Seven factors that drive today's gas shale business

Don Warlick,Warlick International, Houston

In today's upstream oil and gas business, the hottest trend over the past four years has been the development and explosive growth of unconventional gas plays. Chief among them has been gas shale development and the surprising economics of these shales, allowing big-play developers to challenge today's lower natural gas prices with technology-based drilling and completion, intelligent field development and management, and (thankfully) sufficient funding to satisfy the significant capital requirements for these huge plays.

But it's no longer 2008, and times have changed along with overall economics. Even with sub-$5 gas we are observing growth in current and early-stage plays accompanied by reasonable returns and acceptable economics. There are a number of factors to consider today when making sense of the unconventional gas space. Accordingly, in this mid-year briefing we've identified seven factors we believe have impact and meaning for E&P, oilfield services and financial services entities who participate in this sizable upstream business.

Natural gas demand improving

Most of the US and Canadian economies are recovering, but it has been slow and halting. The good news is that there is sufficient history to show the path forward to be a relatively positive recovery (but some economists continue to worry about a potential fall-off in the overall economy).

Remember that natural gas consumption in North America will cycle according to season — winter is the high-demand period with summer consumption largely driven by additional power generation requirements. Some positives evident now include more gas-fired demand in the power generation sector due to higher summer temperatures plus a bit of growth in demand for petrochemical production based on gas feedstock. It appears that the overall demand for US and Canadian natural gas in the 6 to 18 months ahead will be at best, slow and steady.

Natural gas prices and oversupply affecting all gas drilling

There is good news and bad news involving natural gas prices: The good news is that LNG that might otherwise be landed in the US and Canada is not coming because of low prices. The bad news is that low gas prices are making it difficult to defeat challenging economics for both unconventional and conventional gas development. Of course there is the exception in successful gas shale plays like the Marcellus, Haynesville, and others where established gas portfolio players are capable of low-cost development and high-volume production.

The supply outlook for both the US and Canada is not good and anticipates a continuing overhang unless the hot temperatures of July continue through August and perhaps early September, adding to natural gas consumption in the power generation sector. For some time now, analysts have worried aloud about the US gas supply and its impact on prices. We agree with most and think there is a good case for continued weak pricing with oversupply being the most significant depressing factor. Table 1 provides two experts' forecasts for Henry Hub prices in 2010-2011.

One last point: There is a fundamental shift in natural gas pricing today where the newest gas is not necessarily the most expensive (i.e., production from highly efficient, high-volume gas shales). This is unlike years past when the newest produced resource, whether oil or gas, would normally cost more. But that's the situation in unconventional plays and also an opportunity for unconventional gas developers to operate on more economic bases in the present. High gas prices are always welcome but today we can have reasonable expectations that unconventional gas development can be successful even with diminished natural gas prices.

Resource portfolios — adding more oil

One look at the natural gas price forecasts elsewhere in this article and one realizes that to be a big-play gas developer it's an absolute to have nerves of steel and plan on the long term. But during 2009, while gas prices deflated, it was crude oil that had a second comeback from a rise and fall in the prior 18 months. So with anticipated gas prices bounded in a $3 to $5 range what are Chesapeake, Newfield, EOG, Petrohawk, and others with large gas portfolios to do?

The answer is to spread investments over into oil and ideally in those unconventional plays where the same gas shale development technologies can be applied. The Eagle Ford shale play in South Texas is a good example. It has three distinct segments of thermal maturity variation so that its northern strip offers an oil window; the middle window an equally appealing liquids-rich strip; while the southern window is a dry gas strip, still attractive as a gas shale opportunity. In North Texas' Fort Worth Basin there is the Barnett Combo, which EOG is developing on a fast pace.

There are other shale oil opportunities (remember it is shale oil formations that are laid down on continuous bases while oil shale is altogether different — it's kerogen-based, similar to Canada's oil sands, and needs very high crude prices to sustain development).

Whatever the case, E&P companies are the ultimate energy banker who will invest in the best opportunities for the most attractive return. For those companies big in gas shale development and have sizable positions in experience, life is OK. Add some oil opportunities and it could be better. So for the time being there will be competition for capital in every oil and gas company when it comes to playing the portfolio for best returns — and right now oil looks pretty good.

International influence is growing

There is no question there is a sizable unconventional resource potential around the world. Thanks to the fabulous success of US and Canadian unconventional developments, the appeal for the same kinds of development is now strong in Europe and in Asia.

All of that is evidenced by the international players involved in recent unconventional resource joint ventures in the US, and soon in Canada. E&P companies like Eni, Statoil, Total, BG Group, plus others yet to be revealed are participants in North America and are anticipated to have their own designs for Eastern Hemisphere development. Remember also there are investment players like Mitsui, Sumitomo, and Reliance Industries (also with E&P development in India) delving into gas shale development not only for the returns and also some experience for future opportunity.

Importantly, there are good reasons for growing unconventional plays in the Eastern Hemisphere — Europe is wishing to increase gas resources, but also to reduce reliance on Russian gas. China has huge coal and coalbed methane resources and is clamoring to secure energy resources of all kinds.

What's in the cards for international influence? Anticipate more investment from these kinds of players to continue in both the US and in Canada.

Acquisitions have huge impact — will there be more?

