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US shale drillers laughing to the bank

Two huge deals, amounting to over $5 billion, show the US shale-gas revolution is not over yet

Despite a bearish outlook for natural gas prices, the flow of foreign dollars into North American shale-gas plays continues unabated. France’s Total and China’s Sinopec have each secured multi-billion dollar joint ventures with two of North America’s largest shale gas producers.

Total will pay $2.32 billion to farm in for 25% of Chesapeake Energy’s Utica shales in Ohio, while Sinopec struck a $2.2-billion partnership with Devon Energy covering emerging plays in Mississippi, Michigan, Louisiana and Colorado.

The terms are particularly attractive to the US companies, which will continue to operate the assets and control the pace of development – including the acquisition of more land.

The transactions show continuing high levels of interest in North America’s unconventional basins, even as natural gas prices fall to decade lows. According to the US government’s Energy Information Administration (EIA), Lower 48 inventories finished the week ending 30 December at 3.47 trillion cubic feet (cf), up 11% from a year earlier and 15% higher than the five-year average (see Figure 1).

Consequently, Nymex futures prices are sub-$3/million British thermal units (Btu) in the peak demand season – the worst winter prices since 2002. Prices have fallen by almost 75% since 2008, when they reached $13/million Btu, and are at their lowest since the 2008 financial crisis (see Figure 2).

But that hasn’t stopped gas producers from opening up prolific new shale basins in virtually every corner of the continental US, contributing to what was already a massive gas-supply bubble.

Outside dollars fuel boom

Figure 2: US Henry Hub gas price
Figure 2: US Henry Hub gas price

It’s been the influx of cash from the likes of Total and Sinopec that has allowed shale drilling to continue unabated. To offset sharply lower cash flows, companies such as Chesapeake – and now Devon – have sought outside funding to continue drilling even as commodity prices fall.

Sinopec will end up paying 80% of Devon’s development costs in five new shale fields for a 33% share of production. By recovering the up-front development costs, Devon has the luxury of maintaining production growth without cutting back core spending in other areas. “This arrangement improves Devon’s capital efficiency by recovering our land and drilling costs to date and by significantly reducing our capital commitments,” said Devon’s president and chief executive, John Richels.

About 60% of the company’s 17.24 trillion cf equivalent of proved reserves are gas. According to financial analysts Raymond James, Sinopec’s purchase price amounts to about $5,500 an acre, which is generous given the falling natural gas futures curve.

Chesapeake’s own numbers claim its 3.6 million net acres of shale are worth about $46 billion – or more than three times its market capitalisation of $15 billion. In that sense, the land being sold is worth more than the gas held in it and Chesapeake has set the mould for monetisation. The Total deal is Chesapeake’s seventh international partnership, raising about $14.8 billion to date. Chief executive Aubrey McClendon said the cash would “help develop the play more aggressively than we could have with our own resources”.

For Total, which already has a joint venture with Chesapeake in the Texas’s Barnett Shale, it gains a larger foothold in the US unconventional-gas sector at a time when prices can’t reasonably fall much further, even if they are expected to remain volatile. Total’s share price drop in the wake of the deal suggests it paid too much, but long-term growth is all but assured as natural gas displaces coal and oil for power generation, and in the transport sector in the larger North American market.

"This joint venture will provide a material position in a valuable long-term resource base under attractive terms,” said Total’s head of exploration and production, Yves-Louis Darricarrere.

Markets expected to stay weak in 2012

Figure 1: US gas in storage
Figure 1: US gas in storage

The longer-term outlook for natural gas is optimistic, even if the short-term remains weak. But when the gas market will rebound is the $4.5 billion question for buyers such as Sinopec and Total.

North American gas prices by fell some 40% in 2011 and financial houses such as Goldman Sachs continue to slash long-term forecasts, suggesting any price relief is at least a year away. Raymond James doesn’t see a return to $4.50/million Btu before 2014, which is still considerably lower than the $6/million Btu that the industry considers sustainable.

Ironically, the negative fundamentals have barely put a dent in US rig counts, which rose all through 2011, because of the high numbers of commitment wells that must be drilled to retain millions of acres of prospective new land. In other words, producers couldn’t stop drilling if they wanted to, inadvertently aggravating an already challenging business environment.

And that trend looks set to continue this year, with Devon and Sinopec planning 125 new wells on 1.2 million joint-venture acres, virtually assuring that rig counts won’t be coming down in their mutual interest areas.

While courting outside investment has proved effective at shoring up balance sheets in the interim – Devon will have an extra $500 million to reduce debt – it does little to address the structural imbalance from too much supply and insufficient demand.

In any other era, that would be cause for retrenchment, but not in 2012. As long as foreign majors continue to put up billions for the privilege of joining North America’s unconventional-gas revolution, otherwise unprofitable producers such as Chesapeake and Devon will continue to laugh – and drill – all their way to the bank.

Figure 3: US rig count
Figure 3: US rig count
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