Shale gas continues to provoke fierce debates and discussions, and has split the world into two opposing camps. The skeptics claim that this is yet another financial bubble that is bound to collapse sooner or later.
Shale gas continues to provoke fierce debates and discussions, and has split the world into two opposing camps. The skeptics claim that this is yet another financial bubble that is bound to collapse sooner or later. Their main arguments center around high production costs, low domestic prices and shaky finances. The supporting fact is that the United States and Canada are so far the only countries to produce shale gas on a large scale. Other arguments are based on the potential environmental hazards of the shale gas technology.
The advocates of the shale gas revolution offer their own arguments. For example, IHS Global Insight writes in a survey prepared for America’s Natural Gas Alliance that the shale gas contribution to GDP was more than $76 billion and the shale gas industry supported 600,000 jobs in 2010. The growth of shale gas is leading to lower natural gas and electric power prices, which offers competitive advantages to all gas consumers.
I will not go into technological, geological or environmental aspects of shale gas production, because I do not have professional knowledge of these areas, but I can write about the economic side. We have recently made a special survey of the financials and economy of the U.S. shale gas industry and some of the companies involved. Here are the main conclusions.
Firstly, shale gas production is a major industry. In 2011, its production in the United States reached nearly 200 billion cubic meters (bcm), or approximately 30% of gas production in Russia. Production rates at the biggest shale gas deposits are comparable to large natural gas deposits (Table 1).
Table 1. Natural gas production at some fields, in bcm
|United States, shale gas|
Source: National energy agencies, IEF estimates
Despite impressive production figures, the shale gas industry is a patchwork of a large number of small and medium-sized companies. Only few companies (XTO Energy/Exxon Mobil, Chesapeake Energy, Southwestern Energy, and EOG Resources) produced more than 10 bcm of shale gas last year. Thus, even though major oil and gas producing companies entered the shale market in the past few years, it remains largely independent.
Secondly , despite major price fluctuations over the past five years, shale gas producers report sustainable financials. Their operating income margin is 20% to 25%, but their EBITDA margin is more variable, although mostly in a positive way (Chart 1). Profitability plunged only twice, in early 2009 due to the reassessment of investment based on new prices, and in the middle of 2012, when prices fell due to a rapidly growing offer on the domestic market.
Chart 1. Profitability of U.S. shale gas producers, 2008-2012
Source: Bloomberg, IEF estimates
Note: These financials are the weighted average assessment of 14 companies for which shale gas is the main business.
In January-September 2012, prices on the U.S. market were below US$100 / thousand cu m, although they were 50% higher a year before. And yet the industry development has not stopped. Why?
Most companies are hedging price risks, so that effective sale prices differ from prices on the spot market. Our survey has shown that the largest producers sold their gas in 2012 at prices that were 20% to 40% higher than spot market prices.
Another major factor is business diversification through increasing the share of liquefied hydrocarbons and crude oil in overall output. Faced with low prices and overproduction, gas companies responded by increasing the output of higher priced products. Over the past two years, shale gas producers increased the output of gas condensate almost threefold, whereas gas production remained stable throughout 2012 (Chart 2). They have nearly stopped drilling dry gas wells and focused instead on the production of combination (fat) gas, which is earning them additional income from the sale of liquefied hydrocarbon gases (LHG), and on oil projects. One of the reasons behind these decisions is the major difference between oil and gas prices.
Chart 2. The production of gas, liquid hydrocarbons and oil by U.S. shale gas companies, 2008-2012
Source: Bloomberg, producers’ data, IEF estimates
Note: This refers to the production of gas, condensate and oil by companies that mostly specialize in shale gas
Considering domestic prices, the situation in the shale gas industry is complicated, yet it cannot be said that it is rapidly moving towards bankruptcy. The debt level in the industry remains acceptable, and shale gas companies have at least investment-grade credit ratings. Rather, the prompt actions taken by the majority of shale gas players, as well as rapid changes in their strategic priorities and in the structure and cost of investment programs, show that the industry is able to flexibly react to market signals. This also allows it to influence production costs.
According to our estimates, the long-term cost of shale gas production in the United States is about US$ 140-170 / thousand cu m. These estimates are confirmed by shale gas companies, as well as by the analysis of individual investment projects at large shale gas fields. In 2012, gas prices were lower than the long-term outlook for production costs, which explains the overall negative financial result in the industry.
Chart 3. U.S. shale gas production costs, 2003-2012
Source: Bloomberg, producers’ data, IEF estimates
Note: These financials are the weighted average assessment of natural gas production by 12 companies for which shale gas is the main business
Investment activity has plummeted, above all in terms of drilling, which may stabilize shale gas production in 2013-2014. To ensure the industry’s growth, domestic prices should not be lower than long-term prime costs. The growth of domestic demand by the power generation and chemical industries and households will boost domestic prices that will stabilize at US$ 150-200 / thousand cubic meters. The U.S. Department of Defense is using these data in its long-term forecasts. Low domestic prices would discourage the inflow of investment into the shale gas industry.
What does this mean for the Russian gas industry and its position on the global market? The main shale gas threats are not connected with direct competition on Russia’s traditional and perspective markets, but with changes in the trade flows of liquefied natural gas (LNG). All of the shale gas produced in the United States is delivered to the domestic market. The import of traditional gas has plummeted due to the rapidly growing production of non-traditional gas in the United States. This is why LNG designed for North American markets has been redirected to Europe and Asia. LNG deliveries to Europe, including those that are not associated with long-term contracts, have intensified price competition among suppliers. As a result, the difference in prices between the spot market and long-term contracts tied to oil prices has grown dramatically, forcing Gazprom to offer discounts in order to maintain its market standing.
Calculations of shale gas costs show that shale gas is an expensive commodity, much more expensive than natural gas produced at the existing large fields. In principle, shale gas cannot be cheap, because its extraction involves the use of additional, highly expensive technology. Any innovations that are able to reduce the cost of drilling for shale gas will also reduce the cost of traditional gas.
Therefore, Russian natural gas will remain price-competitive in the foreseeable future. But it is important that these advantages are used wisely, for example, by adopting an adequate pricing policy that would maintain the competitive edge for Russian gas. The shale gas revolution does not directly threaten Gazprom, but it could be seen as an incentive for enhancing the Russian gas industry’s efficiency and for promptly reacting to market changes, as shale gas companies are doing.