ExxonMobil's acquisition of XTO Energy in late 2009 was a $41 billion blockbuster. In one fell swoop it allowed ExxonMobil to gain substantial position in the leading gas shale plays in the US plus access to experienced engineering/development management to plan the path forward. A high quality deal in all aspects, but perhaps most important is that this event advances a solid, well-financed player into the frontline for timely unconventional gas development. We may have arrived at a point today in the unconventional space that bigger is better and that scaling up is the answer to low-end economics.

In April, 2010 Dominion's remaining Appalachian E&P business was finally sold (recall that Dominion had some relatively widespread holdings in the US unconventional space, then decided to exit that business). CONSOL Energy paid $3.5 billion in cash for 1.4 6 million acres plus production of 41 BCFE from about 9,000 wells. They report that as a consequence they are now the largest producer of natural gas in the Appalachian basin.

Then there is the May 2010 acquisition of Marcellus-focused East Resources Inc. by Royal Dutch Shell for the princely sum of $4.7 billion. Shell had been searching and analyzing unconventional resource opportunities across North America for some time, and probably the East Resources deal was the only one that could be in their pipeline.

Doubtless other majors and super-independents are watching ExxonMobil and Shell with more than casual interest as they observe the tremendous growth of land-based unconventional resource plays across the US and Canada. Undoubtedly, many are trying to determine if now is the time to enter before it's too late. In addition, the recent Gulf of Mexico oil spill disaster and its fallout give pause to the big GOM players as to how they may wish to invest future capital.

Will there be more such acquisitions? The probability is high for all the above reasons, plus the fact that unconventional gas (and oil) development calls for huge development campaigns that need landholdings with significant areal extent, application of the latest technologies, experienced talent to manage the business, and staying power to handle future price fluctuations, growing government/regulatory oversight, and not least, investor demands and desires.

Private equity gaining speed

More is coming, as evidenced by recent deals in gas shale plays. Two conditions are supporting private equity growth here: The opportunities themselves as gas shale development are calling for significant funds with currently-attractive payout; the other comes from the private equity side where leveraged buyout deals have dried up — private-equity firms were involved in transactions worth $32 billion in FH2010, only 10% of the volume in FH2007.

A good example of what's characterizing the current attraction for private equity in the gas shale space is the recent Shell Marcellus buy-in. Just a year ago in mid-2009, Kohlberg Kravis Roberts & Co. (KKR) invested $350 million into privately-held East Resources Inc., a very small Marcellus E&P player. On May 28, Royal Dutch Shell acquired East Resources for $4.7 billion. Of the 11 US gas shale transactions, accounting for $17.9 billion in FH2010, this was the biggest. Reportedly KKR enjoyed a fourfold return — in just a little more than one year.

KKR isn't stopping there:

• In February 2009 KKR executed an agreement with Premier Natural Resources LLC in making select more traditional energy investments across North America.
• Most recently, in mid-June, the firm announced intentions to spend up to $400 million in a partnership with closely-held Hilcorp Energy Co., holding 40% of the deal to develop oil-bearing properties in the Eagle Ford.

And more private equity players are coming — like the Blackstone Group LP, Carlyle Group, and First Reserve (with its recent NFR Energy LLC deal with Nabors Industries to invest up to $1 billion in the Haynesville Shale).

So what is the chemistry here? For gas shales there is huge production potential but the overall development costs can be enormous in massing up landholdings, employing expensive technologies, and managing smartly to drive down costs. It appears that the appropriate model for private equity is to acquire partial ownership of independent E&P companies today — the gas scale space is calling for enormous capital but with potential for significant cash flows in the future — thereby private equity is supplying required capital and operating support to get there.

Joint ventures — an ocean of cash for development

This is a huge driver supporting unconventional gas development, with special emphasis on gas shales. Over the most recent 10 quarters, 2008-2009-FH2010, Tudor Pickering Holt & Co. reports there have been 41 joint ventures of consequence with focus on the unconventional resource area. Marcellus leads with 13 JVs, followed by the Haynesville with eight. And more are coming.

Chesapeake Energy was the first gas portfolio player to utilize the joint venture model in securing capital to develop high-cost unconventional plays. In fact they were most recently in Asia discussing the possibilities of investment in Chesapeake's Eagle Ford and Marcellus plays. The Chinese are very interested in learning and replicating North American development techniques to apply to their own coalbed methane and gas shale plays. Companies like China National Petroleum Corp. and China Petroleum & Chemical Corp. are in the forefront. Don't be surprised if those names come up in the US and Canada sometime soon.

It is instructive to view representative joint venture deals just to recognize the impact they are having in the unconventional gas area, shown in Table 2.

There's more: On July 19, India's Reliance Industries Ltd. (already a participant in two huge US gas shale deals) expressed an interest in Quicksilver Resources' Horn River Basin holdings in northern Alberta.

Another joint venture? An acquisition? The events of the past two years have taught us to expect the flow of these events or deals, both large and small to continue as gas shales and other unconventional resource development increasingly call for more capital.

Summary

The upstream oil and gas business is evolving through a surprising, steady recovery after a disastrous 2009. The exceptions include gas shale development in high-end plays like the Haynesville, Marcellus, and soon the Eagle Ford — but not to take away from the respectable performance of the Fayetteville, Woodford, and Barnett.

When one evaluates each of these plays, he will find several E&P leaders who set the pace. They do so via experienced management, a long-term mindset, smart development, and we believe, a good understanding of the driving factors we discussed that will impact the future of these gas plays.

About the author

More Oil & Gas Financial Journal Current Issue Articles
More Oil & Gas Financial Journal Archives Issue Articles
View Oil and Gas Articles on PennEnergy.com