Is there a correction in the cards for unconventional shale plays?

Don Warlick, Warlick International, Houston

Today's oil and gas business is like poker, with amazing similarities: In both of these games there are big risks and big rewards. Both have (in the vernacular of poker) "tells" or clues about your game – habits, behavior, etc. that tell on you, giving information about your game management and potential for success.

Among the top 10 tells in poker:

• Trembling hands
• Anxiety
• Glancing at chips
• …and the ever-famous "weak is strong and strong is weak"

Sound familiar?

We've been there before

Figure 1, which shows drilling activity for US land rigs, exemplifies the roller-coaster ride experienced by the upstream sector during steady growth in 2002-2008, the downturn of 2009 and the subsequent recovery through 2010 and the first half of 2011.

Hopefully that experience will not be replicated anytime soon. The oil and gas sector had an extended seven-year ride (thanks to what took place in unconventional gas shale development) that finally ended in 2009 (also thanks to unconventional gas, when prices crashed). As the industry is currently experiencing drilling expansion with development going forward, especially with a focus on shale, helped by high oil prices, the outlook is quite positive.

But as many in oil and gas, manufacturing, and the investing space know, where there is an up, there will be a subsequent pause in activity, a downturn or a correction – at some point in time. Are we due for a correction? Yes.

Will it be soon? It's always possible, but conditions today don't indicate clearly that such an event, however sizable, is on its way.

There have always been cycles with multi-year runs in drilling and upstream development. The issue is when that step-change will take place and how extreme it will be. Given that the last up cycle continued for seven years, can we expect a similar situation? Probably not, given current economic and political conditions in the US, plus the overall global situation. More about that later.

The shale terrain

The shale oil/liquids and shale gas plays shown in the map at the beginning of this article are a significant part of the upstream business. It's estimated that these plays account for more than 85% of total US contract drilling, directional services, pressure pumping, and related oilfield services.

It's important to point out that among these important shale plays four of them – the Marcellus, Eagle Ford, Bakken, and Haynesville – account for about 50% of the just-noted 85% oilfield services spending. There is also the Permian, which is growing in size and stature, a great example of a legacy oil play that is renewing itself in this new age of shale oil development.

Times have changed since the Barnett evolution and so have gas shale economics, which are currently quite modest across all basins. Marginal but temporarily acceptable returns are largely due to operators holding and maintaining their properties in tightly-managed conditions. The early entrants were fortunate in that they negotiated low lease costs for acreages that usually had the best prospects. Thereby the sizable multi-play operators like Devon, Chesapeake, and others were able to amass sizable gas shale positions within large portfolios. But when natural gas prices fell apart in 2009, all economics were recalibrated.

It is a totally different picture for crude oil/liquids shale plays. A good example of a stellar basin for new shale oil development is the Bakken, ranked sixth among world-class oil finds – and growing.

There are five top E&P producers in the Bakken who lead the 60 or so operators active in this play: Hess, EOG, Continental, Marathon, and Whiting. Continental, which has drilled many Bakken horizontals, can expect a rate of return that exceeds 40% at a crude oil price of $80 per barrel, 55% at $90, and more than 65% at $100/bbl.

Shale development activity in the US is being led by interest in crude oil and liquids potential. In the doing, the oilfield service sector must fast-cycle and ramp up quickly to handle drilling and completion activity for shale basin leaders. An example of extreme growth is the ongoing addition of new hydraulic horsepower. A projected 50% more horsepower is being added to the North American frac fleet this year, a stunning number in a white-hot sector. Could this be a worrisome example of what happened in past upturns with high-ranging dynamics? Time will tell.

Some downsides

The successful gas shale development story that took place during 2002-2009 is well-chronicled and certainly a lesson in supply/demand economics. On the way up with increasing natural gas prices and growing natural gas production, the supply/demand model behaved as predicted. In 2009 the model also worked as expected, reacting negatively to a growing supply overhang and gas prices that fell off quickly.

The biggest lesson in gas shale economics was both the success of the so-called gas revolution, and then the collapse in natural gas prices, occurring when a significant gas supply had been constructed. A technology implementation occurred early in the drilling boom for gas shale and a learning curve was quickly replicated across subsequent gas shale developments. It then became a game of engineering and real estate as these plays filled out. Today it's a business environment involved with marginal economics and the anticipation of better times to come for natural gas.

As a consequence of the heated-up development, the US extended its gas resources in a big way. The Potential Gas Committee reported earlier that the total potential gas resources in the US grew from 1,317 trillion cubic feet (tcf) in 2006 to 1,898 tcf in 2010. That big increase was largely due to gas shale drilling and development during those four years. Even with the supply overhang gas production is still sizable. For example, in January 2009 average gas production in the US was 64 BCFD, but three years later in January 2012, average production rose to 70 BCFD. Certainly we have a world of gas and will for some time.

There are other challenges also, related to scrutiny and government oversight. A headline example is the focus on hydraulic fracturing by the US Environmental Protection Agency, now in the beginning of a multi-year study of fracturing and its applications across the country. Other government entities like the US Department of Interior and the US Department of State have combined forces to slow TransCanada's new Keystone Pipeline System.

Finally, while the Macondo blowout in the Gulf of Mexico is a fading memory, resulting changes in approval, oversight, and operations have an impact (and probably for the long term, a positive one).

