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Expect Shale to Go to the Majors, Investor Says

May 25, 2011
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Domestic shale gas will increasingly be developed by the majors, an energy industry financier told an audience in Pittsburgh on Monday.

While the story of shale gas to date is one of crafty independents like Devon Energy Corp., Southwestern Energy Co. and Range Resources Corp. taking exploration risks in the Barnett, Fayetteville and Marcellus shales, those plays will increasingly belong to big players like Chevron Corp. and ExxonMobil Corp., Lynn Bass, a principal at GasRock Capital LLC, said during Steel Business Briefing's Shale Plays Tubular Conference.

"It may not seem obvious right now," Bass said, noting that large independents continue to dominate exploration activities. But because shale plays are expensive and labor intensive, yet also repetitive, Bass believe only the majors can bring low-cost capital, large staffs and the ability to capture the economies of scale inherent in shale plays by developing technologies and applying them over and over on thousands of wells.

The largest leaseholders and most active companies in the major domestic shale plays right now are still primarily large independents, such as Chesapeake Energy Corp. in the Marcellus and Haynesville, EOG Resources in the Eagle Ford and Southwestern in the Fayetteville.

But a run of high-profile deals in the past year lend credence to the idea that the majors like shale (see Daily GPI, June 28, 2010; Shale Daily, May 5; Feb. 3). Those include ExxonMobil Corp. acquiring XTO Energy, Shell Oil acquiring East Resources Corp., Chevron buying shale assets from Atlas Energy and Chief Oil and Gas, and Marathon and ConocoPhillips grabbing acreage in plays like the Eagle Ford and Bakken Shales.

If shale gas and large shale oil plays increasingly go to the majors, Bass expects the smaller companies to turn to overlooked oil plays.

In step with those changes, Bass expects the financial world to develop tools that better match the unique risks and rewards of shale. Shale plays typically have less exploration risk than conventional oil and gas plays, but also have a sharper decline curve in the early years of production.

Private equity firms, Bass said, are more likely to fund the riskier years of exploration, but usually expect to double or triple their investment, whereas commercial banks are more likely to fund the less risky years of later development and therefore require a lower return on their investments. In between are "mezzanine investors" like GasRock that bridge the gap during the middle stages of development.

A typical shale project, therefore, is likely to move through a range of potential financing options over its lifetime.

Bass believes that while shale gas is a boom for drillers, it has lowered returns for investors.

With gas at $9/Mcf, shale projects could expect internal rates of return between 20% and 100%, leaving enough room for a mid-level investor like GasRock to expect a 20% to 40% return on its investment, Bass said. But those target returns aren't possible at current gas prices, he said.

Therefore while many companies tout break-even costs between $3 and $5/Mcf in shale plays, Bass believes gas prices need to be between $6 and $8/Mcf to support drilling over the long term, a figure he based on cost figures in financial filings that he admits might already be outdated.

Still, Bass said, "the price of gas may have to reflect the price of oil more than it does now."

GasRock Capital is a private investment firm focused on domestic energy companies and projects, with more than $600 million in various financing facilities. In addition to his work at GasRock, Bass also sits on the boards of several small exploration and production companies.

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