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# Mark Anthony's  Instablog

Mark Anthony
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Mark Anthony, is an IT professional and who had a scientific research background before joining the information revolution. Visit his blog: Stockology (http://stockology.blogspot.com/)
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• ##### Implication Of Shale Gas Boom And Bust Examined

There is an ongoing controversy on shale gas boom and bust. The controversy is whether the shale gas is economical to produce. Critics say EURs (Estimated Ultimate Recovery) of shale wells were exaggerated using flawed models; and that the industry painted a rosy picture while the productions come out short of expectations.

Whether a shale gas well is economical or not relies on these things:

1. The life cycle total costs of exploration and production.
2. The EUR, estimated ultimate recovery from each well.
3. How fast is the gas produced and turned into revenue?
4. The market prices of natural gas produced.

I will discuss how the industry projects shale well declines; why the EURs are often over-estimated; and why the industry faces gloomy reality of non-profitability of shale gas wells. I will try to explain technical concepts using lay man's English to investors. If you are confused, just look at the pictures and then go to the conclusions.

To B or not to B - That is the Question

I once wondered what the b parameter was. Arthur Berman mentioned it when he criticized the hyperbolic models that shale gas experts use to calculate EURs. Berman claimed that such models over-estimated EURs.

All natural gas (NG in brief) wells, conventional or shale gas, see highest daily production rates on day one. Production rates decline continuously throughout well life cycles. Shale gas wells could lose 80% of production rate in the first year. Thus modeling the declines correctly is the key to predict EURs. Since few shale wells have gone through whole life cycles, there is wigging room for experts to come up with different decline models.

I developed my own shale gas decline model. The NG industry uses a formula first developed by Arps, called type curve formula. It is an empirical formula. Empirical means there is no physics support, but by experience the formula seems to match actual data nicely. My model and the Arps type curve model are compared below:

(click to enlarge)

(click to enlarge)

As it comes, 0<b<1 is the reasonable range for the parameter. But the industry prefers to use b>1. This gives higher EUR values. But it also leads to infinity, which is not allowed in nature.

Not willing to point fingers, I believe there is a perfect explanation why they tend to come up with b>1. Read my detailed discussion. The Arps model has too few freely adjustable parameters to fit the data, so b is biased and could be off the accepted range.

But still, when b>1, the Arps type curve diverges to infinity. Thus it fails to model the long term decline of gas wells correctly.

I think my own model, with one more parameter than Arps', can better describe the shale gas declines. To verify, I used Berman's chart on Haynesville shale. I super-imposed my own model and CHK's type curve onto the chart, to see how good they match:

(click to enlarge)

My model seems to match the data better than the CHK model did. There is no long term Marcellus well data yet. But in long term, the CHK model is problematic as it has virtually no terminal decline:

(click to enlarge)

Arthur Berman pointed out that during early well productions; models with vastly different b values all look similar. The differences only show up in the long term, leading to vastly different EUR values.

Since there is insufficient long term data to tell which model works better, Let me run both models to analyze Marcellus shale wells.

Profitability Case Study on Marcellus Shale Wells

I obtained a type curve chart for Marcellus shale wells from an EIA document. I used the parameters to construct the same Arps type curve for calculation and comparison with my model:

(click to enlarge)

The D and b parameters were not given. But given the cumulative production at one, five and ten years, I easily found out the D and b used, and verified that I had the correct values:

• D = 1/3 per month; b = 1.461 (b>1!); IP = 4.11 MCF/day. I obtained the same 1 year, 5 year and 10 year productions.

It came out that the claimed EUR of 3.75 BCF was the cumulative production after exactly 500 months. The daily production would drop to 0.095 MCF/day, or worth \$228 at \$2.40/mmBtu gas price, enough to pay one day's minimum wage.

Did Chesapeake Energy (CHK) honestly believe that shale gas wells could last that long and at such a low yield? In fact, as the function is divergent (b = 1.461 > 1), they could theoretically keep the wells running forever and brag about any high EUR number they like.

