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Bearish gas market mauls shale bulls

As North America’s gas-storage tanks near capacity and prices stay low, the continent’s shale-gas sector is being forced to reassess. Is the boom over, or is the market forcing a much-needed correction?

North American natural gas producers are buckling under the weight of bearish fundamentals. US firms Chesapeake Energy and ConocoPhillips are the latest to slash spending and cut production in their respective unconventional-gas plays.

Chesapeake said it was responding to market realities, as it hacked its 2012 operating budget by two-thirds, to about $1 billion from $3.1 billion last year.

The Oklahoma City-based company, which produces about 9% of US gas production, said it will shut in up to 1 billion cubic feet a day (cf/d) of output and pare back capital spending allocated to dry-gas shale plays, such as the Haynesville, in Texas and Louisiana. In addition, it plans to cut the number of rigs it has drilling by half, from 47 to 24 in dry-gas plays, and defer tie-ins of new wells, to delay the onset of new production.

Oversupplied markets

Through it all, the company’s mercurial chief executive, Aubrey McClendon, seemed determined to stress a sense of obligation for its role in oversupplied gas markets. In a 23 January statement, he said: “Having led the industry in natural-gas production-growth over the past 10 years, we recognise the need to demonstrate leadership and take action now to protect value for our shareholders. We hope today’s announcement helps disprove the view held by some industry observers that producers fail to act rationally in times of unusually low natural gas prices.”

It’s a stunning retreat for a company that, just weeks ago, vowed to keep drilling in the face of record North American gas-storage inventories. By its own numbers, Chesapeake can be credited – or blamed – for a third of all US gas production increases in the past five years. It’s a record that underscores the dilemma for US gas producers, which have enjoyed great success and diminishing returns in North America’s new shale basins.

Chesapeake joins Canada’s Talisman Energy, which has also slashed spending as a result of a prolonged period of low prices. Talisman will shift dollars out of Pennsylvania’s Marcellus Shale into Texas’s oil-rich Eagle Ford and Alberta’s Duvernay, and cut back on core areas, including the Montney tight-gas play.

Combined, the companies will pull about $4 billion of investment from North American dry-gas plays this year. And more companies are expected to follow suit.

On 25 January, ConocoPhillips said it would reduce its 2012 gas output by about 4% and shift activity to the Eagle Ford. Australia’s BHP Billiton, which spent $20 billion acquiring US shale assets in 2011, reports its fourth quarter financials on 8 February and it remains to be seen if it will press ahead with some $4.5 billion in planned spending for 2012. Other big producers, such as Calgary’s Encana, will also report spending plans in the coming weeks.

But with Chesapeake taking the lead, it’s virtually a foregone conclusion that other big gas producers will fall in line.

Storm clouds gather

And the big investment cuts might not be the only dark cloud on the horizon. The Energy Information Administration (EIA) recently cut its estimates of technically recoverable US shale-gas resources by 42%, to 482 trillion cf. Last year, that figure was 827 trillion cf. Most of the reduction was because of a 66% downward revision for the Marcellus Shale, which is now estimated to hold 141 trillion cf of technically recoverable reserves, rather than the 410 trillion cf announced last year.

The EIA said the revisions came from longer histories and production data from individual wells drilled after 2008. Most shale wells have been in production for less than five years and it’s still unclear as to what constitutes typical well performance – which, in turn, determines expected ultimate recoveries. Given that well performance varies widely from field to field, and even within the same rock formation, hyper-inflated resource estimates could prove overly optimistic.

The uncertainty is attracting the eye of regulators. Last August, the Securities and Exchange Commission (SEC) began an investigation into shale-gas disclosure practices and the methodology for determining reserves valuations. Under SEC rules, oil and gas companies must provide engineering reports detailing reserves at least once a year.

Given the latest EIA numbers, it’s possible that producers could be facing a wave of downward revisions to established reserves – and this, when combined with a 50% drop in natural-gas futures prices, could have a severe effect on net-asset values. This is the worst-case outlook, but these days, it can’t get much worse.

Paradigm shift

With this in mind, the latest spending cuts can either be seen as a return to capital discipline, or sheer panic in the face of a crushing return to market forces. Prolifigate spending on North American unconventional gas has yielded a bounty of resources, but created a glut of supply that threatens the very industry that created it. Producers are losing billions supplying the market at below-cost rates, even as they drill more wells to maintain market share. Many have relied on infusions of outside investment from Asian players to help maintain drilling rates. Until now, activity appears not to have been about profitable – or even sustainable – growth, but growth at all costs.

One consequence of the rush to prove up prolific new basins is that North American gas inventories are threatening to exceed theoretical capacity constraints by as early as this summer. Nobody knows what happens when storage hits capacity, which is an estimated 4.5 trillion cf, or even when that will happen. But it is a worry for financial analysts. Prices would fall even further – perhaps even below $1/million British thermal units (Btu) – forcing producers to shut in production, starting with the highest-cost fields. Not coincidentally, these would be the newer shale plays, in which firms have invested substantial financial, and intellectual, capital.

A subtle, dramatic shift

No longer will shale plays be judged on the resources they hold, but rather, on how profitable it is to produce them. The new era of basin-on-basin competition underlies a subtle, but dramatic shift in thinking, from a fear of shortage to an abundance of supply. Under the old rules, it was about finding enough gas to meet demand. Now it’s about finding enough demand for the gas.

There are signs that the market may finally be turning. North American industrial demand is climbing at the fastest rates in decades, but, in absolute terms, it remains lower than it was in the 1970s. On an energy-equivalent basis, gas is now cheaper than coal or oil and it’s only a matter of time before it sees higher take-up in the broader economy. But how long it will take for that happen is a hard question to answer. For many producers, it may be that natural gas’s golden age will come too late.

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