Musings: Marcellus Shale: The Glass Half Empty Or Only Half Full?

Reading press releases and writing news articles can lead to wildly divergent interpretations of the same information depending on the writer’s knowledge of the subject.  The latest examples are the news stories about the recently revised estimate of the volume of natural gas and crude oil contained in the Marcellus formation, which underlies a large portion of the mid-Atlantic region of the country.  The latest resource assessment of this basin was posted on the web site of the United States Geological Survey (USGS), the official chronicler of the mineral resources of the country, early last week. 

The USGS determined that there is an estimated mean of 84.2 trillion cubic feet (Tcf) of natural gas and 3.38 billion barrels of natural gas liquids

The Devonian Marcellus Shale, as the USGS calls it, spreads throughout the Appalachian Basin extending from central Alabama northeastward to New York State.  The map in Exhibit 1 shows the extent of the basin that was the USGS focus in its assessment of undiscovered oil and gas deposits there in the Marcellus formation.  The USGS determined that there is an estimated mean of 84.2 trillion cubic feet (Tcf) of natural gas and 3.38 billion barrels of natural gas liquids.  This latest estimated resource potential is significantly higher than the USGS’ prior estimate of 2 Tcf of gas and 0.01 billion barrels of liquids made in 2002. 

In preparing its estimate, the USGS calculates numerous scenarios but with differing levels of confidence in the numbers.  In this case, the USGS estimated that there could be as much as 144 Tcf of gas in the Marcellus, but with only a 5% level of confidence, to as little as 43 Tcf of gas with a 95% certainty.  The same was true for their natural gas liquids estimates, which ranged between a highly confident 1.55 billion barrels to a more speculative 6.2 billion barrels.

Exhibit 1.  Marcellus Shale Is A Significant Basin

To understand our point about reading press releases, a writer for the Associated Press produced an article used by many newspapers that hyped the view that the USGS now believes there is substantially more gas in the Marcellus shale than it previously believed.  That is definitely a true statement.  On the other hand, Bloomberg News titled its article on the press release “Shale reserve estimate slashed.”  This is also true.  How can both be true you ask?  We explained how the first story could be true since between 2002 and 2011 the USGS did dramatically increase its estimate of undiscovered hydrocarbon reserves in the Marcellus. 

The slashing estimates article reflects the writer’s knowledge (or his research) that the new USGS estimate is about 80% less than the official estimate made by the Energy Information Administration (EIA) earlier this year.  That agency published a study in July, authored by INTEK, Inc., titled “Review of Emerging Resources: U.S. Shale Gas and Shale Oil Plays.”  In the report, the Marcellus shale was credited with 410 Tcf of “undeveloped technically recoverable shale gas and shale oil resources remaining in discovered shale plays as of January 1, 2009.”  The study was dated December 2010, but the data and its conclusions were utilized by the EIA in the preparation of its Annual Energy Outlook 2011 (AEO2011), which is the official forecast employed by the federal government to estimate the future supply and demand of every form of energy consumed in this country. 

The new USGS estimate is about 80% less than the official estimate made by the EIA earlier this year

The AEO2011 suggests that as shale gas resource estimates have more than doubled since the AEO2010 report, gas production should grow almost fourfold and eventually account for 47% of the nation’s 2035 estimated total natural gas production, which in turn will have grown by 25% over that time period.  One impact from this gas production growth is that future prices will not reach anywhere near as high a price as earlier AEO forecasts projected.  The AEO2011 report suggests gas prices in 2035, based on 2009 dollars, will average $7.07 per thousand cubic feet (Mcf), but could be as low as $5.35 because of the greater gas supply. 

In the preliminary version of AEO2011, the EIA acknowledged the risks to estimating potential resources.  They wrote that “Over the past decade, as more shale formations have gone into commercial production, the estimate of technically and economically recoverable shale gas resources has skyrocketed.  However, the increases in recoverable shale gas resources embody many assumptions that might prove to be incorrect over the long term.”  We doubt many readers paid any attention to the EIA’s cautionary warning. 

At the time the AEO2011 was released, the increase in the Marcellus shale resource potential was considered not only valid, but possibly conservative since there were other estimates by acknowledged students of the formation that exceeded the EIA’s estimate.  The most noteworthy forecasts have been prepared by Dr. Terry Engelder at Penn State University.  His most recent estimate said there was as much as 500 Tcf of gas in the Marcellus shale, nearly 20% more than the EIA estimated and six times the new USGS estimate.

