SHALE GAS iN USAGAME CHANGING TURNAROUND IN GAS MARKETS

PREPARED BY:

JIGYASA PURWAR

ContentsINTRODUCTION...................................................................................................................................3

HISTORY................................................................................................................................................4

CURRENT SHALE GAS MARKET CHARACTERISTICS.................................................................5

IMPACT OF SHALE GAS.....................................................................................................................5

DEPRESSED GAS PRICES.......................................................................................................................5

REVIVAL OF PETROCHEMICALS & MANUFACTURING..........................................................................5

REDUCED DEMAND FOR COAL............................................................................................................5

CLEANER ELECTRICITY..........................................................................................................................6

EMPLOYMENT GENERATION...............................................................................................................6

GEO-POLITICAL CONSEQUENCES.........................................................................................................6

ENVIRONMENTAL IMPACT..................................................................................................................6

EXPORT OF U.S. SHALE GAS.................................................................................................................7

ECONOMIC ANALYSIS OF SHALE GAS SCENARIOS....................................................................7

COST BENEFIT ANALYSIS......................................................................................................................7

OPEC’S PRISONER DILEMMA & GAS CARTEL.......................................................................................8

CONCLUSION.......................................................................................................................................9

APPENDIX...........................................................................................................................................10

REFERENCES......................................................................................................................................13

INTRODUCTION

Shale gas is essentially natural gas formed from being trapped within shale formations. It has become an increasingly important source of natural gas in the United States over the last few years. Its importance can be gauged by the fact that in 2000, it was only 1% of U.S. Natural Gas Production but by 2010, it was about 20% and Energy Information Administration (www.eia.gov) estimates that by 2035, it will be 46% of United States gas supplies (Figure 1). This sudden glut has had very interesting ramifications in the market. Natural Gas prices are at historic lows and this low price is impacting other industries which have now begun using natural gas as fuel source due to the cost advantage.

This unconventional gas boom has also put the United States firmly in the path of energy independence – something which can give a lot of political leverage over the OPEC cartel. Its game-changing impact has been in the fact that it is going to turn U.S. from a gas importer to gas exporter – especially to European markets where gas prices are at a record high. The domestic gas price is likely to rise in the next few years, because of increasing demand. Yet it will remain far below European and Asian prices, so the industry and exports should still grow. America is estimated to have enough gas to sustain its current production rate for over a century.

To say this change is astonishing is an underestimation. Barely five years ago, was U.S. expected to be a big gas importer. Between 2000 and 2010 it built infrastructure to re-gasify over 100 billion cubic meters (bcm) of imported liquefied natural gas (LNG). Yet in 2011, American LNG imports were less than 20 bcm. Efforts are now under way to convert idle re-gasification terminals into liquefaction facilities, in order to export LNG. All this has happened in a matter of four years. In what is another reflection of America’s continued and accelerated march to energy independence, a recent International Energy Association report8 says that by 2017, America will become the largest oil producer surpassing the likes of Saudi Arabia and Russia. It will be totally self-sufficient in energy by 2035. Politically and economically, it is news of huge significance and impact.

It will be hard to find a market turn-around bigger than this!

HISTORY

Shale gas was first extracted as a resource in Fredonia, NY in 1821 in shallow, low-pressure fractures1. Horizontal drilling began in the 1930s, and in 1947 a well was first ‘fracked’ in the U.S2. Work on industrial-scale shale gas production did not begin until the 1970s, when declining production potential from conventional gas deposits in the United States spurred the federal government to invest in R&D that ultimately led to directional and horizontal drilling, micro seismic imaging, and massive hydraulic fracturing. Early federal government investments in shale gas began with the Eastern Gas Shale’s Project in 1976 and the annual FERC-approved research budget of the Gas Research Institute, where the federal government began extensive research funding in 1982, disseminating the results to industry2. The federal government also provided tax credits and rules benefitting the industry in the 1980 Energy Act2. The Department of Energy later partnered with private gas companies to complete the first successful air-drilled multi-fracture horizontal well in shale in 1986. The federal government further incentivized drilling in shale via tax credit for unconventional gas from 1980-2000. Mitchell Energy achieved the first economical shale fracture in 1998 using an innovative process called slick-water fracturing3. As the success of Mitchell Energy became apparent, other companies aggressively entered the play, so that by 2005, the Barnett Shale alone was producing nearly 0.5 trillion cubic feet of natural gas per year. As producers gained confidence in the ability to produce natural gas profitably in the Barnett Shale, with confirmation provided by results from the Fayetteville Shale in Arkansas, they began pursuing other shale plays, including Haynesville, Marcellus, Woodford, Eagle Ford, and others.