Let me show what the Arps type curves look like, and how they compare with my model:

(click to enlarge)

The lines that go down represent production rates drop over time. The two lines that go up are cumulative productions. Tow red lines were from my model. The rest were from CHK Marcellus type curves and from sample Arps curves with different b values.

As it shows, my model and the CHK model is similar at the beginning. It is hard to tell who is right from well production data in the first 10 or 12 years. The big difference starts to show up after 145 months, or 12 years. At the tail end, my model shows a reasonable terminal decline, while CHK's model shows almost no terminal decline. It keep going and going like the battery bunny.

Limited natural resources should have a terminal decline phase. As the remaining resource is depleted, the volume that comes out is roughly proportional to what remains. In math, when the change rate of a quantity is proportional to the quantity that remains, it is known to be an exponential decline.

(click to enlarge)

The above chart is the same as the previous one, except that I reduced the time scale for a closer look.

I replicated the Marcellus type curve and confirmed that my model works. I can use the data to calculate the profitability of Marcellus shale wells based on different gas prices and costs.

Gloomy Profitability Reality of the Marcellus Shale Wells

The industry produces shale gas to make money, not to provide a charity. Currently natural gas prices are deeply non-profitable. Most believe that the NG prices will recover. The question is, once the gas prices return to normal levels, say \$4 or \$5 per mmBtu, will the shale gas industry be able to make a profit?

Some NG executives claimed they were profitable even at \$2/mmBtu gas prices. They probably did not count costs like land leasing, G&A expenses, and interests on loans. They probably expected to produce the wells for 40 or 50 years. (CHK used 500 months life span to obtain 3.75 BCF EUR for Marcellus wells). They might not have calculated inflation and depreciation of currency. I want to use data to find out.

Spending \$15M to drill a well and break even in 30 or 50 years is not profitability. Profitability means there is a reasonable hope that when all dollars and cents are counted, you recover all the costs within a reasonably time period, and then begin to make a reasonable profit.

Let's start with lifetime total costs of Marcellus wells. CHK gave \$3.6M drilling cost, \$1.12/mmBtu finding cost for an EUR of 3.75 BCF. That makes \$7.8M. The actual figures are higher when you count in all the excluded costs. The figures were provided several years ago. Consider how much gold and other commodities have gone up, it is safe to say the costs are proportionally higher today.

I think a lifetime per well cost of \$15M is reasonable for calculation. There are also interest costs. Let's say the interest rate is 5%.

Maintaining production and delivering the gas also has costs. I will assume \$30K per month for that. My profitability model starts with \$15M in debt. As gas revenue comes in, the debt is gradually paid off. Where the lines cross the X axis are the break even points.

Here are the results. I added a line representing \$18M cash that bears 5% interest for a comparison:

(click to enlarge)

The result is pretty distressful. Remember I used CHK's own model:

• To reach break even in 10 years, CHK's model requires \$9.84/mmBtu gas price. My model requires \$9.94/mmBtu.
• After breaking even at 10 years, the CHK model continued to match upwards as if there was no terminal decline.
• My model has a terminal decline. It made a small \$2M net profit 20 years after \$15M was invested. It went downhill afterwards, dashing any hope of profitability. At 35 years it reached another break even point, on the way down.
• The guy who deposited \$15M to earn 5% interest saw his money doubled in 14 years. CHK, even using its rosy model projection, did not see \$15M in profit until 40 years. That was a meager 1.7% annual return for 40 years.

The above assumed gas price could reach nearly \$10/mmBtu. Ten years just to break even is unacceptable. Let's see higher NG prices:

(click to enlarge)

At \$12/mmBtu, things looked better. Both CHK and my projection reached the break even point in 5th year, and continued to make profits. But in no time did either model do better than the \$15M cash earning 5%. Some one sits at home was earning more interest than the companies who work in the wild to produce gas could profit.

At \$13.05/mmBtu, CHK finally caught up with the performance of cash deposits in 12 years, but only momentarily. Even at \$14/mmBtu gas prices, my model still lost the competition to the cash deposit at 19 years, time period that Jean Valjean served for stealing bread. Oh les Misérables!

