DOUGLAS C. NESTER, Chief Operating Officer, Prime Offshore

The US oil and gas industry today is dominated by the ever-growing list of unconventional reservoirs, such as the Eagle Ford, Bakken, Barnett and Marcellus. Fueled by advancements in horizontal drilling and stimulation methods, the US is leading the world in defining the reserve potential in these emerging resource plays. The reserve potential for resource plays in North America continues to be a moving target as new well results are obtained and production trends become established. Schlumberger recently took a stab, putting total North American unconventional resources at about 8,200 Tcf. This success in our backyard is now expanding into other areas worldwide, where some estimate as much as 75% of all global resource reserves ultimately exist.

There is no doubt that the potential of unlocking enormous recoverable reserves from resource plays is reshaping our industry. The nearly overnight creation of boom towns in remote areas of North Dakota, South Texas and Pennsylvania are evidence of this change. In the midst of all this euphoria, however, I have become concerned that our continuing success in resource plays is installing a permanent ceiling on the price of natural gas.

Microeconomics. In classic microeconomics, supply is defined simply as the quantity of a product that a producer is willing and able to bring to market at a given price in a given period of time. The basic law of supply states that as the price of a commodity rises, producers will expand their supply to the market. Supply is limited by the following factors: 1) production costs, 2) the technology used in production, and technological advances, 3) the price of related goods, 4) expectations about future prices, and 5) the number of producers.

It is easy to see that these factors are indeed important controls within the context of our industry. Based on relatively stable gas prices for over a year, it may be logical to think that the US gas market is presently at equilibrium (i.e., where the quantity of a commodity supplied equals the quantity demanded). In reality, we are not in a period of equilibrium, as supply is greatly outpacing demand.

I believe the growing gas supply from resource plays will create an ever-increasing downward pressure on pricing that will continue unless a major change in market conditions results in significant demand increase. But what event or events can create such a change in demand? Will manufacturers switching from oil to gas be enough to change demand? Will transitioning cars from gasoline to natural gas be enough? Maybe the upheaval associated with the displacement of oil and power from OPEC nations by gas producing countries will do it. If not, my big question is simply, What if natural gas supply essentially becomes infinite within our lifetimes?

Infinite supply. The idea that gas supply can become essentially infinite is what I call the “X-Box economy.” The definition of “infinite supply” comes from many of the electronic games that our children play. Nearly all modern action and war games are based on the premise of infinite supply. In many of these games, a container never runs out of its contents. Is it possible that—similar to games where containers produce endless amounts of water, food, fuel, health or ammunition—we have found in these resource plays a container with an essentially endless supply of gas?

I would like to sidestep the debate as to the profitability of these resource plays and just reflect on some existing statistics. Detailed studies by respected companies like Credit Suisse and Morgan Stanley show that at current pricing of $3.75–$4.00/MMBtu, many of these resource plays are not economic. The most economically attractive plays are those that are predominantly oil rich, like the Bakken, or contain substantial NGLs, such as portions of the Eagle Ford and the Marcellus.

However, spending in plays that are marginal or sub-economic is continuing. Some of this spending is due to lease commitments, drilling commitments and the need to book reserve additions. It is interesting to note that from 2000 to 2005, companies in these plays reportedly spent about 82% of their cash flow on drilling. This increased to 100% of cash flow after 2005, and in early 2011 drilling costs reached 122% of their cash flow totals. Whether this makes good business sense is not material for this discussion. What the trend shows is that huge investments by smart individuals and savvy companies are being made in these plays.

I doubt that these investments are being made without some confidence that the reserves being defined will someday become economic (or more economic). Pricing in the X-Box economy has little hope of changing, so advances in technology will be needed to greatly reduce finding and development costs. There is evidence that we are building better and more cost-effective mousetraps to help capture these unconventional reserves. An economic analysis by Talisman Energy—active in the Marcellus, Eagle Ford, Utica and Montney shales—shows a steady decline in breakeven pricing from $8.50/Mcf in 2008 to $6.50 in 2009, to $4.50 in 2010, to a projected $3–$4 in 2011.

X-Box economics. Imagination or reality? Can an X-Box economy really exist? I think we will know the answer within the next few years. One of two events will occur to determine whether the X-Box economy is a reality or just another crazy idea. The first would be an overall failure of resource plays to live up to their potential. We would see this through decline trends that prove ultimately to be more linear than exponential and individual well recoveries that are much lower than expected. The second event would be a breakthrough in our ability to lower costs—either through advances in drilling and completion methods or through more reasonable up-front business transactions. I will watch to see which occurs first.