Marcellus Shale Gas: The Energy Sector’s Next Major Profit Play
With natural gas hovering at about the breakeven point for new field development – and with a glut continuing to weigh down prices in the U.S. market – this would hardly seem to be the place to look for investment opportunities.
During the next six months, however, these circumstances will begin to change. And with those changes will come one of the biggest new opportunities in the U.S. energy sector.
There will be two key factors to this shift:
- First, gas demand is returning. And that increased demand will be accompanied by a renewed interest in drilling. Residential use is now matching volumes seen prior to last year’s financial shock and power production is actually above pre-crisis levels. It is industrial demand that languishes, continuing to reflect the sluggish recovery as a whole. Yet even here are signs that demand is awakening. Demand had experienced a year-over-year decline of 11% in August. By the end of October, however, that decline will have narrowed to 6% or less.
- Second, production from conventional (or freestanding) gas fields in both the United States and Canada is declining. That means domestic volume will turn to unconventional sources. And leading the list is shale gas. Until about 10 years ago, it was too expensive to extract. But a technology that moves large volumes of water under high pressure – called a “frac” – and horizontal drilling have made shale the up-and-coming domestic gas source.
The Massive Marcellus
While there are several U.S. shale plays now producing – most noticeably the Barnett Shale Field surrounding Fort Worth, Texas – attention is already fixed on The Marcellus. Forming a huge “C” beginning in south central New York, extending across central and western Pennsylvania and ending in West Virginia, this may be the mother lode. The operating companies think so and have been moving in for more than a year. About 60% of the production is probably coming from Pennsylvania.
Fewer than 350 wells have been drilled, but pay zones tend to be larger, pressure higher and recoverable volume greater than projected. That means the initial estimate of 50 trillion cubic feet (cf) of recoverable gas (out of the more than 500 trillion thought to be there) could well be low. My current estimate is closer to a 17% extractability level or about 85 trillion cubic feet.
To put it another way: That volume would meet all U.S. demand for almost five years – or Pennsylvania’s needs for the next 113. On another matter of interest, there have been no “dry holes” from any of the wells spud to date. That’s right – a 100% success rate!
Currently, New York Mercantile Exchange natural gas prices are around $5 per 1,000 cubic feet and that continues to depress drilling nationwide. However, Marcellus wells can generally remain profitable at a level of between $3.60 and $6, and Pennsylvania permits for new wells are rising. I believe prices will be about $5.40 by the end of this year and will then rise to $7 by mid-summer of 2010 – reaching $10-$12 by 2011.
Clearly, as we move into the New Year, the Marcellus will be on everybody’s radar.
Prices are headed higher for three key reasons.
First, we will have a colder winter this year than last, meaning the drawdown from storage will be greater. With 3.7 trillion cubic feet set aside at the moment, a historic high, there will be more taken out than last year’s 1.2 trillion.
Second, we still have more than 40% of the rigs off line nationwide, resulting in a significant cut in production in the face of rising demand.
Third, demand on both the industrial and power generation fronts will continue to rise. I expect gas usage for electricity production this year to increase by 1.5% to 2% over 2008, a significant result when we consider the horrendous energy picture earlier this year. On the industrial side, the five leading indicators directly related to production are poised to begin moving into positive territory.
A rise in energy use always precedes such an upward movement, and natural gas is the principal fuel to benefit most directly from increasing production. The location of the Marcellus also positions its production well for efficient supply to an industrial sector needing the energy – especially in Pennsylvania, where an expiring electricity price cap threatens an already vulnerable employment base.
With production moving to shale nationwide, the Marcellus has a decided pricing advantage over other plays. While it will take a contract price of $8 per 1,000 cubic feet to make most Fayetteville fields profitable, word has it that almost 50% of remaining Barnett volume may well require a contract price in excess of $10.
More than 50 operating companies have already moved into the Marcellus. Among them, the companies to watch include:
- Range Resources Corp. (NYSE:RRC), the first driller in the Marcellus.
- Chesapeake Energy Corp. (NYSE:CHK), flush off a joint venture with Norwegian StatoilHydro ASA (NYSE:STO) and holder of the most lease territory.
- Independents Anadarko Petroleum Corp. (NYSE:APC), EOG Resources Inc. (NYSE:EOG), and Ultra Petroleum Corp. (NYSE:UPL). These three have positioned themselves well to phase in major drilling programs.
- Sources are also telling me that Russian giant Gazprom OAO (OTC:OGZPY) – which recently signaled its North American interest by opening an office in Houston – has been in preliminary discussions about joint venturing in the Marcellus.
But I am saving the most significant Marcellus development for last. After a fierce, 101-day political battle, the Pennsylvania state budget finally passed on Oct. 9. It contains no taxes on Marcellus land available for drilling leases. The profitability of operating in the Marcellus just got even better.