RJB 1077

Shale Gas Companies: All Talk, No Walk?

Great article, and well put.

Press releases are always written with the best foot forward, and are crafted to lead you to the conclusion we the writer wants you to believe.

I can add to the conversation by saying this:

Royalty rates in the US shale plays are increasing, a cost which doesn't show on the operating line in a balance sheet. It's generally a separate line, and many companies use a blended (i.e. total corporate) royalty rate to show lower op costs on their higher royalty plays.

For example. If you were the first to the table in the Barnett shale play in 2004/2005 you could negotiate a 1/8th royalty lease or a 12.5% royalty lease. Turns out that landowners can read, and can find each other in coffee shops or down the road... subsequently in the land rush to acquire acreage companies were forced to offer not only higher bonus payments (as high as $3000 to $5000 per acre, enough to add $1MM to the cost of a shale well) they also offered royalties as high as 35% of gross revenue.

At $4 gas, and $2/mcf operating cost (which is as low as can reasonably expected.) a 35% royalty only allows $0.60 per mcf to pay out capital and make a return. On a 2 BCF shale well that's only $1.2MM worth of return at a flat $4 gas price. We barely paid for the land in our example let alone paying out the well, the pipeline, the compressor station... (I'd say we just lost about $8MM actually.)

The shale plays will make money for some at $6... but not for all, and they will provide a reasonable level of new production at $7 to $8, but remember... we always drill the best wells in our inventory first, and the shale wells we drill in 2010 & 2011 are not going to be as productive as the wells in the sweet spots... the wells we drilled in 2006 thru 2008.

Keep thinking critically, and I'll leave you with an anecdote. Other commodities have had these sorts of supply gluts in the past. People talk about an unlimited supply, and that the price will never rise above X again. We've just spent 7 years running to stand still in terms of North American gas production, and with the downturn we've decimated company cashflows and with it the ability to re-invest to put on 2010's gas...

Where do you think gas prices are going?

Natural Gas: Long-Term Bull, Short-Term Bear (Part 2)

Great attempt, but you're all over the place and lack a unifying thesis. Reiterating multiple articles shows you are well read, but you have not done much to interpret them for your audience. I can't speak to your technical analysis, but I can certainly add to the discussion regarding the fundamentals on the supply side.

It is my opinion that the market is not nearly as over-supplied as you would like to believe. I have the luxury of a couple more data points on the storage numbers, but I am happy to argue against your opinion without the storage numbers... Storage is not the market... storage is just that; storage, it's where you put a product that isn't ready to be sold. Let's try not to pretend that it means more than it does.

Much like the oil tankers sitting awaiting their contracted delivery date, gas can be redirected to caverns when it would otherwise be delivered to market. It's a little more difficult to do but the producers who own storage facilities are able to preferentially direct gas into storage rather than sales. You've seen the contango... what would you do if given the choice? Obviously, you would jam more gas into storage earlier in the season rather than sell it a poor price.

No where in your article do you really touch on the one defining basic of the supply side natural gas markets, and that is decline. Our wells never produce as much gas as they did the day before. It's a fact, and directly related to the way in which reservoirs deplete. The average gas well drops to 65% to 68% of it's productivity rate year over year.

Shale wells aren't so lucky... they free fall, with the Haynesville shale being remarkably dramatic in it's declines... wells decline to less than 20% of initial rate within a matter of months... Perhaps you are not aware, but the Canadian gas giant Encana, is farming out their Haynesville assets. The play isn't good enough for their own money!

Much of the decline in these wells can be directly attributed to the rock itself... the shales are impermeable, a fact that can be overcome via stimulation, but nothing can change the fact that they are exceptionally poor reservoirs. Porosity's of 3% mean that the volume of gas to shale is pretty pathetic, and don't think that you're going to get all the gas from that 3%... if you are lucky 50% of that will be recoverable.

Operating cost estimates I have seen for these plays from the research houses are largely fiction. Long term items such as royalty rates, pipeline differentials, and fixed costs for compression are high. The Barnett shale, once the holy grail of the shales requires $8/GJ to generate a 15% return outside of the core of the play, it is my opinion that none of the other shales are markedly better. $4 isn't going to cut it... $6 begins to make the numbers go round, but only for the best situated producers not enough to move the market.

Company cashflows available for re-investment haven't dropped proportionately with the drop in gas price. While prices are half of the required prices to make these plays go, margins are off by 75% at the least, and for many companies have gone negative.

Who is going to pay the bill to put next years gas on? Bank's? Major's? Independents? All of them are taking cover from the dramatic drop in prices... (as senseless and thoughtless as it has been.) There is no desire for re-investment, oh and let's not forget that shale gas currently only accounts for a very small fraction of the market. Conventional gas is even more difficult & costly to replace.

I could go into a long discussion as to why LNG doesn't affect the low end of the market, but if you are interested you can read some of my other comments on that particular subject...

I won't give trading advice, as that is not my area of expertise. One thing I will say is would be very careful with shorting this market. Unlimited downside, and a finite potential for gain sounds pretty scary to me when you consider that supply and demand are well on their way to re-balancing. (Look at the rig count drops you mention!)

