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Analysts: Shale Plays Trigger 'Massive' Shift in U.S. Output

Shale plays have triggered a "massive upward shift" in U.S. natural gas production and are driving unprecedented growth, with output from publicly traded exploration and production (E&P) companies in 2Q2008 up 6.7% year-over-year (y/y), according to data compiled by energy analysts.

The independents "continue to drive a sizable portion of the overall growth -- increasing the gas rig count by 15% and gas production by 13% y/y -- close to the 1:1 ratio we have observed in the overall market," said Raymond James & Associates Inc.'s J. Marshall Adkins, Wayne Andrews and Cory Garcia.

Gas production from the privately held producers and smaller publicly held E&Ps not surveyed by Raymond James "appears to be starting to play a far more significant role in the supply picture," said the Raymond James trio. "While only posting a 1% increase in activity, we estimate that the private producers grew production by 10% during the quarter. For the majors, on the other hand, this quarter provided further evidence of the group's downward trend in production, with volumes down 5% y/y and down 1.6% sequentially."

Higher initial gas production rates from unconventional U.S. resource plays, which in the Barnett Shale of Texas alone are more than five times more than the average U.S. well , "have temporarily overcome the long-term trend of declining well productivity across the industry," they said.

The start-up of the deepwater Independence Hub last year "is serving to temper the historical declines out of the Gulf of Mexico," but "the downtime at the hub for much of 2Q2008 clearly shows that core supply is what is principally driving overall domestic growth," said Adkins and company in their latest Stat of the Week. The deepwater gas hub was shut in for about 50 days in May and June (see NGI, June 23).

The "decline rate treadmill will finally catch up in the Barnett and cause production levels to plateau at some point over the next three to five years (albeit at a level that could be at least 50% higher than the current run-rate in the play)," but "accelerated development of the Haynesville -- along with many smaller shale plays -- should be kicking in just in time to keep the U.S. swimming in natural gas," said the Raymond James team.

The shift toward resource plays should cause the U.S. gas supply to continue increasing at a steady pace, according to Raymond James.

"In fact, if we look at production guidance from U.S. gas producers, we can extrapolate y/y growth in total 2008 U.S. wet gas supply of around 4.5 Bcf/d (or 7.5%)," said the Raymond James analysts. "It is this unabated surge in domestic gas supply that has been the cornerstone of our cautious stance on natural gas prices."

Raymond James' survey covers more than 50% of total U.S. gas production, but the results may not reflect the remaining producers, which consist of mostly privately held E&Ps.

"Given the vast number of these small players, it is difficult to get an accurate assessment of what their production is doing," wrote Adkins and his team. "However, we can get a general idea by subtracting out the volumes reported in our production survey from the industrywide production data" supplied to the U.S. Energy Information Administration (EIA). "Using this methodology, which we readily admit is imperfect (especially given that we do not yet have EIA data for June), we believe that private operators grew production by about 10% during 2Q2008. This compares to minimal growth in the private operators' rig count."

Barclays Capital energy analysts Michael Zenker and George Hopley expect y/y average marketed gas production to grow 3.8 Bcf/d in 2008, followed by 2-3 Bcf/d in 2009 and a "likely" gain of 2 Bcf/d in 2010. Growth is possible beyond that, they said, but the size and duration are "highly dependent" on price levels.

"We expect growing supply in the U.S. for 2008 and beyond," said the Barclays duo. "Now, recent producer reports are suggesting that the success in developing shale gas will spread to other plays -- with growth in Woodford and Fayetteville already in evidence, Haynesville the next promising area, and Marcellus/Lower Huron to then follow. Other plays, including in the Rockies, will add to this supply. This will lead, in our view, to continued growth in U.S. gas supply into 2009 and beyond."

Energy consultant Stephen Smith of Natchez, MS, said the surge in production no doubt has contributed to the drop in gas prices for the past several weeks.

The "most significant reason for the sharper gas price decline," said Smith, is that U.S. gas production reported by the EIA "has been remarkably strong." The output will be equally strong through the summer, he said.

"The market has no doubt noticed that for the months of June and July, the combined year-over-year 'loss' of 3 Bcf/d of 'liquefied natural gas plus net Canadian imports' appears to have been fully offset by increased U.S. production," said Smith, referring to EIA data.

"The source of the production surge is not a mystery," said Smith. "Early production news and reserve estimates from the Haynesville Shale indicate that it could ultimately exceed the Barnett Shale in reserve potential. The Marcellus Shale and others are also worthy of note."

The Raymond James analysts warned that the rising output would lead to lower gas prices. Smith agreed, but he also cautioned that the rising output may hurt near-term E&P spending in some of the emerging and marginal shales in North America.

"The only problem is that concerns about increasing gas production have now driven gas prices down the range where some of the new shale plays have marginal economics," Smith noted. "It is beginning to appear as if cash flows to reinvest in 2009 are likely to be smaller than in 2008, from the perspective of just the E&P companies. However, recent acquisitions suggest that the major oils are also moving into the shale plays with large investments."

Eventually, drilling efficiency gains should gradually slow while at the same time field decline rates "take their toll and overall prospect quality diminishes," the Raymond James analysts said. "Unfortunately, with the emergence of new shale plays seemingly every month (hello Haynesville), it could be years before U.S. gas production growth rates begin to taper off. Thus, with supply showing little signs of slowing anytime soon, the y/y storage deficit is set to dissipate, and our view remains that gas prices potentially have further downside."

The Barclays analysts cautioned that the "pace is uncertain" to grow production for producers operating in some of the shale plays because of three factors: the learning curve to understand a shale's unique fracture characteristics; pipeline constraints in certain areas as production outpaces takeaway; and possible regulatory roadblocks in communities that may prove less friendly to energy development (i.e., Colorado, Pennsylvania and New York).

"The burgeoning supply growth is likely to outpace trend level demand growth, boosting storage inventories and pushing prices lower in 2009 and likely beyond," said Zenker and Hopley. "By contrast, we expect a storage fill in the U.S. in 2008 of 3.5 Tcf, which we believe should keep prices balanced in the $8 range through 2008."

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