By Arthur N. Budge, Jr.

In the first quarter 2011 edition of The Producer, I wrote about recent “Game Changers” in the oil and gas industry, discussing the impacts of the development of unconventional oil and natural gas reservoirs and of the resulting new production on domestic and international energy markets.  Recently some media channels have reported what appears to be a populist backlash against the development of these resources.  On further analysis, much of this appears to be orchestrated by special interest groups including environmentalists, and those with vested interests in “alternative energy” and the coal industry.  The attacks come in two forms; environmental and economic.

The primary environmental claim is that hydraulic fracturing can damage drinking water sources.  Recently, EPA (Environmental Protection Agency) Administrator Lisa Jackson testified before Congress that she is not aware of any proven cases where hydraulic fracturing has contaminated ground water.  There are no documented cases of this occurring in the sixty year history of the use of hydraulic fracturing to stimulate oil and natural gas wells.  There are cases where poor well drilling practices have allowed produced gas to seep into nearby water wells, but this is not due to hydraulic fracturing.  The formations being fraced are thousands of feet (8,000’ below the surface in the case of the Barnett Shale) below the freshwater zones and are separated from the freshwater zones by multiple layers of impervious rock.  The physical energy in the fracing process is not sufficient to cause the damage claimed.

The second argument is that these resources are not economically viable.  Following is a discussion of our assessment of the economic viability of unconventional oil and natural gas, and some of the fallacies or misleading statements in recent news articles.

Conventional Reserves

To understand unconventional reserves, it is necessary to define conventional reserves.  All conventional oil and gas reservoirs are formations of porous rock which are in some manner “capped” (trapped) by a non-porous layer of rock.  Most conventional reservoirs are made up of sandstone or carbonates such as limestone or dolomite.  Sandstone reservoirs were formed by the layering of eroded sand and silt over millions of years.  Carbonate reservoirs were formed over millions of years by the precipitation of minerals out of sea water.  Collectively sandstone, limestone and their variants (mudstone, siltstone, clays, dolomites and shales) make up sedimentary rocks.

Sedimentary rocks have different degrees of porosity and permeability.  Porosity is the space between the grains of sediment.   The more porous the rock, the more gas or liquids it can hold.  Permeability is the degree to which the pores in the rock are connected.  If the pores are well connected (higher permeability), then gas or liquids can move through the sedimentary rock and the natural cementing materials that “hold” the rock grains together, allowing for production.  In very “tight” or low permeability rocks such as shale, the oil and gas do not readily flow through the rock, even under great pressure.

 

Porosity – space between the grains of sediment.                   Permeability – connections between pores

Rocks in which the pores are not well connected may not be sufficiently permeable without artificial stimulus.  Some conventional formations, such as certain dolomites, could not be economically produced until the development of hydraulic fracturing.  Hydraulic fracturing is used to increase the permeability of the reservoir rock.  This process was introduced in the west Texas oil fields about sixty years ago.

Unconventional Reserves

The difference between conventional and many unconventional reservoirs is the degree of permeability of the sedimentary rock.  Many unconventional reservoirs are composed of shales.  Shales are even less permeable than carbonates.  Drilling oil and natural gas wells in shales was not economically viable until the development of horizontal drilling in the 1990s.  Horizontal drilling greatly increases the volume of the shale formation opened by the drill bit.  Hydraulic fracturing then increases the permeability of the exposed formation.

“Insiders Sound an Alarm”

On June 25th a front page New York Times article titled “Insiders Sound an Alarm Amid Natural Gas Rush” written by Ian Urbina is an example of the disinformation and misleading reporting being presented by some with a predefined agenda.  Mr. Urbina has a long history of anti-energy industry pieces for the New York Times. In this article he cites emails and documents from unnamed “industry insiders” stating that natural gas shale plays are uneconomic at current prices, reserves are purposely inflated, and he suggests that these drilling programs are ponzi schemes, equating the shale plays to the dot.com bubble.

Natural Gas Shale Wells Are Uneconomic?

Many natural gas shale wells are uneconomic at current prices. It is necessary to receive more than $4 per mcf (thousand cubic feet) for natural gas to recover the cost of drilling the wells.  Prices are currently in the low $4 per mcf range.  However, the current low price is due to the increase in domestic natural gas production from unconventional natural gas development over the last ten years.  During that period unconventional gas has increased from insignificant levels to over 25% of the U.S. natural gas supply.

