Shale is dead? Long live shale!

June 4, 2013
Published in corporate Gazprom Magazine Issue 4

The sun of shale gas has set. The scope of drilling is slowing to a trickle, production is declining, while debts of shale projects are growing. Drilling rigs are being converted to more profitable shale oil. However, European combatants of the shale revolution keep faithfully proclaiming the forthcoming gas welfare in their countries.

Kings can do everything

Not long ago, between 2006 and 2007 the sun of shale gas rose in the skies of the energy sector. At that time the wholesale price of the ‘blue fuel’ was USD 600 per 1,000 cubic meters in the USA. Producing companies used to perform hydraulic fracturing with horizontal directional drilling, which made it possible to cut down the production costs to quite an acceptable level of USD 150 to 200. The shale gas production soared and materially surpassed rather modest forecasts of the US Energy Information Administration (EIA). Production growth is wonderful news, but the production growth that many times surpasses the forecast is intriguing news, giving the impression that a new high-yielding business has emerged.

The industry was invaded by new people, often outsiders with no necessary experience. But it bothered hardly anybody – soft credits, tax exemptions, vast outlooks. It seemed that in a moment money would flow like a river. A gold mine. The new Klondike. Shale rush.

By 2009 shale gas was in the spotlight of global media. Suddenly long-term forecasts started to be made about it – one more exotic than the other. In particular, it was said that the production growth in the USA would lead to a drop in European gas prices, and that would consequently cause the collapse of the so-called Russian gas monopoly. There surely was some logic in it.

Before the shale industry started its rapid development, the USA had been considered to be a most promising liquefied natural gas (LNG) market – there were hopes for high purchasing prices and ambitious plans for growing imports. Major projects that couldn’t be abandoned overnight were oriented towards the USA. Suddenly the demand for foreign gas in the USA subsided and the need for new markets emerged to sell the LNG that the USA didn’t want anymore. It is evident that these LNG volumes could be redirected to Europe. Oversupply would lead to a drop in prices and cheap liquefied natural gas would gradually oust expensive pipeline gas from the European market. Moreover, the Old World inspired by the US experience would also start producing shale gas definitively undermining the position of the Russian energy sector.

At first, everything pointed to the fact that these forecasts would soon come true. LNG carriers headed to Europe, and spot market prices dropped. It seemed that in just a little while the world would change: prices would be low, there would be enough LNG for everyone, Europe would start producing its own shale gas and would reject Russian gas. The USA was doing its best to export the shale revolution and set up its own export projects. They easily found ardent supporters in the European camp – Poland at first, and then Ukraine.

Poland immediately declared itself the future shale basket of the entire Europe. Local politicians made bold claims that their shale gas would be enough for 100, and even as much as for 300 years. They were enthusiastically approved by the counterparts from over the ocean who said that Poland should be bolder in estimates – shale gas would be enough for as much as 400 years. And it would be fine, be it confirmed by geological surveys. In a situation like that one could say anything, set any volumes and timescales. Exploration licenses were handed around right and left both to local companies and such majors as Chevron and ExxonMobil. The most fantastic starting dates of large-scale production were announced – 2013, 2014 at most.

Numerous forecasts started taking into account the growing role of shale gas. It was particularly stressed that any day now shale gas would impose traditional suppliers reduce prices. It was considered good style to discuss not just the possibility of developing gas shale in Europe, but the fixed starting dates. But it couldn’t last long. First warning lights flashed in 2012.

It is a big secret where king goes!

In early 2012 after a number of surveys ExxonMobil declared that it was economically inexpedient to produce shale gas in Poland. However, it didn’t dent the confidence of local authorities in this resource at all, especially since it was planned to soon announce the results of the survey conducted by local experts and dedicated to recoverable shale gas reserves in Poland. Several days before their announcement Nikolai Budzanovsky, State Property Minister said that estimated reserves could amount to a total of 1 to 2 trillion cubic meters of gas, whereas the International Energy Administration insisted on the level of 5.3 trillion cubic meters. But the reality turned out to be way more modest – from 346 to 768 billion cubic meters of gas. This news came as a bombshell. But the Polish authorities pretended nothing had happened and announced the necessity of determining its shale gas potential by 2019, that is three years before the expiry of the contract with Gazprom. However, there were far less promises to become the second Norway for Europe, especially since ExxonMobil completely gave up on the Polish project in summer.

Late last summer the British press announced that BHP Billiton, one of the world’s largest mining companies had fallen the victim of a soap bubble in the American shale gas market. It reported a 40 per cent profit slump. This was preceded by a USD 2.84 billion writedown of the Fayetteville field (Arkansas) shale gas business value. It’s worth mentioning that the company had entered the local market a year and a half before – in early 2011. It spent some USD 20 billion on a number of transactions.