All the best, but don't forget to look on the other side of the trade!

Roger-

Natural Gas Is Heading to 1997 Levels, Should Stay There Awhile

Hi Buck,

Yes the essence of my comment is that gas is a constantly declining product. And continuous reinvestment via drilling is required simply to keep supply from dropping like a rock through the demand curve.

That process has already begun, and is irreversable without a rise in prices. As for your question, there isn't a level where LNG would ever set the low marginal cost, as there just isn't enough of it available. Even if industrial demand goes to zero, LNG is not available in quantities enough to offset the decline.

LNG has the ability to set the high margin, but the low price will be set by conventional, and then unconventional land based supply.

Price will rise in 2009.

Remember we can jam 4 TCF into storage, which is only 16% of a normal years usage... that leaves 84% of the supply/demand equation that the storage picture can't speak to.

It's all about supply destruction, and demand destruction... prices can'd drop any further or supply will artificially drop below demand as people turn gas wells off instead of selling at a loss at the wellhead.

I appreciate this discussion is about LNG, but I think you are looking for an answer that will be found elsewhere. LNG doesn't have as much impact as you write about in your article.

Cheers,
Roger


On Apr 28 07:31 AM Buck East wrote:

> RJB-thank you for the comment and great analysis. Your point (and
> others') about conventional supply shut-in is salient and appreciated.
> However, LNG import capacity is increasing in this country and also
> in Mexico, which is the backdoor to the U.S. Market. Am I right in
> saying that at the heart of your position is the idea that supply
> will drop off worse than demand? I suppose this is the core of the
> debate, and I agree that those who trade on "storage" may be bias
> toward demand and blind to projecting production numbers further
> in the future. Decline in demand, as manifested by less NG uses in
> electricity and manufacturing, may have only begun to show itself--would
> your analysis change if we had Dow at 5500 and 20% real unemployment?
> What amount of LNG imports, in your opinion, would keep prices sub
> $3? sub $4?

Natural Gas Is Heading to 1997 Levels, Should Stay There Awhile

Not quite.

Your numbers on LNG transport costs are reasonable, but there are a few reasons I think you are shorting an exhausted bear market. It's all about volumes at the margin...

A few basics...

North American demand is ~25 TCF a year. We've used over 1 Quadrillion cubic feet of natural gas since WW2, and recession or not gas use is entrenched in this econcomy.

Industrial demand is about 30% of that, and if it's off 50% that's only 2.5 TCF a year. Power, electricity and heating usage numbers don't correlate to price, and demand in those areas is not dropping.

If you forecast 1.1 TCF a year in LNG you are suggesting that 4% of a normal market can be supplied by LNG, at the port. You haven't assumed any cost to transport gas from LNG terminal to end user, but lets call that a given.

Conventional gas production still makes up the vast majority of North American Production, approximately 20 TCF year. This gas has a marginal cost of $8.50 per MCF, and a decline rate of ~30% annually. If the price isn't $8.50 reinvestment drops, and this wedge of gas declines to 14 TCF in a year and 10 TCF in two year. Already we have just lost more than 10 times the LNG market you predict... so much for 4% of the supply setting the price!

Shale gas was forecast to triple in productivity to 18 BCF a day or 7 TCF a year over the course of the next 3 years, though current drilling rates will not accomplish that. Declines in shale wells are HUGE, up to 60% in the first year. Shale gas facilities are engineering nightmares unless drilling is constant. Compression ratios go out of whack, and base load of the compressors becomes a serious issue. You've got to have gas to compress gas otherwise compressors don't work.

What is likely to occur is a series of fractionated markets... this is largely due to the inadequate pipeline infrastructure between markets. There is only so much gas that can travel from Texas to NYC, and other area of use. If gas can't make it out of an area, the area price drops.

Shale players and LNG in Texas are in for a big headache, but the market as a whole is destined to rise again, and soon. Gas costs money to move on land... compression is not cheap, and pipeline tariffs can be as high as $1.44 per mcf (believe me I own pipelines, as well as gas wells.)

Differentials will be greatest in markets that have LNG terminals & shale gas like Texas, while other regions will see higher prices. This exact situation exists in the Rockies region and has since the discovery of the giant Pinedale field. You may remember that gas traded down to $0.07 per mcf in Pinedale a few years ago, and that was during the boom.

Prices will not be sustained at the levels you predict as the costs of supply are nearly an order of magnitude higher than in 1997-1998 time periods. Royalties go up as people hear about the "Big finds" and service companies charge more and more for the same work as plays become more well known.

Select operators, in the right areas will be able to profitably produce gas at $6 in the big shale plays, but the market is headed back to $8 to offset the major declines coming in conventional production.

It may be a bumpy ride along the way, but the traders in NYC seem to only know the "storage" trade. That's only a part of the supply/demand picture and is really irrelevant when the entire cost structure is examined. Once injection numbers start to disappoint the guys on the floor watch out, the bear market's over.