Shale Gas Hype: Subprime 2.0?

MONDAY, MAY 7, 2012

Shale Gas Hype: Subprime 2.0?

If my RSS reader is any guide, most of the press about shale gasmag-glass_10x10.gif has focused on two issues. First, shale gas is in considerable supply, cheap to produce, and burns far cleaner than other fossil fuels. Second, shale gas does not look so hot environmentally, all in. Fracking can pollute ground water (and potable water is our most scarce resource) and releases enough methane to make shale gas as detrimental as coal. Still, it has been treated as the Great Hope for America’s energy woes, a way to turn the US into an exporter, and maybe it will cure cancer too. Obama touted 100 years of shale gas reserves, and manufacturers envision an American revival based on cheap fuel.

The problem is that the good part of this story is largely wrong. Shale gas supplies are overestimated, and it is not as cheap as it has been touted to be. The big reason is that shale gas wells, unlike oil wells, peter out really quickly. The result is that the viability of shale gas as a solution to America’s high energy consumption level is only on an interim basis. Shale gas is more likely to be a stopgap, a 25 year solution rather than a 100 one.

As with the housing bubble, analysts and journalists who understand the economics are giving clear warnings, but they don’t seem to be getting much of an audience. For instance, Jeff Goodell in Rolling Stone wrote in March:

At the same time, scientists began to conclude that America’s reserves of natural gasmag-glass_10x10.gifhave been overhyped. In January, the Energy Department cut its estimate of the amount of gas available in the Marcellus Shale by nearly 70 percent, and a group affiliated with the Colorado School of Mines warns that there may be only 23 years’ worth of economically recoverable gas left nationwide. Even worse, new studies suggest that because of fugitive emissions of methane from wellheads and pipelines, natural gas may actually be no better than coal when it comes to global warming.

In February, no doubt annoyed by Obama’s State of the Union claim of 100 years of shale gas, aeberman of The Oil Drum wrote a detailed post explaining in some detail what the supply side looks like. One key fact: the US is already at the point where it is drilling less productive wells:

In 2001, the U.S. natural gas decline rate was about 23% and the annual replacement requirement was 12 Bcf/d when total consumption was 54 Bcf/d. Today, the decline rate is estimated to be 32% and increased consumption of gas means that approximately 22 Bcf/d must be replaced each year.

And the broader implications:

The shale revolution did not begin because producing oil and gas from shale was a good idea but because more attractive opportunities were largely exhausted. Initial production rates from shale are high but expensive drilling and completion costs make economics challenging…

Shale plays have produced a land grab business model in which hundreds of thousands of acres are acquired by each company. Unprecedented lease costs have become the norm often based on limited information and science.

Operators have indulged in over-drilling these plays for many reasons but adding reserves, holding leases and company growth are among the main factors particularly with the low cost of capital. The inevitable result has been the collapse of prices as supply exceeded demand. Most analysts forecast that the future will be much like the present, and that natural gas will be abundant and cheap for decades to come. There are, however, strong and consistent indicators that natural gas supply may be less certain than most observers believe and require a higher price to be developed economically. Natural gas demand is growing as fuel switching for electric power generation continues, and will be increased by environmental regulation in the coming years. The U.S. will shift more of its future energy needs to natural gas in many sectors of the economy. The best justification, in fact, for the land grab and over-drilling spree is expectation of higher prices. Those companies that grabbed the land and held it by production will profit greatly once the true supply and cost of shale gas is recognized.

In March, Wolf Richter also explained why the super low shale gas prices ($2.28/MMBtu) were not a sign of a great new energy source, but lack of producer discipline:

Natural gas is dirt cheap, hovering at a 10-year low. In the US, that is. In other parts of the world, natural gas is four, five times more expensive—a rare discrepancy in a globalized economy…

But there is a problem: price. Natural gas is too cheap…drilling activity is collapsing. In 2008, the peak of the drilling bubble, there were at one point over 1,600 rigs drilling for natural gas in the US. During the financial crisis, the rig count fell off a cliff, then recovered a bit, but now is in free fall again. Last year at this time, there were 882 rigs drilling for gas. Two weeks ago, the count was down to 691. Last week it was down to 670 rigs (Baker Hughes).

Fracking has turned into a massacre for producers…at current prices, drilling activity will continue to shrink while production at wells drilled over the last two years is plunging. At some point, the massive amount of gas in storage will be drawn down below a normal level. But production can’t be cranked up from one week to the next. Perceived or real shortages will drive up the price, but not to an equilibrium where producers barely break even and consumers enjoy low-cost energy. It will be a spike. We’ve been through this before.

But why the comparison to subprime? The biggest producers are more land/lease speculators than energy companies, in terms of how they seek to make money. And they’ve been speculating in a highly leveraged manner. Per John Dizard of the Financial Times:

Even before the most recent gas price crash, the shale gas producers were spending two, three, four, and even five times their operating cash flow to fund their land, drilling, and completion programmes.

The widely accepted claims of huge volumes of cheaply produced energy did not square with this deficit financing…

Too much money was borrowed, on complex and demanding terms. Wall Street should have provided reality checks to the shale gas people; instead, they just provided cashier’s cheques with lots of zeroes at the end….Prices will have to adjust upwards, a lot, to cover not only past debts but realistic costs of production.

There is an echo of the late residential real estate financing bubble in the shale gas story. Consider the parallels.

Institutional investors sought to capture excess return while “hedging away”, or simply avoiding, classic sectoral risks (whole loan default risk, dry hole and gas price risk). The ultimate effect is their assumption of larger, less initially visible, and less manageable risks (securitisations backed by unenforceable foreclosures, very large, quickly-depleting, high cost shale operations).

The same institutional investors could not find enough “investment grade” risk to fill those baskets in their portfolios (triple A or double A operating company bond issuers, investment grade energy company equity). In the case of the energy industry, the rise of national oil companies reduced the opportunities for integrated majors or even conventional-prospect-oriented smaller public companies.

US national policy tilted the capital markets’ risk/reward calculation to a favoured set of investments (subprime/ “non-traditional” mortgages, gas substitution for coal, or gas-fired backup for renewables).

The promoters had a “story” for institutions (home mortgages have a low historic default rate/ shale gas fields have little, if any, dry hole risk, and are a way to ‘manufacture’ gas).

The lead companies in the industry devised complex structured products, often priced by OTC derivatives (tranched home equity asset-backed securities, impenetrable joint venture agreements and scantily disclosed hydrocarbon hedges).

The issuers’ apparent risk mitigation was validated by expert opinion (rating agencies/ sellside geology consultants).

The sad bit isn’t just that we seem to be playing the same tired scripts over and over, but that finance now seems to be based on deeply flawed incentives and risk sharing that encourage the manufacture of bad loans. I focused on current readings to contrast them with the hype, but consider: Dizard (not an energy expert, he’s only as good as his sources) was issuing warnings in 2010. As he points out, journalists, again in a parallel to the housing bubble, have been as remiss as the promoters.

Topics: Credit markets, Derivatives, Energy markets, Environment, Free markets and their discontents

Email This Post Email This Post Posted by Yves Smith at 1:44 am

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Biharilal Deora, CFA, ACA


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