Monday, June 13, 2011

The Road to Success

Canada's shale gas producers are paving the way to successful exploitation of a massive resource

This article appears in the second volume of CSUG's Energy Evolution Guidebook & Directory
By Peter McKenzie-Brown

The shale gas revolution has turned the natural gas business upside down at a pace no one could ever have imagined. There is now tough competition in North American gas markets and the legendary successes of junior oil companies in the province—a crowning achievement of western Canada’s way of doing business –is in decline. Juniors can’t be really small anymore because they now generally require a lot of start-up capital. Crashing gas prices have put some into receivership, forced many to merge and forced all to change.

Perhaps Winter Petroleum—a small, privately held company—typifies the situation for little gas producers. With operations in the northwest corner of Alberta, the company got its name because its properties can only be drilled during the winter, according to president Duncan McCowan, a geologist.

“Winter drilling requires a lot of equipment and it’s expensive,” he says, “and our production is remote from major markets. Because of cost structure and transportation, we’re finding it tough to compete in U.S. markets.”

His company hasn’t let any employees go, however. “We are still slightly profitable, but we can’t grow. We’ve cut back our capital spending completely and many of our operational items too. (Dry gas) activity in that part of the province is at a standstill.”

McCowan points to a decline in the number of junior companies, partly through bankruptcies like that of Drake Energy, which was a neighbour to his own gas company, Winter Pete.

“Today you need pretty serious money for a start-up. A few million dollars won’t go very far anymore, because the new technologies we’re using involve horizontal wells and multi-stage fraccing. It used to be you could drill a well for a couple hundred thousand dollars. Today it takes millions, and financing groups are putting together a fund of, say, $35 to $70 million and then putting an experienced management team in charge. There are fewer mom and pop petroleum companies around.”

Peter Tertzakian of ARC Financial Corp. says two other important trends favour consolidation and larger companies.

“Bulking up to get costs down helps you deal with lower prices. It gives you economies of scale. A related factor is that a lot of companies are migrating to horizontal drilling and completion strategies, but that’s very expensive.”

On average those wells cost $4.5 million, and there have been many wells that cost $8 million or more. “By drilling fewer wells that are more expensive each, you need more backbone – you need to be a bigger company.”

The companies most at risk are those that are heavily leveraged and biased to natural gas, but many of the smaller ones are successfully implementing what he calls “revitalization strategies: shifting their focus to liquids-rich gas, or even prospecting for oil. A small amount of liquids in the gas stream can make a big difference” since it often has a greater market value than oil.

Compare that situation to the one announced in February, when PetroChina made a huge counter-intuitive deal with EnCana Corp. While other major Asian investments in the Canadian petroleum industry have mostly gone into the oilsands, Petro-China put its money into shale gas. The two companies announced that they had inked a $5.4 billion deal by which they would become equal partners in EnCana’s Cutbank Ridge gas field in British Columbia. This investment, which surpasses Sinopec Corp.’s $4.65 billion acquisition of ConocoPhillips’ stake in Syncrude last year, is Asia’s largest single bet on North America’s energy sector.

According to EnCana spokesman Alan Boras, the focus of this effort is natural gas, not the associated gas liquids.

“We are always looking for ways to maximize the value of our assets, and natural gas liquids extraction is an important part of that process,” he says. “However, that is not our major focus.”

Since the company does not see natural gas prices above $6.63 per thousand cubic feet in the foreseeable future (2021), EnCana clearly is basing its business plan on something other than an upward move in North American gas prices.

One of those ideas is low-cost production. According to Boras, “In the Montney, where we have done the deal with PetroChina, our wellhead cost is about $3.15 (per thousand cubic feet).”

The deal will enable the Chinese to “get an early return on their investment, and then take the technology back to China to use it there. That certainly is part of what they’re thinking. The Chinese have recently talked openly about their need to increase domestic gas use.”

In addition to low-cost production, new pipe in a region already riddled with infrastructure could lower future transportation costs. This is the significance of the National Energy Board’s recent approval of TransCanada Corp.’s plan to build a $310 million pipeline to connect British Columbia’s Horn River shale gas region to its Alberta mainline system.

Ascendancy?
While the gas industry isn’t exactly in the ascendant, some trends suggest that ascendancy might not be far off. This isn’t readily apparent, since shale gas has backed Canadian producers out of traditional U.S. markets and driven down prices.

