Wednesday, August 24, 2011

Pugh Clauses and Shale-Gas Activity. By Peter Staas

I came of this review article on shale gas economics. Now with posting natural gas prices in the blog header, reprinting this revealing article is a good introduction.

2 Sep 2010. Investing Daily.

“Why hasn’t Chevron made a bigger splash in North American shale gas? During last year’s third-quarter conference call Vice Chairman George Kirkland indicated that an oversupply of natural gas had prompted management to curtail its drilling activity in the Lower 48 states.

Kirkland elaborated on this decision during a recent conference call to discuss Chevron’s second-quarter results: “We like unconventional gas where we can make reasonable returns…[Our US holdings] don't presently make development sense because the gas price and the market conditions with oversupply in the U.S. just doesn't make it attractive.”

This statement reflects an apparent anomaly in the domestic market for natural gas: Drilling activity in unconventional plays remains robust despite depressed natural gas prices–a puzzling disconnect that prompts many investors to steer clear shale-gas producers.

Attractive economics in some of the nation’s hottest shale plays partially explain why producers continue to ramp up production, even as the seasonally weak “shoulder” period approaches and concerns.

As my colleague Elliott Gue explains at some length in Why Some Natural Gas Is Worth $7.28, producers in the Eagle Ford and Marcellus, two shale plays rich in natural gas liquids (NGL), continue to enjoy solid profit margins. NGLs such as propane, butane and ethane tend to command a higher price that tracks crude oil; for many producers, the natural gas is almost an afterthought.

But NGLs don’t explain why drilling activity remains strong in the Haynesville Shale, a dry-gas play in Louisiana and east Texas. Although profit margins aren’t as attractive as in liquids-rich areas, producers can still eke out positive returns because the play is so prolific. …

Why then is Chevron’s Vice Chairman down on the US natural gas market? The answer relates to the Pugh Clause, a term contained in most of the leases that producers sign with landowners in parts of the US.

Louisiana attorney Lawrence Pugh pioneered the clause in the 1940s to ensure that energy companies developed leased land within a reasonable amount of time.

Although these clauses vary slightly, they generally require the operator to make the well commercially viable within a certain period. Producers that fail to comply with these requirements run the risk of losing their lease–and a substantial amount of money.

Chevron doesn’t pay royalties on its holdings in Colorado’s Piceance Basin, and its position in the Haynesville Shale is “held by production” (HBP)–that is, the company produced commercially viable wells within the allotted time frame. In other words, Chevron has the flexibility to curtail drilling activity without fear of forfeiting its acreage.

Many producers aren’t in this boat. The case of the Haynesville Shale is particularly instructive, as the returns aren’t as compelling as those offered by the Eagle Ford and other liquids-rich plays.

Producers began snatching up acreage in earnest in 2007 and 2008, primarily under three-year terms; most management teams readily acknowledge that ensuring that these leaseholds are HBP is a top priority.

Consider these comments from Aubrey McClendon, CEO of Chesapeake Energy (NYSE: CHK) at Bentek Energy LLC’s Benposium earlier this summer: “If I had my druthers we’d be running no more than a couple [rigs]…You’d be surprised how much drilling is not voluntary today.”

This urgency to complete leaseholds afflicts many in the industry and explains why drilling costs have increased dramatically over the past year. According to one of the most cost-effective producers in the Haynesville Shale, fracturing costs have increased 35 to 40 percent in 2010, further squeezing margins. I discussed rising service costs in shale-gas plays in the Aug. 17 issue of The Energy Letter, Big Fracking Deals: Investing in Shale Gas Production. …

Pressing deadlines to secure leaseholds and an influx of cash from JVs and asset sales also explain why producers continue to drill at a frenzied pace despite lower natural gas prices.

At the same time, the disconnect between gas prices and drilling activity offers investors an attractive opportunity to pick up best-in-class names at cheap prices. The bearish outlook for natural gas prices continues to weigh on related stocks.”

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