Shale gas: the new subprime market?

“The word in the world of independents is that the shale plays are just giant Ponzi schemes and the economics just do not work.”

Surprisingly, this statement did not come from an environmental activist. The New York Times revealed that this email was signed by IHS Drilling Data - a known energy expert. In total, there are hundreds of internal communications concerning shale gas operations which were published by the NYT on June 27, 2011. These massive number of documents reinforce a disturbing fact: the shale gas industry is based on recognized false assumptions. It’s a lie that multibillion dollar giants in the industry are trying shove under the carpet to avoid having the same fate as the housing market.

The shale gas industry dug itself into a hole

Over a three year period, the released documents addressed all aspects of this new industry – principally on natural gas deposits in the southeast of the United States (Barnett shale and Haynesville shale). From the beginning, the primary problem was that the amount of gas reserves were overstated. While press releases and public statements from Chesapeake claimed the life of the shale gas wells would last up to 50 years, certain geologists were skeptical that it would even last 20 years. In an email dated March 17, 2011, one geologist noted:

You are completely correct about questioning the life of these wells. Our engineers here project these wells out to 20-30 years of production and in my mind that has yet to be proven as viable. In fact I’m quite skeptical of it myself when you see the decline in the first year of production. In some of the wells they are great wells and will produce significantly for that length of time, but some of these wells die off rapidly.

As stated by the head of the PNC’s investment funds in an email, the problem with this is “Money is pouring in like crazy to take advantage of the new ‘new thing’ of an energy play that is inherently unprofitable.” In 2009, the world’s leader in oil Exxon Mobile bought XTO (a natural gas start-up company) for $41 billion. Later in June 2011, Exxon dished-out $1.7 billion to buy Philips Resources. To avoid breaking this profitable cycle, certain companies used questionable methods to avoid investors doubting the projects.

As it concerns the stock market, Argus Research Group’s analysis (an investment company) notes its concerns about Chesapeake’s “aggressive accounting policies.” To obtain money, the company resorts to volumetric production payments, so that gas is bought at the future market rate instead of the current price. Yet instead of noting the gas sold by this method as debt, Chesapeake artificially inflates its production as indicated in stocks – and they try to cover it up like it’s not a problem.

Preventing the cash flow from drying up

According to the documents procured by the New York Times, there are a few oil rigs which are efficient among the 10,000 wells which Chesapeake owns. Yet there are surrounding wells where gas sales barely covers the cost of operations. Some areas have already started showing signs of exhaustion, such as Fort Worth in Texas. In this region west of Dallas, Chesapeake aggressively bought extraction right on private property paying as much as $27,500 per acre. If the shale gas “boom” is discovered to be an empty promise, the local economy could collapse faster than the oil giants’ market price – especially since the latter is already starting to prepare a plan B.

The sine qua non for the business to be profitable has not been achieved – only a significant increase in the price of oil would make shale gas’ extraction a logical economic decision. As pointed out by the author of “The Revolution of Shale Gas” and Canadian physicist Normand Mousseau:

Shale gas’ current predicament is already comparable to the dot com bubble. Currently, natural gas costs four Canadian dollars per gigajoule (one gigajoule = one-sixth a barrel of oil), but cost about six dollars to produce.

To mask this problem, certain companies are already planning on drilling more wells to hide other operations’ lack of profitability. In anticipation of the collapse, the leading oil service provider Schlumberger came up with a very cynical solution: resell the wells to someone who isn’t the brightest crayon in the box. There have been no concrete conclusions from this seemingly unavoidable financial collision course in the industry, except a statement from Anglo-Energy Corporation:

The herd mentality into the shale will eventually end possibly like the sub prime mortgage did.

With the SEC on edge, and Democrats requiring that energy agencies are more accountable in estimating their reserves, this prediction may very well be realized.

Photo Credits: FlickR Auzigog ; Afroswede ; Bradphoria.