Shale Gas Hype: Subprime 2.0?

If my RSS reader is any guide, most of the press about shale gas 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 gas have 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.

This post originally appeared at naked capitalism and is posted with permission.

15 Responses to "Shale Gas Hype: Subprime 2.0?"

  1. richtfan   May 8, 2012 at 9:23 am

    There is NOT one actual piece of evidence that fracking harms any groundwater. Never has. Please point to something other than the Gasland video for proof.

    • Edmund Burke   September 24, 2012 at 11:47 pm

      dream on: Scientific American: “EPA Finds Fracking Compound in Wyoming Aquifer” (Nov. 10, 2011).

  2. Lance Sjogren   May 8, 2012 at 9:33 am

    "Shale gas is more likely to be a stopgap, a 25 year solution rather than a 100 one."

    Yes, but buying mankind 25 years before the post-fossil fuel die-off of the human race occurs is nothing to be taken lightly.

  3. tom   May 8, 2012 at 10:44 am

    in addition, how do you know shale gas reserves aren't going to last 100 years? What is your source?? I like where the article is going as a mover/change agent but this piece is one giant slice of conjecture.

  4. James McMurtry   May 8, 2012 at 12:24 pm

    If you want to discuss the shale gas prices being too low, you need to be considering the long term contract price, not the spot price.

    The spot price shoots up and down and distracts civillians – the contract price (the 2 year, 5 year and 7 year price) are what industry players make decisions off of.

    And these long term contract prices are settling into a nice sweet spot – high enough to drill, low enough for industrial consumers to build factories and infrastructure.

    As to a reduction in drilling – this is simply not true. The drillers are redirecting from dry shales to wet shales. The latter also produces gas, but also produces NGLs, as well, and NGLs are priced in a manner that tracks the price of oil. Since oil is now trading at an incredibly high price relative to gas in this country, this response represents an industry that is nimble and market oriented – not one that "lacks discipline".

    This mocking tone your article carries, with the implications that shale energy is some sort of passing fad, combined with your lack of basic industry knowledge, does very little credit to you as a writer, investor, and, for that matter, a human being.

    • duke_of_URL   May 9, 2012 at 9:32 am

      James, you are exactly right. I have seen hedge prices on gas through 2016. They are far better than spot prices. In addition, as the newer shale plays age and settle into predictable production levels, with lower declines, they will become great targets for MLP acquisitions. The wells may not produce like they did in their first 5 years, but they will continue at a stable rate for years to come.

  5. falk burger   May 8, 2012 at 2:23 pm

    Judging from the comments, Yves is spot on as usual. "Don't take away our bubble!" they wail. What I find fascinating is that the current glut was predictable, yet we are not reaping the benefits. Why? Where are the entrepreneurs? Where is government? Where is leadership? We can assume the oil lobby is working overtime to scare investors off shale gas, but why are they so threatened by gas, having just relented on electric cars? Shale gas conversion could help the economy out of its slump, but whom am I kidding? Rather than wean us off oil and onto more mature energy sources, gas would be hailed as panacea. That's "bubble" in English.

    • James McMurtry   May 8, 2012 at 3:31 pm

      "Where are the entrepreneurs? Where is government? Where is leadership? "

      There is plenty of leadership from the private sector. Just Google "Ohio cracking plant" or "Louisiana GTL plant".

      The shale revolution isn't like the smart phone revolution. It won't be glaringly obvious to outsiders – you have to look a bit for the benefits. That doesn't mean the benefits aren't real.

      The Eurozone is going down the tubes. In contrast to them, the US is doing incredibly well.

      If you are grateful that the US is much, much better than Europe, then thank a fracker.

      • falk burger   May 9, 2012 at 5:28 pm

        Nonsense. Cars don't come from the dealership ready to burn gas, and the growth in infrastructure is virtually nonexistent. Just because you've drunk the Kool-Aid doesn't make others obtuse. In a normal, American, entrepreneurial environment this would all have been available about ten years ago, and we'd all be happily fueling up on shale gas today – too happily, probably; we should be in the mother of all energy bubbles already. Why not?

        • James McMurtry   May 10, 2012 at 10:49 am

          You sir, are a clown. The US has the strongest natural gas infrastructure in the world. I use it to heat my house. My neighbor uses it to both heat his house and heat his water.

          It would be nice if we could use it in cars as well, but that doesn't mean the infrastructure we have is anything other than very, very good.

  6. Dory Hippauf   May 8, 2012 at 3:07 pm

    "I can assure you that buying leases for x and selling them for 5x or 10x is a lot more profitable than trying to produce gas at $5 or $6 per million cubic feet." ~ Aubrey McClendon, CEO and former Chairman Chesapeake Energy.

    One can not help to wonder if Chesapeake and others of that ilk are serious about drilling for gas or just out to sell real estate. Sub Prime 2.0? You Bet!

    • James McMurtry   May 8, 2012 at 3:33 pm

      Please, your ignorance is glaring. CHK is doing tons of drillnig in the Utica shale.

      Are you shorting CHK? Or just trying to help out the shorts? I don't care either way, I'm long CHK, buy have plenty of powder still dry, and would be happy to buy more in the single digits.

  7. Debbie Ziegler Lambert   May 8, 2012 at 3:31 pm

    As for the Marcellus Shale Field, I work in a Kentucky law firm and I can tell you it is a giant scam. You are right about the reason: recapitalizing broke mining companies, but there is also another bubble you missed or probable were not told about.

    • James McMurtry   May 8, 2012 at 7:36 pm

      Yeah a clueless paralegal from redneck country telling us all above "the big gobmt scam called shale gas". (eyeroll)

      Please, put your teeth back in and go back to the meth lab… you're embarassing yourself

  8. Debbie Ziegler Lambert   May 8, 2012 at 3:32 pm

    That is not what I wrote above.. IT problems.