10 September 2014

The Popping of the Shale Gas Bubble

For much of the past decade we have been inundated by reports of how the wonders of technology, specifically horizontal drilling and hydraulic fracturing, have unleashed a new era for energy supplies. Industry leaders have touted that shale gas, along with burgeoning shale oil production, will lead to America’s energy independence, kindle a manufacturing renaissance, lower bills for everyday Americans and create millions of much-needed jobs. While there is little doubt that booming shale gas production, along with a very deep recession put an end to the natural gas price spike of 2008, much of the accepted conventional wisdom about the longevity of the shale gas bonanza is wrong. America’s shale gas resources and reserves have been grossly exaggerated and today’s level of shale gas production is unsustainable. In fact, due the distortions of zero interest rates and other factors, an enormous shale gas bubble has developed. Like all bubbles, this one will pop sooner than expected and when it does, the aftermath will be very unpleasant.

By now I am sure you are saying to yourself, ‘Who is this guy?’ He certainly does not know what he is talking about since everybody who is somebody has been saying the exact opposite for a long time. From the US government’s Energy Information Administration (EIA), to Pulitzer Prize-winner author Daniel Yergin to T. Boone Pickens, to Michael Lynch; all these experts have supported the notion that we have a surfeit of natural gas just waiting to be harvested. How can they be wrong? Similar to the prevailing belief about the housing bubble before it burst, much of today’s thought regarding natural gas supplies has come from people with a vested interest in selling the dream of a ‘Shale Gale’ that will eliminate foreign energy imports, boost employment and increase GDP. However, reality is far different from what has been portrayed in the mainstream media. In my book, Cold, Hungry and in the Dark: Exploding the Natural Gas Supply Myth, published a year ago, I examine many of the reasons for this disconnect. Unlike much of the hyperbole published about shale gas, my book contains nearly 600 footnotes and much empirical evidence supporting my thesis. Cold, Hungry and in the Dark overwhelmingly refutes the idea that increasing shale gas production will create a “new era” in America’s economy and instead shows that a severe deliverability crisis quietly looms on the horizon. And, no, I am not an environmentalist with an ax to grind against the oil and gas industry. I am an independent analyst who has covered the energy industry for more than 15 years, an author and contrarian.

Make no mistake; shale gas production over the past 12 years has been nothing short of phenomenal. From a standing start a dozen years ago, shale gas production has grown to account for nearly 50 percent of America’s gas production. However, the shale gas boom is rapidly maturing and we are quickly approaching a point where shale gas production heads into decline. In fact, the majority of shale gas basins in America are already exhibiting declining production.

Before discussing how the coming natural gas crisis will unfurl, let’s debunk some of the most commonly held myths about the shale gas.

1) The US has a 100-year supply of shale gas. While many grandiose claims about the potential supply of shale gas, such as ‘the US has a 100-year supply’, have been made in recent years; almost none have ever been supported by any empirical evidence. According to the EIA, marketed production in 2013 was 25.6 trillion cubic feet (tcf). Therefore, using last year’s rate of production, a 100-year supply would be 2,560 tcf of gas. (Note: Total US supply consists of marketed production plus net imports.) No one has ever been able to identify the shale gas fields, resources and reserves that would supply this bounty. More importantly, given that America is the most thoroughly explored petroleum producing country on earth, it is very unlikely new shale gas fields lie in wait of discovery. The only justification ever given for the 100-year supply claim has been that future developments in hydraulic fracturing (“fracking”) technology will unlock all that shale gas that has already been identified. While recent advances in horizontal drilling and hydraulic fracturing have been remarkable, technological progress does not follow a straight line.

