Grupo de Economia da Energia

What the impacts on the current revolution market of the shale gas?

In natural gas on 25/07/2011 at 00:15

By Edmar de Almeida 

The development of technologies for production of shale gas has been considered a revolution for business and economics of natural gas. Many agents and even the U.S. government believe that unlinking price of natural gas from price of oil in the United States is a structural phenomenon that reflects the new technological and geological context of the natural gas industry. There is a perception that the technological revolution of shale gas will affect permanently not only the U.S. gas industry, but also the global gas trade. Those believing this structural show the following arguments to support this view:

  • The current shale gas resources in the USA are equivalent to 3.5 times the volume of all proved reserves in the USA today. Moreover, the availability of shale gas resources is not restricted to USA. A recent survey conducted by Department of Energy (DOE) has pointed out the existence of large volumes of shale gas resources in 48 sedimentary basins in 32 countries, including Brazil, Argentina, Bolivia, Uruguay and Paraguay.
  • The technological learning process in the last 10 years has reduced dramatically the cost of producing shale gas. The main innovations were: i) reduction of the time for drilling wells, ii) improvement of horizontal drilling techniques, iii) improvement of geological knowledge in production areas, iv) development of hydraulic fracturing technology and standardization of equipment. These innovations have reduced production costs to less than US$ 3 per MMBtu, in the best producing areas.
  • Besides reducing the cost of production, many authors report the lower market and geological risk as an inducer of investments in the shale gas areas. In fact, besides the geological risk is lower than conventional gas one, the shale gas projects are characterized by a short period of investment and production. Much of the gas production is concentrated in the first periods of three years. Price of gas in the U.S. market through contracts in the futures market can be guaranteed in such period. This reduced risk has facilitated the attraction of low cost capital for the sector.

Due to the above reasons, many agents have supported that the changes in the U.S. gas market are structural, in particular regarding the price level. The U.S. Department of Energy, for example, has revised down its forecast for future prices of natural gas. These forecasts indicate a price of gas 3-3.5 times lower than the price of oil in the U.S. market from 2011 to 2035 in the reference scenario. That is, the price of gas would rise slowly from US$ 4 to about US$ 7 per MMBtu in the period, while oil would rise from US$ 13 to US$ 22 per MMBtu in the same period. During this period, the production of unconventional gas (Compact Sands, Shale Gas and Coal Gas) would increase from 50% to 74% of the total volume of gas produced in the USA.

This of American government’ view is shared by most private market agents. DOE has received application from about 10 companies to obtain license for gas liquefaction projects to export LNG. DOE granted license to Cheniere, an American gas company, which plans to invest billions of dollars in a liquefaction plant in the same site, where a gas regasification plant already operates. The liquefaction plant design relies on a prediction that price of gas will remain at least US$ 5 per MMBtu cheaper than price of gas in Europe. Once again, the price differential between the USA and Europe would be based on the hypothesis of unlinking the price of gas from price of oil in the USA, while the price of gas in Europe would tend to remain linked to the price of oil.

However, not everything is a blue sky in the shale gas revolution:

  • Production costs are not exactly those informed by companies. Despite the formation of a consensus among analysts that the current production cost of shale gas is 3-4 dollars per MMBtu and the projects’ average rate of return around 30%, more focused studies present a different situation. The production cost of shale gas may vary widely according to the projects, the marginal cost of production now is US$ 6-7 per MMBtu, and profitability related to projects have been below 10% per year. Experts who advocate this view explain the growing investment in shale gas due to the following reasons: i) many investor companies protected themselves from prices of gas going down in 2009 through the futures market; ii) due to the excess of current liquidity in the financial market, companies can attract capital even for low-profitable projects; iii) due to the price of gas going down, new investments have been directed to gas producing areas with associated liquids; iv) the recent shale gas “race”, major oil companies have acquired concessions in producing areas when the price of gas was already down. These companies now have legal obligations to invest, even in the low price scenario.
  • Costs that are high in relation to the current market price (about US$ 4.4 per MMBtu) can increase significantly with the evolution of environmental regulation. The U.S. environmental legislation is outdated before modern drilling and hydraulic fracturing technologies. Currently, there is an increased mobilization of the environmental community, so that states can adopt a specific environmental legislation for shale gas. Texas has already done it and became the first U.S. state to approve a specific legislation for shale gas. From now shale gas producers in Texas will be required to disclose the chemicals used for hydraulic fracturing, as well as all the technical characteristics related to the well to be drilled.

For the above reasons, new perspectives diverging from consensus on the idea of shale gas revolution arise. These divergent views await a solid recovery of price of gas in the United States according to U.S. economic recovery. On the one hand, this recovery could push the growth of gas demand, mainly from an increased demand for electricity. On the other hand, the recovery of demand would imply a rise in interest rates, reducing the availability of capital to low-profitable projects.

Every good energy economist should be wary of consensus in the energy markets. The energy sector is too complex to justify lasting consensus. The shale gas revolution itself was out of scope of experts until the conclusion of the facts. It is time to pay more attention on the shale gas economics before stating with such certainty that the price of gas will be down in comparison with price of oil over the next 25 years.

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