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Natural Gas Shale Extraction – Potentially More Costly Than Expected November 2, 2009

The price of natural gas has been a bargain lately when measured by the energy content of gas compared to crude oil.  Some attempts have already been made to substitute cheap natural gas for expensive oil.  While both commodities have declined significantly from 2008 highs, natural gas prices have been even more depressed due to the discovery of large shale deposits and the belief that extraction technology has improved to the point where explorers will be able to easily exploit the new discoveries.  Market participants may be jumping to premature conclusions.

Shale Deposits – The Solution to Dry Holes?

John Dizard, writing for The Financial Times today, makes a number of interesting observations regarding the question of how shale deposits will impact pricing for natural gas in the United States.  Mr. Dizard believes that promoters have been selling investors on shale deposit exploration by promising more predictable returns compared to the typical experience of exploration which often includes expensive dry holes:

Time and again, with all the three dimensional seismic imaging, reservoir engineering, and so on, people drill wells to 5,000 or 6,000 metres only to get a dry rock collection. Finding oil and gas requires a significant amount of trial and error. Bankers, brokers, and institutional investors do not want to hear this. They want to hear that the businesses they invest in are predictable.

The search for predictable and stable returns combined with the relative ease of finding shale deposits could lead to a fund raising bonanza for exploration firms even though the cost of shale extraction tends to be high:

This is where the technology comes in. Hydraulic fracturing, or “fracking”, is a technique to force liquids through a drill hole at high pressure to create cracks in gas or oil-bearing rock. The gas or oil flows through those artificial cracks to the wellbore. To keep the cracks open, the operator may mix in “proppant”, such as little ceramic spheres. It’s all difficult and ingenious, and requires a lot of expensive equipment and skilled people – including skilled promoters. Someone in Houston came up with the concept of shale gas production as “manufacturing”. The shale rocks are so uniform, you see, that the risk of a dry hole would be almost entirely eliminated.

Wonderful At First, But Potentially More Expensive Later

Despite the high costs of extraction, the uniform and high rates of production initially seem to justify the effort, particularly given the lower risk of dry hole costs.  However, Mr. Dizard cites an industry expert who believes that the initial rates of production may end up slowing down as rock formations collapse once significant amounts of gas have been extracted.  This would then require more expensive processes in which new fractures are created in the formations to keep gas flowing.

Despite the limitations, there is obviously a price at which natural gas production from shale deposits will make economic sense:

Ben Dell, of Bernstein Research in New York, whose work is respected by both sides in the debate, says: “The average well deteriorates more in quality, and more wells fail, than people believe. Still, I think a rise in prices would make more (shale prospects) economic. Plenty of plays work at $9 per mcf [1,000 cubic feet].” This less-than-expected productivity in the leading gas sector tells Mr Dell that US gas production will decline on the order of 10 per cent next year, leading to $8-$9 gas, or $3 to $4 more than the forward curve anticipates.

Low cost natural gas producers can take some comfort in the strong possibility that shale extraction may end up being much more expensive than people are anticipating which would require much higher natural gas prices to justify the effort.  The idea that cheap natural gas from shale formations will further depress prices from current levels seems hard to believe given what industry experts are saying about the complexity and expense associated with shale extraction.

Disclosure:  The author owns shares of a company engaged in the exploration and production of natural gas.  No opinion is being provided regarding the near term movement of the price of oil or natural gas.  The author does not recommend short term speculation in commodities.

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