2) Technological advancements will increase shale gas supplies. Despite the continuing and significant advances in horizontal drilling and hydraulic fracturing technology, we have seen huge a huge reduction in the EIA’s estimate of technically recoverable resources (TRR) for shale gas in recent years. In 2011, the EIA published a study compiled by consulting firm Intek Inc. (more on Intek later) that estimated the US had 750 tcf of underdeveloped technically recoverable shale gas with 410 tcf in the Marcellus shale alone. However, shortly after this report was published, the US Geological Survey published a report that estimated the Marcellus to contain approximately 84 tcf of technically recoverable gas. In early 2012, in its Annual Energy Outlook Early Release, the EIA, based largely on the findings of the USGS, reduced its estimate of the Marcellus by 65 percent to 141 tcf. The wipeout of 269 tcf from the Marcellus reduced the total US TRR downward by 36 percent. In other words, after the reduction in the estimate for the Marcellus, total US shale gas resources stood at 481 tcf, or less than a 19-year supply of natural gas based on 2013 rates of production.

Now that US shale gas resources have been chopped by 36 percent, are weunderstating the potential of shale gas? Absolutely not. To put into perspective how inflated the EIA’s expectations for shale gas were in its 2011 report it commissioned Intek to prepare, consider the following: The biggest field in the Western Hemisphere by production history is the Hugoton field of western Kansas which has produced approximately 37 tcf over its 60-year productive life. In their report, Intek estimated there to be three shale gas fields, the Barnett, Haynesville and the Marcellus, to each have more potential than the Hugoton. Given that shale gas is extremely difficult and expensive to extract compared to gas from conventional reservoirs (i.e. Hugoton), I find it highly unlikely that the three biggest fields in US will turn out to be shale fields. Additionally, the shale gas industry has written off tens of billions of dollars of shale gas reserves that are not coming back despite the more than doubling of US natural gas prices over the past two years. More importantly, the majority of shale gas fields that were expected to provide increasing production for decades are now experiencing production declines. However, don’t just take my word for it, let’s get into specifics.

Based on the reasons I discuss in detail in Cold, Hungry and in the Dark, such as high production decline rates of wells and small sweet spots accounting for nearly all the commercially successful wells, there is substantial evidence shale gas resources remain significantly overstated. The Antrim shale of Michigan is an excellent case in point. According the Michigan Public Service Commission, the Antrim has produced approximately 3 trillion cubic feet (tcf) from more than 10,000 wells since commercial production began in the late 1980s. Production peaked in 1998 at slightly more than 540 million cubic feet per day (mmcf/d) and has dropped every single year since 1998. In 2013 the Antrim produced only 100 mmcf/d, an 80 percent reduction from its peak year. Given the significant production history of the play, scarcity of remaining drilling locations and its very clear terminal production decline¾despite a substantial increase in natural gas prices since its peaking¾it is reasonable to assume the Antrim will produce no more than 1 tcf over its remaining productive life. However, the 2011 Intek/EIA reports shows there to 20 tcf of resources left to recover in the Antrim. As noted in my book, I contacted Intek for an explanation on how they, with all of the production history of the Antrim, concluded it could produce nearly 7 times more gas than it had already produced. I was never given an explanation.

Tower for drilling horizontally into the Marcellus Shale Formation for natural gas, from Pennsylvania Route 118 in eastern Moreland Township, Lycoming County, Pennsylvania, USA (Photo credit: Wikipedia)

While every shale play is different, it appears that “magical thinking” has impacted the EIA’s/Intek’s estimates of other fields as well. Even after the massive reduction of resources from the Marcellus, it has become increasingly clear that the EIA is overstating America’s total shale gas resources by a factor of four. I provide substantial empirical evidence in my book that the US has approximately 120 tcf of recoverable shale gas remaining. I am not the only one who has found the 2011 Intek/EIA report, which became the source for countless talking points on the potential of shale gas and oil, to contain gross overestimations. My friend and colleague, David Hughes, Geologist Emeritus of the Geological Survey of Canada and a Fellow at the Post Carbon Institute, published a report in December 2013 titled Drilling California: A Reality Check on the Monterrey Shale, that concluded that the Monterrey Shale, which Intek estimated to contain 15 billion barrels of shale oil, was far smaller. Turns out, after several other researchers came to similar conclusions as Hughes and much media attention was focused on the huge discrepancy between Hughes’ conclusion and those of Intek, the EIA downgraded its estimate of total oil resources in the Monterrey from 15 billion barrels to only 600 million barrels, a 96 percent reduction. While I do not expect such a large estimate reduction for America’s shale gas resource base, substantial reductions are warranted given the production history of shale fields and our increased understanding of their potential.

