Exploding Marcellus Has More in the Tank
In last week’s Energy Letter, I discussed the one million barrel per day (bpd) milestone for North Dakota oil production, and provided a refresher on the geology and the players in North Dakota’s Williston Basin.
Another energy production milestone was recently announced by the Energy Information Administration (EIA), and it is just as amazing as North Dakota’s rise as a major oil producer. In an Aug. 5 report, the EIA noted that natural gas production in the Marcellus Formation has exceeded 15 billion cubic feet per day (Bcf/d) for the first time. This amounts to nearly 23% of all US natural gas production, and some 40% of all US shale gas production.
Marcellus gas production has increased from 2 Bcf/d in 2010 to 15 Bcf/d today, and it is now the largest shale gas producing region in North America. In fact, the current 15 Bcf/d is equivalent to Canada’s average rate of production last year, and nearly three times Mexico’s.
So this week in honor of another milestone, let’s take a tour of the Marcellus.
Marcellus Overview
The Marcellus Shale is a black shale formation found largely underneath Pennsylvania, West Virginia, southern New York, eastern Ohio, and extreme western Maryland. Most Marcellus wells are drilled at a depth of 5,000 to 9,000 feet beneath the surface, and are then turned horizontally up to 10,000 feet. The wells are hydraulically fractured to release (primarily) the natural gas from the shale. Much of the Marcellus production to date has taken place in Pennsylvania, where the thickness of the formation ranges from 20 feet in the northwest of the state to more than 250 feet in the northeast.
Just as the Three Forks formation in North Dakota underlies the Bakken, the Utica Shale underlies large parts of the Marcellus, but the Utica also extends further west into Ohio. Above the Marcellus lies the Upper Devonian, and the entire region is part of the Appalachian Basin.
Just to put into perspective what a big deal this shale gas play is (if the explosive growth of Pennsylvania’s gas production is insufficient), the EIA estimated in 2009 that Pennsylvania’s proved shale gas reserves were 88 billion cubic feet (Bcf), which is equivalent to less than a day and a half of US production. At the end of 2012, the EIA had upped that estimate to 32,681 Bcf, a 371-fold increase. Over that same time span, West Virginia saw its own proved shale gas reserves increased from 14 Bcf to 9,408 Bcf.
Fracking 101
The Marcellus is really ground zero for the controversies surrounding fracking, so let me make a small digression to bring readers up to speed. Hydraulic fracturing, or “fracking” had been around since the late 1940s and has been used for decades to promote higher production rates from oil and gas wells across traditional production regions like Texas and Oklahoma. Fracking has been used to stimulate oil and gas production in more than 1 million wells in the US.
Fracking involves pumping water, chemicals and a proppant down an oil or gas well under high pressure to break open channels (fractures) in the reservoir rock trapping the deposit. Oil and gas do not travel easily through these shale formations, which is why they need to be fractured. The proppant is a granular material designed to hold those channels open, allowing the oil (or natural gas) to flow to the well bore. Some common proppants include sand, ceramics, glass beads — even walnut shells have been utilized, but sand is by far the most common proppant in use.
While fracking has been around for decades, two developments in recent years are responsible for thrusting the technique into the public eye.
The first is the fairly recent development of combining fracking with another common technique used in the oil and gas industry — horizontal drilling. Like fracking, horizontal drilling was invented decades ago, and has been widely used in the oil and gas industry since the 1980s. As its name implies, horizontal drilling involves drilling down to an oil or gas deposit and then turning the drill horizontal to the formation to access a greater fraction of the deposit. These horizontal laterals can be up to 10,000 feet in length, and therefore cover a much greater area below ground than a conventional vertical well.
Source: ProPublica
The second development is that drilling started to push into populated areas unaccustomed to oil and gas development. If fracking was still relegated to the traditional oil and gas producing states, I doubt much of the public would have heard of it. But these populated areas weren’t used to having energy development in their backyard, and as it began to happen many people rebelled against this intrusion into their lives. As someone who believes that fracking is generally safe, I can nevertheless understand the desire by locals to keep it out of their neighborhood. Even ExxonMobil CEO Rex Tillerson joined a lawsuit (which he later dropped out of) against a fracking-related development in his neighborhood.
I don’t want to get into the a long digression on the evidence regarding the environmental implications here. There is enough material there to fill two or three Energy Letters. I will just say that I believe fracking is generally safe, and concerns over water supplies are mostly overblown. (There is generally more than a mile of rock between fracked zones and water supplies). However, I think there is substantial evidence that reinjecting wastewater from fracking back into the ground is responsible for the enormous increase in earthquakes in my home state of Oklahoma.