The Reality Could Be Worse As Real EURs Are Much Lower

The projections were bad enough. But the reality could be worse!

The discussions above were based on a model that the industry provided. The model has exaggerated the EUR and under-estimated the steep decline of gas wells. Even my model tried to match the industry model, instead of the actual production data. The real data could portrait a gloomier picture.

Using Arps formula with a b>1 is bad enough. What made things worse is that the industry experts simply tried to fit the first 120 or 180 days of well production data with a set of parameters. Then they calculate the EUR based on the parameter set.

But during early stage of a well's production, ANY parameter set could fit the data! So there is room to push for a very high b value and make it look fits. The higher the b value, the higher is EUR.

Here is one example originally from Ultra, another gas producer in the Marcellus play. See the type curve chart where I superimposed my own data fits:

(click to enlarge)

Based on the fit by Ultra engineers, the b is as high as b=1.522 and they obtained EUR=3.75BCF. The dotted blue line was my fit to show that I replicated their red fit curve. However I have another fit, as the magenta line. My fit seems to match the well production data better, especially look at the mid-section. But my fit would suggest a EUR of only 1.8 BCF by 500 months.

Making matters worse is NG producers have racked up mountains of debts developing shale gas wells. The shale gas over-drilling, over production, the decade low NG prices and the subsequent capital destruction is destroying the US NG industry.

America still needs natural gas. The NG industry as a sector will not go away. But there are serious questions on whether shale gas is really a viable energy source, or is hydraulic fracturing technology really effective in the long term. People have too many questions, but the industry refuses to tell the full truth. Even today, there is still no disclosure on what is contained in the hydraulic fluid used.

Do you feel comfortable investing in a sector where you do not know the full truth? I don't.

The Implication for Investors

In recently times we heard a lot of talks of abundant, cheap and clean natural gas to replacing dirty and filthy coal. Coal is dirty. But we do not have a choice. Coal is still the cheapest and most abundant fossil fuel we can count on. Old king coal is not going away any time soon. I am convinced the deeply discounted coal sector is the best investment opportunity in 2012.

I am bullish in natural gas prices. The NG industry needs to keep drilling to maintain overall production, but they are losing capital selling gas at a deep loss. This is unsustainable:

(click to enlarge)

But I do not recommend United States Natural Gas (UNG) or any ETF based paper future contracts.

I continue to caution people to pay attention to the unfolding drama of capital destruction in the natural gas sector. A lot of shale gas players need to go belly up. There will be a time when all the nasty stuffs are put out for all to see. At that time there might be some survivors worth picking up. But avoid these names now:

• Chesapeake Energy Corp. [CHK]
• Constellation Energy (CEP)
• Cabot Oil & Gas Corp. (COG)
• ConocoPhillips (COP)
• 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)

I maintain that the US coal sector is a much better investment opportunity, due to strong international demands, recovering demands and aggressive production curtailments by coal producers, and finally but not the least, the ongoing capital destruction in the shale gas industry is leading to drilling activity falling off a cliff. A natural gas shortage could be loom in a few months. That outcome is extremely bullish for both NG and coal. But since coal prices are only moderately below profitable margin, coal producers stand to benefit the most, when a natural gas price rally shifts demands back to coal in a few months.

I continue to recommend these great values in coal:

• James River Coal Company (JRCC)
• Patriot Coal (PCX)
• Arch Coal Inc. (ACI)
• Cloud Peak Energy (CLD)
• Alpha Natural Resources (ANR)
• Consol Energy (CNX)
• Black Hills Corp. (BKH)
• Walter Energy (WLT)
• Westmoreland Coal (WLB)
• Peabody Energy (BTU)
• Nacco Industries (NC)
• Alliance Resource Partners LP (ARLP)
• Market Vectors Coal ETF (KOL)

I am getting cash to buy more coal stocks.

Disclosure: I am long JRCC, PCX, ACI, ANR, BTU.

• ##### Shale Gas Type Curves And Profitability Explained

There is an important controversy on shale gas boom and burst. The controversy focuses on whether the shale gas is economical to produce or not. Critics say the shale industry exaggerated the EUR (estimated ultimate recovery) of shale wells and painted a rosy picture while the productions come out far short of expectations.