This additional supply from unconventional sources has driven natural gas prices down materially.  Five years ago, natural gas wellhead prices were $8 per mcf, with futures trading up to $12 per mcf.   These lower prices permeate the U.S. marketplace, helping to keep production costs of electricity down and providing further incentives to convert fleet vehicles to natural gas. Recognition of the potential for a dramatic natural gas price decrease due to the supply potential from unconventional development led Five States to sell its portfolio of natural gas properties in 2007 when the wellhead price was $8 per mcf.

The current industry consensus, as reflected in the futures price of natural gas on the New York Mercantile Exchange, is that over time the price of natural gas will increase.  As the initial shale wells deplete and production from them declines, the price of natural gas will rise.  At the point that it rises above replacement cost, the incentive to drill more wells will return.

Many companies are drilling these wells today because they have made a long-term commitment to this business on the expectation that prices will increase over time.  They have done this by investing in large leasehold positions.  These leases are typically for a three to five year term.  If production is not established within the primary term, the lease is lost.  Once production is established, the term of the lease is extended as long as production is maintained.  Many of the unconventional natural gas wells being drilled today are drilled to maintain these leases, with the intention of drilling additional wells when market prices warrant.

Shale Reserves Are Overstated?

There was a lot of skepticism within the industry a few years ago regarding the amount of gas that could be produced from unconventional reservoirs.  With natural gas from shale production now providing 25% of the U.S. supply, it is hard to argue with the significance of this resource.  The primary source of reserve information is the Energy Information Administration (EIA), which is a division of the U.S. Department of Energy.  Michael Schaal, director of the Office of Petroleum, Natural Gas and Biofuels of the EIA strongly disagrees with Mr. Urbina’s position.  http://www.eia.gov/pressroom/releases/pdf/shale_gas.pdf

Insiders Harbor Serious Doubts?

Mr. Urbina asserted in his New York Times article that many “insiders” in the natural gas industry harbor serious doubts about the long-term viability of the natural gas market. There are numerous rebuttals to the methodology and validity or bias of the “experts” cited by the author.  One is an expert witness for the coal industry.  Another is described as “a member of the advisory committee of the Federal Reserve Bank of Dallas”.  A spokesman for the Federal Reserve Bank of Dallas commented that the individual is an unpaid volunteer on a citizen committee.  If you would like more details, please contact me.

Five States’ Position

Our experience to date, and that of our peers, is that unconventional reservoirs are a huge energy resource for the United States.  EIA analysis confirms major domestic reserves from these resources.

As with all oil and gas investments, there is risk in reserve forecasts.  Risk in forecasting is a part of the analysis of any developing resource.  There is also risk in exploration, development and production, as well as risk in market pricing of the underlying commodities.

We have concluded that the unconventional oil and gas plays can provide attractive investments for our funds.  The exploration risk in many of these plays is materially smaller than in conventional exploration.  In many cases, the risk is closer to developmental drilling risk than exploration risk.

We have participated in nine Bakken wells in Five States Consolidated I, Ltd. on acreage held by both shallower and deeper production we have owned for about fifteen years. We have been very pleased with the results to date.   The Bakken is an unconventional oil play in North Dakota and Montana, developing oil wells in a major shale formation.  Some EIA estimates project that in a few years the Bakken will be providing up to twenty percent of the total U.S. oil supply.  We plan to continue participating in Bakken wells proposed on our existing acreage.

The development pace in the Bakken is so intense that many independents cannot fund their drilling obligations on wells being proposed on their acreage out of existing cash flow.  This is providing excellent opportunities for mezzanine funding.  We are pursuing several mezzanine and development opportunities in this play for Five States Energy Capital Fund 1.

We are also focusing on acquisitions and development opportunities in the first unconventional natural gas play in the U.S., the Barnett Shale in north Texas.  We stayed on the sidelines during the boom period in the Barnett Shale.  Now that the boom is waning and the development of the play is maturing, we expect to find acquisition opportunities based on attractive valuations.

As with all direct investing in oil and gas acquisition and development, the competition is fierce.  Thorough due diligence is a necessity.  Market volatility risk remains high.  This market volatility risk increases the need for proper structure when investing in high break even cost assets.  These risks can be managed through appropriate structure and the prudent use of hedging.  We believe the risk adjusted returns in this area are as attractive as any we have seen in the industry in the last eight years.  Unconventional plays should provide an attractive additional source of investment opportunities for Five States investors for the next decade.