N. America’s gas drilling frenzy won’t end in 2011

December 20, 2010

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

North America’s shale revolution has run out of control, with leases forcing firms to step up drilling even as gas prices slump. The riot should last through 2011, even though many wells are money-losers. All this should lead to a wave of consolidation and joint-venturing — like the deal Talisman Energy announced with Sasol on Monday — in the gas patch.

Over the past few years new drilling techniques promised to redraw the U.S. energy picture. Hydraulic fracturing, or fracking, has opened access to vast quantities of gas trapped inside rock. Even cautious estimates put this new treasure trove at around 616 trillion cubic feet — equivalent in energy terms to 106 billion barrels of oil, roughly Kuwait’s proven reserves.

These resources are a potential win-win for America’s politicians too — allowing them to reduce dependence on foreign oil-producing countries while also cutting carbon emissions from dirty coal.

But the shale pioneers have become victims of their own success. The magnitude of the reserves unearthed by the likes of Chesapeake Energy and XTO, now a division of Exxon Mobil, has sent prices plunging — even as an economic revival has perked up demand. Gas now trades at little more than a third the level of June 2008.

Yet instead of cutting back, the energy industry has intensified its drilling. The number of rigs drilling shale has doubled since 2007 to over 500, according to Houston merchant bank Tudor, Pickering, Holt.

Part of the explanation for this perverse behavior is the structure of leases for the land. Drill-it-or-lose-it leases often compel firms to pump gas or kiss goodbye to their claims — which can cost up to $30,000 an acre in prime parts of Louisiana or Texas. Involuntary drilling of this kind will only start to die down towards the end of 2011.

Any natural brake on self-destructive activity has also been weakened by a spree of joint ventures. Eager to get a taste of North America’s new energy bonanza, foreign energy firms are bankrolling drilling costs in exchange for a share of the spoils. In Monday’s deal, for instance, South Africa-based Sasol agreed to pay 75 percent of Talisman’s drilling costs in exchange for a 50 percent interest in some of its Canadian shale assets. It’s easier to keep drilling when spending somebody else’s money — even though as many as half of all new wells are uneconomical at current gas prices, according to Tudor, Pickering.

So far much of the pain of collapsing prices has been cushioned by hedging. But the prolonged decline in gas prices means this protection will start to slip away in early 2011. Even so, natural gas supply is expected to climb another 5 percent. And if the gas price moves higher, there are an estimated 1,000 wells waiting to be completed.

Depressed prices would typically draw out more demand as gas displaces coal in electricity generation and, in time, motorists opt for natural gas vehicles. This should happen eventually. After all, while the price of a barrel of oil is hovering around $91, natural gas is offering the same amount of energy for the bargain price of $27. Even traditionally cheap coal is under threat from gas at current prices.

The trouble is that demand will take years to emerge. Shifting parts of America’s transport sector to natural gas — as countries like Argentina have done — takes time and investment in infrastructure like filling stations. Meanwhile in the absence of a carbon tax, natural gas is only gradually gaining ground in electricity generation as geriatric coal plants are retired.

With supply shooting higher and demand creeping gently, natural gas prices should remain below $5 per million British thermal units through 2011. For those energy producers locked into gas drilling, that makes more joint ventures or asset sales likely. And others will look to beef up on oil-producing shale assets, particularly in the Bakken region of North Dakota and the Eagle Ford shale in Texas. Gas specialist EOG Resources has already blazed a trail, boosting liquid output by around 43 percent against 2009. Chesapeake also has been shifting toward oil, and Sasol may be able to help Talisman do the same.

This may sound like bad news for energy firms awash in cheap gas. But it’s good news for Houston’s sought-after cadre of energy bankers. They will be called upon to broker more deals, joint ventures and capital raisings than ever before.

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