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What should we make of the economics of US shale gas industry?

9th May 2014

By: Saliem Fakir

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There is heightened activity on the shale-gas front. Government is pushing ahead with hydraulic fracturing, or fracking, and the Department of Environmental Affairs (DEA) recently completed a life-cycle analysis (LCA) of shale gas, compared with conventional gas.

The picture presented by the DEA report is nuanced and the LCA shows the footprint is more likely to be higher upstream than downstream. In other words, shale gas exports will increase our emissions profile but domestic use and displacement of coal will reduce the emissions profile.

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The DEA admits in the report that data sets are very narrow and not sufficient to make conclusive comparisons of the footprint at the well head, between shale and conventional gas, as most data is from the US, predominantly from two sources: government and an industry body.

At least we have a better sense of what factors influence the carbon footprint of shale gas.

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Despite all of this, the economic viability of shale gas has yet to be established. The US has 80% of the world’s hydraulic horsepower dedicated to fracking gas from a number of shale gas and tight-oil plays. So far, the shale gas revolution has not been widely replicable outside the US.

This has largely been the result of the fact that low prices in the US have been hard to reproduce elsewhere. So, what are the key factors that may adversely affect the production of ‘cheap’ gas in the South African context? Or shall we say: What can we learn or still need to know more from the US case?

For one, the key issue in the Karoo – water – is not as abundant as in the US. The eco- nomics of water for fracking remains an uncertainty. There could be more economical ways around this, with more efficient uses of water or other sources of supply but intui- tion will tell you that more effort involved in getting the right quantity of water means more costs. There could also be substitutes for water but so far no such reliable or economical substitute has emerged.

Pivot issues tend to invite higher compliance and governance measures, which means more costs to produce gas. These costs could have an influence on final well-head costs. The relationship between environmental standards and fracking costs will matter in the end as scrutiny in the South African context is likely to be higher.

Secondly, low gas prices in the US have resulted in financial strain for independent operators, and large foreign players like Shell and BHP Billiton have had to impair or write down their investments in the US.

A recent analysis of the financial performance of 35 companies demonstrated that a high gas output has no correlation with positive financial performance. Cash flows are negative, exploration and development costs had gone up by more than 20% by 2012, despite high learning rates, significant technical efficiencies and drilling performance. The poor relation between cash flow and revenue streams are worrying many of the players involved in pure gas plays. Continued lack of performance will influence investor capital allocations and investments elsewhere in the world.

So, what explains this constrained financial performance? Several factors may have contributed to this – gas-to-gas monetisation have pushed gas prices well below well-head costs (anywhere between 30% and 50%), decline rates for shale gas wells are much higher than originally predicted (since we do not have a long-term record, the future productivity of these wells is hard to predict), and the debt burden of these firms is limiting further capital allocations to new projects.

The story that is starting to emerge from the US experience, as the industry grows, is much more layered and complex than is cast in local debates on shale gas economics.

The consequence of lower gas prices is that many independent and small drillers have had to shift focus away from pure gas plays to a mix of tight-oil, gas and liquid natural gas (LNG) plays to be able to sustain their operations. Even in these shifts, the bottom line performance of these companies remains unclear for now.

In the case of the US, and of crucial importance, is the proportion of dry to wet gas that is extracted. Wet gas has higher value because by-products such as LNG can be sold for higher prices as they are oil-indexed in their pricing. It is understood that the Karoo shale gas will be dry gas and, for this reason, the economics of dry and wet gas has to be closely studied.

Companies that are under financial pressure are quickly also pushing hard for the US to authorise greater gas exports to take advantage of the price arbitrage that exists between LNG exports from the US to Asia. The US’s advantage is that it can very cost effectively convert existing LNG terminals into export terminals if one considers the fact that the average capital cost of building LNG terminals has grown 300% in the last ten years. However, the extent to which the US Congress will approve gas exports is still to be seen.

Ironically, the fever-pitch manner in which gas production has unfolded in the US could well also be its demise. As analysts point out, given the numerous players in the gas market and their financial burdens, gas production looks to be undisciplined as cash-negative firms have to continuously drill to remain above water. In the short term, the industry could well be on its way to a crash and some players could be on a death treadmill under current gas price conditions.

After the turmoil, there could well be a restructuring and rebalancing of production to bring gas prices to their economical, optimal levels. The prediction is that marginal players will disappear, less economical sites will be abandoned and the most productive plays will make the industry more sustainable. Overall, gas production in the US will come down. But by then gas will no longer be cheap and so the dynamics of energy pricing in the US will change. This scenario playing itself out in the US is a far cry from the uninformed hype for shale gas going on in South Africa at present.

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