Musings: The Value Of Shale Gas Is In The Eye Of The Beholder

In late July, Chesapeake Energy announced positive second quarter 2011 results. In the release, the company stressed the significance of its stake in the Utica shale formation in eastern Ohio, the next hot play in the shale revolution underway in this country. The company stated the following:

"Based on its proprietary geoscientific, petrophysical and engineering research during the past two years and the results of six horizontal and nine vertical wells it has drilled, Chesapeake believes that its industry-leading 1.25 million net leasehold acres in the Utica Shale play could be worth $15 - $20 billion in increased value to the company. Chesapeake's dataset on the Utica Shale includes approximately 2,000 well logs, full-suite petrophysical data on approximately 200 wells, 3,200 feet of proprietary core samples from nine wells and production results from three wells. As a result of its analysis, the company believes the Utica Shale will be characterized by a western oil phase, a central wet gas phase and an eastern dry gas phase and is likely most analogous, but economically superior to, the Eagle Ford Shale in South Texas."

We found this paragraph quite interesting. Management suggests that its land position, given the superior reservoir potential of the Utica shale, could be worth between 75% and 101% of the company's total market capitalization. Using the values suggested in the earnings release, Chesapeake estimates its land position is worth between $12,000 and $16,000 per acre. That seems high, especially after we reviewed an investment analyst's report on another E&P company with meaningful exposure to the Utica shale, including acreage it owns in partnership with Chesapeake. 

Management suggests that its land position, given the superior reservoir potential of the Utica shale, could be worth between 75% and 101% of the company's total market capitalization

In a Citigroup Global Markets research report on EV Energy Partners, a master limited partnership that explores and develops oil and gas properties in various states including Ohio, the analysts attempted to put a value on the company's Utica acreage. The report stated the following about how the analysts were valuing this asset:

"Given that the Utica Shale is an emerging play, there are very few transaction comparables available to use as an anchor for our valuation. Even so, according to our research, over the past twelve months, transactions in the Utica Shale have been completed for an average of $2,200/acre ranging between $1,500 and $3,600/acre (i.e. most recent transaction implies $3,600 per acre; announced in 3Q11). In comparison, CHK indicated that its 1.25 million net leasehold acres in the Utica Shale could be worth $15 to $20 billion, which implies a value of $12,000 to $16,000 per acre.

"In addition, we have looked for comparable transactions in the Eagleford Shale given early indications that the Utica is fairly similar in potential. Based on our analysis, since late 2009, Eagleford Shale assets have sold at an average price of $9,000/acre ranging between $1,000 and $23,000 per acre (i.e. most recent transaction implies $20,000 per acre; announced in 2Q11). Our valuation of EVEP's Utica Shale position, conservatively assumes applying a value of $5,000 per acre to the partnership's 213,000 net acres…"

The Citigroup analysts have a very different, and an appropriately conservative, view of the Utica shale value since there have been very few wells drilled and there is little or no production history

Clearly, the Citigroup analysts have a very different, and an appropriately conservative, view of the Utica shale value since there have been very few wells drilled and there is little or no production history. Given Chesapeake's highly optimistic pronouncement of the Utica shale being superior to the Eagle Ford, we started reviewing previous press release announcements about company developments.  That search led to our reviewing Chesapeake's comments in its March 24, 2008, press release. There, it stated the following about its new Haynesville shale play:

"Haynesville Shale: Based on its geoscientific, petrophysical and engineering research during the past two years and the results of three horizontal and four vertical wells it has drilled, Chesapeake believes the Haynesville Shale play could potentially have a larger impact on the company than any other play in which it has participated to date."

Notice the wording of the two announcements. Also, Chesapeake projected that a $7 per thousand cubic foot (Mcf) gas price for the life of a Haynesville well with an economically ultimate reserve (EUR) volume of 6.5 billion cubic feet (Bcf), the company would earn a 42% pre-tax return. About a year later, with natural gas prices firmly locked in a $4 per Mcf range, the company said the return would only average in the low single digits. The company cautioned, however, that if the EUR was only 4.5 Bcf, then the return would be zero.  Recently, Chesapeake reduced its activity in this shale basin.

Over the past half decade, assessments about the economic value of shale formations have shifted.  Certain shales were touted as being the next biggest gas field in the U.S., only to disappoint its promoters. The flood of natural gas has depressed prices and forced strategic adjustments to emphasize liquids-rich shales, although these formations continue to contribute substantial new gas production to an oversupplied market. The industry's move into the populous Northeast region of the country has energized the environmental movement to attack it over its gas shale drilling and completion technology. In recent days, the gas companies spearheading the shale revolution must feel like the American revolutionary army wintering at Valley Forge in the late 1770s – cold, hungry, ill-dressed and questioning their plight, but still inspired by the ideals underlying the revolution. 

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

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