Whether a shale gas well is economical or not relies on these things:

1. The life cycle total cost of exploration and production.
2. The EUR, estimated ultimate recovery from each well.
3. How fast can the gas be recovered and revenue realized.
4. What is the market price of natural gas produced.

I will discuss how the industry models shale well declines. Why they often over-estimate the EUR, and why the industry faces gloomy reality when it comes to the profitability of shale gas wells.

To B Or Not to B - That is The Question

If you have read Arthur Berman, the outspoken critic of the shale gas industry, you might have wondered what was the b parameter. Berman often referred to the b parameter when he criticized the hyperbolic decline models that shale gas experts use to calculate EUR. Berman believes that such models lead to EUR over-estimates.

All natural gas wells, whether conventional or shale gas, have their highest daily production rate on day one. They continue to decline throughout their life cycles. The declines of shale gas wells are very steep. Thus correctly modeling the decline is the key to correctly project the EURs. Since few shale wells have gone through a whole life cycle, it leaves plenty of wigging rooms for experts to come up with all sorts of decline models and push for more optimistic results.

I have developed my own shale gas decline model. The gas industry uses a formula first developed by Arps. They call it type curve. It is an empirical formula. Empirical means it is not supported by physics, but merely by the experience that it seems to give good results.

My decline model and the Arps type curve model is compared below:

(click to enlarge)

As you can see, 0<b<1 is the reasonable range for the parameter. But the industry prefers to use b>1. This often leads to much higher EUR estimates. But it is problematic as it leads to infinity. Nature does not allow infinity.

Do experts deliberately use a parameter that looks ridiculous from basic physics, in order to intentionally over-estimate EUR? I think I have a more reasonable explanation without pointing fingers. The Arps formula is inadequate that it has only three freely adjustable parameters. When you remove the IP (initial production rate), which is a trivial parameter confined by the total production, you are left with two parameters, initial decline rate D and parameter b. The D can be removed by scaling the time. Thus b is the only adjustable parameter. When b=0, it is just exponential decay. When when a wells decline does not follow simple exponentially decay, which is mostly the case, you have to push b away from 0 for a better data fitting. This often leads to b being pushed too high and b>1.

But the shale gas industry experts should know better! They should know that the Arps formula has its limit and can no describe the long term trend beyond the first few years, as it has only three freely adjustable parameters. They should have learned from school that the b>1 should not be allowed in the Arps formula as it leads to divergence and infinity.

I think my own model, with one more parameter than Arps', can better describe the shale gas declines. To verify, I used Berman's chart on Haynesville shale. I super-imposed my own model and CHK's type curve onto the chart, to see how good they match:

(click to enlarge)

My model seems to match the data better than the CHK model did. There is no long term Marcellus well data yet. But in long term, the CHK model is problematic as it has virtually no terminal decline:

(click to enlarge)

Arthur Berman pointed out that during early well productions; models with vastly different b values all look similar. The differences only show up in the long term, leading to vastly different EUR values.

Since there is insufficient long term data to tell which model works better, let me run both models to analyze some data.

Profitability Case Study on Marcellus Shale Wells

I have studied an EIA document and obtained a type curve chart for Marcellus shale wells. I could use the parameters to construct the same Arps type curve for calculation comparison with my model:

(click to enlarge)

The D and b parameters were not given. But given one year, five year and ten year cumulative production and a 3.75 BCF EUR, I could easily found out the D and b used, and verify that I had the correct values:

• D = 1/3 per month; b = 1.461 (b>1!); IP = 4.11 MCF/day. I obtained the same 1 year, 5 year and 10 year productions.

It comes out that the claimed EUR of 3.75 BCF is the cumulative production after exactly 500 month, or 40 years and 20 months. The daily production will drop to 0.095 MCF a day. It could fetch \$228 at \$2.40/mmBtu gas price, enough to pay one day's minimum wage.

