Shale Plays and Lower Natural Gas Prices:

A Time for Critical Thinking

Arthur E. Berman

Labyrinth Consulting Services, Inc., 623 Lorfing Ln., Sugar Land, Texas  77479

EXTENDED ABSTRACT

In mid-July 2008, the United States somewhat unexpectedly discovered that it had an oversupply of natural gas, and prices fell sharply.  Jen Snyder, head of Wood Mackenzie Ltd.’s North American Gas Research Group, recently said that the development of shale gas plays has caused “a significant potential over-supply” (Oil and Gas Journal, 2008).  Shale plays had become increasingly irresistible to the North American industry before prices fell this summer.  Many traditional exploration and production companies, including some majors, decided to become shale players, and many are still considering the possibility despite low gas prices.  The global financial crisis has accentuated the aversion to risk that fueled shale plays to begin with, and it seems that no one now wants to pursue anything but shale.

In the first half of July, spot gas prices were more than $13.00 per million British thermal units (MMBtu).  Six weeks later, the price had fallen below $8.00, and in March 2009, it is less than $4.00/MMBtu.  Some analysts predict that gas prices will be in the $4.00-6.00/MMBtu range at least through the end of 2010.

A total of 1966 horizontally-drilled producing wells from the Barnett Shale were evaluated to determine commercial gas reserves using standard decline methods.  Based on this analysis, using a net-to-producer cost of $6.25/MMBtu, only 30% of Barnett Shale wells will realize revenues that meet or exceed drilling, completion and operating costs in the most-likely case based on assumptions incorporated into a 10% net present value (NPV10) economic model.  At current gas prices, only 11% of these wells will pay out and, using realistic netbacks, only about 2% of wells make money.

I have struggled to understand the appeal of shale plays based on economic factors, and thought that low gas prices would greatly reduce activity.  At $10.00/MMBtu, about half of horizontally drilled and fracture-stimulated Barnett Shale wells were commercial, so, while prices were rising even higher, shale plays made some sense.  At current prices, however, the play has little commercial justification, and completion rates appear to be dropping accordingly.

Fourteen Haynesville Shale wells with sufficient production history to project a decline rate were similarly evaluated.  These had average estimated ultimately recoverable reserves (EUR) of 1.5 BCF (billion cubic ft), and 67% (10 wells) had reserves less than 1.5 BCF.  This is an early evaluation, and does not include several recently completed wells because of insufficient production data.  Reserves were, with one exception (5.3 BCF), considerably lower than the 6.5 BCFE (billion cubic ft equivalent) most likely per-well reserves, and than the 4.5-8.5 BCFE range, claimed by the leading operators in the play, Chesapeake and Petrohawk.

Problems with the Haynesville Shale include high decline rates and costs.  Average monthly decline for the wells that I analyzed is 20-30%, and projected annual decline rates average 80-90%.  Rapid decline makes initial production (IP) rates unreliable indicators of well productivity.  The average production history of wells used in this analysis is less than five months; current production rates already average only 48% of IP.

How can we understand what is happening with shale plays?

The diffusion model of innovation (Ryan and Gross, 1943; Rogers, 1962) shows that people adopt new ideas and technologies slowly, and that only about 5% of people make the decision to adopt based on information.  The other 95% decide because of the views of opinion leaders in the community, and on the eventual social momentum that develops—what Malcolm Gladwell called the “tipping point.”   The 5% who base decisions on information in the diffusion model are critical thinkers; the rest are conventional thinkers.  Conventional thinking drives people to continue to pursue shale plays despite the lack of commercial justification.  Until opinion leaders change their views or funding evaporates, the play will probably continue.

Certain myths about the domestic gas business must be clarified in order to put shale plays in context.  These plays are an important component of domestic natural gas production, but represent a relatively small—though growing—portion of the total gas supply.  Shale gas represents approximately 5 BCFD (billion cubic ft per day), or 21% of total gas production from unconventional reservoirs.  The Barnett Shale accounts for two-thirds of shale gas production (~3.5 BCFD).  Tight sands, by contrast, account for 13.5 BCFD, or 60% of unconventional gas supply.

Second, these plays involve considerable risk.  Seventy-five percent of wells are commercial failures at gas prices that are higher than at present.  Great emphasis is placed on engineering ideas and technology, but it seems that concern for geological and geophysical understanding is uneven among shale players.  All shale plays are the different, and require unique approaches based on thermal maturity, structural factors, fracturability, and identification of sweet spots.

Third, economic models must be aligned with full-cycle PV10 industry standards.  Wood MacKenzie’s Snyder said that established shale plays have “sufficient volumes available at a development break-even price of $5.50/MMBtu or below” (Oil and Gas Journal, 2008).  I don’t believe that.  Many industry analysts do not consider true operational costs, including interest expense for debt service, in their evaluations.  Investment company analysts are marketing a product, and make a commission on stock that they sell to clients; their analyses cannot be truly objective.  They do little investigative research, and generally accept information on rates, reserves and declines provided by the companies that promote these plays.  I do not know any credible industry analysts who believe that shale plays are commercial below $7.50.  Present netback gas prices in the Barnett Shale are about $2.75/MCF (thousand cubic ft) and $2.50/MCF in the Haynesville Shale (March 2009, RBC Richardson Barr), and no shale plays are commercial at that gas price.

The present over-supply of natural gas may be relative, and that would be positive for shale plays.  Spot prices rose to $13.00/MCF because of an imbalance between supply and demand.  Prices fell when about 2 BCFD of additional supply came online from the Independence Hub, Thunder Horse, and Tahiti in the offshore Gulf of Mexico, in addition to increased unconventional gas production, including shale gas mostly from the Barnett Shale.  Monthly natural gas production over the past year averaged approximately 1.75 TCF (trillion cubic ft).  The additional 2-3 BCFD that produced an over-supply is only 3.5-5.5% of total production.  Many circumstances might quickly upset the supply-demand balance and result in higher prices.  At the same time, the global financial crisis will probably reduce demand, and somewhat offset other factors that may favor rising price.  The point, however, is that the difference between what the market perceives as over- and under-supply can be razor thin.

Finally, gas rig counts and rates have fallen sharply in recent months from more than 1600 rigs in September 2008 to 810 in late March 2009.  Some predict that rig counts may fall to 500-600 in coming months.  Unconventional wells have steep decline rates, and any decrease in drilling will quickly result in dramatically lower gas production from these plays.  That, in turn, will affect supply, and prices could rise, but may also expose the ephemeral contribution of unconventional gas sources to total natural gas supply.

I expect shale plays to be part of the natural gas landscape for a while, despite the fact that they are marginally commercial at best.  Most companies in these plays have a lot of debt, and the only way to service the debt is to generate cash by drilling wells to produce gas.  I hope that operators will continue to learn how to reduce cost, optimize production, and better incorporate geology and geophysics into their play strategies.  It is not certain that the U.S. has a long-term over-supply of natural gas, or that today’s surplus is chiefly because of shale gas production.

Shale plays represent a disturbing tendency in the exploration and production business away from critical thinking.  The belief in reward without risk is irrational.  Failure to acknowledge the marginal economics of the play is bewildering.  Unless opinion leaders confront the underlying economic and geological risks of these plays, I fear that a financial crisis may develop that will discredit the exploration and production industry. 

Berman, A. E., 2009, Shale plays and lower natural gas prices:  A time for critical thinking:  Gulf Coast Association of Geological Societies Transactions, v. 59, p. 77-79.

AAPG Search and Discover Article #90093 © 2009 GCAGS 59th Annual Meeting, Shreveport, Louisiana