Arthur E. Berman
Ohio Oil and Gas Association
March 2009
Shale Plays and Lower Natural Gas Prices
A Time For Critical Thinking
Premise of the Presentation
• Natural gas prices have collapsed since July 2008• The forecast for lower demand suggests that low prices will persist• In 2008, domestic U.S. gas production reached a historical high and an over‐supply of natural gas now exists• There is an irrational tendency in the E&P industry to pursue shale plays despite over‐supply of natural gas and lower prices• A detailed evaluation of Barnett Shale rates & reserves indicates that production was marginally commercial at higher gas prices, and that only a fraction of wells are commercial at current prices• An early evaluation of the Haynesville Shale play suggests that wells have similar rates & reserves as the Barnett Shale, but at twice the cost• It is possible that U.S. natural gas prices may fall as low as $2.00/Mcf by September 2009, and that the gas rig count may approach 500• The drop in gas well drilling combined with the high decline rates of U.S. wells suggest a price rebound in the last quarter of 2009• There is a bright future for natural gas in general, and possibly for some shale plays• The Shale play “manufacturing” paradigm must change: a better business model is needed – geology & geophysics matter!
In mid-July the U.S. unexpectedly discovered it had an over-supply of natural gas
Yet, there is an irrational tendency to continue pursue shale gas plays
2005‐2006 Hurricanes Katrina‐Rita Supply Interruption
2008 Price Anomaly
U.S. gas production has reached a new high
2001 Over‐Supply
2008 Over‐Supply
6.7% Increase in domestic production, much from conventional sources in Gulf of Mexico (Thunder Horse, Mad Dog, Independence Hub, Tahiti)
But a respectable amount has also come from shale plays
But reserves have flattenedAnd these are questionable because unconventional reserves booked at higher gas prices may now be non‐commercial
Result: Reserves/Production (R/P) has fallen
This is the basic reality that is being ignored at the moment
High decline rates are the reason that R/P is static: new reserves are being produced as quickly as they are found
The North American Gas picture is worse: recent gains are marginal
• Canada and Mexico reserves and production are declining• This broader perspective means that the future for natural gas is better than most people think!• LNG will become more important: this means that domestic operators must work smarter: shale players must learn to base their programs on geology & geophysics!
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The Shale Play Paradigm
• The “resource play”: there is no riskSource & charge: 100% PsTrap: 100% Ps (there is no trap, or the reservoir is the trap)Reservoir: 100% Ps (brute‐force engineering takes care of that)
• A “manufacturing process” where drilling and completion are primary, and geology & geophysics are secondary at best
• Investment community loves this concept: no risk, high reward—the same thinking that produced the global financial crisis!
• ...and what about ongoing demand & price support while everyone is rushing to produce all of this no‐risk gas?
An irrational belief that gas prices would continue to rise
• and a failure to recognize the signs of a slowing economy, and a looming financial crisis by at least the summer of 2007• some of the rising price is because of supply‐demand concerns, but most is because of rising cost
Barnett Shale Horizontal EUR Evaluation
• This is the model for other shale plays• About 10,000 wells• Most wells drilled horizontally with fracture stimulations since 2003• Well costs $3.25 MM from published 10‐K and conference call data• Standard NRI (75%) & severance tax (7.5%) values• LOE‐G&A ($1.25/Mcf) from published 10‐K and consortium data• Lease costs ($1,250/acre) from published data
Is all acreage equal?
Isn’t it reasonable to assume that there is a geological reason for the observed distribution of production trends?How much capital
has been destroyed because of the manufacturing approach?
Barnett Shale: operating costs & sales price• Carrizo is a relatively small, independent E&P company• Most current operations are in the Barnett Shale• Company has a reasonably transparent history of providing costs• In 2007, capex was $231.4 MM & drilled 96 gross/68 net wells
It costs almost $2.50/Mcf to operate a well, in addition to capex(leasing, drilling & completion)!
