Among North America's natural gas fields, the Marcellus is broadly recognized as one of the lowest-cost sources of supply. However, when it comes to estimating specific natural gas price levels - in Henry Hub terms - that would be required to support sustained drilling activity in the field, there appears to be a fair amount of divergence in opinion among investors and analysts. Estimates vary widely, from as low as $2.50/MMBtu to over $5/MMBtu.
In 2012, despite the deeply depressed natural gas price environment, the trajectory of production growth from the field showed no signs of slowdown and in 2013, the Marcellus will likely make another massive step up in terms of supply volumes.
The question regarding the field's drilling economics appears increasingly important as the Marcellus may prove to be not only a "baseload" source of natural gas but also a marginal source of supply and as such would play a role in setting the "equilibrium" price for natural gas nationwide. Indeed, the Marcellus is enormous, both in terms of its geographic extent and gas resource it holds, and has proven so far very capable of overcoming infrastructure constraints. The Marcellus is also a very non-homogeneous field, both in terms of well productivity and gas/liquids mix, resulting in great variability of returns from area to area.
What do operators themselves think about the Marcellus economics? In fact, many of them readily share their outlooks. In this note, I will briefly review estimates provided by several Marcellus operators for dry gas areas and will try to derive implications for natural gas prices. In a follow-up note, I will focus on wet gas economics.
MARCELLUS DRY GAS ECONOMICS
Anadarko Petroleum (NYSE:APC) owns interests in a total of 760,000 gross acres (260,000 net acres) in the dry gas portion of the play in Northeast and Central Pennsylvania and operates a significant portion of its acreage, primarily in Lycoming, Clinton and Center Counties. Despite being a very strong operator with a large position in a prolific part of the play, Anadarko struggled in the Marcellus during 2012 when Nymex averaged ~$2.75/MMBtu. The company has cut its rig count and concentrated drilling activity in select areas. In its latest presentation, Anadarko reported that it has achieved significant improvements in well economics due to inventory high-grading and operating efficiencies, with the average well now expected to deliver 8 Bcf EUR at $7 million cost. The metrics are impressive (and beat Haynesville's parameters), particularly given that wells in the Clinton-Lycoming area tend to be deeper and more expensive than in some other areas of the Marcellus.
The company's drilling economics chart indicates that even with all the operating improvements achieved, its Marcellus drilling program still needs ~$3.25/MMBtu Nymex to deliver a 20% pretax drilling rate of return (which in my view is required at the well level for a development project to be economically viable). Notably, this puts the Marcellus at the bottom of Anadarko's opportunity set in the U.S. The graph also implies that for the Marcellus to begin winning capital from Anadarko's other plays (assuming rate of return is the capital allocation criterion), Nymex price must exceed ~$4.25/MMBtu level.
With Anadarko's development cost in the Marcellus approaching the $1/Mcf level, the indicated returns may appear somewhat low. To rationalize it, one needs to take into account midstream costs in the Marcellus that often are high, driven by the capital cost of constructing new gathering and processing infrastructure. The long production "tails" and compression costs typically incurred early on in the well's life also impact the returns.
Range Resources' (NYSE:RRC) illustrative economics for the same Clinton-Lycoming area is based on the "development mode" cost of $6.2 million per well and 10 Bcf EUR for a 4,900 foot lateral with 17 stages. A 20% return requires a ~$3.00/MMBtu Nymex. At ~$4.00/MMBtu Nymex, drilling becomes highly economic (40%+ returns).
Range's well metrics in this example seem to be more of a development mode target rather than today's delineation phase reality. Therefore, the $3.00/MMBtu Nymex price would probably understate (and significantly) what Range currently needs to achieve a 20% on their drilling program in the area on average.
Similar to Anadarko, Range has higher-return investment alternatives to dry gas drilling (particularly super-rich areas in Southwest Pennsylvania).
Noble Energy / Consol Energy Joint Venture
In its recent investor day presentation, Noble Energy (NYSE:NBL) provided rate of return estimates on their Marcellus JV's drilling program in Southwest Pennsylvania and Northern West Virginia. For dry gas acreage, which is operated by Consol Energy (NYSE:CNX), Noble seems to be using a 7 Bcf EUR and $7.3 million D&C cost per well assumption.
