Deconstructing the 100 Years of Natural Gas Abundance Narrative

In its recent report, the U.S. Energy Information Administration (EIA) has managed to put a wet blanket on California’s hope for another oil renaissance when it slashed the potential amount of oil trapped in the Monterey deposit by 96% – from 13.7 billion right down to 600 million barrels. This ‘recalibration’  also serves to shine a sobering light on the shale oil and gas revolution hype which has been fed to the public in recent years.

For a casual observer who cannot be bothered to look beyond the headlines, the shale oil and gas boom, brought on by the revolutionary advent of hydraulic fracturing (fracking), has introduced a new era of energy abundance to North America. The narratives among the oil and gas industry, government bureaucrats and mainstream media would have you believe that U.S. natural gas production continues to grow by leaps and bounds. Fracking has made natural gas and oil very cheap. There is enough gas to last the U.S. 100 years (e.g. this March 2014 CNBC report and Jan 2014 Obama’s speech ). The U.S. will rival Saudi Arabia and become a net exporter any time soon. And gas price will remain $4.50 per million cubic feet (mcf) for the next 10 years and below $6.00/mcf for the next 20.

The reality, however, is very far from the truth and that our energy future is far from certain once you examine the field data closer and look beyond the obfuscation and fine print.

There are a few key concepts when it comes to natural resource extraction which anyone engaged in the energy debate should be somewhat familiar with, regardless of which side of the debate one is on.

Background

First, some background to put the whole picture in context.

  • The advent of the shale oil and gas boom has been nothing short of spectacular. It now accounts for 40% of U.S. gas production and a 50% increase in oil production in a short few years.
  • The dominate shale gas plays are Haynesville, Barnett, Marcellus, Fayetteville, Eagle Ford and Woodford. These top six plays account for 88% of all shale gas production.

(Click to see larger image)

US shale gas production by play Source: David Huges

  • The drilling frenzy in the past couple of years resulted in a huge increase in gas production, causing the gas price to temporarily crash to below $2/mcf at one point. The price has since recovered to $4.50 – $5/mcf.
  • The U.S. currently remains a net importer of natural gas.

US gas production & imports_Page_05 Source: David Huges

 

How much is available? Reserves versus resources.

One needs to understand how resources are classified in order to count properly.

There is a widely misunderstood concept of resources versus reserves when it comes to natural resources. In a nutshell, resources represent a very rough wet finger guess of what is available out there, whereas reserves are far more accurate as a result of drilling and rigorous data analyses.

Further, resources can be classified into sub-categories as follows:

Technically Recoverable Resources (TRR) – represents the resources which are recoverable using current recovery technology, without regard to cost. Economically recoverable resources are technical recoverable resources for which the costs of discovery, development, production, and transport, including a return to capital, can be recovered at a given market price, according to the U.S. Geological Survey and, by and large, the EIA.

Speculative, Possible and Probable Resources – TRR are further subdivided into speculative, possible and probable categories.  Only probable TRR have been tested by drilling and are, therefore, known to be, in fact, technically recoverable. This category is generally about 25% of TRR, and perhaps 50% of probable TRR may become reserves. In other words, only about 12.5% of TRR are likely to become reserves.

Reserves – these are the small subset of those resources that can be booked as commercially producible, and, therefore, likely to be developed. Again, a fraction of reserves is ultimately extracted which becomes production.

The diagram below depicts the relationship among these different types of resources and reserves.

Resources vs ReservesSource: Labyrinth Consulting Services

 

Looking at the diagram above, it would become obvious to anyone that resources and reserves are very different things, and not all resources are created equal.

Take how to count your future earning power as an analogy. Reserves would be similar to your earnings from employment – that is, the total amount you would earn until you retire, assuming that you stayed healthy enough to work and do not die before retiring, stayed employed, your employer does not go bankrupt and the industry does not go obsolete and the global economy does not go into the toilet, etc., etc. Probable resources are like the fact that you have very good entrepreneur skills and you figure you would be able to make a certain amount by being in business using the skill advantage that you possess. Speculative resources are like you came up with a brilliant business idea in your dream which would replace Google and Facebook, and, man, image how rich you could be when that idea gets implemented.