Costs shown are not commonly considered in evaluations of shale plays and operators by many “analysts” (industry outsiders) because critical thinking requires inside knowledge & experience
True “netback” price rarely usedThis phenomenon creates incorrect
perceptions about the “success” of shale plays, and the likely continuation of over‐supply
Cost/McfeLease Operating Expense 1.32$ General & Administrative 0.57$ Interest Expense 0.33$ TOTAL 2.22$
Carrizo Oil & Gas Company
East Texas Sales Cash EquivHouston Ship Channel 3.60$ Katy 3.67$ Tennessee Texas, Zone 0 3.64$
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Barnett Shale: natural gas price
If the cost to produce gas is ~$7.50/Mcf, when does a company make money?
$7.50/Mcf
How can a company hedge prices in these periods?
The upside to the hedge is less than the produced cost. Who is on the other side?
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Barnett Shale EUR HistogramFrequency Cumulative %
Barnett Shale Horizontal EUR Histogram (1966 wells)
Economic threshold @ $6.25/MMBtu net
<30% of wells pay out or make money (~1,500 MMcf EUR)
The average EUR for horizontal Barnett Shale wells is 1.2 Bcfe
54% of wells 0.5‐1.0 Bcfe EUR71% of wells <1.5 Bcfe
•Model does not include transportation & gathering fees, interest expense, re fracs, DD&A, etc.•Carrizo’s LOE + G&A for Q4 2008 were $1.89/Mcf vs. $1.25 in this evaluation•CHK’s “produced cost” is $7.25/Mcf • Model used lease cost of $1250/acre vs. “core” area costs in 2008 of $10,000+/acre•At current prices, 11% of wells meet threshold• Using current netback prices (no hedging), 2% of wells meet threshold
Barnett Shale Core Area (Tarrant County) Evaluation
• Overall, success rates are similar to average reserves in the play, though certain operators in the core area have apparently learned how to improve on the average (though the success rates are still unacceptably low)• Sensitivities are also somewhat typical of the overall play, and they indicate why a minimum gas price of $7.50‐8.00 is necessary given the current state of reserve predictability
Barnett Shale drilling has decreased
Many operators have shifted emphasis to the Haynesville Shale
• “IPs” impressive, up to 24 MMcfd• HK claims 160MMcfd/3wells• Probably not really a shale play• Most production from sandy‐silty intervals within Haynesville Shale•Apparent lower unit cost/Mcf than Barnett because of high rates• Over‐pressured & deeper than other shale plays• Costs are very high‐‐$7.5 MM D&C cost per well• Acreage is high—up to $30k/acre, average $15k/acre
20 wells studied with enough production history to evaluate
Penn Virginia Fogle Unit 5HHarrison County, TX1.25 Bcf EUR
Chesapeake Bledsoe Properties 1Caddo Parish, LA1.03 Bcf EUR
• Standard rate vs. time decline curve method• Hyperbolic approach with 20% terminal decline• Economic limit of 1 MMcf/month (33,000 cfg/day) to cover lease operating
costs ($5,000/month @ $5 gas & 8/8) – very generous since the notional LOE+G&A cost for 1MMcf/mo = $12,500
• Generous approach to decline with limited data
Decline rates are very high
• Average monthly decline rate is 25% (a 10 MMcf/d well produces 300 Mcf/d after 1 yr)• 57% of wells decline 20-35% per month
IPs are higher than actual daily rates (using maximum 30‐day period)
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Haynesvile Actual Daily Rate vs. IP HistogramFrequency Cumulative %
• Average maximum producing rate is 80% of IP• Discrepancy is greater in 50% of wells
15 wells have enough production data to decline: reserves are disappointing
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Haynesville Shale Reserve HistogramFrequency Cumulative %
• EUR averaged 1.5 Bcf• 67% of wells had reserves from 0.5-1.5 Bcf• Haynesville reserves similar to Barnett at twice the capital expenditure
What is the near‐term outlook for natural gas prices?
2009 Q1 09E Q2 09E Q3 09E Q4 09E 2009E H Hub Bloomberg $6.13 $5.66 $6.04 $7.00 $6.21 NYMEX Futures $4.81 $4.03 $4.36 $5.03 $4.56 H Hub Raymond James $4.90 $3.25 $2.50 $4.25 $3.73
• Most forecasts are bearish• But there are broad differences in estimates• The truth is that no one knows• What is the balance between decreased demand, over‐supply, and the marked drop in rig rates?• EIA estimates an average 2009 gas price of $5.01/MMBtu
The current over‐supply & recession
• $13.10/MMBtu in early July 2008—$4.23 today• 1,606 gas rigs in September 2008—867 today
Half the gas consumed in 2007 was produced fromwells drilled within the prior 40 months!