For the large part of early 2000s, big independent oil companies and national oil companies shied away from shale gas deposits citing unreliable technology, unproven reserves and general aversion to pure gas deposits. Shale gas plays were the battleground for medium sized independent companies and small operators. All that changed in December 2009 when Exxon announced its acquisition of XTO Energy for $41 billion. XTO Energy was the biggest player in natural gas fields and by buying it, Exxon suddenly catapulted itself into a major gas producer. At that time, Exxon found a lot of synergy for the deal due to the increase in reliability of the fracking technology as well as its own assessment of gas reserves which had proven to be more than anticipated. Record 10 year highs for gas prices also helped in providing economic justification for the deal. Exxon’s acquisition, as it turned out, was just the first of many and natural gas industry witnessed a series of acquisitions, mergers and entry of national oil companies in the U.S. gas market. The standard strategy followed by these companies has been to buy up acreage from US independents, and apply superior balance-sheet power to increase exploration and production. The next major to enter the natural gas market was the mining giant, BHP Billiton, which announced its entry by its acquisition of Petrohawk Energy. BHP was just part of a rush into shale gas acreage in the southern states of the US by a large herd of oil majors, including BP, Total, Chevron, PETRONAS, CNOOC, Petro China, BG, Shell, Mitsubishi and Mitsui, and they are all victims of their own success. This increased activity has resulted in a production surge that will eventually turn the US into a petroleum products exporter, but is crushing its domestic gas prices in the meantime.

CURRENT SHALE GAS MARKET CHARACTERISTICS

In the past 5 years has shale gas been recognized as a "game changer" for the U.S. natural gas market. The proliferation of activity into new shale plays has increased dry shale gas production in the United States. Higher natural-gas prices in recent years (2003-2008) and advances in hydraulic fracturing and horizontal completions had made shale-gas wells more profitable in the recent past. However, the recent successes in Shale gas mean that North America has been the leader in developing and producing shale gas. The great economic success of the Barnett Shale play in Texas in particular has spurred the search for other sources of shale gas across the United States and Canada. A Department of Energy report states that in the first quarter 2012, USA imported 840 Bcf (785 from Canada) while exporting 400 Bcf (mostly to Canada); both mainly by pipeline. Almost none is exported by ship as LNG, as that would require expensive facilities. Gas Prices have gone down to $3/MMBtu due to shale gas as compared to Europe where they are around $10/MMBtu. This cost advantage coupled with the gas glut in U.S. has established a strong case for gas exports.

IMPACT OF SHALE GAS

The increase in shale gas activity has resulted in several interesting positive and negative consequences for the U.S. and international markets. Some are listed below:

DEPRESSED GAS PRICESThe abundance of shale gas supplies has dramatically reduced the gas prices as shown in Figure 3. In the short term, this price depression will make U.S. Shale gas operations unprofitable. This could prompt companies to scale back production to keep prices in check. However, such an option can rarely be exercised with full effect due to operational complications. Even if the U.S. allows gas to be exported, the rise in price would still be checked. A recent study conducted by NERA Economic Consulting5 concluded that exports could raise the domestic price of natural gas by between 22 cents and $1.11 per million cubic feet within five years.

