Unconventional shale plays: the Last Little Thing

As noted in my post “Gas drillers’ debts prompt liens against leased property,” The New York Times has made available online a number of confidential documents written by insiders in the oil and gas drilling industry and financial analysts who specialize in it. Far from being tree-hugging, environmentalist tracts, these are emails and memos written by people working for companies many of which, publicly, are extolling unconventional shale plays like the Marcellus as the Next Big Thing.

Privately, the officials from these companies discuss the fact that gas drilling in unconventional shale is not profitable at current prices, and won’t be until and unless those prices get up in double-digit range. That means that the companies have to survive, not by producing gas, but by taking on debt or obtaining income from flipping leases, pledging future production, or attracting equity from investors. This tends to promote a hand-to-mouth kind of existence in which payments to contractors may all too easily fall behind, producing the liens discussed in the previous post. More generally, though, it means that making money relies on hyping the shale plays to the investors, lease or future production purchasers. And the insiders voicing their opinions in the New York Times document dump believe that such hype is poorly grounded in fact.

According to the documents, the extent and consistency of the fields is questionable, the rapidity of production declines understated, the extent of reserves and the lifetime of wells grossly overstated. And the flipping of leases depends on the “greater fool” mentality of any speculative bubble: it depends on how many people are left who can be convinced, without basis in fact, that the thing in question is valuable.

In a conference held in October of 2008, Chesapeake’s McClendon openly admitted that the company’s business model consists as much in flipping leases as in producing gas. He said, “I can assure you that buying leases for X and selling them at 5X or 10X is a lot more profitable than trying to sell gas at $5 or $6 mcf.” (Note that gas prices have fallen well below that mark since then.) The problem is, of course, that a lease is only worth anything if its possible to make a profit on selling the gas produced from it. As soon as potential buyers lose their confidence that this is possible—as the seller clearly has in this case—flipping will no longer be possible, and the bubble bursts.

In one internal memo, an employee of IHS Drilling Data, a research company that specializes in energy issues, writes that “the word I hear from every company” is that the Haynesville and Marcellus shales are “not economic.” In another, an official from Anglo-European Energy, an oil and gas company, writes, “After buying production for the last 20 years, hopefully I know the characteristics of great wells (flat decline curves, low operating costs, large production) and as you know the shale plays have none of these. The herd mentality into the shale will eventually end possibly like the sub prime mortgage did.”

An official at Suemaur Exploration and Production, a subsidiary of Dominion E & P, which is one of the largest independent natural gas and oil operators in the United States and Canada, writes in an email, “I am also a shale skeptic and think as an industry we are claiming we have a long-term solution to the American energy problem but do not bother to tell anyone the potential cost. I think we have a bunch of 25-year-old analysts driving the boat and people who should know better looking the other way while peeling off part of the pie.”

As the above selection suggests, the financial problems foreseen by the authors of the New York Times documents are not confined to the gas companies, those who invest in them, or even owners of leased properties. The American people, some of them think, are being taken for a ride by gas companies that are promoting a major switch to natural gas infrastructure while prices are low, in order to get a captive audience for it when prices rise—as they will, for instance, if the current push to develop LNG exports is successful.

The documents contain a March, 2011 exchange between a federal energy official and a geologist at Chesapeake, in which the federal official writes, “The way I see it, is if industry can get Congress behind natural gas through policy, then industry has US by the balls in terms of allowing development to continue as the shale wells that are already drilled rapidly deplete—higher prices, more money for industry, and more dependence on drilling.”

So much for the supposed patriotism involved in supporting the natural gas alternative as a primary focus for the U.S. Natural gas hype is not about finding a real solution for America’s energy problem; it is about diverting U.S. investment into the dying fossil fuel industry for a few more decades, providing them with one last round of profits while making it even more difficult and expensive to switch to sustainable fuels when the shale plays go bust.

As noted in my post “What they’d be doing if they really thought it was a bridge” http://www.blogger.com/blogger.g?blogID=9122098558418781512#editor/target=post;postID=7997215950543860034 from November, 2012, I do believe we need to go on using natural gas for a while, and some of that almost certainly has to come from unconventional plays. But unconventional shale is not the Next Big Thing, it’s the last little thing from a dying industry. Let’s wrap it up, and move on to energy sources that can last us for millennia.

Gas drillers’ debts prompt liens against leased property

An article published recently by Reuters ( uk.reuters.com/article/2012/12/27/chesapeake-mcclendon-idUKL1E8NQ2H720121227 ) reports that a number of contractors have filed liens against property that has been leased to Chesapeake Energy for gas drilling in Bradford County, PA. The liens were filed after the contractors experienced difficulty collecting payments for services rendered from Chesapeake. According to the article, such liens have been filed against properties leased by Chesapeake elsewhere in the country as well.

 Not only could such liens make it difficult for the property owners to sell their properties, but according to Stanley B. Edelstein, a Philadelphia construction law attorney quoted in the article, "Depending on the language in a mortgage, it could be an act of default."

 This new vulnerability is only the latest to be disclosed in what has been a series of revelations about the potential for financial trouble for owners of properties that have been leased for gas drilling. A number of major lenders, including Wells Fargo, the nation’s largest mortgage lender, and Bank of America, have adopted policies banning the granting of mortgages for such properties. Home insurance companies have also voiced concern, and in July it was reported Nationwide Insurance will not cover damage related to fracking.

With regard to the potential for liens, it could be argued that Chesapeake Energy, under the aegis of Aubrey McClendon, seems to have been uniquely badly managed relative to the various companies now drilling the Marcellus Shale, and that therefore the danger to future lessors to other companies is negligible. However, an  examination of documents recently made available by The New York Times (http://www.nytimes.com/interactive/us/natural-gas-drilling-down-documents-4-intro.html) would suggest that Chesapeake is just the weakest of the companies employing a deeply flawed business model in the Marcellus. That model has cash flow problems—just the kind of thing that leads to delayed payments to contractors—baked into the cake, and if it is as prevalent as the documents suggest, those who choose to lease their land for gas drilling are opening up their property to a significant risk of liens.

I’ll have more on the New York Times documents and the flaws they reveal in the structure of the unconventional gas drilling industry in an upcoming post.