Noble is using an escalated "reference case" for natural gas that calls for the Nymex price to increase from $3.50/MMBtu in 2013 to $4.50/MMBtu in 2016 and then grow by $0.25/MMBtu, or approximately 5%, each year through 2022. Given the steep decline curves and financial discounting, the front end of the price forecast has the greatest impact on the NPV. Therefore Noble's "reference case" is, in my estimate, approximately equivalent to $4.00/MMBtu in flat price terms. As a result, the graph above seems to imply a ~$3.75/MMBtu flat Nymex price that would be required for a 20% rate of return in the JV's dry gas areas. The lower productivity of the dry gas window in Southwest Pennsylvania relative to Lycoming's sweet spot (7 Bcf on average vs. 8-10 Bcf on average, respectively) makes a material difference in terms of threshold natural gas price.
Talisman Energy (NYSE:TLM), with approximately 200,000 net acres in Tioga, Bradford and Susquehanna counties, has dramatically scaled back its Marcellus program, with only one rig currently running. Talisman's presentation states that the company needs $3.50-$4.00/Mcf to "break even" in the Marcellus. Notably, Talisman was one of the very early entrants in the Marcellus and already holds most of its acreage by production. The company is under no pressure to drill and its one-rig program may in fact be sufficient to avoid steep declines in its Marcellus volumes. The stated $3.50-$4.00/Mcf range may reflect Talisman's threshold rate of return at the project level.
National Fuel Gas
Seneca Resources, the E&P arm of National Fuel Gas Company (NYSE:NFG), is yet another Marcellus operator who chose to scale back drilling in the field. Seneca plans to run 3 net rigs in 2013, down from 7.5 net rigs a year ago, and will cut its capital in the Marcellus by 40% year-on-year.
The reduction is even more pronounced in the dry gas area. Seneca plans to maintain just two rigs operating on its 55,000 net leasehold acres in Potter, Tioga and Lycoming Counties, with activity concentrated in DCNR Tract 100 in Lycoming County where results have been the strongest. Importantly, drilling activity does not appear to be driven by the HBP deadlines: Seneca states that they have no major acreage expirations until 2018.
It appears that the three rig program is sufficient to grow Seneca's production in the Marcellus by 20%-35% in 2013 (in fact, the growth target may be vastly exceeded in 2013 based on recent well results).
Seneca does not provide direct drilling economics estimate, however, their expected returns for Tract 100 operating area should be similar to Range's estimate, given type well 10+ Bcf EURs and location similarity. Therefore, $3.00/MMBtu Nymex may be sufficient for a 20% return at the well level (recent very strong well results reconfirm this estimate and suggest that even higher returns may be achievable). Seneca has identified at least 40 additional wells in Lycoming County to be drilled in the next two years. The company's Tioga acreage is less productive and likely requires $3.50-4.50/MMBtu price for a 20% return.
The super-productive dry gas sweet spot in Susquehanna, where Cabot Oil & Gas (NYSE:COG) estimates its average EURs at 11 Bcf (probably conservatively), so far is in a class of its own in terms of well economics, areal extent and degree of confidence in future drilling results. Cabot's expected rates of return clearly should be substantially higher than those reported by many of their peers in dry gas areas. The company has commented in the past that their Marcellus program could earn compelling rates of return even in a sub-$3/MMBtu gas price environment. (Cabot's latest presentation states: "Rates of return in Susquehanna County rival or exceed all of the top U.S. liquids plays at current commodity prices")
Southwestern Energy (NYSE:SWN), with much of its acreage encircling Cabot's, may also prove well endowed with an inventory of highly productive drilling locations.
Well performance curves that Southwestern has been providing in its presentations certainly look encouraging and hint at many wells having 10+ Bcf EURs.
