The Shale Gas Fantasy and Profit When the Bubble Bursts
Commodities / Shale Oil and Gas Sep 18, 2013 - 09:15 AM GMT
The numbers don't lie—but politicians and industry bigwigs do. While pundits still wax poetic about an era of American energy independence, Bill Powers, author of the book "Cold, Hungry and in the Dark: Exploding the Natural Gas Supply Myth," sees productivity plummeting in almost every major shale play. In this interview with The Energy Report, Powers tells us to forget about LNG exports and a manufacturing boom and get positioned for a bust. How? Invest in energy equities. Powers names his favorites for maximum returns when the bubble bursts.
The Energy Report: Your last interview in May stimulated more discussion on how much natural gas supply we actually have in North America. Have there been any significant developments since then to support your views on the long-term supply picture?
Bill Powers: More data points have come in supporting my views and making it very clear that the Fayetteville and Haynesville shales are now in decline and the Barnett had a very steep, 17% decline in H1/13 on a year-over-year (YOY) basis. It is now producing about 4.6 billion cubic feet a day (Bcf/day), which is substantially down from its peak of near 6 Bcf/day. The facts are starting to show that declines for the older shale plays such as the Barnett, Haynesville, Fayetteville and Woodford are very serious. More important, once production growth from the Marcellus slows down, it will no longer be able to offset declining production from shale plays as well as conventional, offshore, CBM and tight sands production, which are all in terminal decline.
TER: Have companies been overproducing?
BP: There are still about 40 rigs running in the Haynesville. That's dry gas with no associated liquids. Virtually every one of those wells will be uneconomic at under $6 per thousand cubic feet ($6/Mcf) and probably closer to $7/Mcf. About 80% of production will come within the first two years for most Haynesville wells, so current gas prices have an outsized influence on an individual well's economics. There are still a number of companies out there willfully drilling uneconomic wells, which boggles my mind. These companies are continuing to drill to keep their production from collapsing entirely.
Last year, Chesapeake Corp. (CHK:NYSE) wrote down 4.6 trillion cubic feet (4.6 Tcf) of proven reserves from its Barnett and Haynesville shale wells. At the end of 2012, Southwestern Energy Co. (SWN:NYSE) wrote down the proven reserves of its Fayetteville Shale assets from 5 Tcf to 3 Tcf. Other companies, such as BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) and BP Plc (BP:NYSE; BP:LSE), took huge write-downs. BG Group Plc (BRGYY:OTCQX; BG:LSE) also took a big write-down due to poor performance of its Haynesville wells. The list goes on and on. These reserves were supposed to have a 90% confidence level of being producible and generating a 10% rate of return using existing technology.
The low price of gas alone isn't causing these write-downs. A lot of it has to do with the poor performance of these wells. There's been a lot of evidence put forward by myself, Art Berman, who wrote the forward to my book, and David Hughes, that the shale industry has overbooked its reserves by approximately 100%. The write-downs of the last few years have largely proven this out. More importantly, if shale operators are writing down reserves at the rate we've seen, this also speaks volumes about the total recoverability of all shale gas in the United States.
The two really bright spots right now are the Marcellus and the Eagle Ford. There have been thousands of wells drilled through the Marcellus over the years for both the Oriskany, directly underneath the Marcellus, and the Trenton Black River Trend, also below the Marcellus. Operators have had the advantage of using a very good cheat sheet to know where to drill first for the best wells. Additionally, all the knowledge operators gained in developing other shale plays has greatly accelerated the ramp-up in Marcellus production. For example, operators began drilling horizontal wells early in the lifecycle of the Marcellus due to experience gained in the Barnett, Fayetteville and Haynesville. The strong growth in the play has really been the only thing that has kept gas production even close to flat this year in the U.S. As I discussed earlier, it will not be long before future shale wells will not be able to replace production from older wells.
The decline will become more evident once the aerial extent of the Marcellus fields becomes more clear. This is starting to happen in southwestern Pennsylvania, where Range Resources Corp. (RRC:NYSE), one of the most aggressive producers in the region, is now saying in its investor presentation that it and other operators have defined the outer limits of some fields. Once you run out of the high-quality, liquids-rich drilling locations in Washington County (southwestern PA), you will get a very large fall-off in productivity.
TER: Why all the production overestimates regarding U.S. shale reserves?
BP: Many of the people promoting the 100-year myth were doing it for either financial or political reasons. Let's look at why the U.S. government promoted the myth. The government has the idea that if the U.S. were to become an LNG exporter through the rapid development of shale, we would lessen the importance of Russia on the world's stage. Ernest Moniz, who's the head of the Department of Energy, is a big advocate of exporting LNG. He recently granted the fourth LNG export license to Dominion Cove Point LNG (D:NYSE) to open an export facility in Cove Point, Maryland.