Low prices have made much of Canada’s conventional gas uneconomic in distant U.S. markets, and many producers are in trouble. In recent years the only major commodity to decline in price and stay there, natural gas has mostly defied winter demand for heat and summer demand for air conditioning.

The price collapse is forcing the industry to dramatically restructure, clouding the outlook. Such legacy assets as Canada’s Arctic gas fields look increasingly like white elephants: the likelihood of a pipeline from north to south is slipping ever farther into the future.

According to Robin Mann, president of AJM Petroleum Consulting, “Because of the development of shale gas formations like Montney and Horn River and others with great potential right next to infrastructure and pipelines, and with our existing conventional gas and our exports to the United States going down daily, we have more than enough (gas) for our own (use) so why is it important to build these pipelines? Why are we worrying about anything north of Alberta and B.C.?”

Consumers are happy with lower prices. Companies are not, however, and neither is the government of Alberta—now into its fifth consecutive year of deficit budgets.

One Alberta politician with ideas on the issue is Wildrose Alliance leader Danielle Smith, who doesn’t have to worry about balancing this year’s provincial budget. She sees the collapse in gas prices as an opportunity.

“There is so much we can do now to increase demand: fuel switching, the Pickens Plan (to increase gas use in automotive transport) in the United States, increasing use of gas for power generation.”

She even talks about installing modern-day gas-fired Stirling engines in our homes, to generate both heat and power. “If we do these things, consumers win. So does the environment and so do gas producers.”

In a way, those simple ideas describe a path that could bring the industry out of its funk. They are also consistent with much of what the industry is already doing in response to a rapidly changing business environment.

One industry response has been to reduce natural gas drilling--at this writing, at a one-year low. Companies are focusing instead on drilling for oil. According to ARC Financial’s Tertzakian, “this capital migration continues to be a positive leading indicator for natural gas price recovery.”

The industry is also responding to low prices with rapid adaptation of technology. It is cutting costs, seeking profitable niches and developing better markets. In addition, consumers are responding to the attractive price of natural gas, and policymakers are seeing it as a low-carbon alternative to other fuels.

And North America’s dominance in shale gas development makes it for the first time a potential large-scale manufacturer of liquids made from natural gas.

Gas-to-liquids
The gas-to-liquids concept is most evident in the billion-dollar deal Talisman Energy struck late last year with Sasol, the South African petrochemicals giant. The deal involved selling a 50 per cent interest in Talisman’s Farrell Creek shale gas properties in British Columbia. Eventually, the partnership could develop a plant using Sasol’s gas-to-liquids technology to turn the gas into a desirable liquid fuel. This is proven technology: Shell, for example, is constructing a $6 billion gas-to-liquids project in Qatar, the tiny Middle Eastern country with 15 per cent of the world’s proved natural gas reserves.

Another way to solve the stranded gas problem is to create liquefaction facilities for natural gas exports. When finished, the $3 billion Kitimat LNG project will become another face in the global LNG market—competing with, for example, Qatar.

According to Rosemary Boulton, the founding president of Kitimat LNG, “we’re experiencing a bigger gas bubble than we have seen in western Canada for 20 years, and this makes (LNG exports) a particularly viable proposition. We need to develop LNG to meet the needs of gas markets other than those in the U.S.”

Apache Corporation and EOG Resources obviously agree, since in December they bought out her start-up company—after it had received development approvals—and Canadian gas giant Encana Corp. came onboard with a 30 per cent interest this past March.

Countries like India and China will eventually begin developing their own shale gas resources but at present “Japan and Korea are the world’s biggest importers of natural gas,” says Boulton, “and they have no indigenous supply.”

She adds that “there are a number of ways you can write a price contract, and one of them is based on the price of WTI. That’s a pretty good price for exporters. For importers, it’s a lot better than a contract based on the price of Brent (North Sea) oil. Markets in Asia price natural gas relative to the price of oil, so that could be very attractive.”

Bill Gwozd, a vice president of Calgary-based Ziff Energy Services, agrees. “If you have an Asian market that’s prepared to pay (an LNG) price that’s linked to oil, we think (shale gas production) can surge.”

Boulton sees room for expansion of Canada’s international LNG business. “The Kitimat project is approved for five metric tonnes or 700 million cubic feet per day. The pipeline will be capable of supporting a much bigger project—doubling (project capacity) is certainly viable.”