Gas Production by Vintage Year
The context:U.S. Vintaged Daily Gas Production Contribution to December 2007 Volume
Slide courtesy of IHS
Oil demand is an excellent indicator of economic conditions
• The current recession was evident at least as early as Q1 2008• Oil demand has declined 7.42% (1.6 MMbopd) since January 2008• Demand appears to be stabilizing
In 2001, there was an over‐supply of gas & a recession
•Price cycle approximately 60% longer than rig cycle• 6‐month lag for rig decline after price decline began• Price recovery began half‐way through the rig decline cycle
Analysis of the 2000‐2002 Cycle
A scenario for the 2008‐2009 Half‐Cycle
• ~550 rigs by Sept• ~$2.00/MMBtu• Price decrease same as in 2000• Rig decrease greater (66% vs. 44%)
•Price cycle approximately 15% longer (vs. 60% in 2000) than rig cycle• 3‐month lag (vs. 6‐months in 2000) for rig decline after price decline begins• Price recovery not incorporated in the model
Another scenario for the 2008‐2009 Half‐Cycle
• ~470 rigs by August• ~$4.00/MMBtu• Price decrease less than in 2000 (70% vs. 84%)• Rig decrease greater (71% vs. 44%)
•Price cycle approximately 20% shorter (vs. 60% longer in 2000) than rig cycle• 3‐month lag (vs. 6‐months in 2000) for rig decline after price decline begins• Price recovery 60% into rig decline cycle (vs. 50% in 2000)
Cause of over‐supply: an irrational belief that gas prices would continue to rise
Despite the cyclicity of natural gas markets over the past 8 years
Plank Road Fever and Shale Plays: a possible analogy
• In the late 1840s, thousands of miles of toll roads were built with wooden plank surfaces to connect frontier areas to newly built canals & railroads
• Plank roads were better: smoother, faster, all‐weather, allowed heavier loads, higher speeds, fewer break‐downs
• Demand was so great that the construction explosion was called “plank road fever”
• Economics were based on planking life of 8 years
• It soon became evident that plank life was much shorter, 3‐4 years
• Plank road fever ended abruptly by the mid‐1850s and became part of transportation history
• Shale Plays have similar pattern of explosive growth based on questionable economic assumptions, followed by reality
Observations and Conclusions• The 2008‐2009 natural gas price collapse is more complex than recent reversals because of the global recession/depression• Over‐supply was inevitable because of new production in the Gulf of Mexico & from onshore unconventional plays• The over‐supply resulted in part from an irrational belief that gas prices would continue to rise, perception of no risk, and plentiful speculative capital at low interest rates• There was also a failure to recognize
underlying fundamentals of gas price formation: supply, demand, storage• E&P executives did not see the underlying weakness of the U.S. economy at the same time that natural gas prices were rising• It is still too early to be certain, but early production data from the Haynesville Shale does not suggest that this play will be more commercial than the Barnett; the Marcellus Shale is more speculative
• It remains unclear why the E&P industry continues to pursue shale plays despite lower gas prices• Perhaps they are out of other ideas & need to re‐focus their efforts on the technical side of the business: a return to more conventional reservoirs & risk tolerance• It is possible that natural gas prices & rig counts will continue to fall for awhile• Prices will probably rebound in Q4 2009, and will be stronger in 2010
Observations and Conclusions
• There is a bright future for natural gas in general, and possibly for some shale plays• Rigorous application of full‐cycle economics & a disciplined approach to investment are required• A business model based on realistic costs & profit margins, lower overhead, fewer promoters & more technical evaluators• The Shale play “manufacturing” paradigm must change: geology & geophysics matter!
Critical thinking is the key!
Arthur E. Berman
Ohio Oil and Gas Association
March 2009
Shale Plays and Lower Natural Gas Prices
A Time For Critical Thinking