REVIVAL OF PETROCHEMICALS & MANUFACTURING The glut of cheap gas has helped underpin a revival in manufacturing and helped lower electricity costs for consumers. Natural Gas is a very important feedstock used by several companies and the current gas prices ensure that they now enjoy second-lowest energy costs in the world6 after the middle-east companies. Recently, LyondellBasell(NYSE:LSB) reported that its costs to produce ethylene, a key chemical for plastic production, fell by 46% due to availability of cheap natural gas. Its stocks have seen 52-week highs in recent times. Dow Chemical also recently announced plans to spend $4 billion over the next five years, building plants, to cash on cheap U.S. Shale Gas. The company said it made economic sense since every 10 cent drop in ethylene cost boosts its earnings by $200 million.

REDUCED DEMAND FOR COALThe sudden increase in gas supplies has meant that it has begun replacing coal and other fuels as a preferred energy source for power plants that have easy access to this gas. This preference is illustrated in Figure 4. Domestic demand for thermal coal has dropped sharply with the Dow Jones Coal Index falling over 40% this year with some established companies in this index like Arch Coal(NYSE:ACI) hitting 12-year lows. This has resulted in a lot of companies postponing capacity addition by 5 years, closing some coal mines and even lay-offs. It is just the opposite story from petrochemical companies.

CLEANER ELECTRICITYThe persistence of low natural gas prices has had an impact on the utility industry as well. The abundant supply has provided economic justification for gas combined cycle power plants. These power plants will gradually replace our nation’s aging coal-fired generation fleet. Our electricity will become cleaner, cheaper, and more efficient, and the superior ability of natural gas combined cycle turbines to ramp up quickly will allow easier grid integration of variable energy sources like wind and solar power.

EMPLOYMENT GENERATIONThe proliferation of activity in unconventional gas could not have come at a better time for the American economy. This period of gas-boom coincided with the worst economic recession in recent decades to provide a glimmer of hope in an otherwise gloomy scenario. By some estimates, it has added more than 600,000 jobs to the economy and over the next few years the job addition will stretch to millions. Another important fact is that this addition has happened in regions with traditionally low industrial activity – North Dakota, Arkansas & Pennsylvania.

GEO-POLITICAL CONSEQUENCESThe rise of the natural gas production in U.S. will have geo-political consequences as well. Pipelines from Russia now supply a big chunk of the natural gas to Western Europe, but alternative sources could undercut Moscow's sway. In Asia, the U.S. can bolster allies such as Japan and South Korea by helping lessen their dependence on gas imports from unstable regions. It also gives U.S. a handy leverage to use against the arm-twisting tactics of the OPEC Cartel. The shock waves of America's gas boom are being felt elsewhere in the world as well. Development of Russia's vast Shtokman gas field in the Barents Sea, $40 billion project which was intended to supply America with LNG has stalled. Qatari LNG, once earmarked for America, is going to energy-starved Japan. Yet a bigger change is expected, with large-scale shale-gas production possible in China, Australia, Argentina and several European countries, including Poland and Ukraine.

ENVIRONMENTAL IMPACTMost of the natural gas production relies on a technique called ‘fracking’. Specialized fluids at high pressure are injected in the formation to break the rock and release the trapped natural gas. For a single well, multiple fractures are done. Environmentalists have long been raising the concern of polluting ground water with this technology. Besides this, there is also an adverse impact on the renewable energy industry. It is suffering a downturn as a result of competing with natural gas generation on a cost basis, and a federal production tax credit that seems poised to expire at the end of this year. Installation of new renewable energy facilities has now all but

dried up, unable to compete on a grid now flooded with a low-cost, high-energy fuel that can provide power on demand.

EXPORT OF U.S. SHALE GASThe biggest turn-around that this gas glut has resulted is in putting the U.S. on the path from being a gas importer to a gas exported. The gas price depression widens the gap between gas prices in U.S. and other countries especially in Europe and builds a strong case for exporting gas. A recent study commissioned by the U.S. government5 predicts that there are massive economic benefits to be unlocked by allowing export of domestically produced shale gas. Gas producers are eager to export more, while big consumers including manufacturers and chemical companies are not in favor because exports could raise domestic prices. Environmental groups, meanwhile, fear that allowing exports would encourage more natural-gas production.

