Thursday, August 25, 2011

The Natural Gas Conundrum

I wrote last about natural gas prices in my October 14, 2010 post "Update on Natural Gas Prices". Current natural gas prices seem to have stabilized between U.S. $4 and $4.50 per mcf. The number of drilling rigs in the U.S. aimed at natural gas is 900 suggesting, using Chesapeake's forecast a production drop to 53Bcf down from 68Bcf/d at the peak of the 2008 gas boom when prices were as high as $8/mcf.

The I.E.A. states that 2011 produced approximately 22Tcf/year or 57 Bcf/d with Shale gas providing 5.22 Tcf/d or nearly 25%. A somewhat more optimistic picture, but does that mean Chesapeake is wrong? Shale gas production rates decline as fast as 68% from their initially reported production. That is faster than the depreciation of a new car in its first year. Thus gas production drops from 5.22 to 1.67Bcf/day if we were talking about new wells; older wells decline a lot less fast but their production rates are a lot less. A good well that starts out at 6,000,000 cubic feet per day would decline to 750,000 cubic feet in four or five years or an average annual decline rate of 22-23%. Assuming an even distribution of old and new wells, that means that to keep shale gas production even, 1.14Tcf of gas has to be added each year or 3.1 Bcf per day or between 500 to 1000 wells at a typical cost of $7.5 million per well. Yes that is an investment between $4 and 8 billion each year.

Unfortunately at current prices it is not economic to drill such expensive wells. When gas prices were hedged in 2008, the effects of this economic reality has been softened and companies like Encana remained profitable for the duration of those high priced hedging contracts but that is now coming to an end. Guess what, Encana just put its 'high quality' unconventional gas plays in North Texas up for sale. Chevron and even the president of Chesapeake (who regularly sells of parts of their holdings) claim that they cannot justify drilling these wells. The only reason shale gas is being drilled is because investors consider it sexy and the company's 'reserves' grow rapidly each year (well that is book keeping not cash flow). So a company's reserves and thus book value may increase but it is not making positive cash flow.

Chesapeake's original gas forecast is in my mind still valid, although delayed by the reserve's addition and land addition game. But overall, with improving economic conditions, we are moving every day closer to higher gas prices. Yes shale gas has caused an energy revolution and we will have plenty of it for the foreseeable future, but we will have to pay a higher price than today's. Just like we do with oil. I would not be surprised to see $6.00 to $7.00 gas within a year and a revival of Alberta's conventional gas industry.

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