Is Shale Gas a Ponzi Scheme?

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The New York Times’ war on shale gas continues with two more big stories by Ian Urbina. The front page of the Sunday paper featured “‘Enron Moment’: Insiders Sound Alarm amid a Natural Gas Rush”, complete with pullquote “Word in world of independents is that shale plays are just giant Ponzi schemes.” That was followed today by “Behind Veneer, Doubt on Future of Natural Gas”. Both articles are based primarily on piles of emails, the first from industry sources and the second from EIA staff. I hate to say it, but on the whole, both pieces are of pretty poor quality. That’s a shame, because both – particularly the first one – had the potential to raise some important issues for debate.

I can’t say that I’ve read through all of the hundreds of pages of documents that the Times has posted on its site. But I’ve gone through a good enough slice of them (including all the emails that the Times references in its articles) to get a feel for how Urbina went about using them in his stories. There’s a pattern: Urbina was clearly looking for negative views of shale gas, and had no problem finding them. Given the massize size of the industry, and the number of financial bets being placed upon the sector, that shouldn’t be a surprise. What is a surprise is that Urbina hasn’t done much to put them in context.

I’m going to focus on the Sunday story here, because it’s much more interesting, and because some of its sources raise some genuinely important issues, which I’ll get to in a few paragraphs. In contrast, today’s story is mostly a mix of some frustrated EIA analysts’ complaints and some healthy internal EIA debate taken wildly out of context.

Three Problems

Back to the Sunday story. The first bit of context worth noting is that the story relies heavily on geologists’ concerns about shale gas economics. That should be a red flag. There are very few emails from industry accountants or economists in the story. The geologists’ critiques follow an irritating pattern: most of them basically say that projected levels of gas production are implausible at current natural gas prices. This, of course, is beside the point: no one serious think that today’s gas prices are going to hold forever. (If this technique sounds familiar, that’s because it is: it’s the way that some of the more simplistic arguments for peak oil operate.) The question is whether production can continue at large volumes at reasonable prices. I don’t see anything in the emails that argues against that.

I should be clear: there are also emails from investors and a few non-geologists. Some of them even raise legitimate concerns (I’ll come to those in a moment). Others are more ridiculous: one investor, for example, notes that his emails to producers have gone unanswered, and concludes that they must have something to hide. But the guy also admits that he’s never invested in oil and gas. Perhaps the producers simply thought that he wasn’t worth their time.

My second problem is that the story conflates several issues. There’s an extended part that talks about how landowners in some parts of Texas have gotten hurt by falling prices for their mineral rights.  Indeed that is a real issue for those people who have been hurt. It is not clear what its relevance is to overall shale gas prospects. Heck, falling prices for mineral rights would help make the shale gas industry more stable (and gas prices lower) over the long haul.

The third problem is that many of the emails come from 2008 and 2009, when shale gas was still a much murkier industry. Lots of the technical debates that are played out in those emails have come a long way since. In particular, the steep initial decline rates for shale gas well were indeed surprising to many at the time. But they are not today – steep initial declines are standard in industry and analyst understanding of shale gas economics. The Times story implies that it’s got news on how these wells operate, that that this news might force a revision of analysts’ assessments. But what it presents isn’t news in 2011, and hence the impact on assessments of shale gas ought not be nearly as significant as one might superficially expect.

The Times descriptions of the emails (not just in the article, but in the document database)  also betray a serious lack of understanding of the industry. For example: UBS cautions gas investors to “not get excited”, which the Times takes as a warning against gas producers in general; if fact, it’s a warning against people who are betting on higher gas prices, which the analyst thinks are unlikely given the abundance of shale gas (i.e. completely contradicting Urbina’s thesis). Another great one: Dan Yergin is apparently a member of the news media, not the head of a large consulting firm.

The Real Issues

But enough nitpicking: What are the legitimate issues raised in the emails? I see at least three. The first is that SEC rules for estimate reserves may lead to an overstating of some companies’ resources. I don’t understand this space well enough to comment on this particular issue, but I hope to read more from those who do.

The second is that the current spot price for natural gas is deceptively low because companies are hedged. Many companies sold much of their production forward when gas prices were much higher than they are today. That allows them to continue operating despite the fact that some of their wells might be uneconomical if they had to sell all their gas at the current spot price. (Of course, if those producers hasn’t sold so much gas forward, the spot price itself might be higher today.) Despite what the Times implies, this is not news to anyone who follows the sector. Many of us have believed for a long time that the natural gas price required to support the current level of production is a decent bit higher than the spot price is today. This doesn’t change the bottom line for serious analyses of policy implications.

