Sunday, December 30, 2012

Living with the Gale

Shale gas and tight gas revolutionized the North American gas industry, and forced players to adapt to new realities
This article appears in the January 2013 issue of Unconventional Resource Guidebook and Directory 
 By Peter McKenzie-Brown
The revolution in unconventional gas, which uses horizontal wells, fracturing and new completion strategies to produce natural gas directly from shale and tight sands has turned the natural gas business upside down at a pace no one could ever have imagined. Although it caused pain among gas producers, it has also created opportunity for Alberta as one of the world’s great gas-producing basins.

The gas revolution began driving gas prices into the cellar four years ago and, by doing so, fundamentally changed the industry. Companies got a lot bigger through mergers. This helped them bring costs down so the resulting economies of scale could help them better deal with lower prices. It also enabled them to better finance the multi-million dollar wells and production systems that are part and parcel of this brave new world of gas production.

The companies most at risk were those heavily leveraged to natural gas. Many of the smaller ones successfully revitalized themselves by prospecting for oil or, of particular interest, shifting their focus to liquids-rich gas. A small amount of liquids in the gas stream can make a big difference in production economics because the value of those liquids is closer to the market price for oil.

Even the basic structure of the industry changed. As it pushed prices down, unconventional gas backed many Canadian producers out of traditional U.S. markets. And recently, a consortium announced a proposal to construct a pipeline from Ohio’s Utica shale gas project to southern Ontario. If this project receives regulatory approval – a strong probability – it could represent a future challenge to Western Canada’s dominance as a natural gas supplier to central Canada.

At present, according to a resource report from Ziff Energy Group, sand reservoirs in the Montney and Duvernay are the main sources of unconventional gas in Canada. Two-thirds of Canadian gas will originate in similar tight reservoirs by 2020, with the higher-cost Horn River shale gas in Northeastern BC serving as the main supply source for exports to Asia. By contrast, in the US six major shale gas plays and some minor shale plays will contribute more than a third of that country’s gas supply by 2020. Put another way, unconventional gas production – mostly tight gas in Canada, shale gas in the United States – is here to stay.

Seven Reasons: Roughly speaking, the drilling, operating, and marketing of gas tends to cost producers more than $5 per thousand cubic feet, while North America’s gas price now languishes in the $2 to $3 per thousand cubic foot range. If that is so, why in the world is anyone drilling for the stuff? According to Bill Gwozd, Ziff Energy Group’s senior vice president, there are several perfectly good reasons why natural gas drilling hasn’t gone the way of the dinosaur.

For one, after you have locked up the land you have to drill to keep possession. “It’s a marginal economics problem. You’re screwed if you don’t drill, but you’re also screwed if you do; you will lose money on every molecule you produce. The issue is, how do you get screwed less?”

Also, of course, if you can produce liquids-rich gas, the gas is a loss-leader. Profit from the liquids offsets losses from gas sales. New export markets for LNG are a rarity: a bright spot for producers.

A third reason? Gwozd observes that, when you form a joint venture, you may find yourself in a position in which partners have covered all your sunk costs, “so your expenses are covered at rack rate. Your costs may be only two dollars, so for you the economics of producing that gas may be very good.”

There’s always the matter of financial hedging. It doesn’t happen often, but companies sometimes find opportunities to lock up gas for production next year at prices which are favourable today.

There are other reasons based on the realities of being a producing company. Good producers understand the need to maintain staff, proving up reserves to show shareholders what assets are behind the stock price and simultaneously demonstrating the viability of the company. And some, because of many years of success, have easy access to capital – as Gwozd put it, “friends with lots of money who believe they should invest that money in developing production.”

And then, of course, there is the matter of due diligence. Many people in leadership positions are optimistic about longer-term gas prices. They think that by drilling now they will be able to lock in lower-cost gas before prices jump in the near future. These folks are the contrarians in today’s gas markets. Are they right?