Now, back to the Marcellus.
Just Hype?
The shale gas boom has a lot of critics, both from an environmental perspective and from an economic and/or sustainability perspective. One frequent criticism is that shale gas wells deplete rapidly in the first year or so, and therefore more and more wells must be drilled just to make up for what has been depleted. This is absolutely correct, as can be seen in the following graphics from the EIA:
Source: Marcellus Region Drilling Productivity Report
The graphics clearly show that cumulative legacy production falls rapidly (and for individual wells the decline is even steeper), but to date this has been more than offset by production from new wells. This of course can’t go on forever, and when the drilling sites are saturated the region will likely see gas production decline steeply. Most forecasts don’t anticipate a decline setting in for at least a few more years, but it’s something we will be watching closely here.
Companies in the Marcellus
Space constraints don’t allow me to take a deep dive into the Marcellus companies, which are more diverse than the Bakken producers I highlighted last week. Among the major Marcellus producers covered in depth in The Energy Strategist are Cabot Oil and Gas (NYSE: COG), EQT (NYSE: EQT), Range Resources (NYSE: RRC) and Southwestern Energy (NYSE: SWN). However, these companies vary in lot in their production (gas versus liquids) and risk profile. Further, the Marcellus has logistical constraints in some areas for getting the gas to market. This has resulted in significant regional discounts on Marcellus gas at times, but has also created enormous opportunities for pipeline companies and infrastructure providers in the region.
Conclusions
The Marcellus Shale and surrounding Appalachian Basin have a growth story every bit as impressive as that of the Bakken, which I covered in last week’s Energy Strategist. The area has become the most important shale gas producing region in the country, despite challenges from environmentalists. In addition, there are logistical challenges that have prevented this gas from reaching some of the lucrative markets of the northeast. We expect more growth from the Marcellus and like a number of companies operating in the area. Join us at The Energy Strategist for in-depth analysis and profitable recommendations of the companies riding the Marcellus boom.
(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)
Portfolio Update
One Last Thing About Kinder Morgan
As the article in last week’s Energy Strategist made clear, Kinder Morgan’s (NYSE: KMI) proposed buyout of its affiliated master limited partnerships provides a number of cheaply purchased advantages for current shareholders Namely it provides faster, more secure dividend growth based on tax offsets and distribution savings secured at the expense of the limited partners in those MLP affiliates.
The added financial flexibility will allow the company to promote a faster dividend growth rate to investors and give it the means to continue investing in costly but potentially lucrative new projects.
Last week’s market action reflected the prevailing view that this was a deal without losers, other than the taxman. KMI shares jumped 15%, and the price of the MLP affiliates increased even more, incorporating, in addition to KMI’s rise, much of the modest acquisition premium on offer.
In fact, as noted last week, KMI shareholders got much the better deal than the MLP limited partners, one reason we raised the buy limit to $45. Below that level, shares should provide good value over the medium term.
But this is also a situation where, if that target were hit, we would likely advise readers to take profits in the near term. Why? Because the merger will more than double KMI’s share count, and put 55% of the float in the hands of the former MLP limited partners. Inertia will ensure that a lot of those newly issued shares will stay put. But some will need to be sold to pay many of those partners’ big tax bills, and more will hit the market as investors opt to invest in other MLPs rather than accept the reduced, taxable yield Kinder Morgan will be offering them.
That’s not a pressing concern now in the afterglow of the deal but will loom larger later this year as the merger closing approaches. The bottom line is that KMI shares will exhibit heightened volatility relative to the midstream sector at least through the year’s end, and will be on a short leash here accordingly.
— Igor Greenwald
Stock Talk
Don D.
Great article, I have been invested in MWE who seems to have a large collection and processing operations in the East, with that if we see such falloff in productions, here is a two part question who might be the biggest winners in this situation, Second with all the flaring of gas in the Dakota’s who do you feel could construct a collection and processing operation there for solid investment?
Robert Rapier
Don, sorry for the slow response. I have been in the middle of a move, and getting my oldest son off to college.
MWE is in a great position, and as Igor pointed out in reply to another reader’s question it is a likely takeover target.
On the flare gas, a lot of people (including me) are working on this problem. Beyond the collection and processing options are options to convert the flare gas to something else on site like a liquid fuel or chemical that can then be more economically transported. So far there is no clear winner, but the North Dakota government is clamping down on flaring and thus someone is going to step up. I am closely watching this situation to see who that might be.
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