Musings From The Oil Patch
Comment of the Day

July 22 2011

Commentary by Eoin Treacy

Musings From The Oil Patch

Thanks to a subscriber for this report by Allen Brooks for PPHB covering the US energy sector. Thanks also for securing permission to reproduce it in Comment of the Day. There is a great deal of interest and I recommend taking time to peruse it but here is a section on the economics of unconventional gas drilling:
In conventional gas projects, significant upfront investments are made to tap into the whole of the interconnected gas reservoir at once, applying a tailor-made and optimized field development strategy. The present value of conventional gas fields is continually maximized by applying a rigorous value assurance review (VAR) system, using pre-determined decision gate-stages as part of the company's auditable records. As a result of the established VAR process, cash flows of traditional or conventional gas projects invariably perform adequately and deliver high IRRs. In contrast, field development plans for unconventional gas operators are highly susceptible to economic pressures.

The traditional VAR process does not provide a guarantee for profitable unconventional gas operations. A fundamental handicap for unconventional gas development projects is that optimized well development and maximization of net present value are marred by much higher subsurface uncertainty. There is no gas interconnectivity between wells in unconventional reservoirs and the lack of gas communication means appraisal well data give very limited information over the rest of the acreage under leasehold or licensed. High variations in reservoir quality cannot be excluded by initial appraisal wells. Sweet spots only emerge gradually and after considerable expenditure has been made while the drilling of new wells advances to cover the acreage acquired. The initial risk in new unconventional gas plays is therefore very large. Opting out also remains a hard decision throughout the field's development as that would mean deferred losses are moved closer to recognition.

At the heart of the argument is the difference in investment time horizons and the gas production curves of the wells that generate the returns producers count on when beginning projects. In the exhibits nearby, we show the plots of the two different well types - conventional and unconventional. From looking at the unconventional gas chart, the projected gas curve resembles a tight gas or coalbed gas well rather than a gas shale well, but the analysis is similar. An interesting side note is the amount of taxes paid by producers in a conventional well versus an unconventional well, which would seem to be important for federal, state and local governments desperate for revenues.


Gas shale investments by companies such as Exxon Mobil Corp. (XOM-NYSE), who purchased XTO Energy for $41 billion, and BHP Billiton (BHP-NYSE), who invested $4.7 billion in the purchase of Fayetteville shale assets, were cited by one investment analyst as proof that they knew more about the profitability of this resource rather than a PNC Wealth Management analyst who questioned the flood of money coming into the gas shale industry that reminded him of the dot-com bubble. The major players moving into the gas shale business are confirming the existence of the resource and its long-term potential, but not necessarily its near-term profitability. A point we, and almost every critic of gas shale economics, acknowledge.

The big distinction in this debate is that these major investors have large and diversified portfolios of assets with a range of profitability from very low to very high. Under the portfolio management approach for oil and gas assets, these low-profit gas shale investments are counted upon to become high-return assets at some point in the future and can help absorb low-return energy projects acquired in that future period. Going from low-return to high-return assets necessitate a step change in oil and gas pricing and/or significant improvements in technology to extract the gas that reduces its cost meaningfully.

Eoin Treacy's view At Fullermoney, we have maintained that shale gas is a game changer for the energy sector for quite some time. The reasons for this include its availability, security, proximity to major markets, low carbon emission credentials and price. The development of shale gas reserves in the USA is happening in tandem with a global boom in the development of liquefied natural gas terminals. However, identifying the best way to profit from this theme is complicated by the fact that the prolific initial supply associated with unconventional shale gas wells has helped to depress prices.

Leading shale gas drillers have generally lagged mid-tier oil companies but this is beginning to change. At least part of the reason for this is that they are increasingly moving towards exploiting shale oil reserves. The strong bullish commonality in the sector reflects heightened investor interest.

Anadarko Petroleum remains a leader, found support in the region of the 200-day MA a month ago and has returned to test the April peak. While somewhat overbought in the very short-term a sustained move below $70 would be required to begin to question medium-term upside potential.

This Chart Library Performance Filter of 15 shale gas drillers and service companies in the USA, UK, Poland and Australia exhibit impressive commonality. They have almost all found support in the region of their respective 200-day MAs and are rallying. Clear downward dynamics and sustained moves below their recent lows would be required to check scope for additional upside.

One of the most successful strategies for benefitting from the unconventional gas boom has been to concentrate on companies that benefit from low natural gas input prices. This has primarily been in the fertiliser and chemical industries. The Chemical sector in particular has been an outperformer. Also see Comment of the Day on June 13th.

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