BP, Royal Dutch Shell and BG Group also fell victims of changes in the US shale gas market. For example, Shell released the data on profit decline in 2012. Simon Henry, Chief Financial Officer of the company stated that the company was dealing with losses in the American market due to low gas prices. Peter Voser, Chief Executive Officer, in his turn, noted that it might take a decade to develop shale gas reserves in the UK, and field development might still be extremely complicated. BP also announced the losses in the amount of USD 5 billion, and BG Group lost USD 1.3 billion.

Chesapeake Energy closed 2012 with a loss of about USD 1 billion. In addition, the company almost signed its own death warrant by cutting down capital investments into drilling by 70 per cent.

However, for these companies shale gas was not the main business area. Things were much worse for those who risked it all on shale. For example, Chesapeake Energy, the US second major gas producer had to borrow and re-borrow funds from banks to pay off debts without losing their attractiveness. By the mid-2012 the company had to sell a number of assets – a pipeline, land, etc. This, however, didn’t resolve the major problems, namely, the growing debt and the net profit slump, and Chesapeake Energy closed 2012 with a loss of about USD 1 billion. In addition, the company almost signed its own death warrant by cutting down capital investments into drilling by 70 per cent.

All these incidents were taking place in the background of growing environmental protests – at times more reasonable, at times not. The sensational GasLand movie by Josh Fox criticizing shale gas development from the environmental point of view was followed by the Promised Land directed by popular actor Matt Damon. After the movie’s first night, 200 Hollywood stars and musicians joined the campaign against hydraulic fracture (‘fracking’) for environmental safety reasons. The idea of a cultural figures coalition against the fracking industry was put forward by Yoko Ono and Sean Lennon.

Such close attention to the fracking is explained by the protesters’ anxiety about soil and water sources contamination caused by the use of toxic chemicals in the fracking process. Numerous evidences of plant and animal decease along with water combustion from excess methane are revealed. But so far, the threat of light earthquakes only can be treated as a proved and really grave risk provided that shale gas is occasionally produced in the immediate vicinity of a consumer. For instance, wells are drilled right beyond the Dallas (Texas) airport fence. It unwittingly raises a question: if a runway is designed for operation under the conditions of frequent earth tremors?

King is naked!

Shale gas appeared to be its own enemy. It required extensive drilling. Undoubtedly, this was a real gift for service companies, because such production techniques enabled to engage more than thousand drilling rigs standing idle. In this regard shale gas wells are good as they have an extremely short lifetime. Flow rates fall by 90 per cent within 1 to 2 years, intensive and frequent drilling is required and, besides, the average cost of this kind of well is estimated at USD 2 million. Bonanza and new Klondike, indeed! But this business was never lucrative for ‘gold-diggers’ at all, but for those who, figuratively speaking, sell the spades.

In fact, a drastic growth of the US domestic gas production was supported by uninterrupted operation of a banknote printing press routinely injecting billions of dollars underground. A drastic growth of domestic production means a drastic growth of supply. Gas wholesale prices swooped down in the free market terms. Last spring they reached the bottom – about USD 70 per 1,000 cubic meters. This time that was a joy for industrials, who faced a remote chance to reduce prime costs, create vacancies and steadily compete with China. One should note that Barak Obama bet on the re-industrialization of the USA, but no re-industrialization is possible without an adequate pricing kick back to the Celestial Empire.

But any medal has two sides. On the one hand, shale gas allowed creating numerous vacancies (US media mentioned hundreds of thousands ones) reducing costs for industrials through low gas prices. On the other hand, it came to light last March that low prices for the ‘blue fuel’ affected the US nuclear power generation: 29 new nuclear reactors had been scheduled, but only two of them entered the construction stage. At the same time, shale gas started to undermine investments in renewables. This triggered protests of local equipment manufacturers in every way pressed by Chinese competitors. It means that by developing the shale gas industry the USA ‘cured’ one sector and ‘crippled’ the others.

Slight panic at the US market was caused by gas export plans. Thus, Andrew Liveris, CEO of Dow Chemical (second world largest chemical company in terms of sales), opposed large export volumes of the American gas, because it wouldn’t meet interests of consumers and manufacturers, like his company, due to a price increase caused by export operations. The shale gas industry itself would certainly benefit from this measure, but it’s most likely to have been discarded and the US Government is in no hurry to approve the construction of LNG export terminals – low prices look much more attractive. Certain measures on the domestic market development are surely being taken to balance supply and demand, for instance, promotion of gas-fired vehicles. But these measures are not enough. Under such conditions the cheap US ‘blue fuel’ flooding the global market is out of the question.

