs and decline rates:
They also provided a chart of the daily production rate for the play:
Based on the data, I was able to build a spread sheet to model the well declines to match the data. I then adjusted the terminal decline rates so that I could correctly match the actual production rates.
When I super-imposed my projection chart onto the SWN chart, the two matched perfectly as shown below:
My production decline model chart is shown below.
Each line represents the combined production rate of all wells drilled in or before the corresponding quarter. As shown, the production decline becomes progressively steeper. No wonder that after adding 131 new wells, SWN managed to increase the quarterly production by only 5 BCF, or the equivalent production of just 16 wells?!
Estimating the Decline Rate and the EUR
Having successfully modeled the actual production data, I used my spreadsheet to get some interesting numbers:
- At the end of Q2, SWN's Fayetteville play produced at a rate of 1.95 BCF/day. Total production of existing wells declined at -0.28%/day. That's a stunning 64% annualized decline rate.
In my "long tail of natural gas" article, I showed a chart indicating that the total NG production in the U.S. was declining so fast that annually 32% of the production needs to be replaced by new wells. But here in Fayetteville, up to 64% of production must be replaced each year!
With these numbers, I have a smart way to calculate the EUR per well without complicated modeling. SWN produces 1.95 BCF per day. It loses 0.28% of the production rate per day, or 5.46 mmCF/day. SWN can maintain constant production by drilling just enough new wells to compensate for the loss. Since each new well brings in 3.5 mmCF/day initial production rate, we need 5.46/3.5 = 1.56 new wells per day.
Since the production is maintained at a constant, each day we are exchanging 1.56 new wells for 1.95 BCF of production. So we figure:
- EUR = 1.95 BCF / 1.56 = 1.25 BCF/well.
Can Fayetteville Shale Ever Be Profitable?
Let's crunch more numbers. SWN has the best Fayetteville assets in the industry combined with the lowest costs in gas drilling. If they can not make a profit there, no one can.
Let me continue to assume SWN drill just enough wells to maintain flat production. It makes the calculation much easier. To maintain 1.95 BCF/day, SWN needs to drill 1.56 wells a day. For a 90 day quarter that's 140 wells needed. SWN drilled only 131 wells in Q2! That is not even enough to maintain flat production!
Their production did increase in Q2 from Q1 because they drilled 146 wells in Q1, which comes to full quarter production in Q2. But in the long term, they must drill 140 wells a quarter to maintain production.
SWN spent $635M on Fayetteville in Q2 and drilled 131 new wells. Not all money is spent on drilling, but it's all related to Fayette play. To keep drilling 140 wells per quarter, a rough estimate is SWN needs to spend proportionally more, at $678M per quarter.
The expected NG production is 1.95 BCF/day times 90 days = 175.5 BCF. Not all the NG production belongs to SWN. Part of it belongs to operating partners and royalty owners. SWN owns roughly 70% of the production, or 123 BCF. This is the NG production SWN obtains, after spending $678M. So the break even NG price is $678M/123BCF = $5.51/mmBtu.
But this is only part of the cost. We have not calculated the costs of exploration, finding and acquiring the assets, all the fees and taxes. When everything is counted, I think $8/mmBtu is the break even price.
Implications for Energy Investors
Many people criticized the NG industry for over-hyping of shale gas and over-estimating production and profitability potential. I showed easy methods to calculate the true decline of shale gas wells and the true EUR per well, based on actual SWN production data. You should be alarmed by these results.
I continue to believe that NG prices are going a lot higher, and that coal prices are going a lot higher. However the coal sector stands to benefit most. Current coal prices are very close to the profitability threshold. More importantly, the sector is at such a huge discount, that the cyclic movement of this sector can bring huge profits soon.
In contrast, the NG industry is in a looming disaster, as NG prices are far below what it takes for shale gas to be truly profitable. The shale gas hype will be proven to be one of the biggest mistakes in the history of energy investment. It is absurd that investors put 75 times more money in the NG sector, versus the coal sector.
Such an extremely lopsided misplacement of investment does not happen very often. It happens because most people only read headline news and they all thought natural gas is cheap and abundant, and that coal is dead. This presents a huge opportunity for people willing to spend time to learn the facts so as to know better than the public. Once again, my advice is to get out of the NG sector and into coal.
The discussions above are relevant to the following issues:
- NG players: EnCana Inc. (NYSE:ECA)
- Chesapeake Energy [CHK]
- Southwestern Energy [SWN]
- SandRidge Energy (NYSE:SD)
- Anadarko Petroleum Corp. (NYSE:APC)
- Apache Corp. (NYSE:APA)
- EOG Resources (NYSE:EOG)
- WPX Energy Inc.(NYSE:WPX)
- Coal players: Arch Coal Inc. (NYSE:ACI)
- James River Coal (JRCC)
- Alpha Natural Resources (ANR)
- Peabody Energy (BTU)
- ETFs: United States Natural Gas (NYSEARCA:UNG)
- Market Vector Coal ETF (NYSEARCA:KOL)
Disclosure: I am long JRCC, ANR, ACI, BTU. 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.