The new USGS estimate will call into question all the optimistic projections for the Marcellus.  It will force everyone to question what the USGS sees, or doesn’t see, that everyone else assumes as gospel.  Moreover, the EIA has already indicated it will incorporate the USGS estimate into its figures, cutting the Marcellus resource assessment by 80% and total U.S. gas shale resources by nearly half.  Will producers who are active in the Marcellus pull back?  The reserve cut will add further ammunition to the Securities and Exchange Commission (SEC) inquiry into the disclosure of reserves made by producers active in the shale gas plays in their federal filings and their investor presentations.

It will force everyone to question what the USGS sees, or doesn't see, that everyone else assumes as gospel

Another question is what happens to some of the academic and think tank research on the impact of the gas shale revolution on the industry and the nation’s energy policy.  For example, several studies have been prepared by the Baker Institute at Rice University dealing with these topics.  One involved a presentation made by Dr. Kenneth Medlock, the James A Baker, III, and Susan G. Baker Fellow in Energy and Resource Economics at the Baker Institute Energy Forum, to the Dallas Federal Reserve Bank in 2009 and how the gas shale contribution has increased since then. 

In the Dallas Fed presentation of late 2009, Dr. Medlock presented a chart on shale gas production by basin in North America through 2040.  As can be seen by examining the chart in Exhibit 2, the role of Marcellus gas production is significant as we move into the 2020 and after time frame.  Marcellus production growth is tied to its large resource potential and the assumed low-cost economics of the play. 

Exhibit 2.  Marcellus Had Significant Role In Supply

This spring, Dr. Medlock gave an updated presentation at the American Association of Petroleum Geologists (AAPG) annual meeting in Houston.  In this presentation, Dr. Medlock projected that in 2040 total shale gas production will be 5 Tcf per day greater, or over a third more, than in the 2009 forecast.  Marcellus production at the end of the forecast period (2040) is projected to reach 4 Tcf per day, or more than a third greater than in the earlier forecast.  Importantly, in a blog published on the Houston Chronicle web site in response to The New York Times investigative reports questioning shale gas estimates made by producers, Dr. Medlock highlighted that his research relied on USGS data for its projections.  That would suggest Dr. Medlock will need to revise his model’s forecast. 

Exhibit 3.  The Role Of Marcellus Has Grown In Forecast

Equally important, we are starting to see industry consultants question some of the critical assumptions made by gas shale producers about the ubiquitous nature of the resource and its low cost, translating into strong profitability for the companies.  A case in point is a recent report by industry consultant Wood Mackenzie Inc.  It was clear from the report that they have become more cautious about the overall success of producers in gas shale plays largely because of the better understanding of the nature of gas shale deposits and the economics of producing them.  They see the oilfield service companies beginning to capture much of the recent improvement in producer profit margins due to technology improvements in producing gas from the plays.  The key cautionary conclusions of Wood Mackenzie are captured in the final paragraphs of its report.

“Over time, it has become apparent that the original premise that shale gas plays offered limited to no finding risk has increasingly been thrown into question.  While the hydrocarbon molecules may be present in the play, being able to produce them commercially remains a challenge.  Additionally, while the plays offer long-life potential, this will only be realized through significant ongoing capital investment.

“Only the very best shale gas plays will have a long-term future supported by operational efficiencies, which will continue to advance, coupled with a new focus on applying subsurface science and technology, and will help to identify the sweet spots and yield more long-lasting results.  The ultimate winners will be those companies that proactively screen shale gas opportunities, awaiting the coming market correction and executing on the best deals.”

The reason Wood Mackenzie believes there is a “coming market correction” is its conclusion that based on full-cycle economics, the majority of gas plays are uneconomic.  In their calculation, it appears that only the Marcellus and Eagle Ford plays are safely profitable today.

Exhibit 4.  Almost All Gas Shales Are Uneconomic

As we have postulated for a long time, the existence of a huge gas shale resource is unquestioned.  What has been at issue for several years has been the economics of extracting the gas in a market that continues to be oversupplied due to strong drilling by producers driving gas prices lower.  Higher gas prices will come at some point in the future, but in our estimation it will largely be driven by producers reigning in their drilling, although likely coupled with some increase in demand.  When might we see this market change?  We guess it may start in the second half of 2012.