What's new in exploration

	Vol. 230 No. 1
ARTHUR BERMAN, CONTRIBUTING EDITOR, bermanae@gmail.com

Shale plays and lower natural gas prices: A time for critical thinking

In mid-July 2008, the US somewhat unexpectedly discovered that it had an oversupply of natural gas, and prices fell sharply. Jen Snyder, head of Wood Mackenzie Ltd.’s North American Gas Research Group, recently said that the development of shale gas plays has caused “a significant potential oversupply” (Oil & Gas Journal, Dec. 1, 2008). I am disturbed by an irrational tendency in the E&P industry to pursue shale plays despite oversupply of natural gas and lower prices, since most of these plays were marginally commercial at higher gas prices.

I have struggled to understand the economic appeal of shale plays. I thought that lower gas prices would greatly reduce shale activity, but this has not occurred. In the first half of July, spot gas prices were more than $13/MMBtu. Six weeks later, the price had fallen below $8, and further dropped below $6 in early December. Some analysts predict $5−6/MMBtu range at least through the end of 2010.

At $10/MMBtu, about half of horizontally drilled and fracture-stimulated Barnett Shale wells were commercial, so while prices were rising above $10, shale plays made some sense. At $6, however, only about 25% of Barnett wells will pay out (World Oil, November 2007), and all indications are that prices will fall lower or, at best, remain near current levels. While leasing has largely stopped, drilling continues, and enthusiasm seems strong, at least for the Barnett, Haynesville and Fayetteville Shales. How can we understand what is happening with shale plays?

The Diffusion Model of Innovation (Ryan and Gross, 1943; Rogers, 1962) shows that people adopt new ideas and technologies slowly, and that only about 5% of people make the decision to adopt something new based on information. The other 95% decide because of the views of opinion leaders in the community, and on the eventual social momentum that develops - what Malcolm Gladwell called the “tipping point.”

What causes people to decide to abandon a previously accepted idea? It is reasonable to assume that conventional thinkers do not see that anything has changed until opinion leaders shift their views. Thomas Kuhn (The Structure of Scientific Revolutions, 1962) explained that scientists resist abandoning a ruling theory in favor of a new paradigm with a kind of orthodox fervor of conventional thought, and often ostracize those critical thinkers who point out problems with the existing model. At some point, when opinion shifts to support a new paradigm, the previous theory is unceremoniously dropped, and its remaining supporters are criticized as dinosaurs.

How did our industry get to its present state? The collapse of oil prices in 1982−1986, and the ensuing 13 years of oil oversupply and low prices, created an environment in which cost-cutting and reducing risk were paramount. Thousands of jobs were lost, and companies disappeared as layoffs, reorganizations, mergers and consolidation became the core business of oil and gas companies.

As oil prices slowly recovered, risk analysis teams were formed to manage technical work. Executives abdicated their technical responsibilities to risk committees, and turned their attention to business models. With the help of consultants, they envisioned companies in which exploration and production would become a manufacturing operation, and risk was eliminated. Execution was paramount, standardization was essential, and new geological ideas were unnecessary. The new vision for the E&P business represented the victory of conventional over critical thinking.

Shale plays not only satisfied this model, but they also solved the perennial E&P problem of being opportunity-constrained. Because shale is almost ubiquitous, there are no limits to what can be spent pursuing new and existing opportunities. This shift was widely supported by the capital investment community because of the low perceived risk, and the fact that non-scientists and conventional thinkers could understand the play.

While these plays are an important component of domestic gas production, even among unconventional gas supplies, tight gas and coalbed methane dominate current production.

These plays involve considerable risk. The fact that 75% of wells are commercial failures at current gas prices is a tangible risk. Great emphasis is placed on engineering ideas and technology, but concern for geological and geophysical controls is uneven among shale players. All shale plays are different and require a thorough understanding of thermal maturity, structural geology, rock fracturability, silty or sandy beds within the shale package, and sweet spots.

Also, economic models must be aligned with full-cycle PV10 industry standards. Wood MacKenzie’s Jen Snyder says that established shale plays have “sufficient volumes available at a development break-even price of $5.50/MMBtu or below.” I don’t believe that. I do not know of any credible industry analyst who believes that shale plays are commercial below $6; many believe that it takes $8.

Additionally, the current gas oversupply is not mainly due to shale production. Prices fell when about 2 Bcfd of additional supply came online, not from shale, but from conventional reservoirs in the Gulf of Mexico at Thunder Horse, Tahiti and fields supplying the Independence Hub.

Finally, rig counts and rates have fallen sharply in recent weeks, and some predict that hundreds of rigs will be idle in early 2009. Huge resources have been claimed in shale plays with relatively few wells and little performance history to support them. Huge investments have been made in dozens of shale plays. Only a few of these have any realistic possibility of resulting in commercial outcomes, and then only when operators greatly reduce costs and improve well performance. Even Snyder concludes, “Simply stated, there is no requirement for the rapid near- to mid-term development of some of the more expensive or challenging shales, such as the Marcellus or Horn River; the market can be adequately supplied without those volumes.”

Shale plays represent a disturbing tendency away from critical thinking and conscientious accounting. The SEC did not perform well in regulating the practices in the banking industry that led to the current financial crisis. Perhaps it is time for regulators to ask executives in the domestic E&P industry some critical questions about shale plays before another financial fiasco unfolds.