The Shale Gas Bubble

On the first of this month I mentioned reading an article from Oil Drum on the Marcellus shale play.  The article suggested that shale gas would only be profitable when the market price is above $7 mcf.  Now other analysts are saying that 7.50-8 mcf is needed to cause shale gas to break even.  In an article by Dave Cohen, the words “bubble”, “sleight of hand”, “shenanigan”, “magic tricks” and “fraud” are terms that are being applied to shale gas.  The bottom line is that drilling takes place in order to increase reserves so that the play seems to increase in value but the reserves are overstated because they require decline rates which are much less dramatic than they have proven to be.  Cohen summarizes (emphasis his):

The shale gas boom has been the sole bright spot in America’s energy picture, and maybe the only bright spot in the economy as a whole. And what does that bright spot turn out to be? An asset play whereby shale gas producers, conniving with bankers, inflate their own value, hoping to get out while the getting is good.

I’ve now completely emptied my portfolio of Enerplus Resources which is seriously invested in the Marcellus shale play.  Enerplus has a lot of other great things going for it, and a fat dividend, but when you see an investment that doesn’t make sense then it is time to get out.

(Hat tip:  Devon Shire, “Can Shale Gas Companies Who Drill Uneconomic Wells Make Good Investments ?“)

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Marcellus disappoints

An important report from Oil Drum, published at the Business Insider, explains that the Marcellus shale play will not break even when natural gas is selling at less than $7/Mcf, as the result of faster than expected decline rates for the wells.  Why then do companies continue to drill?  The report says:

Returning to the broader subject of shale plays in general, why do operators keep drilling while their own over-production has depressed the price of natural gas by half of its value since January 2010? It seems fairly clear at this time that the land is the play, and not the gas. The extremely high prices for land in all of these plays has produced a commodity market more attractive than the natural gas produced.

Foreign companies invest in U.S. shale plays for different reasons but the most often-stated reason is to learn about the technology that they may be able use to their advantage in future shale plays around the world. It is possible that some companies enter into joint ventures with U.S. shale operators for strategic reasons based on fears of future resource scarcity particularly as China expands its efforts to control everything from petroleum and minerals to rare earth metals around the world.

Read more: http://www.businessinsider.com/marcellus-shale-disappointment-2010-10#ixzz144mz6QDy

But with currently reported natural gas futures at $3.84, it does not seem like this play is going to be viable.  Indeed, the report explains that while debt for Marcellus-focused companies has gone up and reserves have increased somewhat, shareholders’ equity has dropped dramatically.   To add insult to injury, the states of Pennsylvania and New York are placing moratoriums on new drilling in the play for fear of the new fracking technology that is used to exploit these wells, and in the case of Pennsylvania, because of a dispute between the republican legislature and the democrat Governor Edward Rendell over the drilling tax; of course, it’s the democrat who is insisting on a higher rate and has thus issued the moratorium.  I wonder if Governor Rendell has read the Oil Drum report showing that the drilling is largely unprofitable in the region.  This is no golden goose.  But I suppose a brass goose can also be strangled by taxes.

As a result of this, I’ve decided to sell 50% 75% 100% (update 11 Nov) of my holdings in Enerplus (ERF.un: TSX; ERF: NY) which has a large Marcellus shale operation.  This follows an excellent run for Enerplus, which still has many other great holdings.  Along with Marcellus, Enerplus recently acquired some lands on the US side of the Bakken.  I am uncomfortable with their large stake in the US with Obama at the helm–he illegally shut down  drilling in the Gulf and he and the other democrats in the US intend to destroy the US-based energy industry, all while subsidizing Brazil and Soros.  I will probably sink the funds that are now freed up into Pengrowth Energy and Penn West Energy, which are both listed as Action-List Buys by TD Newcrest.  These can also be bought on the New York Stock exchange and they can thus add to my US dollar carry trade.

The bad news for Marcellus shale may turn out to be good news for conventional natural gas plays in Canada, and it would come at an excellent moment.  The shale plays in the US have put great pressure on the prices causing a glut of available gas. I am maintaining my shares of Perpetual Energy (PMT:TSX) which dropped about 7% immediately after being trashed on BNN by Eric Nuttall of Sprott Asset Management (hat tip: Devon Shire), who said it is due for a dividend cut if natural gas prices don’t improve soon.  Some think that dividend cut is already factored into the current price. I’m looking to buy in at $3.85-4.00. Nuttall, a cognoscente of the Canadian oil industry, claims that no managed funds own Perpetual, only retail investors because of its high dividend yield.  Ouch!  He excused himself for previously recommending Terra Energy (TT:TSX), a natural gas weighted junior (which I started buying recently).  So Nuttall is not inerrant.