Musings: Natural Gas Shales A Game Changer, But LNG Exports?

It is popular to proclaim that the energy world has changed – unconventional natural gas is now conventional – but has it really?  In 2009, the Potential Gas Committee (PGC) at the Colorado School of Mines suggested that America's technically recoverable natural gas resources totaled 1,836 trillion cubic feet (Tcf) with fully one-third accounted for by natural gas resources found in shale formations underlying many of the existing oil and gas producing basins.  Because the industry has proven its ability to tap these trapped gas deposits, the PGC felt obligated to report them as additional resources.  When coupled with the 238 Tcf of proved natural gas reserves, as determined by the Department of Energy/Energy Information Administration (DOE/EIA), the total potential gas supply resource potential of the country swelled to 2,074 Tcf, an increase of 35%.  Clearly this is a significant volume of natural gas resources, the largest in the 44-year history of the PGC.  What caught the attention from the media, investment analysts and energy industry executives was the 542 Tcf increase in the PGC's assessment of total U.S. natural gas resource potential in the two-year time span between the 2006 and 2008 surveys, as the estimated total grew from 1,532 Tcf to 2,074 Tcf including proved reserves. 

The Potential Gas Committee suggested that America's technically recoverable natural gas resources totaled 1,836 Tcf with fully one-third accounted for by natural gas resources found in shale

Based on this new, huge resource potential, it became popular to merely divide the total resource base by the annual volume of natural gas consumed in this country and arrive at estimates of 100 years of supply.  The prospect of a domestic energy supply source of this magnitude has lulled people into assuming that the nation's foreign energy dependency is destined to be eliminated.  As a nation, we only need to make some infrastructure investments and incentivize consumers to use more gas and America is home free on energy.  Not!

Exhibit1"

The first big mistake many people make is misunderstanding that the estimated resource potential is a long way from proved, producing reserves, if the transition is ever completed.  Therefore, it becomes imperative to understand the composition of the potential resource estimate as it may suggest the likelihood of these resources successfully transitioning from potential to actual supply.  In Exhibit 2, we have broken down the PGC's estimate of the nation's gas resource potential into probable, possible and speculative reserves – the typical definition of oil and gas reserves provided by companies in their various regulatory filings.  In the probable category we have included the DOE's estimate of proved natural gas reserves.  The approximately 700 Tcf of probable gas reserves, at the current 25 Tcf of annual gas consumption rate, suggests the U.S. has about 28 years of gas supply, but only 10 years of that supply life is accounted for by the existing proved reserves, which is about the ratio of proved reserves to production that has existed for many years.

Exhibit1"

Based on the data, the nation has close to 800 Tcf of possible reserves, the ultimate amount being dependent on additional drilling, adequate prices and some technical success in order to move them into the probable reserves category in the future.  It is difficult to estimate how successful this shift will be. 

By confusing possible resources with proved reserves, the popular myth of the U.S. possessing 100 years of natural gas supply was born

More importantly, fully 30% of the PGC’s estimate of the ultimate potential resource base falls in the category of speculative reserves meaning these reserves need technological advances and likely much higher prices in order to move into the probable category, although they could migrate into the possible category more easily.

By confusing possible resources with proved reserves, the popular myth of the U.S. possessing 100 years of natural gas supply was born.  Recent years of swelling gas production, driven by the technological success of horizontal drilling and hydraulic fracturing, convinced many that the U.S. was now the land of plenty.  Because the U.S. economy was mired in one of the deepest recessions since the Great Depression, demand for natural gas fell just as production mushroomed creating a huge surplus of gas supplies that at times forced producers to cap production not only because it was uneconomic to produce due to low wellhead prices, but also because sometimes there was limited storage space for the gas.  During winter storage is usually less of a concern for the industry, but during the shoulder months during spring and fall when heating and air conditioning demand remains low, storage capacity can become a challenge for gas prices.

We worry that the nation's gas supply myth may be creating a potentially serious future supply problem for the country.  As the popularity of the view that the U.S. has more natural gas than it can use has grown, it is becoming politically popular to promote the increased use of gas in applications where it has had limited success to date, such as the transportation fuels sector, or that we should begin exporting larger volumes to capitalize on the arbitrage advantage of U.S. gas prices.  Converting a meaningful segment of the U.S. auto and truck fleets to direct burning of gas either as compressed natural gas (CNG) or liquefied natural gas (LNG) will require years and possibly decades, along with the need for significant investment to retool engine manufacturing plants and to construct refueling facilities across the nation.

