The Shale Gas Rush

Environmental concerns aren’t even the greatest threat to this investing area, however. Greater threats loom in historically low prices of natural gas and questions about how the industry presents its current assets and future prospects.

Thanks to new drilling techniques, the price of natural gas has sunk to 10-year lows. In 2010, there were 487,000 wells producing natural gas in 30 states, according to the U.S. Energy Information Administration (EIA), the statistics branch of the U.S. Department of Energy. All of this new drilling, however, has pushed down prices to one-third the level of 2005. This has been great for consumers, who have seen lower electricity bills, but it is a mixed blessing for manufacturers.

For one thing, oil and gas companies that once built their plants overseas are now building again domestically. Moreover, U.S. companies that use products created from natural gas, like plastics, are seeing a huge price advantage over international competitors.

But just as high oil prices are pushing up the price gasoline and enriching oil conglomerates, so too the low price of natural gas is hurting the drilling companies. The Nasdaq Natural Gas Index (XNG) has dropped 7.1% over the last year while the S&P 500 has risen about 10%. As a result, oil and gas companies are cutting back on their drilling in some of the biggest natural gas plays, like the Marcellus Shale that stretches from New York to West Virginia and the Barnett Shale in Texas.

Simon Rosenberg, a portfolio manager and analyst at Snow Capital Management, a boutique investment firm outside Pittsburgh, Pennsylvania, says he sees “fertile ground” in the natural gas sector. The fourth-warmest winter on record has left producers with an oversupply of fuel, Rosenberg explains, but it’s a mistake to believe that means natural gas price will continue to fall.

“Gas is now trading 60% below its marginal cost of production, 85% below the cost of oil on BTU-equivalent basis, and substantially below the cost of coal,” says Rosenberg. “In the long run, we believe market forces will drive demand higher through substitution of other fuels and reduce production to a rate that balances demand.”

Producers will carry out that reduction by cutting output, a process that has already started. “Once the supply response becomes evident, we expect the price of gas to recover and the shares of natural gas exploration and production and oil service companies to recover along with it.”  Uncertain Reserves

The greatest risk for investors, though, may lie in attempting to assess just how much natural gas exists and how much can be extracted at a profit. For example, earlier this year the EIA cut back its estimate for the amount of gas contained in the Marcellus shale. Just one year after predicting that Marcellus held 410 trillion cubic feet of natural gas, the agency cut its forecast by two-thirds, to 141 trillion cubic feet, in January 2012. In that same report, the agency reported there was a total of 480 trillion cubic feet of natural gas in all of the United States, a reduction of almost half of an earlier number of 830 trillion cubic feet.

And those are the official estimates. An investigative report by the New York Times in June 2011 found that companies may be overestimating the size of their reserves and overstating the productivity of their wells. Worse, hundreds of industry emails obtained by the paper cast the search for natural gas in shale formations in a highly negative light. Industry insiders compared the current craze over natural gas prospects to the dot-com rush of the late 1990s. One went so far to compare shale plays to Ponzi schemes because “the economics just don’t work.”

Central to the concerns among these industry participants is the long-term viability of the plays themselves. In simple language, the wells are running out of oil and gas faster than expected. It is common for drilling sites where gas is extracted with the “fracking” method to have highly productive initial years and then slowly declining later years. A geologist at Chesapeake Energy, the second largest producer of natural gas in the United States, told a federal energy analyst in March 2011: “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 [percentage] decline in the first year of production.” Indeed, the Times report found that less than 20% of the wells in three major shale formations are likely to emerge as profitable and less than 10% of some 9,000 wells surveyed had recouped their costs within seven years.

Rosenberg, for one, says it may be difficult to calculate how much natural gas the U.S. holds, but that it surely is a lot. To his mind, the data on production decline rates “clearly support” predictive models used by the industry to determine resource flows over time. “One can certainly not argue that the resources do not exist in large quantities,” Rosenberg says. “Whether that is more or less than original estimates is beside the point.”