The looming prospect of the U.S.'s becoming a major exporter of natural gas underscores how the energy revolution is transforming the nation's economic prospects. Just a few years ago, many energy companies were planning to build facilities to import liquefied natural gas into the U.S. But thanks to technological advances, combining hydraulic fracturing and horizontal drilling, the U.S. has in a short time become a gas-producing powerhouse.

One export terminal—Sabine Pass Liquefaction LLC in Louisiana—has already received Department of Energy approval. Fifteen other projects, which could export as much as 21.5 billion cubic feet of gas per day, are awaiting approval. That is roughly one-third of total U.S. production!! One potential exporter is the largest U.S. gas producer, Exxon Mobil Corp., which is teaming up with Qatar Petroleum for a facility near Port Arthur, Texas. This also opens the prospect that natural gas could become more of a globally traded commodity like crude oil. Currently, the difficulty of shipping natural gas means that prices in Asia and Europe are several times the U.S. price.

ECONOMIC ANALYSIS OF SHALE GAS SCENARIOS

COST BENEFIT ANALYSISFor the purpose of this paper, we will focus on one independent gas producer, Chesapeake Energy. As per its annual report9, its total expenses to produce 1 MCF of gas were around $3.09. At the 2010 price of $4.48/mcf, it was making a net profit of $1.39/mcf. For a predominant gas producer like Chesapeake, this means that its fortunes are very closely linked to the gas prices. However, the profits of producer companies are hardly any basis to determine benefits. It is the gain to the consumers that defines that. This means that we look at a traditional demand-supply curve for natural gas as shown in Figure 5.

The benefit to the consumers is the difference between the market price and the price customer is willing to pay. The area above the current price, as shown in Figure 5, illustrates this ‘Consumer Surplus’ benefit. For better estimation of the customer benefit from a particular gas producer, it is essential to know the slope of the demand curve. In the scenario of a supply glut like in the current market scenario, this slope turns to zero. With a large number of shale gas producers in

the same basin/region, any costs will approximately be the same for all producers eliminating any particular demand curve for any particular producer. Considering that each producer faces the same demand, hypothetical demand is a pro-rata share of the basin demand and is downward sloping.

To put a figure around this consumer surplus, let us assume that this price depression does not lead to any increased consumption. The Henry Hub spot price for gas was $3.95/mcf in 2012 and $7.97/mcf in 2008. The difference in prices over three successive years was $4.02/mcf. The total gas production in 2008 was 25.6 tcf. This puts the consumer surplus value at around $102 billion, a conservative estimate given our simplifying assumption. This very large amount of consumer gain from technology induced price depression is virtually an elephant in the room. As long as current production is maintained, it is likely that this benefit will be seen year over year.

OPEC’S PRISONER DILEMMA & GAS CARTELOrganization of Petroleum Exporting Countries (OPEC) has long indulged in building a cartel around oil supplies. It is essentially an organization of countries whose fortunes are over-reliant on its oil exports. Unlike other commodities, oil exhibits a greater degree of scarcity and is a major indicator and influence on the economy worldwide. OPEC plays a major part in determining its price. However, OPEC has not been able to achieve its objective of fixing oil price and maximizing profit for its member nations. The problem that OPEC faces can be described by a common game theory model known as the Prisoner's Dilemma.

The way OPEC works is that they will take orders from their customers. Returning to the group, they will set production quotas for each of their members to satisfy the at a price point of their choosing. If everyone behaves according to the rules they set, the suppliers (OPEC), with perfect information and control on supply, will profit in a similar manner as a monopoly.