Hey, I am also a billionaire if I count all the possible and speculative resources I possess.

 

So 100 years is realistically how many years?

So armed with the above basic concepts, let’s go back to the 100 years gas supply claim and qualify what that really means.

The number seems to come from a report released in April 2011 by the Potential Gas Committee, an organization of petroleum engineers and geoscientists. The report presented an optimistic view of 2,170 terra cubic feet (tcf) of potential resources.  At the 2010 rate of American consumption – 24 tcf per year – that would be a 95 years of gas supply (which got rounded up to 100 years).

The graph below breaks down the overall shale gas resources in the U.S. into various sub-categories.

US shale gas resources breakdownSource: future tense

 

Based on the above classifications and the amount of resources actually recoverable from each resources category, the overall supply amounts to 225 tcf, or 10 years’ supply.  Add that to the other 11 years of proved reserves, the total comes to 21 years.

Assuming the current rate of consumption remains unchanged (highly unlikely, see below), there is about 21 years of supply of gas in the U.S.

Click here for details on how these numbers are derived.

Potential demand growth for gas

As the price of natural gas has gone down substantially thanks to the recent increase in shale gas supply, many sectors of the U.S. economy are planning to shift their energy needs to natural gas. As an example, the power generation industry is switching more of its fuel mix from coal to natural gas. There are calls to convert the nation’s truck fleet to run on natural gas.

Another potential demand for gas comes from exports. Currently, applications for natural gas exports total 42 billion cubic feet per day, the majority of which have already been approved. This compares to U.S. 2013 natural gas production of 67 billion cubic feet per day. Assuming the facilities for exports (LNG terminals) get built in the next few years and the price of U.S. LNG is competitive against other gas exporters around the world, the amount of gas slated for export will account for more than half of the U.S. current gas production.

Production cost of shale gas

 “Don’t believe ANY reserve number unless it is linked to a price” – a favorite saying in the resource industry

Supply availability is dependent on price.

The life cycle production cost of shale gas (see details here) varies depends on many factors, including the following:

  • The ultimate gas recovery (EUR) from a well
  • The sunk costs drilling a well
  • The land costs
  • The cost of pipelines, process facilities and transport to market
  • Tax and royalties
  • Interest paid and interest rates
  • Corporate overhead

According to Ken Medlock, Senior Director of Rice University’s Baker Institute Center for Energy Studies, some wells are profitable at $2.65/mcf, others need $8.10… the median is $4.85.

Based on this estimate, every shale gas producer was spilling red ink in 2012 when gas price dipped below $2.00, which sad state of affair prompted the CEO of Exxon this lament:

“We are all losing our shirts today. We’re making no money. It’s all in the red” (quote)

At the more recent price range of $4.50 to $5.00, at least half of the producers do not make any money. Unless the price of gas rises further, the current cost model is simply not sustainable for the majority of  gas producers.

Depletion rate and the drilling treadmill

Once on a drilling treadmill, it is like trying to go up a down escalator. It becomes harder and harder to maintain the current rate of production, let alone expanding it.

Unlike conventional gas wells, shale gas wells experience rapid decline rates. Analyses from actual field data have shown that production falls about 65% within the first 10 to 15 months, and the 3 year decline rate for gas wells is about 80 – 90%.

What does that mean? Well, it means that every three years or so, you would have to replace all of your currently producing fields – just to maintain the same level of production. Gas output would rapidly decline should the gas producers drill fewer wells. In the Bakken and Eagle Ford plays, it takes roughly 2500 new wells a year, in each play, just to keep production flat.

