Last June, the Potential Gas Committee announced the highest US natural gas resource estimate in its 44-year history, largely due to the success of producers exploiting the gas shale formations underlying many oil- and gas-producing basins in the US.

The emergence of gas shales as the driving force for North American oilfield activity raises questions about this resource’s role in the industry’s future. Many believe gas shales have forever changed the US energy picture for the better by enabling greater harvesting of a cleaner fossil fuel. Others challenge the economics of gas shales, suggesting producers are merely destroying shareholder capital once again.

Potential Gas Committee historical forecasts of US gas resources (Source: Potential Gas Committee, from American Gas Association presentation, Sept. 21, 2009)

Are we about to enter Utopia or witness a train wreck in 2010?

Many producers claim gas shale production is remarkably profitable, but those claims rest on a shaky foundation of reserve and production cost estimates. While the potential is attractive, the rewards may be some time off.

Past to present

The gas shale revolution sweeping the US is spreading to Canada and other international locations with a positive impact on global gas resources. The successful applications of horizontal drilling and hydraulic fracturing technologies have been driving this revolution since the early 1980s when George Mitchell began trying to produce natural gas from the Barnett shale formation underlying the Fort Worth basin where his company had been producing for years. Following nearly two decades of trial and error, Mitchell eventually cracked the gas shale code by harnessing these technologies.

Between 2006 and 2008, US natural gas resources increased by 35% to 1,836 Tcf, with one-third represented by gas shales. In fact, the entire growth in estimated gas reserves over this two-year period is attributable to the development of gas shale resources.

Gas shale production also has increased dramatically.

From 1 Tcf of production in 2006, gas shale production has more than doubled to 2.4 Tcf in 2009 according the Energy Information Administration (EIA). The EIA forecasts gas shale production will nearly double to 4.5 Tcf by 2020. Equally impressive as the production growth is the role gas shales will play in the nation’s fuel mix. In 2006, gas shale production accounted for 4.5% of US natural gas supply, which is projected to expand to 20% by 2020. Part of this growth will offset declining Canadian gas imports that are projected to fall by 1 Tcf over this period.

The attraction of gas shales is their production profile — substantial initial production (IP) from wells and large economic ultimate recovery (EUR) potential. These characteristics have convinced producers that the economics of gas shales can be attractive, even in an era of relatively low natural gas prices. Of course, the economic history of the Barnett shale was dependent on rising gas prices in the latter 1990s, as early drilling and completion technology improvements merely offset the high cost of developing the resource.

Economics

Leading gas shale producers claim Barnett wells are economic with natural gas prices above US $1.35 per Mcf.

As the industry has moved to exploit other gas shale basins, technological improvements have yielded greater IPs and supposedly EURs too. The conventional wisdom is that the Haynesville, Fayetteville, and Marcellus shales, despite higher lease expenses, are economic with gas prices in the $1.50 per Mcf range. These newer and highly prolific gas shale formations have wowed the energy world with IP flow rates substantially greater than conventional or even Barnett wells. But associated with the strong IPs is a more rapid production decline than the historical norm. This has set the industry on a steep treadmill to sustain production.

Gas shale production has increased dramatically, from 1 Tcf of production in 2006 to 2.4 Tcf in 2009. (Source: Energy Information Administration)

There has developed a strong debate within the industry about the economics of gas shales. Leading producers argue that huge IPs are associated with large EURs and long productive well lives, making developments profitable even in today’s low gas price environment. Critics suggest production decline rates are much greater and residual producing volumes so low that EURs are overstated, undercutting profitability estimates. With high acreage costs, large royalty payments, and expensive wells, critics question whether gas shale producers are making any money at current gas prices. Critics suggest gas prices must rise to the $7 to $8 per Mcf price level before producers break even.

Energy investors have embraced the gas shale phenomenon. In fact, if producers don’t have gas shale acreage to highlight in investor presentations — suggesting reserve and production growth — they are ignored in the marketplace. By overstating producing gas shale reserves, companies are able to show extremely favorable finding and development (F&D) economics. Low F&D costs are critical for producers to tap Wall Street for the funds necessary to sustain their aggressive gas shale drilling efforts.

Changing history

The nature of gas shale formations has altered the historical operation of producers. Blanket formations have reduced the need for seismic analysis to identify drilling prospects. By eliminating exploration risk, gas shale developments have become “real estate” plays with some engineering content. There has been a mindset shift among producers that gas shale developments are the equivalent of manufacturing operations, where the well drilling and completion process is repetitious following an initial successful well.

The cost of leases and their relatively short lives have placed a premium on accelerated exploitation. As a result, the industry has been outrunning its ability and desire to complete wells given low natural gas prices. Producers with significant gas volumes previously could hedge at higher prices. This price disparity augmented cash flows. Additionally, large gas shale producers tapped Wall Street for additional capital, entered into joint ventures with larger companies lacking a presence in these plays, and sold assets. But the surge in gas shale production, coupled with the recession and a lackluster demand for natural gas, has pressured gas prices. Producers are now struggling to show both production growth and profitability.

With the gas industry in some disarray due to weak prices, gas producer stocks have suffered. Even producers promising strong volume growth in 2010, as overall industry volumes are projected to decline, have suffered in the stock market. So the announcement in mid-December that ExxonMobil would acquire XTO Energy for $31 billion, or a 25% premium to the share price, was viewed as an endorsement of the future for gas shales.

ExxonMobil’s purchase is a vote of confidence for the gas shale business, but maybe not in the way some see it. Gas producers have been caught in a Catch-22 position of needing to boost production to satisfy Wall Street but having to borrow money or sell assets to do so. The additional production being added, given the weak US economy, means gas prices will remain depressed. ExxonMobil firmly believes in the future of natural gas, both domestically and internationally. Fortunately it has the financial strength to withstand a low gas price environment and marginal returns from gas shale activity until technology helps to lower development costs.

While gas shales may be a savior for the domestic industry, they are likely to present a challenge for the market in 2010.