3) US natural gas production will continue to grow until 2040.

According to the EIA’s 2014 Annual Energy Outlook Reference Case, overall US natural gas production, led by a more than doubling of shale gas production, is projected to grow 1.6 percent per annum between 2012 and 2040. Such a scenario would lift total US natural gas production from approximately 25 tcf per annum in 2012 to approximately 38 tcf in 2040 and would allow for the US to move from its current status as a net importer of natural gas to a net exporter by 2020.

The EIA 2014 Annual Energy Outlook projects US shale gas production will grow from 9.7 tcf in 2012 to 19.8 tcf in 2040. I find the EIA’s future shale gas production estimate over the next couple of decades to be wildly optimistic for two main reasons. First, the majority of America’s shale gas fields are already experiencing production declines. According to the Texas Railroad Commission (RRC), the regulator of oil and gas activities in America’s largest gas producing state, natural gas production from all three shale fields in the Lone Star state are no longer growing. America’s oldest ’modern shale gas field’ (A field where the majority of the wells were drilled horizontally and hydraulically fractured.), the Barnett shale, production peaked in 2012 and has been declining steadily despite rising natural gas prices. The Texas portion of the Haynesville shale is in steep decline due in large part to high decline rate of its wells. More interestingly, according to recently published RRC data, natural gas production from the Eagle Ford shale has hit a plateau despite oil production continuing to grow

Production from the Haynesville shale of Louisiana, which in 2009 was expected to “become the largest gas field in the world at 1.5 quadrillion cubic feet” according to former Chesapeake Energy (NYSE:CHK) CEO Aubrey McClendon, has declined precipitously since peaking in 2012. Haynesville production is now down by nearly 50 percent according to data from the Louisiana Department of Natural Resources. To say the field has not lived up to its lofty expectations would be an understatement. The Fayetteville shale of Arkansas has been on a plateau for much of the past two years due to continued drilling by the play’s biggest operator but will likely see production fall off in the next year as it becomes increasingly mature. Natural gas production in the smaller Arkoma Woodford has been declining for several years and shows no sign of reversing.

There are only three significant shale plays that are growing production currently: the Bakken (which is mostly an oil play), the Utica of Ohio, which remains in an early stage of development and the Marcellus located in Pennsylvania and West Virginia. While there is little doubt that the Marcellus is one of America’s biggest natural gas fields as it singlehandedly accounts for approximately 20 percent of America’s total natural gas production, the Marcellus cannot continue to offset declines in production from conventional fields, other shale plays, CBM and offshore fields. Without the huge growth in production from the Marcellus the past two years, overall US shale gas production would have peaked in 2012.

The second reason I find the EIA’s projection for production growth to be inaccurate is the mistaken belief that higher natural gas prices will bring on substantial new shale gas production. More specifically, according to the EIA’s reference case, the agency expects natural gas prices to rise approximately 3.75 percent per annum between 2012 and 2040 with prices reaching $7.65 per MMBTU in 2040 (in 2012 dollars). While many economists like to think that higher prices will always bring about more supply, the laws of physics and geology always win and in increasingly mature areas, like much of the US, rising prices will at best only slow down the production decline. For example, between 1973 and 1984 the average US price for natural gas rose from $.22 per thousand cubic feet (mcf) to $2.66 per mcf, while production dropped an incredible 19 percent. More recently, US production fell between 2001 and 2007 despite a 50 percent increase in average prices. Clearly, rising prices are not enough to ensure production growth; new discoveries are also needed along with advances in technology. Due to the huge first mover advantages captured by those companies that identify and lease new shale plays and the billions of dollars spent looking over the past decade, I am not optimistic another significant shale gas play awaits discovery and commercialization.