As the popularity of the view that the U.S. has more natural gas than it can use has grown, it is becoming politically popular to promote the increased use of gas in applications where it has had limited success to date

Prior to the emergence of shales as a major new source of natural gas supply, the nation was concerned about our ability to meet future demand.  For many years we were relying on trying to sustain our production volumes while depending upon growing gas imports from Canada to meet demand growth.  Because we became concerned about the ability of Canada to grow its gas exports, the energy industry's focus shifted to importing natural gas in the form of liquefied natural gas (LNG) from other parts of the world.  The U.S. has imported LNG for many years starting in the 1970s and had constructed four import terminals along the East and Gulf Coasts.  As long-term natural gas forecasts called for shrinking domestic production and likely limited growth in Canadian exports to the U.S., LNG became the anticipated source of gas supply that would balance our market.  As the energy industry embraced LNG, proposals for building dozens of LNG import terminals were launched and a few new terminals were actually constructed. 

In the past two years as the gas production surplus grew, the volume of LNG coming to America declined.  It was all about natural gas prices.  Oversupplied domestic gas markets depressed U.S. prices.  At the same time, growing gas demand in Europe and Asia supported higher prices there and thus siphoned away LNG volumes targeted initially for the U.S.  All the domestic LNG import terminals saw their volumes fall to minimal contractual levels.  For the new terminals, this was a serious problem as they had yet to fully establish commercial relationships with gas buyers who might have contracted long-term LNG volumes to move through the new terminals, or their business model was to position them to play the spot LNG cargo delivery market. 

At the present time, two LNG import terminals have submitted applications to the Federal Energy Regulatory Commission (FERC) for permission to add export facilities to their terminals and to be allowed to export LNG.  The terminals are located in Freeport, Texas and Sabine Pass, Louisiana.  Combined they will have the capacity, once modified, to export 3.4 billion cubic feet (Bcf) of gas a day, or about 5% of total gas production today.  The owners of the terminals have petitioned for 20-year export licenses.  Their rationale for exporting gas is that U.S. gas prices will remain low, i.e., below $5 per Mcf, until at least 2023 as forecast by the EIA and thus below gas prices prevailing in other geographic markets such as Europe and Asia.  The belief is that U.S. gas supplies will become more price competitive than other gas supplies for these major geographic markets and therefore can gain market share.

Exhibit1"

In the recent EIA annual energy outlook for 2011 (AEO2011), even after the agency made a big splash with a report showing huge growth in its assessment of the nation's natural gas resources as a result of the success of gas shales, the combination of its estimate of future domestic gas production and gas imports from Canada exactly matches the forecast for gas consumption and nominal gas exports.  The U.S. exports a small volume of natural gas – both through pipelines across the U.S.-Mexico border and via LNG from a plant in Alaska to Japan.  It appears that the EIA's AEO2011 long-term natural gas market forecast has not accounted for either the potential of significant increases in LNG exports or meaningful domestic production growth predicted on growing gas shale volumes.

Exhibit1"

If natural gas wellhead prices remain below $5 per Mcf until 2023, some dozen years from now, it is likely that a substantial amount of gas shale production will not be developed because it will be uneconomic.  If, as some forecasts predict, production from gas shale wells declines sharply as wells age, then any slowdown in gas shale drilling, which sub-economic prices suggest would likely happen, should result in supply shortfalls and sharply escalating prices.  That is a scenario for price instability, albeit at higher than current natural gas prices, that is not attractive for developing large sustained new natural gas demand sources.

The other ingredients in the domestic natural gas story may be the recent application by Apache Corp. (APA-NYSE) for permission to build an LNG export terminal at Kitimat, British Columbia, and a new joint venture formed by Sasol S.A. (SSL-NYSE) and Talisman Energy (TLM-NYSE) to develop a gas-to-liquids plant in Canada. 

If natural gas wellhead prices remain below $5 per Mcf until 2023, some dozen years from now, it is likely that a substantial amount of gas shale production will not be developed because it will be uneconomic

These two projects plan to utilize recently discovered natural gas from shale and tight sand basins in Western Canada to serve export markets in Asia.  While the projects will take several years to be developed, eventually they will siphon off potential gas volumes that might otherwise have been exported to the United States. 

If the U.S. energy industry and its gas market forecasters are wrong about the success of the shale phenomenon, and the U.S. government allows long-term LNG export contracts to be established, the potential absence of new Canadian gas resources might leave the U.S. short of gas supply once again.  While this scenario only addresses the supply side of the equation, what happens if the U.S. makes a serious commitment to converting a significant portion of our transportation fleet to CNG- and LNG-powered vehicles?  Might America be faced with having to retool its economy and energy business once again when the gas supply shortage develops, with a huge economic cost due to poorly-vetted investments?  Don't rule out the potential for the myth of “100 years of gas supply” to lead this country into another energy disaster as energy market regulators have done numerous times in the past.

G. Allen Brooks works as the Managing Director at PPHB LP. Reprinted with permission of PPHB.

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