A Shale Gas Bubble?

Last weekend the New York Times published a front-page article raising serious questions about the true scale and economics of the production of natural gas from shale, invoking the specter of another asset bubble. To say that this created a buzz would be an understatement. Yet while the article addressed important concerns, it mischaracterized the overall situation by conflating the fortunes and prospects of individual companies with the long-term viability of exploiting the underlying resource. Even if some prominent shale-focused companies were to fail, that wouldn't alter the quantity of shale gas in the ground. It also wouldn't change the fact that shale gas accounted for more than 15% of domestic US natural gas production in 2009 and is expected to supply at least 25% by 2035, even in the most pessimistic shale gas scenario included in the Department of Energy's 2011 Annual Energy Outlook. Comparisons to Enron or the Dot-Com bubble make little sense when the shale gas bonanza has shifted the fundamentals of physical supply and demand, irrespective of its effect on the equity values of companies in this sector.

I understand why the Times' assessment might resonate just now. In the aftermath of a series of asset bubbles and the economic contractions they helped trigger, skepticism about claims such as the game-changing potential of shale gas comes naturally, particularly when it appears that some industry and government insiders don't share the consensus enthusiasm for shale gas. There's nothing wrong with asking some tough questions, particularly given the scale of the opportunity and what it could mean for long-term electricity prices and the displacement of higher-emitting fuels. I have made a career of asking tough questions, myself. However, I also hope that these government officials asked questions at least that tough before issuing billions of dollars in cash grants, loans and loan guarantees to renewable energy developers and electric vehicle start-ups with shorter track records than most shale drillers, and facing greater uncertainties.

That's not as much of a non sequitur as it might seem, because of the prominent placement of the article and its context within the series of probing articles the Times has done on shale gas and its main enabling technology, hydraulic fracturing or "fracking." I wouldn't be surprised to learn that that the paper's editors, like many in environmental circles, find the development of this resource to be an unwelcome diversion on the path to a lower-carbon future. After all, while natural gas emits much less greenhouse gas than coal over its lifecycle, particularly for electricity generation, it certainly emits much more than wind, solar and geothermal power. Many renewable energy projects have struggled to compete with the low cost of gas-fired power generation that shale gas helped bring about. Ultimately, the price of natural gas lies at the heart of both the concerns raised in Sunday's story and the worries of many environmentalists that cheap gas could delay the shift to renewables by many years--although I would remind them that gas-fired power also looks very helpful for enabling the grid to accommodate more renewables.

If I thought that natural gas prices were likely to remain at their current level of roughly $4 per million BTUs indefinitely, I might share some of those concerns. I'd also be even more vocal than I have been in highlighting the opportunity for gas to displace imported oil at an energy equivalent of under $25 per barrel. However, there are good reasons to believe that today's prices aren't just the result of abundant shale gas, but also of a weak US economy. It's no coincidence that they fell precipitously as the recession was starting to bite in the second half of 2008, in tandem with oil prices. Stronger growth is likely to bring more demand from existing users, along with new demand of the type I highlighted in Monday's posting. If the futures market reflects the current consensus on prices in the future, then that consensus expects a fairly steady increase in gas prices in the next few years, reaching $6/MMBTU by late 2015.

By itself that would resolve many of the concerns of environmentalists about competition between gas and renewables, as long as renewables like wind and solar continue on their recent cost-reduction trajectories. It would also negate many of the notions in Sunday's article, because at $6 the project economics of most of the shale plays the Times considered would be cash-positive or at least cash-neutral. That means a driller could finance development without having to bootstrap into it by selling reserves, a practice that appears to have inspired the Times' references to shale gas as a form of Ponzi scheme.

Meanwhile, at an average of $6 per MMBTU the price of natural gas would still be lower--and possibly less volatile--than in the boom years of the last decade, while remaining cheap enough to eventually displace a lot of imported oil. The resulting $35 per oil-equivalent barrel would have looked expensive as recently as 2003, but it would be a bargain in today's world.

In its larger context Sunday's article, by making a case that the future output of shale gas could be much lower than has been assumed, lays the groundwork for opponents of shale development to claim that it is both too risky and not material enough to be worth the risks they attribute to it. After studying this issue carefully, I am convinced that neither aspect of that proposition is correct. Shale can be developed safely, particularly when following guidelines such as the Operating Principles for shale and tight gas that Shell just put out. And shale certainly looks big enough to make a significant difference in the energy balances of entire countries, including both the US and China. Not every company producing shale gas will be financially successful, but that's been true in the oil patch since Col. Drake drilled his first well in 1859. In the unlikely event that shale gas turned out to be a bubble, it wouldn't be the first one in the history of oil and gas exploration. However, if it were a bubble, like previous ones it would leave behind a large number of wells that will be producing vitally important energy for many years to come, whatever the fate of the companies that originally drilled them.