However, the system begins to break down when they start to lose control over the inelastic demand and as well as when their individual suppliers misbehave. Let's look at a scenario. The world economy has become so weak that the demand for fuel has plummeted. This means the demand curve shifts left or at least becoming less steep and more elastic and weakens OPEC's ability to keep prices up at least in the short term. This deflates the price of oil and makes it harder for individual OPEC member countries to maintain enough cash and net exports to support the GDP which is largely dependent on oil export. Possibly, one of the members will cheat and produce more oil than in its OPEC stated quota in order to generate revenue to cover the shortfall from the drop in oil prices. This shifts the supply curve to the right and drops the price further compounding the effect. This is exactly the same model as the well documented game theory model (Cheater’s Paradox) where OPEC members are the prisoners, producing additional oil is considered cheating and the reward matrix is expressed as marginal increments in GDP. This process repeats until the supply stabilizes and the price finds a new home, much lower than is expected (which is exactly the case in the current economic environment).

U.S. has long been held hostage to OPEC’s cartelization of oil. Being a big oil consumer, its economic health has often been dictated by OPEC’s price fixes and has led to political stand-offs as well. It was so much of a problem that America decided to create a strategic oil reserve

(currently estimated to be 100 billion barrels of oil) that could be released on presidential orders in the U.S. market to depress any artificial price hike implemented by the OPEC cartel. Since U.S. was an importer of OPEC oil, this move made sense as a hedge against artificial rise in oil prices. With the rapid increase in shale gas and associated oil, domestic oil production has risen sufficiently that America is no longer as heavily dependent on OPEC oil.

There is so much glut in production that there is even a talk of forming a gas cartel with U.S. on the lines of OPEC10. The idea of a ‘Gas Opec’ has been around for years, with Russia and Iran signaling interest back in early 2007. Algeria, which was opposed to the idea back then, has become much keener on production limits as the gas price has plummeted relative to crude oil. The whole thing seems to be a bit of a prisoners’ dilemma, with few countries having confidence that production cuts would be successful enough to warrant the short-term pain of losing export revenue. OPEC itself, while effective, is hardly a model of quota discipline and relies heavily on a few states – mainly Saudi Arabia, by far the biggest producer – to enforce production cuts. Qatar, the world’s biggest gas exporter, has invested heavily in building new LNG facilities and is not interested in reducing production. Russia, another of the group’s biggest exporters, no longer supports the idea either, despite recent comments from Gazprom dismissing the success of US shale gas.

CONCLUSION

Shale gas is dramatically altering the dynamics of the gas world, including several investment strategies that were based on gas shortfalls in America. LNG import facilities built to cover for that shortfall are now left stranded or are being converted to export facilities. The abundant low-cost gas from shale and other sources presents a tremendous opportunity for value creation across several sectors in the economy. As in all changing markets, there will be winners and losers. Those who hedge their risks in time stand the chance of great economic benefit. Without doubt, the biggest contribution of shale gas has been in putting America firmly on the path of energy independence and thus freeing itself from any arm-twisting by the OPEC. Just for this, the shale gas boom needs to go down as one of the biggest market-changing events in recent times.

APPENDIX

Figure 1 - U.S. Natural Gas Production4

Figure 2 - U.S. Energy Production and Consumption (in Quadrillion BTU)4

Figure 3 – Henry Hub U.S. Natural Gas Prices ($/MMBtu)4

Figure 4 – U.S. Energy Production by Fuel4

Figure 5 – Natural Gas Supply-Demand Curve Analysis

Figure 6 – U.S. Shale Fields

REFERENCES1. http://www.dec.ny.gov/docs/materials_minerals_pdf/nyserda2.pdf 2. http://www.chathamhouse.org/publications/papers/view/185311 3. http://www.economist.com/node/21558459 4. http://www.eia.gov/ 5. http://finance.yahoo.com/news/u-gas-exports-clear-hurdle-022400484.html?l=1 6. http://beta.fool.com/tdalmoe/2012/08/01/shale-gas-boom-double-edged-earnings-sword/

8324/7. http://www.economist.com/node/21556242 8. http://finance.yahoo.com/blogs/daily-ticker/u-pass-saudi-arabia-energy-production-iea-says-

170907660.html?l=19. http://www.chk.com/Media/Publications/AnnualReport/Pages/default.aspx 10. http://blogs.ft.com/energy-source/2010/04/19/gas-opec-looks-less-likely/#axzz2ELaoFKHk