Gross production of natural gas in 48 continental United States showed a 0.9 per cent drop in January versus the previous month, i.e. down to 72.1 billion cubic feet per day, with the decrease seen during two months.

As the shale gas selling price was set up below its prime cost, the scope of drilling in the gas industry reduced drastically. As was mentioned above, in order just to keep up with the current production level, it’s essential to drill regularly. However, by late May, the gas industry had as few as 340 drilling rigs operational. It’s been the lowest number since 1999. For reference, there were about 1.5 thousand drilling rigs in operation during the 2007–2008 production bloom. Of course, it’s explained by more efficient production technologies, etc., but the problem (according to EIA) is that gross production of natural gas in 48 continental United States showed a 0.9 per cent drop in January versus the previous month, i.e. down to 72.1 billion cubic feet per day, with the decrease observed during two months. Provided the extremely short service life of shale gas wells, one can be sure that the production decrease will carry on.

Fortune telling about king

Let’s make an assumption, probably disputable. We are about to believe the time of shale gas is nearly over. The USA will soon face a massive insolvency of producers and multibillion losses of major companies. In this case the United States is likely to nationalize de facto a certain part of the shale gas industry and announce that the bubble has burst. It’s in the interest of the United States to have the bubble burst exactly this year, at least not later than in early 2014. The fact is that the presidential election has been recently held and we have as much as three years left until the next one. By allowing the bubble to burst right now the US Government will have three years more to find a decent successor for shale gas, as it used to be the successor of the real estate market, and the latter – the successor of dotcoms. Perhaps, it would be shale oil that can sell at high costs. The majority of drilling rigs are being converted to this resource. The shale is dead, long live the shale.

The time of shale gas is nearly over. The USA will soon face massive insolvency of producers and multibillion losses of major companies. In this case the United States is likely to nationalize de facto a certain part of the shale gas industry and announce that the bubble has burst.

The only thing is true: shale gas really influenced the global market, because the US domestic production increased and shale provides nearly 200 billion cubic meters of the ‘blue fuel’ now. It’s a tremendous volume that couldn’t help changing the balance of forces in the domestic market. And the US market changes inevitably affect the global economy. The Shtokman project rescheduling turned to be the most notable consequence for our country and, say, in Germany the share of lignite-fired power generation increased considerably due to a low cost of lignite exported from the USA. Exactly, the US coal industry suffered from the shale revolution as well.

But the real consequences and those forecasted by the ‘well-wishers’ of our country and, in particular, of Gazprom should be differentiated. Thus, the fall of the US gas prices badly struck not Russia, but the suppliers proximate to the USA and the highest prime cost industries. In other words, it was Canada and shale gas producers that suffered in the first place. Major LNG players were in the second place. Another scenario would have been a miracle. And the miracle didn’t happen.

Cheap LNG didn’t flood Europe and didn’t result in excess supply in the medium term. The United Kingdom gave an exemplary lesson this year. It will be reminded that the island country was not ready for an unexpectedly cold spring. The UK faced nearly a disastrous situation late March as the remaining gas reserves were enough only for two days and spot prices reached USD 800 per 1,000 cubic meters. Besides, hopes for large LNG supplies faded. The British consistently tried to fill their storages with gas, but they did it with an utmost care as the weather forced them to extract almost the entire amount of the injected dribs and drabs. This situation reveals a rather simple fact that is, however, may be not obvious to most people – there is no oversupply of gas in Europe. LNG flows shifted to the area of the strongest demand and high prices, i.e. to Asia.

By the way, Econgas, the largest Austrian gas importer, suffered serious losses in 2012 as well. Unstable LNG supplies are among the reasons for that. Econgas acquired Gate LNG terminal in Rotterdam. The Austrian company could import 4.4 billion cubic meters of gas, but didn’t. However, regasification facilities were nevertheless contracted – this inflicted about EUR 30 million losses on Econgas. Gate LNG was commissioned in September 2011. It’s designed for 180 LNG carriers a year, but took only 10 vessels in 2012 and none in the first quarter of 2013.

Despite all this, Ukraine and Turkey announced their shale gas projects. The latter plans to start production in 10 years, and Ukraine promises even to export its gas to Europe by this time. Poland doesn’t back down shale gas projects as well. But France, Germany and the UK with much more larger and developed economies, treat shale with caution.

The final point of the shale story for our country and Europe will not be massive insolvency of specialized American producers and losses of major oil and gas companies. It will be the start of building a new string of Nord Stream mentioned in the document signed by Alexey Miller and Paul van Gelder, CEO of Gasunie. The fourth string will be the proof that shale gas is just a trifling matter and Europeans have no real alternative to cooperation with Russia.

Alexander Frolov