Industry mainly wanted the ability to sell acreage to latecomers. Chesapeake Energy championed this model by generating a lot of excitement after making a discovery and then selling out a significant chunk of that acreage to a latecomer, who would almost always overpay. This strategy was actually discussed by the former CEO, Aubrey McClendon, in an October 2008 conference call. Industry needed money to develop its own acreage and also to generate higher stock prices so they could acquire other assets or companies more cheaply. David Hughes has talked about how it would require $42 billion ($42B) to keep gas production flat in the U.S., while shale operators only generate around $32–33B dollars a year in revenue, and probably closer to only $8–9B in cash flow. They are far outspending their cash flow to drill additional wells.
Looking at academia's role, there was a case where Penn State put forward a very optimistic report that was paid for by the industry and that payment was not disclosed. After a community group discovered this, the dean of the Earth Sciences Department redacted the report and reissued it with numerous changes and proper disclosure as to the source of the funding. The report discussed the economic impact on Pennsylvania from the Marcellus and made some very optimistic projections.
Unlike a lot of people who make statements about the amount of gas that's out there and provide little or no empirical evidence to support their claims, I have almost 600 footnotes in my book that explain exactly where my estimates of future shale gas recoveries come from.
Other promoters of the 100-year supply myth include people such as T. Boone Pickens, who has a very self-interested agenda to get natural gas vehicles onto the road. Pickens, who said on CNBC in 2011 that the U.S. will recover 4,000 Tcf and has never provided any support for this statement, promoted this patriotic idea that we should convert our vehicle fleet to natural gas rather than buying oil from the "enemy." Pickens has been known to refer to certain oil-exporting nations as the "enemy."
However, Pickens almost never discusses the fact that he is one of the largest owners of Clean Energy Fuels Corp. (CLNE:NASDAQ), a company that is one of the biggest providers of natural gas refueling stations and that stands to benefit significantly from the growth of natural gas vehicle adoption. The legislation that T. Boone Pickens is advocating for in the Pickens Plan, which includes large tax credits and grants to the natural gas vehicle (NGV) and NGV refueling industry, would benefit him uniquely because he owns approximately 18.1 million (18.1M) shares of Clean Energy Fuels stock. Pickens' shares are currently valued at around $230M. There are very few people, and you can count them on one hand, who want to discuss the reality of shale gas, which my book does.
In addition, the Securities and Exchange Commission (SEC), after heavy lobbying, changed its rules in 2010 to allow for a significant increase in proven undeveloped reserves to be booked, so the SEC was also complicit in the perpetuation of the shale gas myth. Without this change in how shale gas reserves were booked in 2010, most shale operators would have been forced to take large write-downs rather than booking increases in reserves. I believe this rule change by the SEC grossly distorts the value of a company's reserves since it allowed for a large increase in the booking of proven undeveloped reserves.
TER: What other economic consequences do you see if and when your views become reality?
BP: I think it will be similar to the housing crisis, where a handful of people saw it coming and profited from it. There was significant evidence that housing prices were unsustainable, but most people were surprised when the housing bubble popped. People from Alan Greenspan to Ben Bernanke and others had a lot of information about the economy and how unsustainable house prices were, but did not want to talk about it publicly. There's a saying that "the impossible can become the inevitable in the blink of an eye." I think this will happen with natural gas. For example, in the first week of December 2000, gas prices went from around $4/Mcf to over $10/Mcf in only a few trading sessions. This was due to falling production, lower storage levels and a cold spell that set in across much of the United States. This price spike was the first of numerous spikes during the last decade.
In the late 1990s, Enron and other companies like Calpine Corp. (CPN:NYSE) built dozens of natural gas-fired power plants on the belief that the price stability between 1984 and 1999 would continue for several more decades. The build-out of gas-fired power plants was led by large demand increases from the electricity generation industry at a time of falling production. Few remember that U.S. gas production fell from 2002 to 2007.
Shale gas is a finite resource. When prices start to escalate, unfortunately, the situation will be even worse than the spikes we had in the early part of the 21st century, and even more so than the 1970s. From 2000–2010, we were able to increase our imports of LNG, and in the 1970s we built dozens of nuclear-fired power plants and hundreds of coal-fired power plants to reduce demand for natural gas. Now we are seeing the nuclear industry in decline, with five plants shutting down this year out of 104 plants, and many more closing in the next two to three years. Dozens of coal-fired power plants will be shutting down before mercury emissions laws take effect in 2015 and few new plants are likely to be built given the stringent emissions standards.
