After Further Review

Jim Brown
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Gas drillers like Chesapeake raced out to acquire all the acreage they could find in places like the Marcellus, Haynesville and Barnett Shale. They spent billions snapping up everything in sight. They spent so much that the money left over to develop those properties was chicken feed.

Expectations for vast amounts of new production capability created a land rush mentality. Companies who were not even in the shale gas drilling yet rushed to acquire some land so they could brag in their annual reports that they were moving into the lucrative shale gas business.

Fast forward about five years and the game is changing. Early wells in the Barnett Shale came on like gangbusters and production was surging. This was so easy that the number of wells exploded. The Tarrant county, the area surrounding Fort Worth, reported more than 100,000 new leases recorded in 2007 alone at rates from $15,000 to $37,000 per acre and some included a 25% royalty to the land owner. Drilling advocacy groups claim as many as 108,000 new jobs were produced by the drilling boom. Over 14,000 wells have been drilled in the Barnett Shale and an additional 3,000 have been permitted.

The promise of shale gas drilling was huge. Every similar formation in North America and many other countries was quickly plotted and land men hired. Unfortunately that promise has been broken.

Now that there has been about five years of production history on the Barnett the ugly truth has come out. Shale gas is a flash in the pan and then it is gone. Of a sample of more than 5,000 wells in the Barnett as many as half of them are already dry or at least no longer producing in commercial quantities. The wells that came in strong tended to deplete as much as 75% in the first year and another 50% in the second year. With wells costing from $3.5 million to $5 million the majority of the wells will never be profitable.

Unfortunately the initial production volumes sparked a gold rush mentality that sent drillers into a frantic race to acquire money so they could put more rigs to work and buy more land. It was a case of a race to profitability. In the occasional dry well it was assumed it was a fluke, we missed the vein. No problem we have plenty more. The maximum production came from wells drilled in the core of the Barnett, the area where the gas was most plentiful and easiest to reach. These wells were drilled first in most cases. Why drill risky wells when the sweet spot is waiting?

Because the core was drilled first the average production per well drilled was very high. Wells were being drilled so fast they could not keep up with the infrastructure and drilled wells set idle sometimes for months before they could be connected to a pipeline. Drillers did not know exactly how strong the wells were until they were connected. While they were waiting they drilled hundreds more. It was a frantic activity to drill because everyone "knew" they were going to pay off big.

There was even a rush to drill the wells with a plan to complete them later when the economic recovery was in full swing and gas prices rose. There are nearly 2,000 drilled wells that are not yet completed. Many of those wells will never produce commercial quantities but nobody knows that until they are completed.

So drillers convinced investors that there was gold in those shales. They raised billions and spent every dime. When gas volumes failed to meet expectations they could not go back to investors and say "sorry, we were wrong." In order to keep the money flowing to service the debt they had to keep drilling at a breakneck pace. Production from new wells comes in strong and the faster they drill the wells the more production they can claim.

This creates a race with the devil. The devil in this case is depletion. Wells that are 2-3 years old and declining to a trickle put a strain on those rising production volumes. Eventually drillers can't punch and complete new wells fast enough to offset the decline from the older wells. Production estimates begin to slide and investors start to become concerned.

As drillers become aware that the devil is winning they devised a way to escape the debt trap. They are capitalizing on the remaining excitement of the shale gas boom by "joint venturing" with unsuspecting partners. Most of those deals announced recently have been to companies outside the USA. These companies see all the activity and feel like they are missing the boat. They don't realize that the U.S. drillers are in a race for survival.

They also want to know how to drill shale gas so they see their joint venture fee as a paid education in shale gas drilling. What they don't realize is that it will be an expensive education.

This has been transpiring for a little more than a year now but in this cross country race there is a bridge out ahead. To complete a horizontal gas well profitably requires what is known as hydraulic fracturing or "fracking." The fracking company pumps hundreds of thousand of gallons of water and chemicals into the well under very high pressure. The high-pressure fluid fractures the shale rocks and creates cracks for the gas to escape. The water is removed from the hole and the frackers move on to the next well.

Unfortunately some of frack water has been known to find passages in the shale that flow into the ground water and well systems of the surrounding community. Initial complaints were ignored or pacified in some way so that the race could continue. As shale drilling intensified in the Haynesville and Marcellus the number of complaints grew from hundreds to thousands. Eventually the volume of complaints became so loud that governments were forced to investigate. Two separate full length documentaries were produced showing the hazards of fracking and shale drilling.

Now state and local governments and even the U.S. House and Senate are starting to take action. In New York and Pennsylvania there are movements to halt gas drilling for a year to allow the investigation to take place. This is a major step for these states because they are reaping billions in fees from the drillers and taxes from the production as well as thousands of jobs created by the gas rush. For them to call a halt and cost themselves billions in revenue illustrates how serious the problem has become.

Hardly a week has gone by this year without an announcement of some driller selling off acreage in a joint venture. All of these new partners are joining the party just in time to see regulators take away the punchbowl. There is going to be some serious havoc in the sector as the truth and the untruths come out.

In very recent months we have seen the drillers beginning to pitch their move to "liquids" as the answer to their profitability. They are all trying to get "oily." For these horizontal drillers it means they are moving to deposits that have an oil component or a high amount of natural gas liquids (wet gas). Oil at $80 is much more profitable than gas at $5. There used to be a normal ratio of cost to btu that kept the two commodities more or less in sync. That broke down when the shale gas bonanza started flooding the pipelines with gas.

The cost to drill a horizontal gas well or a horizontal oil well is roughly the same. Only the payout is different. Companies are moving rigs to places like Eagle Ford, Niobrara and the Bakken as a way to increase their liquids output and escape the rate race in shale drilling in an orderly fashion. Chesapeake has made about $2.9 billion in land acquisitions in the first half of 2010 to lock up leases in "oily" plays. The company has now created a leading position in a dozen different liquid rich plays. CHK has gobbled up 2.4 million net acres, which is nearly equal to the gas acreage they own. They claim the potential is up to three billion barrels of oil equivalent. In order to do this Chesapeake joint ventured with Statoil in it's Marcellus Shale acreage and Total SA in the Barnett. That means they sold those companies on the idea of shale gas and then used the proceeds of the sale to go wet.

EOG Resources is actually ahead of Chesapeake and hopes to have production up to 25% liquids by 2015.

In summary we are seeing the major gas drillers abandoning the shale gas plays and selling their holdings into joint ventures in order to recover cash. If the joint venture is successful then they can get some production kick down the road from shale but in the mean time they are insulating themselves against the coming slowdown in shale gas. When fracking is outlawed in populated areas the company holding that acreage is going down hard. Add that to the rapidly depleting wells already drilled and the companies have to get some liquids flowing fast or the red ink is going to flow and that spells the end to the easy investor money they have been using to buy land.

Shale gas is on the way out but much of the investing public doesn't know it yet.

Jim Brown

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