Does Chesapeake Energy (CHK) honestly believe a shale gas well can be produced for that long. at such a low yield? As a matter of fact, since the function is divergent for b = 1.461 > 1, they could let the well run a thousand year and brag about any arbitrarily high EUR number they like. In 1000 years the EUR would be 11.56 BCF:-)

My calculation results:

(click to enlarge)

As can be seen, my model can match the early stage of decline behavior nicely. But my model can also reflect the terminal decline correctly, but CHK's Marcellus type curve can not. The Marcellus type curve is no longer useful after the first 10 years, as it does not reflect the terminal decline phase correctly.

(click to enlarge)

The above is the same chart like last one, but with a different time scale to have a closer look at short term pattern of the curves.

Once the production decline is known, I can proceed to calculate the profitability of Marcellus shale wells. I assume the following for calculations:

1. Based on numbers contains in CHK's Marcellus type curve chart, they have a drilling cost of \$3.6M, finding cost of \$1.12/mmBtu * 3.75 BCF. Total \$7.8M per well. They excluded many costs. The numbers are several years old so when you add real inflation the numbers are much higher. I assume \$15M per well cost for the calculation.
2. I assume the per month production maintenance cost is \$30K.
3. I start with a debt of \$15M for completing the well. The debt carries a 5% annual interest cost.
4. I assume the principal of the debt is paid off as fast as possible. I tally the number for each month. When there is a debt I subtract interest cost. When there is cash, I add 5% interest income from teh cash.

Here are the results.

(click to enlarge)

I will explain later.

(click to enlarge)

Further reading: Hamilton. Read Arthur Berman on Marcellus. Stay tuned on my main SA article which has been submitted. Cheers!

Disclosure: I am long JRCC, PCX, ACI, ANR, BTU.

• ##### Rebalancing On Natural Gas Continues

US coal is bullish. The coal and natural gas (UNG) sectors are unique that they are quick to rebalance supply and demand under adverse market conditions. You can see the ongoing rebalancing when you analyze the data from EIA.

I will discuss natural gas (NG in brief) data here. The other article, "Rebalancing on US Coal Continues", discusses coal.

Please refer to my instablog post for detailed analysis of the data from EIA and FERC, and on basics of understanding natural gas, coal and electricity. I present just the results and conclusions here.

NG is important to coal investors. Cheap NG competes with coal in the electricity sector. But we need to quantify how much of coal demands were taken away by natural gas. Are coal demands returning now that NG prices have rallied from recently low? Let's find out in the data.

How The Winter Affected NG Demands

The following chart shows NG supply and demand in 2010, 2011 and 2012. The chart is plotted from October to October so that we can see the whole winter better. In the chart:

• S2012 stands for 2012 supply, defined as dry gas production plus net imports; D2012 stands for total demands.
• P2012 stands for demand in electricity power.
• R2012 stands for residential and commercial [RC] demand.
• Industry demand was not included, as it did have much seasonal variation.

Top of the chart are supplies and total demands. The power and RC demands are at the bottom portion.

(click to enlarge)

The NG supply line S2012 is flat and going down gradually. By now, the supply is only 2.69% above year ago level.

The total demand line D2012 fell below D2011 in December, and remained weak in February. It over-took D2011 by April, and kept above D2011 in May. The weaker RC demand (R2012) was the biggest factor in weaker NG demands. But it returned to normal in April.

Demand in the power sector gained. It was not enough to reverse the loss in RC demand. The power demand gain did not seem to be sustained. As shown below, the gap of power demand gain narrowed April and May, while the RC demand recovered:

(click to enlarge)

Natural Gas Supply Is Dropping Slowly

Investors are upset because they saw massive drop in number of rigs drilling for NG, yet there is no evident production drop so far. The weekly NG storage injection is only roughly 30 BCF per week lower than the same week last year.

Actually NG production is dropping slowing. You have to look at the data closer to notice it. The weekly data show small week-by week percentage changes that accumulate. See the chart below:

(click to enlarge)

Today the NG supply is down 3% from the level at beginning of 2012. At beginning of the year, supply was 499 BCF/week. Now it is down to 484. The drop was 8% annualized. Productions of natural gas wells start to decline from day one. The industry must keep drilling new wells to maintain a flat total production. When the drilling slows, total production eventually begins to drop.

