Unconventional Gas

This is not about a particular stock, but about the natural gas sector in general and an analysis of the unconventional reserves. This would be a good starting point if an investor wants to establish a position in the natural gas sector. Also, it explains the success of unconventional e&p companies.

Natural Gas
Natural gas is one of the cleanest burning hydrocarbons and an essential energy source. The depletion rates for natural gas in the U.S. for the fields put into production in 1990 were down 17% after the first year, those put into production today deplete more than 30% during their first year of operation. Demand for natural gas in the United States has more than doubled over the past two decades. However, since 1996, domestic production of natural gas has grown at an annual rate of well below one percent. This slow increase is due to a number of factors, a primary one being that currently producing gas fields are maturing and producing less gas. Overall Canadian production is projected to remain relatively flat and exports to the United States, after factoring in expanding Canadian use, are expected to decline. Canada is expected to use more natural gas to heat buildings and to produce unconventional oil from tar sands, which uses heat from natural gas.

At present, more than 25% of daily U.S. gas production is recovered from tight and unconventional reservoirs which have become an increasingly important part of the equation in meeting natural gas demand. These unconventional gas properties usually have low risk F&D costs less than $2.00/mcfe which are further decreasing over time as efficiencies increase and shale gas reservoir knowledge improves. The unconventional gas reserves are usually tapped using horizontal well technologies, which have depletion rates of upto 70% in the first year of production and require continuous drilling to meet demand. Notably, the overall marginal cost of natural gas supply, including finding, development and operational costs is around $6.50/mcf. Another positive factor effecting natural gas is the potential Cap and Trade system as natural gas is a clean burning fuel. The European experience shows, as carbon prices increase (>$25/ton), the marginal cost of an inefficient coal-fired vs. an efficient natural gas-fired plant will cause a partial switch towards natural gas.

The current situation is that about 45% (from 1,606 to 884) of U.S. rigs have been shut since September 2008. Drillers need to add more than 3.5 bcf/day to offset declines and this means that the gas production going forward will decrease, at a faster pace than demand. This will naturally in due time, lead to higher natural gas prices. Natural gas futures for delivery in January 2010 are trading at a 49% premium to the April contract.

Unconventional Resources
In order to analyze the upside it is important to decipher the unconventional natural gas resource play. These resources could be in the form of tight gas, shale to name a few. Tight gas is typified by large volumes of low quality rock, moderate porosity (ratio of the volume of openings to the total volume of material) and ultra low permeability (measure of the ease with which fluids will flow). fields. The complexities of the depositional setting influences both porosity and permeability in the region, resulting in rapid variation of rock quality over short distances. Most tight reservoirs have to be fractured before they will flow gas at commercial rates.

Advances in technology, principally the Horizontal well technologies with multiple fractures have allowed the unconventional resources to produce at very economic rates. Although no two unconventional resources are alike; tight gas sands and shales have been found and developed for decades. E&P companies (I would suggest, at a minimum to go thru their latest presentations) like Chesapeake Energy, XTO energy and more recently PetroBank among others have used advancing technologies to economically extract resources from unconventional reserves. Economics per well dictate returns of 25-100+% with horizontal wells depending on the natural gas prices.

My research suggests that most of the unconventional gas resources (tight sand or shale) economically speaking are similar in the sense that they are (as management states) long life, repeatable, low risk, large reserve, natural gas resources. Technological improvements have increasing made it possible to economically extract resources from such resources. The recovery factor in these resources usually ranges from 20-30%. The difference economically arises from the development costs. Therefore, factors such as technology, spacing between wells, frac positioning and drilling costs are central and will affect the rate of returns. The challenge is to maximize the flow rate for the lowest cost.

At a time, where most of the integrated oil and gas companies are struggling to add reserves, these unconventional E&P companies can be a good opportunity to add long term, low risk reserves.