4) Continued efficiency gains will make natural gas cheaper. Lots has been written about how the US oil and gas industry has been able to reduce its drilling costs over the years as it continues to come up with innovative ways to drill and fracture shale wells. There is no doubt that the industry makes advances every day on how to more efficiently drill and fracture wells. However, similar to the size of the shale gas prize, efficiency gains have been significantly overstated. That may seem illogical when America’s natural gas rig count is at a 20-year low and natural gas production is near an all-time high. There are a couple of reasons for this conundrum. First, due to the way oil and gas leases are structured, a well must be drilled within the first three years (sometimes five years) of the lease signing for the lease to continue in good standing. Once a well is drilled, even if the well is not immediately connected to a pipeline system, the operator can produce oil and gas from the lease indefinitely. Therefore, given that billions of dollars were spent leasing Marcellus acreage over the past six years, a drilling boom naturally followed. However, due to lack of pipeline availability, many Marcellus wells sat idle for years. Similar to the early years of Barnett and Haynesville development, Marcellus producers have been able to show consistent production growth as new wells are put on production, along with previously drilled wells in inventory, while simultaneously reducing their rig count. Increasing production through normal drilling and the tie-in of previously drilled wells while reducing drilling activity creates the illusion of large efficiency gains. Unfortunately, once the inventory of uncompleted Marcellus wells is depleted, which should occur in the first half of next year depending on the in-service dates of several pipelines, peak production is soon to follow given the high decline rates seen in Marcellus wells and the current level of drilling activity.

Additionally, the natural lifecycle of shale play development is often confused with overall industry efficiency gains. For example, the first wells drilled into a shale field, or any oil and gas field, are usually the most expensive, take the longest and are often the least productive. Once operators get a better understanding of a new shale play and climb further up the learning curve, drilling times and costs rapidly drop before leveling out. As shale deposits mature and companies have developed the majority of their high quality drilling locations, much of the hard won efficiency gains are lost to progressively worse drilling locations. For example, for several years, initial production (IP) rates, a decent predictor of future well performance, have gone down in the Barnett shale despite advances in technology applied to the drilling process. Declining natural gas production from the Barnett, at a time of large advances in technology, should not come as a surprise to anyone who has followed the amazing trajectory of the play over the past dozen years. More than 20,000 wells have been drilled into it (4,000 are already dead) and drilling activity in the Barnett has been declining for the past four years. Additionally, it was once believed that oil production from the northern portion of the Barnett would allow from many more years of natural gas production growth since natural gas is produced along with oil. However, this turned out not to be the case. According to the Texas RRC, oil production from the Barnett has fallen from an average of nearly 20,000 barrels of oil per day (bopd) in 2011 to slightly less than 5,000 bopd in the first quarter of 2014, a decline of 75 percent in only a few years. Oil production in the Barnett will continue its rapid decline even with NYMEX crude prices hovering near $100 per barrel due to lack of quality drilling locations and the high natural decline rate of its wells. Just another example of how high prices cannot overcome a shale field’s advancing maturity.

So what will the coming natural gas deliverability crisis look like? As I discussed in Cold, Hungry and in the Dark, the natural gas crisis that quietly lurks on the horizon is likely will be similar to one experienced in the US between the early 1970s and the mid-1980s. It was during this period when many of the fields that accounted for the robust production growth of the post-WWII era began to decline and demand overwhelmed supply. Rapidly rising natural gas prices resulted in hundreds of thousands of job losses and spiraling home heating, electricity and food costs. Rising natural gas prices further damaged the psyche of the American consumer who was already dealing with soaring gasoline prices at the pump due in part to turmoil in the Middle East. Sound familiar? We caught a glimpse of what the natural gas crisis may look like when a spell of bitter cold descended on the Northeast this past winter causing natural gas prices in the region to skyrocket, paper mills in New England to temporarily close and layoff workers and numerous industrial users to have gas supplies interrupted. Needless to say, many consumers were hit very hard with huge utility bills. At one point last winter, spot natural gas for delivery into the Boston area and elsewhere in the Northeast reached over $100 per mcf.