Due to the gradual NG supply drop, and the fact that current weekly storage injection is about 30 BCF lower than normal, I project that the peak NG storage will reach a normal 3800 BCF level by the fall.

(click to enlarge)

So far as shown in the chart above, the NG storage injection looks on target to reach the normal storage peak by the fall.

A Closer Look At The Numbers

The NG supply and demand numbers, scaled to 30 days months for uniformity, are summarized below:

(click to enlarge)

The biggest winter impact on NG was the reduction in residential and commercial demand. That loss of demand has recovered in April and May. The loss of demand totaled 760 BCF. Increase of the power sector demand compensated a large portion of the demand loss.

The third factor was over-supply. But by May 2012, a large part of the over-supply was already gone. NG supply is still dropping slowly.

The May numbers of NG supply/demand situation did not look bad. Notice the power sector demand gained most in March, taking away some coal demands. The power demand gain diminished to only 82 BCF/month by May, or worth about 5.7M tons of coal.

Looking at these numbers, I believe that natural gas has returned to balanced supply and demand. We could run into a shortage by the fall, as production drop accelerates. Will NG producers rush to drill more wells if NG shortage does occur in the fall? They would not, as they had learned their lesson in over-producing. So in that case, utilities would have to switch some NG back to coal. Thus both natural gas and coal prices are very bullish.

I believe the coal sector is a better investment opportunity than the natural gas sector. Coal stocks are discounted way below where current coal prices would justify; NG stocks still have not reflected the discounts justified by the deeply non-profitable NG prices and by the shale gas controversy. Until we fully understand what's going on in the shale gas industry, stay away from these natural gas plays:

• Chesapeake Energy Corp. (CHK)
• EnCana Corp. (ECA)
• ConocoPhillips (COP)
• EOG Resources Inc (EOG)
• Devon Energy Corp. (DVN)
• Baker Hughes Inc. (BHI)
• SandRidge Energy Inc. (SD)
• Transocean Ltd. (RIG)
• BP plc. (BP)
• Exxon Mobil Corp. (XOM)

New China Stimulus Bullish for Coal

The Chinese authority started a new round of stimulus, although we still do not know how big this new economic stimulus is going to be.

On May 27 of 2012, a mayor of a Southern China city kissed a document he received from NDRC. It's for a new steel plant with 10M tons annual production. The new plant relies on foreign coal as it is far away from major coal bases in Northern China!

China's electricity generation reached 4.7 trillion KWH last year, exceeding the USA by a small margin. That's an average of 536GW of electric power, or only 390 watts per person, much lower than global average. China sold 150 million air conditioning units last year. Each unit consumes 5000 watts of power when turned on. If these units are turned on at the same time, they drain 750GW of power, more than China's electricity grid can handle.

China desperately needs more electricity to meet its demands. As China generates most (80%) of its electricity from coal, it needs to buy coal all over the world to meet its energy needs.

Based on my study of data and facts, I continue to recommend these great values in coal:

• James River Coal Company (JRCC)
• Patriot Coal (PCX)
• Arch Coal Inc. (ACI)
• Cloud Peak Energy (CLD)
• Alpha Natural Resources (ANR)
• Consol Energy (CNX)
• Black Hills Corp. (BKH)
• Walter Energy (WLT)
• Westmoreland Coal (WLB)
• Peabody Energy (BTU)
• Nacco Industries (NC)
• Alliance Resource Partners LP (ARLP)
• Market Vectors Coal ETF (KOL)

I am buying more coal stocks.

Disclosure: I am long JRCC, PCX, ACI, ANR, BTU.

Tags: ACI, ANR, APC, ARLP, BHI, BKH, BP, BTU, CHK, CLD, CNX, COP, DVN, ECA, EOG, JRCC, KOL, NC, PCXCQ, RIG, SD, UNG, WLB, WLT, XOM, commodities
Jun 04 9:51 AM | Link | Comment!

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