In fact, of all the major shale gas fields, namely Barnett, Marcellus, Fayetteville, Woodford and Haynesville, only Marcellus is still enjoying increasing production. Production in all other fields has already peaked and is in decline. If it wasn’t for Marcellus’ substantial increase offsetting the decline of other fields, the overall gas production in the U.S. would already have declined.

So where would you place your bet on when shale gas production is going to peak, 2015 or 2050?

US shale gas production peaksSource: srsroccoreport.com

 

Current predicament of the shale gas industry

Beneath the façade that producers must be making tons of money in this new era of oil and gas abundance thanks to the fracking revolution, the reality is anything but. If you think “We are all losing our shirts today” is a one-off, isolated Exxon misfortune, perhaps a recent presentation from Art Berman below would put that belief to rest. In short, it shows that all major shale gas producers including Chesapeake, Southwestern, Devon and EOG are spending a lot more money on capital expenditures (capex) than they are receiving in cash flow from operations. How much more? About $53 billion more.

US shale gas producer financial results

At a high level the challenges the shale gas producers are facing are as follows:

  • At the current price of natural gas, there is no business model. Period. The price needs to be substantially higher before we should even bother to deal with other issues.
  • They need to spend a huge amount of money upfront on land leases and exploration.
  • They need to pour a huge amount of money on capex – on an ongoing basis – to continue the drilling treadmill in order to maintain production; otherwise production is going to fall off a cliff.
  • The overall business model remains questionable at best based on historical data available to date.
  • The overall operation is cash flow negative, meaning more money needs to be poured in to sustain the current operation while waiting for gas prices to rise and the business model to be proven viable.

So how do the producers manage to come up with the cash to make up for the negative cash flow? Use OPM (other people’s money) of course, by raising money through debt (junk bonds) and equity offerings in the capital market.

Thanks to the central banker’s printing press and zero interest rate policy, there is a huge amount of printed liquidity and a lot of yield hungry investors willing to buy the 100-years-of-gas hype and plough money into this industry. The producers are more than happy to use OPM through cheap debt to keep drilling, while hoping to see their business case turn around if and when the price of gas goes back up.

In other words, at the current price level, the entire industry is not sustainable and survives only on cheap debt. The reckoning will come when investors start to look closer into the financials, get scared and turn off the liquidity spigot. For this industry to be viable at all, the natural gas price has to reset at a much higher level.

Maintaining the gas abundance narrative

In light of the challenges faced by the shale gas industry, they need to maintain public and, more importantly, investors’ perceptions of the economic prospects of the industry in order to allow them to continue to raise large amount of cash for their capex programs while trying to fetch a much higher price for the gas they produce.

Once you understand these imperatives for the industry, then the 100 years of gas abundance and U.S. energy independence memes make sense. They tell investors that it is a good investment opportunity to pour money in.  They also justify exporting a large portion of the new found gas – while the country is still a net importer of natural gas despite this unprecedented gas boom.

Conclusions

So what are they key takeaway points? Here they are:

  • no doubt, shale oil and gas have enjoyed breathtaking growth in the past few years and significantly tilted the energy dependency equation in the country’s favor.
  • There is a lot of gas in the ground, but it is not 100 years’ worth or even half of that. And definitely not at the current price level.
  • The depletion characteristics of shale gas wells mean that the industry will be forever on a drilling treadmill which requires huge capex just to maintain, let alone increase, production. Sooner rather than later, it will run into the brick wall limits of the physical world in terms of how many wells one can physically drill.
  •  The longer term sustainability of the entire shale gas business model remains questionable. Based on the short historical data available, there is little to justify exuberance.
  • Regardless of how the shale gas boom is going to play out, the price will not stay at the current but will reset to a much higher level.

 

Sources and suggested readings

 

Tight oil Shale gas

This article is part of the Tight oil Shale gas in-depth topic. Get a crash course and read the latest developments on this topic.

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  1. dave rush

    Great article.
    Even if the headline numbers were honest, I never believe 100 year economic projections.

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