Musings from the Oil Patch

In the last issue of the Musings, we wrote about good news and bad news for the development of the Marcellus gas shale deposit extending across New York, Pennsylvania, West Virginia and eastern Ohio. This deposit with its multiple shales is considered to be potentially the largest gas deposit in the United States. Its economics are challenging as the area is hilly, the road access is less than ideal, the land holdings are fractured and the public is not necessarily enamored with oil and gas drilling activities, especially hydraulic fracturing, which is key to the successful development of gas shale deposits. Low natural gas prices are potentially the biggest hurdle for Marcellus gas profitability.

Our article discussed the recently released 12-month natural gas production data for wells in the Pennsylvania portion of the Marcellus through June. The data showed average cumulative production for Marcellus horizontal wells in the 5-county core area of the North Central and Northeast part of Pennsylvania. The new data shows solid production results, and in fact, the average well’s production slightly exceeded the expected production suggested by Chesapeake Energy Corp., Oklahoma City, (NYSE: CHK) in a 2008 investor presentation. That chart was presented to show the company's anticipated well economics for its foray into the region. Pennsylvania has a long history of oil and gas having been the cradle of the U.S. oil business with the Drake well drilled in 1859. Coal and oil and gas have a long history in the state and were key commodities that enabled the state to become a leader during the industrial revolution.

The better-than-expected gas shale production was the good news, the bad news was the Environmental Protection Agency's (EPA) request for hydraulic fracturing data from nine oilfield service companies to support the Agency's investigation into whether the procedure should come under greater regulation. In the research for our article, we relied upon an article published in The Scranton Times-Tribune where the writer had interviewed Dr. Terry Engelder, professor of geosciences at Penn State University and a student of the Marcellus gas shale, about the significance of the production data. After commenting about how much better the production data was compared to Chesapeake's 2008 expectation, we pointed out that the professor compared the value of the gas production to the amount of investment gas producers made during the same 12-month period. Costs exceeded all gas revenues. We took the liberty to slide from this simple comparison of revenue to cost to point out that "It is these negative economics that are beginning to play havoc with the profitability of the E&P companies active in the gas shale formations."

Our article was re-published by Rigzoneand it drew a response from Dr. Engelder pointing out the fact that well profitability is determined over an extended period of time and our broad-brush conclusion was inaccurate. Rigzone wrote a follow-up article correcting our misstated conclusion. We want to make it clear that we fully understand the timing issue in determining the economics of oil and gas exploration and production efforts. Our point, which unfortunately is more complex and deserves greater explanation than our one-line observation, is that current low gas prices are nowhere near the prices producers had plugged into the economic models when beginning their leasing and drilling efforts in the region.

For nearly two years, while natural gas prices were falling to below $4 per thousand cubic feet (mcf) of production, but have recently rallied to slightly above that level, drilling and production in the Marcellus was ramping up. A land rush of leasing has been underway which has created extraordinary pressure on the industry to drill the leases in order to hold the acreage by production. Once wells are drilled and begin producing, the producer can choke back the rate of production or possibly suspend the well in response to the low gas price. As shown in a recent leasing report (although hard to read), in Tioga and Washington Counties in Pennsylvania, the most common lease bonus paid was $2,000 per acre with royalty rates (at the wellhead price) ranging between 12.5% and 18.0% in Tioga County and 12.5% and 20.0% in Washington County. The lease terms were reported to be between three years on the low side and 10 years on the high. A large number of leases have been 3 + 2 (three years in length with an option for a two-year extension). Some producers have been trying to secure leases with 5 + 2 terms because of the long lead-times for drilling wells and getting them on production, especially in light of the pipeline bottlenecks for moving natural gas, and in some cases natural gas liquids, to market.

The Marcellus gas formation is an important new resource for this country. Dr. Engelder's estimate in 2009 was that the Marcellus formation contains 2,445 trillion cubic feet (Tcf) of gas in place and about 489 Tcf can be recovered with today's technology. That recoverability estimate represents about 20% of the in-place gas, which is likely low given the industry's history of successful application of technology to gas shale production.

To put into perspective the significance of the Marcellus, it spans a total area of about 95,000 square miles compared to the Barnett, the most successful of the shale plays, with only 5,000 square miles. The Barnett, after 17 years of development, produced 4.8 trillion cubic feet of gas in 2009. An additional positive for the Marcellus formation is that the gas is found at shallower depths than many of the other shale formations being exploited in the country now. The Marcellus tends to be located at depths between 5,000-feet and 8,000-feet, which translates into lower drilling costs for wells and potentially cheaper hydraulic fracturing costs due to the need for less horsepower to break up the shale rock.

The challenge for Marcellus production (and many other gas shale basins) is the economics of drilling and completing wells. Compared to the anticipated well results presented by Chesapeake back in 2008, the gas production data provided by the Pennsylvania Department of Environmental Protection of daily production of about 1.95 million cubic feet per day (mmcf/d) or cumulative production of 0.71 billion cubic feet (Bcf) per well exceeds the Chesapeake target. Certainly the Pennsylvania data is good news. Whether the production data supports increases in the economically ultimately recoverable (EUR) reserves from a well is probably premature to assume. The shape of the well production decline has been a basis of disagreement among people involved in the industry. Is the decline curve parabolic or linear? Only the additional production history of these wells will clarify the decline curve shape.

Continue reading the complete article on the official Energy Musings website.

G. Allen Brooks is managing director at Parks Paton Hoepfl & Brown. Reprinted with permission.