Shale We Dance?

Peter Way Founder and CIO, Peter Way Associates

A shale revolution is underway in the US, and soon it will be "exported" around the world, as unconventional drilling is proving to be a boon to energy producers and consumers alike, notes Peter Way in Block Traders' Oil and Gold Monitor.

In many cultures, dancing is an expression of joy, often publicly displayed and enjoyed. The intended pun in the headline is further intended to reinforce the notion that an underlying enormous strength of the United States of America is that its free-market democracy provides continual incentives for individuals to think and create and improve, knowing that substantial rewards often usually follow such accomplishment.

Currently, because of this, the geology of shale formations is playing a significant role in our national well-being.

It is the nature of the extractive industries, in dealing with natural resources, to maximize the values of any deposit by balancing its richer pockets of product with leaner parts, within the average costs of recovery, so that best overall profit from the deposit can be achieved. The costs of extraction define the economic scope of the resource body, and its ultimate depletion then turns production attentions to higher-cost sources.

Those costs of extraction are the result of learned technologies that usually improve through time, hopefully expanding the life of the resource body with minimal increase in its break-even costs and in the ultimate price for what is being extracted.

In oil and gas recovery, the cost-benefit tradeoff of vertical drilling practice and technology has seen severe degradation when applied to smaller, more distant, and more difficult to reach reserves, resulting in prices doubling in crude oil from $50 a barrel to over $100.

But the mother of necessity has spawned a leap of technology that carries huge economic advantages. Skills learned in vertical drilling allow directional guidance of the drill bit, to the extremes of a shift from vertical to horizontal, and in any desired compass direction.

Coupled with water injection under pressure and the accompaniment of granular materials to hold open fractures induced in shale beds by the water, "fracking" now allows the recovery of hydrocarbons known to exist, but previously uneconomic to recover.

The original objective was to acquire natural gas, but the bountiful surprise was that enormous quantities of crude and other hydrocarbon liquids (NGLs) accompanied the NatGas paystream. Some experiences were of liquids above 90% of the total value. With crude selling at a heat content some five or six times the equivalent NatGas content, oilfield development priorities rapidly changed.

Production of NatGas from older, vertically-drilled wells (dry gas production) is quickly being supplanted by the "unconventionally-produced" equivalent from new-technology "wet-gas" wells, because of the rewards coming from their liquids.

The challenge now is to find markets for all the newly-available natural gas, and find ways to get the gas to those markets. The largest NatGas producer, ExxonMobil (XOM), is preparing to export it for consumption in higher-priced foreign markets.

A major potential natural gas market is in the generation of electricity, now primarily fueled by coal. That fuel's contribution to air pollution can be controlled, but at an additional expense that detracts from coal's price. Transportation, typically by rail to most utilities, is another coal-price offset, dependent largely on distance from mine to powerplant.

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Natural gas has virtually no pollution cost penalties, and its ideal transportation means is by pipeline, which can outcompete rail transit under most circumstances-where a pipeline exists. The problem for NatGas is that pipelines have a high initial capital cost that must be financed up front. That financing needs the assurance of long-term demand contracts for the to-be transmitted fuel.

Once in place, the pipeline is geographically inflexible and fairly fixed in its operating cost, so transmission loads at high levels of capacity are essential. Again, assurances of demand will support the pipeline's financing.

In the past, the demand was always present, but the supply was unsure and irregular, to the point where NatGas only was price-competitive when it was in enormous, accidental, oversupply. Now steady continuous supply is assured, and competitive pricing can win long-term contracts, providing delivery system financing.

This competition between coal and NatGas boils down to the price per million BTUs delivered at the powerplant. Cost of extraction of the fuel from nature's resting place will determine the winner in most cases, after transit and ecological factors are considered. But geographic locations play a part.

Another unexpected development in the exploitation of the shale oil and gas is the quality of the liberated fuels. One major player is indicating break-even crude costs at $37 a barrel, partly because the product is very low-sulfur (sweet) and light in weight. Present WTI crude trading in the neighborhood of $90 suggests that there can be a good deal of elbow room in the pricing of the joint-cost products of gas and oil.

Ultimately, lower crude prices as a result of greater supply and known reserves are a logical outcome of the present scene. That puts a good deal of restraint on stocks of companies with presently known developable reserves that have been valued at present-day higher crude prices, much more than it does on previously less-well-found companies that are now building portfolios of claims to unconventional-development reserves.

That seems reflected in the future price expectations implied in hedging actions by market makers in the stocks of major integrated conventional-play producers.

As these evolutionary implications have become better understood, even the rapidly-developing independents working hard to expand their control over the better-positioned unconventional-production field acreage are being held as less attractively priced. Far fewer of them approach our standards for new investment commitments.

Perhaps there is a "seasonal" impact on investments in general, due to the year-end legislative "deadline" on fiscal reforms. The one group we cover that has several stocks with very attractive prospects, as market makers see it, is among precious-metals issues.

The appeal is not uniform, so it seems to be more of a matter of certain stocks or ETFs having particular appeal in institutional circles. If the price-motivating factor was simply an increase in US currency exchange vs. the underlying metal, then all those investment vehicles should reflect a perceived coming value change fairly equally, and the attractions should be quite similar.

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Related Reading:

US Shale Fields Hold Great Promise

A Bright Future for Natural Gas

The Outlook for Natural Gas