How Does The Shale Gas Scam Work?

Last week the New York Times published a series of articles on shady dealing in the shale gas business. I alerted readers to those articles in The Shale Gas Scam Goes Public, and also included links to my own writings about shale gas. Follow the links in that post for background. Today I discuss how the shale gas shell game works, and I'll quote from the Times' Insiders Sound an Alarm Amid a Natural Gas Rush where appropriate.

The hype surrounding shale gas development has rivaled that which accompanied the "dot-com" boom & bust, and the Housing Bubble. This is  not surprising considering that some of the same flim-flam was involved. However, as with the internet, the shale gas resource is real and it is large. The problem with shale gas is twofold: 1) the gas will be expensive, and is not profitable to produce at current prices; and 2) as respected Canadian geologist Dave Hughes explains, there may be 100 years of gas in these tight shale reservoirs, but it will likely take 800 years to produce it—you've got to poke a lot of very expensive holes in the ground to get the gas. Production decline rates are steep, which is another way of saying that shale gas wells deplete rapidly.

A third issue I will not get into today involves the enormous quantities of water required to get the gas out of the shale.

Click on the image for a better view

After technological breakthroughs in hydrofracking and horizontal drilling allowed the gas to be produced, and with the apparent initial success of development in the Barnett Shale, other shale gas plays (in the Haynesville, the Fayetteville, the Marcellus, etc.) became hot investments, just like dogfood.com. Here's how the scam worked—

• Small and mid-sized shale gas operators rushed to lease the most promising acreage in the various plays, and lots of not-so-good parcels as well. It was a land rush which drove up asset prices just as in any bubble.


• To finance the land grab and support initial drilling efforts—completed shale gas wells cost about 5-7 million dollars—operators went to Wall Street and elsewhere. In short, they went deeply into debt.


• Drilling first in the sweet spots, operators got some very productive wells (measured in cubic feet/day). The operators proceeded to use these high initial production (IP) rates to 1) hype the shit out of shale gas; 2) attract additional financing; and 3) exaggerate the estimated ultimately recoverable gas from the wells. This last, the EUR, is used to calculate bookable "proved" reserves with the SEC. From the Times—

  Company data for more than 10,000 wells in three major shale gas formations raise further questions about the industry’s prospects. There is undoubtedly a vast amount of gas in the formations. The question remains how affordably it can be extracted.

  The data show that while there are some very active wells, they are often surrounded by vast zones of less-productive wells that in some cases cost more to drill and operate than the gas they produce is worth. Also, the amount of gas produced by many of the successful wells is falling much faster than initially predicted by energy companies, making it more difficult for them to turn a profit over the long run...

  “Our engineers here project these wells out to 20-30 years of production and in my mind that has yet to be proven as viable,” wrote a geologist at Chesapeake in a March 17 e-mail to a federal energy analyst. “In fact I’m quite skeptical of it myself when you see the % decline in the first year of production.”

  In order to estimate the EUR, the operator must define a "decline curve" which shows the estimated production over the active life of the well. Shale gas decline rates are steep, as I first explained in a 2009 article A Shale Gas Boom?

  

  You can easily see that there is a lot of wiggle room for operators. If they model a shallower decline curve, and thus stretch it out over a greater number of years, they can boost the EUR, and thus a well's reserves.

• Reserves are the key to the shale gas scam, as the Times explains—

  A big attraction for investors is the increasing size of the gas reserves that some companies are reporting. Reserves — in effect, the amount of gas that a company says it can feasibly access from its wells — are important because they are a central measure of an oil and gas company’s value.

  Forecasting these reserves is a tricky science. Early predictions are sometimes lowered because of drops in gas prices, as happened in 2008. Intentionally overbooking reserves, however, is illegal because it misleads investors. Industry e-mails, mostly from 2009 and later, include language from oil and gas executives questioning whether other energy companies are doing just that.

  The e-mails do not explicitly accuse any companies of breaking the law. But the number of e-mails, the seniority of the people writing them, the variety of positions they hold and the language they use — including comparisons to Ponzi schemes and attempts to “con” Wall Street — suggest that questions about the shale gas industry exist in many corners.

  “Do you think that there may be something suspicious going with the public companies in regard to booking shale reserves?” a senior official from Ivy Energy, an investment firm specializing in the energy sector, wrote in a 2009 e-mail.

• There are two kinds of investors: smart ones and dumb ones. The dumb ones, the suckers, the greater fools, risk losing their money. But the smart ones don't invest unless there is an exit strategy. There were two possible exit strategies.
  1. The shale gas production boom was for real
  2. Operators were dangling themselves as acquisition targets for the big players (i.e. the majors like ExxonMobil, Shell, etc.)
  To make a long story short, strategy #2 has been working, as I described in The Shale Gas Shell Game. Big players like ExxonMobil have acquired controlling interests in or wholly acquired a number of small or mid-sized shale gas operators. The mergers and acquisitions game is ongoing. Exxon Mobil books the reserves, which makes them look good on paper. Reserves are the a central measure of an oil and gas company’s value.

And that, in broad outline, is how the shale gas scam worked (and works). It appears that ExxonMobil is the victim here, but it only appears that way. They defended their investment strategy in CNN Money's Talk of natural gas bubble draws industry ire.

Big energy company executives and government researchers are firing back at a recent New York Times story suggesting the recent boom in natural gas production from shale rock is unsustainable and perhaps fraudulent.

"You really have to wonder why the New York Times is campaigning against cleaner-burning, domestically produced natural gas," ExxonMobil Vice President Ken Cohen wrote in a blogpost Monday. "If the writer had bothered to call us, we would have told him that ExxonMobil's investment approach is disciplined and based on a long-term view of global market conditions."

Exxon, through its $41 billion purchase of XTO Energy last year, is now North America's largest shale gas producer.

First, ExxonMobil has booked the shale gas reserves, phony or not, that increase their valuation. Second, big players like Exxon can afford to wait for natural gas prices to rise, which may take years, but which will also make many more shale gas wells profitable. The Times was very weak on this point—

Production data, provided by companies to state regulators and reviewed by The Times, show that many wells are not performing as the industry expected. In three major shale formations — the Barnett in Texas, the Haynesville in East Texas and Louisiana and the Fayetteville, across Arkansas — less than 20 percent of the area heralded by companies as productive is emerging as likely to be profitable under current market conditions, according to the data and industry analysts.

Gas is currently going for $4.38/MCF (thousand cubic feet, or MMBTU). Most shale gas wells are losers, or only break-even at that price. However, if gas were to rise into the $6-$8 range, the profitability picture changes considerably. Don't feel sorry for ExxonMobil.

That's enough to chew on for today. I will write a third post on the shale gas situation sometime in the near future.

Comments

[Loveandlight]

Based on that decline rate curve chart, it seems difficult to conceive of any circumstances in which these shale-gas wells would be profitable to maintain after a mere two years.

[S. Quade]

Thank you for this post. Let's hope it gets around.

[Norm]

Yeah, that's the tciket, sir or ma'am

[CW]

My geologist friends and myself (also a geologist) have watched this ploy with much consternation but unfortunately we are not suprised. Years ago during one of the oil busts geologists were as high on the distrusted list as lawyers. This is the reason why. Disgusting that people are being roped into these plays. They will not pay out until gas prices are much much higher. Its really very simple math, once an oil well plays out you have an expensive hole in the ground, that the state makes you properly plug by the way so there is even an expense to shutting down a dry hole.