The Nymex gas futures price chart is shown here to provide perspective on recent gas prices relative to their previous patterns both at cyclical highs and at prior stable market environments.
First month gas futures have averaged only slightly more than $4/mmbtu over the last twelve months. While this is double the relatively sustained price plateau that was experienced prior to late 2000 it is still well below the price assumptions that appear to be underlying most companies' expectations for the future and the current long-term Nymex prices after 2012.
For reasons discussed in this issue of On Point we believe that there is considerable risk that the most recent gas price plateau at and around $4/mmbtu may not be sustainable. Slippage down even lower to some point between recent averages and the levels experienced from 1994 through 1999 is a risk with some significant probability.
Why Costs are Falling in North American Resource Plays and Will Likely Continue to Do So
The essence of a core area is two-fold. First, it offers sustainable, profitable reinvestment opportunities for an extended period of time. In short, success is not limited to just one field or asset but can be expected to be achieved multiple times. Second, companies operating in a core area will typically experience a long-term declining supply cost. These two characteristics of core areas apply to exploration-driven plays but are also applicable to the resource-driven plays that are a major growth focus area for a broad spectrum of oil and gas companies.
As we have noted in Cost Watch, industry cost conditions have suggested that externally driven supply and demand side pressures on costs in North American resource plays have been in rough balance throughout most of 2010. As such, neither upside or downside pressures on costs were dominant. Therefore, two different sets of factors will drive the future direction of costs either up or down. The first of these sets of factors are external in nature such as investment strategies and activity levels. The second set of factors are internal to specific plays and to the specific positions of particular companies in these plays.
Of these internal factors the most important is the propensity for company performance to improve as its position in a new play matures. This is typically the combined result of movement along the learning curve and economies of scale both in the drilling operations and with respect to transport and processing infrastructure.
Multiple companies are reporting substantial cost reduction progress due to these internal factors across all major unconventional plays. Results for Anadarko and Chesapeake are two examples that illustrate the broader pattern. The results are shown in Tables 1 and 2.
The importance of this result is two-fold. First, it implies that the effective cost of new wells is falling even though available cost indicators such as rig rates may be more stable. Second, and as a result of the first effect, the price of natural gas required to choke off efforts to bring new unconventional gas supplies on-line is also falling and will probably continue to do so.
Why Rig Counts will Likely Misstate the Future of Supply Side Pressures
Company progress along the learning curves in each of the key plays plus economies of scale are causing a pattern of rising efficiency and, therefore, a potentially extended period of declining supply cost.
This will result in rising supply of gas and oil from the resource plays with falling inputs including, for example, reduced rig time required to drill and complete wells and therefore a lower rig count required to achieve a targeted volume of new wells and supply.
In short, supply side pressures on natural gas prices could rise in 2011 and beyond but rig counts and other conventional measures of capacity utilization could remain relatively stable or even fall. The impact of play maturation and progress along the learning curve on cost structures will be magnified if suppliers of oil and gas field equipment and services misread the situation and add new rigs and capacity thereby driving future day rates down at the same time.
This also suggests that supply can grow, perhaps significantly, even if capital budgets are stable or cut slightly.
Why Investment Programs are Likely to Continue Despite Low Gas Prices
The volume of international capital committed by the large IOCs, smaller and emerging IOCs, and NOCs to gain entry into North American resource plays is obviously of a magnitude that can only be described as world-scale.
Over the period from December 2007 through the present, this group of companies has entered 37 major acquisitions or JV alliances in the North American resource plays. The combined capital committed to entering these plays is US$73 billion in up-front costs (more than half by ExxonMobil alone) plus another US$10.5 billion in first carry obligations.
The magnitude of up-front capital required to gain entry is so large that it will be a very significant driver of the capital strategies of these recent entrants.
Key companies to watch include: ExxonMobil, Shell, BP, and Chevron from the large IOCs; Reliance, BHP Billiton, Statoil, BG, Occidental, Marathon, Hess, Sasol, Sumitomo, and Mitsui from the smaller IOCs; CNOOC and PetroChina from the IOCs. Also some independents have undertaken major recent deals to re-position themselves such as Williams Companies.
The economics of these transactions are already heavily burdened by the entry level acquisition costs. Delays in the drilling programs is an option of dubious value (even though gas prices are low) to the new entrants since such delays will rapidly erode what is left in value generated from the deals. The impact of these pressures is illustrated by BG's recently announced 90% increase in 2015 production targets from its Haynesville and Marcellus shale JV with Exco. Note, also, ExxonMobil's announced plans to double US unconventional gas output by 2020 with all of the growth coming from shale gas. This growth plan implies an additional 3 bcf/d from ExxonMobil alone.
It might be assumed that the supply side pressures on natural gas prices will be offset by one of two possibilities.
The first of these offsetting forces may be the widespread shift in drilling focus to the more liquids-rich plays. This will tend to reduce the volumes of new gas coming online. However, substantial amounts of gas are still a major by-product even in these liquids-focused plays.
The second offsetting force is the likely response of the small and mid-size independents.
Lacking the depth of the large independents and IOCs, i.e., multiple cash flow sources to fund new drilling in a low price environment, these companies are more likely to pull back on drilling plans. This is certainly possible although available evidence at this time is that gas prices are going to have to go lower for this result to follow.
Moreover, three other potentially countervailing factors should not be forgotten.
First, these companies are also beneficiaries of the learning curve process we have described here. Their supply costs are also falling as their positions mature.
Second, while investment by these companies is much more cash flow dependent, it is also true that the valuation of their shares is closely linked to volumetric growth. Major deferrals of drilling programs are not always viable options.
Third, insofar as these companies become distressed they also become inviting targets for additional IOC JV alliances. In other words, additional capital to sustain drilling programs may come from this less traditional source.
Some Final Thoughts
While it is wise to be cautious in trying to strip the hype from reality, it seems clear that the resource potential of North American unconventional oil and gas is of a world scale. By this we mean that:
The potential volume of investment required to develop these plays is sufficient to alter company capital allocation strategies for years to come.
Moreover, the potential volumes of new liquids and gas production are sufficient to alter market balances and, therefore, oil and gas prices.
To appreciate the magnitude of the potential in North America (as well as globally if other areas are proven up) we can compare it to other examples of new world scale plays.
From the global gas industry's perspective, the appropriate analogy for the impact of unconventional resources on current and future markets is the emergence of the North Sea in the late 1960's and early 1970's. The Alaskan North Slope is another potential but less suitable comparable event in some respects.
The history of development of the North Sea (particularly the UK sector of the North Sea) has clear lessons and guidance for the potential ramifications of unconventional resources in North America.
The UK pursued an explicit policy of rapid exploitation of its North Sea potential. This was reflected in an aggressive leasing program.
The UK North Sea (like North American unconventional plays today) became a major outlet for investment, a strategic growth focus area, and a source of volumetric growth for companies across the full spectrum from small independents to the very large IOCs.
As a result, oil and gas production from the UK grew explosively.
Leasing of lands in unconventional plays in the US and Canada show the same patterns of rapid exploitation and diverse company participation.
The flow of international capital into the North American resource plays will enable the same potential for explosive growth in new gas and liquids supplies as we once saw from the North Sea.
Because North American unconventional resources are world scale in terms of potential reserves and production, they will be as important to the future of world oil and gas markets as Iraq, deepwater Africa, and Brazil. Coming at the same time as these other world scale plays, the impacts on the industry will be magnified in ways that few are contemplating today. The implications should be a matter of very real concern for managements, investors and public policy alike.