ANALYSIS AND CONCLUSIONS
There is more than one way of calculating the rate of return on a drilling program and the devil is in the detail. Very often return estimates are "at the well level for the development mode" and do not include overheads such as ongoing geo-science expenses, delineation wells in "fringe" areas, lease extension expenses, operating infrastructure capex, field G&A and corporate overhead allocation, etc. Also, return estimates may or may not include allowance for sub-standard wells, time delays due to well backlogs, etc. As a result, returns at the project level may differ materially from returns on an incremental "typical" well. In this note, I assume that in most cases estimated rates of return are calculated at the well level and a 20% ROR would be appropriate for a development project to be considered economic.
By simply reviewing an ad-hoc set of return estimates provided by various operators, it appears that at $4.00/MMBtu Nymex, the inventory of economic dry gas acreage in the Marcellus is abundant, with many operators having captured enough prolific acreage to grow their volumes for years to come. However, rates of return in most cases appear underwhelming or "break even" and may not compete with operators' other investment opportunities. 10+ Bcf EURs are essentially required for the economics to excel. At $3.00/MMBtu Nymex, only very exceptional sweet spots, such as the most productive areas in Susquehanna and, possibly, Lycoming, make economic sense.
Ostensibly, the economic logic would dictate that a $4.00/MMBtu Nymex price is needed for production from the Marcellus' dry gas areas to continue to grow. In this context, it may appear surprising that dry gas drilling activity in the Marcellus has continued very strong in a much lower price environment and is typically managed by operators "to off-take capacity." The trend would be difficult to rationalize without taking in consideration the rapid evolution of the play.
From an operator's perspective, making capital allocation decisions based on today's cost of supply would mean looking in the rear view mirror. The Marcellus is a relatively young play, and the operating learning curve is still very far from its saturation point. Cost of supply in the Marcellus just a few years from now is likely to be quite different from the play's cost of supply today. It is understandable that operators may be prepared to cope with poor drilling returns during the delineation/acreage retention phase for the opportunity to establish themselves as low cost suppliers several years from now.
National Fuel Gas provides a vivid illustration to that effect. Last week, Seneca announced completion results for its six new Marcellus Shale wells on a pad within its DCNR 100 tract in Lycoming County that had 24-hour peak production rates averaging 17.8 MMcf/d. This represents a 67% improvement in the IP rate on a lateral length-adjusted basis relative to the first 7 wells Seneca drilled on Tract 100. It is difficult to draw numeric conclusions with regard to implied EURs without knowing if completion techniques and flow regimes are comparable between the two sets of wells. But it is probably safe to say that EURs for the new wells are substantially higher than the 10 Bcf per 5,000 ft lateral estimated for the first 7 wells. (All six new wells are expected to be flowing into National Fuel Gas' Trout Run Gathering System by the end of January.)
Seneca's data point aligns well with the very encouraging results from Range, Anadarko and Southwestern in Lycoming County and illustrates that with time, economics in each specific area can improve drastically.
Clearly, acreage quality matters and many (in fact, the majority) of dry gas areas in the Marcellus may not see much development capital. However, it is very possible that just a few years from now, the Marcellus EUR map will show sizeable and numerous 10+ Bcf/well areas that are highly economic and are essentially out of competition among the U.S. dry gas plays (think cherry-picked locations, better completions, longer laterals, pad drilling, optimized supply chain, improved gathering infrastructure - all contributing to better economics). The $3.50-4.00/MMBtu Nymex price that appears to be the threshold for economically sensible drilling for the majority of Marcellus's dry gas areas today may evolve into $3.00/MMBtu already in one or two years from now.
The above discussion leads to the following forecast for dry gas drilling in the Marcellus:
- Off-take capacity in dry gas areas will continue to expand steadily and will likely remain the sole limiting factor for increasing production volumes ("all pipes will be full").
- Drilling programs will show little sensitivity to current natural gas prices.
- A surprisingly low rig count will be sufficient to sustain production.
- Marcellus operators - even those with best acreage - will show unimpressive profitability in the near term and will likely face capital shortages.
- Marcellus-focused stocks will remain "asset plays:" valuation will likely be supported by the quality of undeveloped acreage.
Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.