Upsides for upstream oil and gas

There continue to be positive indications that the current uptrend will continue. A number of examples of continuing support and momentum include the following:

• There has been an ocean of cash made available to upstream and midstream since 2006 that has largely been concentrated on shale plays. Citigroup reported that such capital (which includes investment grade debt, high-yield debt, equity and funds from joint ventures) increased from $20.5 billion in 2006 to $39 billion in 2009 and then jumped to $62.9 billion in 2010. The projection for this year is $67.5 billion.
• In late spring Barclays Capital reported that North American E&P spending during 2011 would increase 16.2% -- a huge increase over its 7% projection last December.

There are other indicators of just how oil economics is working:

• The historic Yates field in West Texas is a good example. Acquired from Marathon by Kinder Morgan, the company is injecting CO2 to maintain production, now at 20 MBD (it was originally 175 MBD). The message: Small changes in recovery can help field economics.
• Over in the Means Field in Andrews County, Texas, ExxonMobil is also injecting CO2 with plans to extract an additional 5 MMB beyond the 300MMB the field has already produced.

One oft-forgotten fact of crude oil production in the US is that every barrel produced will displace an imported barrel – this is unlike the earlier-discussed gas production and oversupply situation. This means that operators chasing oil development, at least at this time, don't face the same difficulties as gas producers. This is a huge plus for oil drilling and development in the US.

All is not lost in the natural gas space. There are new players entering gas shale plays with another objective. They include major E&P operators like Chevron, which earlier acquired Atlas Energy and Chief Oil & Gas in the Marcellus Shale; Australia's BHP Billiton, which bought Chesapeake's Fayetteville Shale holdings; Shell Oil spending $4.7 billion dollars in acquiring East Resources in the Marcellus; plus Exxon Mobil's recent doubling of its lease acreage, also in the Marcellus.

Why is all this taking place with gas at $4? These majors all have a strategy aimed at the mid-term and long-term. Given the environmentally attractive makeup of natural gas, they anticipate gas to become an important fuel again, especially for power generation. At this time about 23% of US electricity is generated from natural gas as a fuel, and there are future plans in power generation to expand gas-fired assets. Generators are recognizing a huge low-price gas supply in future years and also wish to become more accommodating with air quality laws. There is also the problem with nuclear power's image at this time, thanks to the earlier Japanese nuclear radiation incident in the aftermath of an earthquake and tsunami.

There is good news about natural gas in Canada and potential for a gas shale comeback. Canada is facing difficulty now that the US is taking less gas imports. At the extreme, Canada could be thinking about its supply as a stranded resource. The huge new Kitimat LNG Project, a liquefaction facility being constructed on the Pacific coast of British Columbia, is owned jointly by EOG Resources, EnCana Corp., and Apache Canada Ltd. The three companies hope to export their gas in the form of LNG to the Eastern Hemisphere by 2015, giving a boost to continued development of Canadian gas shales such as the Horn River and Montney.

Looking ahead

As Table 1 indicates, crude oil prices are attractive through 2012 and consequently a supportive environment for wet play development. Conversely, the situation for natural gas is as expected, with flat gas pricing.

But there are worries that deal largely with economics, both in Europe and North America. The oil and gas industry must not forget that country economies are actually the final customer for hydrocarbon production. When those economies have difficulty, there becomes a concern for oil and gas demand.

The global economy is no doubt in significant trouble for reasons relating to politics and structural issues as well. For example, at this writing, investors were fleeing Italy's bond markets and European leaders were wrestling to get ahead of a potential economic and financial crisis that relates to concerns over Italy's political stability and solvency. This means we can now add Italy to the problems of Greece, Portugal, Ireland, and possibly Spain as well.

As of early June, the US economy has become tentative, complicated by current debt difficulties and ongoing budget debates in Washington. The US oil and gas business is an integral part of the economic chain involving industrial, commercial and residential sectors in the US. As the overall US and Canadian economies return to a healthy state, so does oil and gas. When slippage occurs and current economic states of affairs go negative, there can also be negative impacts across the energy sector.

How can the oil and gas industry anticipate a possible correction, yet take advantage of drilling and development opportunities evolving right now? It's important to note that in mid to late 2008 there were few who predicted the big downturn of 2009. Today, conditions related to oil development in the shale oil plays are a bit different. At this time, oil production in the US is not sending product into an oversupply (like what is happening in natural gas). Rather, each produced barrel of oil simply displaces imported barrels.

The new political and economic environments in the US and the Eastern Hemisphere have become more complex and worrisome. There is and always will be a chance for a correction that can impact oil and gas development, especially shale development. When is that coming? It's hard to tell, but there are several strategies the oil & gas sector can take to mitigate future conditions that can be brought on by such an event:

• Plan carefully in extending development plays, utilizing sound risk analyses
• Continue efficiency and other improvement programs to drive down costs
• Give emphasis to wet play opportunities, a positive situation now and in the near term
• Periodically evaluate the bigger picture beyond exploration and drilling; remember what was said earlier – the ultimate customer for hydrocarbons is a national economy
• Think strategically in the long term about natural gas – if Chevron, Shell, ExxonMobil, and other big players are expanding into gas shale asset plays and spending billions in the doing, then something's up. So it's probably a good idea to assess gas for future-year opportunity.

The previous points are not the total answer in anticipating a future correction, but this straightforward approach can allow an energy enterprise to both prepare for such an event and also take advantage of current opportunities and business-build along the way.

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