Ascendancy… According to Dave Russum of AJM Deloitte, a petroleum consulting agency, “It is really very difficult to predict just what is going to happen in the natural gas market within the next five years. I think we will continue to see oversupply until we see projects completed that can take natural gas out of Canada, or out of the states. That would seem to be the main driver for improving prices.”

While the gas industry isn’t exactly in the ascendant, some trends suggest that a slow rise to ascendancy might not be far off. This article has already described how the industry is responding to low prices by adapting new technologies, cutting costs, seeking profitable niches and developing better markets.Consumers are happy with lower prices and policymakers see it as a low-carbon alternative to other fuels.

Producers, however, want higher prices, and so does the government of Alberta. One result of the collapse has been five consecutive deficit budgets – including what may be a $3 billion deficit this year. When it announced this unhappy number at the end of August, the province said it was partly because its mandarins had revised natural gas price estimates down to $2 per gigajoule, from $3 in the original budget, released last March.

The best way to reduce the oversupply is for producers to increase sales, and this is beginning to take place. Consumption of gas as a power plant fuel is on the rise, for example. It is now economically viable and environmentally attractive to switch some coal-fired plants to gas. In addition, there is a push to increase gas use in automotive transport. EnCana, for example, has publicly promoted this idea.

Some of the more visionary thinkers talk about installing gas-fired Stirling engines in homes and offices, to generate both heat and power. If this idea gains much traction, it will benefit consumers, gas producers and marketers, and the environment.

But the biggest fix for gas producers may soon begin to build in Kitimat, BC. When finished, the $4.5 billion Kitimat LNG project – owned by Apache, EOG Resources and EnCana – will become another face in the global LNG market. It will compete with, for example, Qatar. Shell has also announced plans to construct its Canada LNG export terminal at Kitimat – a much bigger project, estimated to cost $12 billion. Shell’s partners are Mitsubishi Corp. of Japan, the Korean Gas Corp. (KOGAS) and PetroChina Co.

According to Rosemary Boulton, who founded Kitimat LNG and later sold the company to Apache and its partners, “we’re experiencing a bigger gas bubble than we have seen in western Canada for more than 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.” 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. 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. Markets in Asia price natural gas relative to the price of oil, so that could be very attractive.”

Of course, market forces can change quickly. Only a few years ago – before the shale gas revolution – there were endless proposals for liquefied natural gas (LNG) receiving terminals across North America. Only one of those projects, the Canaport terminal in Saint John, NB, is operating today. Since going into operation in 2009, the project has been able to receive and regasify up to 1.2 billion cubic feet of gas per day, although it hasn’t yet worked at capacity. When it was designed and constructed, Canaport expected to help solve a forecast supply shortage – a testament to the speed with which resource economics can change.

Less and More: There is shale gas potential around the continent. Does the existence of shale and tight gas reservoirs that haven’t even been tested yet portend a market glut beyond the foreseeable future? AJM Deloitte’s Russum straddles the fence on this one.

Development of shale gas in Eastern Canada isn’t likely to develop too soon, he says. “There are environmental considerations and regulatory questions. A lot of these issues have to be resolved before those supplies can come onstream.” The future for unconventional gas, he says, remains in Western Canada, which “already has infrastructure and the necessary regulatory systems (plus horizontal drilling and fracking technology and expertise). We have tremendous advantages compared to other places in North America and, really, many other places in the world.”

Bill Gwozd offers a thought that is counter-intuitive and yet, in the end, cautiously optimistic. “Activity associated with natural gas is dropping. There will be fewer rigs, fewer wells, fewer hotshot drivers, fewer safety people, fewer hotel rooms…just less. However, production volumes will not decline. (Using the new technologies that are available) you can maintain production with only 2,000 to 3,000 new wells per year” – a far cry from the 6,000 conventional wells being drilled less than a decade ago.

Therein, perhaps, lies the good news. It’s anyone’s guess what the future might bring, of course. Notionally, however, a combination of more gas consumption in North America, growing overseas sales and less activity in the gas fields should bring the gas universe into balance. 
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