The third issue is the one raised in the featured quote about “Ponzi schemes”. It is rather amazing that despite the Times’ focus on that quote, it never bothers to actually explain what the Ponzi scheme metaphor refers to. Here’s what it’s talking about: The shale gas industry contains many independent drillers. They often taken on a lot of debt to finance their activity. In particular, they take on a lot of debt in order to buy more leases. (My understanding is that leases tend to be the most expensive part of shale gas development these days.) But leases don’t help them service that debt – they need cash flow to do that. And to generate cash flow they often need to pump and sell natural gas. (They can also raise cash by selling some of their leases, which also feeds the Ponzi metaphor, but there is a limit to this.) What that means is that drillers have an incentive to produce gas even when, all in, it isn’t really economical at current prices. Alas, this feeds into a loop: gas floods the market, driving prices down even further, which creates an incentive for even more new drilling in order to meet cash flow needs. This is compounded by the fact that some operators are required to drill within a certain period of time in order to hold on to their leases.

This is obviously unsustainable: at some point, the cost of production – including leases and profit – needs to be less than the price of gas. That’s part of why many independents are trying to sell themselves to bigger players (who can finance development through their balance sheets rather than with debt, and which can wait more patiently for prices to rise a bit). It’s also part of why some of them are selling off assets. (Unless it’s only selling its lemons, this is not fundamentally different from any growing company selling off some of its equity in order to raise cash.) I have no doubt that some of these companies will fail to last long enough to either see higher gas prices or to sell themselves to entities that have the patience to hang on until the current gas glut gets worked through. Those companies will go bankrupt. (One might even be excused for referring to some of their business models -- but not the whole industry -- as Ponzi schemes.) So what? The Times repeatedly confuses the fortunes of various risk-hungry independents with the fortunes of the industry as a whole. Some investors will lose lots of money; some banks will regret having made loans. That’s life. It’s not clear why I should feel too sorry for them, or why the Times is so worried about saving their hides.

(Also: If shale gas is unsustainable at current prices, not only will prices rise, lease costs will drop, making production less expensive and allowing gas prices to settle lower than if lease costs were permanently fixed. Most land that’s being used for shale gas isn’t nearly as valuable for alternative uses; lease prices should thus be pretty elastic.)

At What Price Shale Gas?

Ultimately, the biggest issue that the piece raises concerns natural gas prices, not overall viability for the industry. (I say “raises” loosely, since the article doesn’t actually make clear that this is the real issue.) Do we have a world of four dollar gas in our future? Or will prices rise to six or seven or eight dollars in a few years, once acreage is consolidated under bigger players who can finance lease costs through their balance sheets and hence might have less incentive to pump out ever more gas in the short term? These questions matter: they have important implications for natural gas policy, climate policy, and for decisions regarding natural gas exports.

So it’s a shame that the article obscures them, because it’s allowing industry officials to ignore the real issues. In a long Facebook post last night, Chesapeake CEO (and uber-shale gas impresario) Aubrey McClendon hits back at the article thusly:

“It is also ludicrous to allege that shale gas wells are underperforming as we sit awash in natural gas, with natural gas prices less than half of what they averaged in 2008.  I also note that CHK and other shale gas producers are routinely beating our production forecasts – how can shale wells be underperforming if shale gas companies are beating their production forecasts and as US nat gas production has recently surged to new record highs (in fact, in 2009, thanks to shale gas, the US passed Russia as the largest natural gas producer in the world). Also, isn’t it completely illogical when this reporter argues that shale gas wells are underperforming, yet acknowledges that gas prices are less than half the price they were three years ago. ”

A proper read of the evidence cited in the article might provide ready answers to these questions: Gas prices might be low because drillers have an incentive to produce even if their wells are underperforming; high production might be evidence for the article’s contentions (which rest on there being incentives to produce more gas in order to generate cash flow), rather than against them; and it’s totally consistent for wells to be underperforming and to have cheap gas at the same time, so long as there are plenty of wells operating for other reasons.

Let me be clear: I’m not saying that the entire industry is being propped up by the dynamics that the Times article is based on. I haven’t done the detailed economics: perhaps prices would be 5% higher; perhaps they’d by 50% higher. But the Times hasn’t done the economics either. And by choosing to indulge in hype rather than digging down into the real substance, it’s missed an opportunity to spark a useful debate too.