Even worse, for the first time in the industry's history, world LNG trade shrank last year. We are seeing record-high global prices for LNG with no sign that this is going to slow down or reverse. When the U.S. is forced to go back out and try to secure cargos to import LNG, the prices we will be forced to pay are going to be much higher. The current price of LNG in Chile, Brazil and Argentina is $14–15 per million British thermal units ($14–15/MMBtu). In Japan and Korea it's been over $16/MMBtu. Even Mexico is currently importing LNG at $16/MMBtu due to demand outstripping supply and lack of pipeline capacity to connect to U.S. markets. The U.S. is going to be forced to pay much higher prices when it will not be able to meet its own domestic needs, as shale gas rolls over and Canadian imports decline as the country begins exporting LNG to Asia via British Columbia.
TER: If we don't have excess gas supply, will that lead to a bust in the planned LNG export terminal business?
BP: Barring a major new shale gas discovery in the very near future, the future of U.S. LNG exports will have to do with how much domestic demand falls off. A lot of these terminals will probably get built only to lie dormant when the government declares force majeure and cancels overseas contracts. Politicians will look at their constituents and see all sorts of suffering, from higher electricity bills to higher food prices to higher home heating bills, and say they are going to pull the export licenses from all these LNG plants. As I say in my book, "Overseas customers do not vote."
TER: To address your earlier analogy to the housing bust, what are some actual investments investors may want to consider to for profit opportunity in the event of a shale gas crisis?
BP: Right now I think there are some great ideas out there. Three of my favorite Canadian companies are Bellatrix Exploration Ltd. (BXE:TSX), Advantage Oil and Gas Ltd. (AAV:NYSE; AAV:TSX) andArsenal Energy Inc. (AEI:TSX)—I'm a director with Arsenal and the company just had some very good news. My favorite company in the United States would be Denbury Resources Inc. (DNR:NYSE), which is very active in CO2 flooding in the Gulf Coast as well as in the Rocky Mountain region.
Advantage has a great Montney play at Glacier, where it has built out its infrastructure. However, the company is not overproducing its fields at a time of low Canadian gas prices. I think management's done a great job and as gas prices rise, the company has tremendous leverage.
Bellatrix is a significant producer that will have room to grow. It has great Cardium acreage and is very leveraged to the Duvernay Shale. The company has significant upside from here.
Arsenal Energy trades at a very low multiple of valuation on any metric and has enjoyed very strong results in North Dakota as well as in central Alberta. It's 75% oil. Again, I am a director and shareholder.
In the United States, Denbury has a very large inventory of projects it continues to develop and is far and away the industry leader at tertiary oil recovery. It gets Louisiana Light pricing for its oil and generates very significant cash flow, even at substantially lower prices. There's almost no exploration risk for the company given that it is reestablishing production via CO2 flooding from previously depleted fields.
TER: What should investors be doing now to benefit from or protect themselves from what you believe lies ahead?
BP: I think that energy equities will provide some of the best returns available anywhere over the next 10 years, similar to what we saw in the 1970s. Shortly after the U.S. eliminated convertibility of the U.S. dollar into gold in 1971, which I consider a default, we saw massive inflation. Oil and gas and precious metals and equities related to these two sectors were among the very few investments that paid off in that era. The returns in those investment classes were fantastic, whereas just about everything else, from government bonds to general equities to tech stocks, got destroyed. I think we're heading toward a similar period. Even though natural gas has been one of the only commodities left behind by the flood of liquidity over the last five years, it is also one of the most volatile commodities. I am looking for a period of serious outperformance by natural gas over the next decade.
TER: Care to take a shot on where you think gas prices may end up in the next few years?
BP: The U.S. is heading toward world gas prices. To recap, this means double-digit prices within the next three to five years for a number of reasons. First, in addition to lower U.S. production, our imports from Canada are going to be diverted toward Asia through LNG exports. Canadian production continues to fall, and 2013 will mark the 12th year since it peaked. Canada will be unable to export to both the U.S. and Asia due to lower production and record domestic consumption. Second, the U.S. is now far more reliant on natural gas to generate electricity than it was in the 1970s. The U.S. got out of that gas crisis by building nuclear and coal-fired power plants, not through increased gas production. Last, this time it's going to be very difficult to destroy demand because we are starting to see manufacturing come back to the U.S. and coal and nuclear plants are closing.
TER: Thanks for joining us today and updating us on your thinking.
BP: Thank you. I greatly enjoyed our interview.
Bill Powers is an independent analyst, private investor and author of the book "Cold, Hungry and in the Dark: Exploding the Natural Gas Supply Myth." Powers is the former editor of Powers Energy Investor, Canadian Energy Viewpoint and U.S. Energy Investor. He has published investment research on the oil and gas industry since 2002 and sits on the board of directors of Calgary-based Arsenal Energy. An active investor for over 25 years, Powers has devoted the last 15 years to studying and analyzing the energy sector, driven by his desire to uncover superior investment opportunities. You can follow Powers on Twitter at ;@billpowers1970 or visit www.bill-powers.com.
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1) Zig Lambo conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: None.
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