While the effect of the upcoming natural gas deliverability crisis will be similar to those suffered by consumers in the 1970s, the solutions will be radically different. First, unlike the last time the US faced an extended period of spiraling prices and demand outstripping supply, the coal nuclear power generation industries will not ride to the rescue. To reduce demand from the natural gas electricity generation sector, US coal generation doubled from 700 billion kilowatts per annum in 1970 to 1,400 billion kilowatts per annum in 1985. In addition to the huge growth in coal-fired generation, the number of operational nuclear reactors grew from 20 in 1970 to 96 in 1985 and kilowatts generated grew from 22 billion kilowatts to 384 billion during this period. Clearly, with approximately 50 gigawatts of coal fired generation shutting down to comply with EPA regulations before the end of next year and numerous nuclear plant closures announced over the past couple years, the US will have a hard time reducing natural gas demand from the utility sector.

But aren’t there other ways to reduce natural gas demand should production falter? Yes, but they are far more painful. The gas intensive manufacturing industries that are locating new production facilities in the US to take advantage of low prices are going to be very difficult to cut off once the deliverability crisis begins. For example, with US gas prices amongst the cheapest in the world and transportation costs on the rise due to rising oil prices, fertilizer manufacturing in the US is on the rise. A $1.8 billion fertilizer plant is under construction in Iowa and when it is completed late next year it will be a large consumer of natural gas. For much of the past two decades the US has seen its fertilizer production decline and has increasingly relied on imports. Additionally, chemical companies from around the world are either building or investigating the construction of dozens of new plants to take advantage of cheap American natural gas. Here again, this will be difficult demand to destroy.

Fortunately, there is much that can be done to mitigate the coming natural gas deliverability crisis. While there will nearly certainly be a pick up in natural gas drilling, I am not optimistic this will be enough to offset the advanced maturity of America’s natural gas fields. Similarly, efficiency gains and turning down thermostats (Remember how well President Carter’s plea and sweaters worked?) will not be nearly enough to rebalance the market once a 1970s-style deliverability crisis begins. The long-term solution lies in the distributed power revolution that is in its early stages. As I discuss in my book, despite incumbent utilities efforts to squash the distributed power revolution, rising consumer electricity prices and the huge leaps in efficiency of recent years in residential solar and energy storage will dramatically change how many Americans view their regulated utility. We will soon see solar panels along with hot water heaters on the roofs of many homes, as we already do in many other parts of the world, as well as energy storage facilities in many basements. While some may think that grid parity for distributed generation will not be reached for decades and in the meantime the industry will need gobs of taxpayer money to be competitive with traditional forms of generation, it won’t. The tipping point is closer than you might think. Spiraling natural gas and electricity prices coupled with additional cost reductions and efficiency gains for distributed power will accelerate the achievement of grid parity. Still not convinced? The recent investments SolarCity (NASDAQ:SCTY) and Tesla Motors (NASDAQ:TSLA) are making in both solar panel and battery storage manufacturing are further proof that the distributed power revolution is for real.

Lastly, the coming natural gas deliverability crisis and bursting of the shale gas bubble will take many by surprise since virtually the entire mainstream media has bought into the unsupported belief that America has decades of cheap natural gas just waiting to be exploited. There will be much wailing and gnashing of teeth as many energy experts falsely claim that, similar to the housing crisis, ‘nobody could have seen this coming.’ This is simply not true. There is a large and growing body of empirical evidence to support the notion that the importance of shale gas has been overstated and that today’s level of shale gas production is woefully unsustainable. Unfortunately, in today’s nonlinear world, the bursting of the shale gas bubble will not lead to a gradual increase in prices, but rather a violent spike that will be very difficult to mitigate. As we lurch closer to the inflection point where Marcellus production growth plateaus and can no longer make for declines in nearly every other field in America, everything will change. Today’s complacency will be replaced by panic as natural gas prices reach shockingly high levels. Don’t be caught off guard!