She doesn’t see a lot of LNG shipments leaving from B.C.’s Lower Mainland, however. “Projects are all about location. I see a lot of objections to a project (there) because of the nature of some communities on the Left Coast.”

Stakeholder engagement

A year ago, American filmmaker Josh Fox released a film called Gasland, which purported to document the dangers of hydraulic fracturing for shale gas. One landowner after another talked about the dangers of shale gas to their health, and some spectacular footage showed a man setting water from his kitchen tap alight – the result, he said, of shale gas polluting his water well.

Ziff Energy’s Bill Gwozd is sceptical. While he acknowledges that the consumption of large amounts of water for fraccing can be an environmental problem in areas where water is in short supply, he’s sceptical about the rest. “Shale gas and ground water are peanut butter and oil,” he says. “They don’t touch each other.

There are a lot of people who want to talk about shale gas polluting groundwater but it just isn’t going to happen.”

He points out that the geological zones which hold groundwater and shale gas can be literally thousands of feet apart, and that dirt and rock under pressure are anything but porous. “So how could deep zones of shale gas pollute groundwater, which is maybe 1500 metres up?”

“You’ve got to believe that the answer is in the details,” he says. “A lot of people complain about shale gas development without bothering to understand the technical issue. When you get into that conversation, they have to come to the conclusion that there is no problem here.”

Well, not entirely. In March Québec’s environment minister, Pierre Arcand, said the government didn’t have enough scientific information about hydraulic fracturing to sanction its further use. Until his department completed its research into what had become a heated public issue, the government imposed a drilling moratorium on Québec’s promising Utica shales.

Ziff’s Gwozd has a kind of conspiracy theory respecting public concern about shale gas. “Who’s driving the environmental objections?” he asks, rhetorically, then offers his own answer: “Anybody (with an interest in) conventional gas, in LNG, in coal, in energy alternatives. If you complain about it, you make it an issue. (To say these worries are based on science) is like the fox telling the bird he doesn’t want to cook it for turkey day.”

Enter Lane Wells, the principal at head•stock, a public consultation firm which specializes in aboriginal communities. Wells describes effective stakeholder engagement as involving “thoughtful, non-adversarial and respectful exchanges of information. Listening to stakeholders is important. Responding to what you have heard is critical.” Stakeholder engagement is becoming increasingly crucial if you want public policies that give you the right just to develop shale gas.

Changing Policy
Public policy is becoming increasingly important in other ways, too. For example, the Obama administration is now behind a drive to make natural gas the fuel of choice in as many energy-consuming applications as possible, with an emphasis on switching coal-fired power plants to gas.

Senior Democrats in Congress are getting behind the stuff, portraying it as an alternative fuel for transportation that can serve as a stopgap until renewable sources of energy, like solar and wind power, become economical on a broad scale.

Reflecting this policy, last year Rahm Emanuel—a congressman and formerly President Barack Obama’s chief of staff—introduced legislation which would have offered tax credits to both gas producers and consumers. The legislation died with last fall’s election, which unceremoniously turfed Emanuel and other Democrats from the House.

The promotion of natural gas as a fuel is popular within the industry also. The New York Times cites William M. Colton, ExxonMobil’s vice president for corporate strategic planning, as a serious natural gas enthusiast.

“If there is any kind of major trend, we think it’s going to be a shift toward more natural gas. Natural gas is available. It’s the most efficient way to generate massive power. It’s affordable. We already have gas infrastructure in place. From a CO2 emissions standpoint, it’s 60 per cent cleaner than coal, and (the U.S. has) 100 years of supply.”

As these issues get resolved, a leaner and meaner industry using advanced technologies and far more capital is emerging. The industry is opening its collective eyes to a brave new world of natural gas—one in which surplus supplies are convulsing the sector in many ways.

“Our intent is to tough it out,” says Winter Petroleum’s Duncan McCowan. “So we’re doing creative things to cut costs—jointly handling gas with our neighbours, for example. We’re optimistic about our geology—the horizontal potential is huge, but we couldn’t justify (horizontal drilling) in this price environment. Sure, we’re pessimistic about gas prices, but we know they’re going to turn. We don’t know when, but when they do we think it’s going to be pretty quick.”
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