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Wood Mackenzie: Playing a smart shale gas hand

Is the Shale Gas M&A Market Ripe for a Correction? 

Neal Anderson
Wood Mackenzie Inc.
Houston, TX
 

Shale gas has captured the attention of the global E&P industry and policy makers everywhere. The primary appeal is its enormous resource potential, which could offer energy importing countries greater energy security in an increasingly volatile world.

The emergence of shale gas plays has driven a more and more frantic M&A market as new entrants seek to gain access at prices that appear to be disconnected with current – and likely future – market fundamentals.

In this article, we make the case for a short-term correction in the shale gas M&A market and examine how this correction is expected to affect the medium- and long-term outlook.

Why is shale gas so attractive? 
Over the past several years, there has been an increasing perception that access to attractive E&P investment opportunities has become more challenging, as some prospective countries remain out of bounds to foreign E&P investment, such as Saudi Arabia. In other scenarios, investors face the prospect of forced expropriation of their assets, as has been the case in Venezuela. Also, some host governments and regulators favor the existing national incumbents over foreign investors, which could be argued is currently the case in countries such as Brazil and Russia.

Coupled with these scenarios, upstream taxation has escalated over this time period1 as governments seek to extract an ever greater share of the economic rent as oil and oil-linked international gas prices have risen.

In addition, the last decade has seen the emergence of the expansionist National Oil Companies (NOCs), which have rapidly become major competitors to the established International Oil Companies (IOCs), aggressively pursuing opportunities and bidding prices for assets that the IOCs find challenging to top.

The rise of shale gas plays in North America and Europe has fulfilled an important industry need, namely the desire to enjoy material growth opportunities in areas where access is open and transparent; where there is no fear of expropriation and the upstream taxation regime is designed to generate an attractive return for all parties involved.

Finally, shale gas plays appeared to offer the once elusive prize of material resources with limited to no finding risk, providing companies with onshore, long-life assets, with repeatable drilling opportunities in attractive, stable regimes.

How did North American shale gas plays evolve? 
The Barnett shale in Texas heralded the potential of shale gas with Devon Energy’s acquisition of Mitchell Energy in 2002 arguably being the key event, as it brought significant capital to bear in exploiting the play for the first time. Throughout the mid- to late-2000s, US Independents began testing the potential of other shale gas plays ranging from the Fayetteville, Haynesville, and Woodford to the Marcellus.

Shale gas production began to ramp up in 2006 (c. 2 bcf/d), supported by strengthening gas prices and operators’ ability to quickly apply new technological knowledge. With material production (c. 4 bcf/d) from shale gas plays in 2007, shale gas plays quickly began to attract interest from across the global industry.

Initially, the larger US Independents began to build positions, e.g., Anadarko, followed by the Majors, e.g., BP, with the European companies in rapid pursuit, e.g., BG, ENI and Statoil. The swift ramp-up in production coincided with a marked fall in demand due to the looming Global Financial Crisis, resulting in natural gas prices crashing from historic highs in 2008. These access transactions were typically structured as Joint Ventures (JVs) with the new entrants usually funding a promoted share of future costs, exacerbating the over-supply situation.

Since then, the pool of potential shale gas investors has expanded beyond experienced onshore North American operators to include companies willing to commit up to several billion dollars to enter and develop plays. It can be argued that they have neither the skills nor experience to efficiently exploit the resource and evaluate selling gas into the most liquid, dynamic natural gas market, alien to their own typically regulated natural gas markets.

The continued waves of new investors have committed c. US$90 billion2 to exploiting the shale gas plays in North America, throwing a lifeline to the established players who have been able to continue to hold and exploit their lease holdings using their new investors’ money.

Who is making money? 
An analysis of the results from Q4 2009 through Q4 2010 of both shale gas operators and related service companies illustrates that the operating margin is increasingly being taken by the service companies at the expense of the operators (see Figure 1). Operators have been responding by bringing activities in-house, which typically has been the domain of the service companies, owning everything from rigs to hydraulic fracture stimulation crews, in an attempt to control service cost inflation.

Supply economics support this financial picture with the majority of shale gas plays failing to break even on a full-cycle basis3 at prevailing gas prices – the notable exceptions being the liquids-rich plays (see Figure 2). This analysis is backed up by a review of current drilling activity, which shows an increase within the liquids-rich plays, e.g., Eagle Ford, at the expense of the dryer gas plays, e.g., Haynesville. The attraction of an additional, valuable, liquids revenue stream is rapidly driving up liquids-rich asset prices.

This harsh economic reality has been postponed through a combination of the continuing flow of new investors, and the ability of operators to hedge gas production at economic prices. Unfortunately, this prop is being removed with companies only being able to hedge their gas production at prices ranging from US$4.00 to US$5.95/mmbtu4.

Figure 1 
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Why is the shale gas M&A market still so strong? 
Given the challenging play economics that are finally being translated in operators’ financial statements, it is important to understand why the M&A market continues to thrive.

It seems that the equity analyst community has played a key role in helping fuel the shale gas M&A market, acting as the chief cheerleader for shale gas plays. A review of historic analysts’ notes shows that their enthusiasm for reserve bookings and production growth has only recently been replaced with a focus on value, namely an analysis of which companies are actually making money, as opposed to recycling money.

The ultimate irony of the current hot M&A market is that historically, greater value has been created through grass-roots entry of resource plays rather than through acquisitions5.

What is the future of shale gas plays? 
While we have made the case that the shale gas market has become over inflated and will in the short-term suffer a correction, select, top-tier shale gas plays will remain a viable growth area in the future. The market correction will herald a change from a sellers’ market to one in favor of the buyers.

Over time, it has become apparent that the original premise that shale gas plays offered limited to no finding risk has increasingly been thrown into question. While the hydrocarbon molecules may be present in the play, being able to produce them commercially remains a challenge. Additionally, while the plays offer long-life potential, this will only be realized through significant ongoing capital investment.

Only the very best shale gas plays will have a long-term future supported by operational efficiencies, which will continue to advance, coupled with a new focus on applying subsurface science and technology, and will help to identify the sweet spots and yield more long-lasting results. The ultimate winners will be those companies that proactively screen shale gas opportunities, awaiting the coming market correction and executing on the best deals.

Figure 2 
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About the author
Neal Anderson (energy@woodmac.com) is the Global Head of Consulting for Wood Mackenzie and was elected a member of the US National Petroleum Council in 2010. He advises clients ranging from the super-majors and National Oil Companies to start-ups. Client projects have ranged from developing new corporate growth strategies to improving both function and business unit performance. Wood Mackenzie's consultants provide strategic advice based on real substance to clients in the global energy, mining and metals industries.


References
1 Wood Mackenzie Global Oil & Gas Risk and Rewards 2004; Government Take Study 2007; Petroleum Fiscal Systems 2010.
2 Wood Mackenzie estimate, aggregate of all shale gas access transactions.
3 Gas price required to make a 10% nominal return inclusive of land costs; current Henry Hub price US$4.261/mmbtu May 20th, 2011.
4 Company reports 2011 floor price.
5 2010 Wood Mackenzie Study of the value created or destroyed by seven North American Resource Play Operators over the last decade, analyzing both grass-roots entry (E&A spend) and entry through acquisition (M&A spend).

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