Shale Play Transforms Natural Gas Economics

Small changes in the natural gas supply are making a profound difference in the market
By Michael Trakhtenberg | April 15, 2011

Henry Ford did not invent the automobile, but he spearheaded the assembly-line approach to car manufacturing which revolutionized the industry. By combining existing principles such as standardized parts and the division of labor for specialized skills, he was able to make cars affordable to almost every household in America. History tells us that small changes can have profound effects. U.S. natural gas production and pipeline infrastructure are experiencing such changes.

And it all starts with a rock called shale.

In basic geological terms, shale is the most common sedimentary rock in the Earth’s crust. Composed of silicon, silt and clay, it is formed of thin layers compressed over millions of years, making it brittle. Deep below the earth’s surface, biological material trapped in the rock is transformed by high temperature and high pressure into hydrocarbons, leaving tiny pores in the shale.

Traditionally, shale served as a source rock for natural gas deposits. Hydrocarbons in the shale slowly migrate upwards, getting trapped in reservoirs such as anticlines and salt domes. After performing seismic surveys to identify the reservoirs most likely to contain natural gas, producers would drill into the reservoir to extract it. This method worked well as long as the reservoirs were easy to find and access, but the depletion of the “low hanging fruit” eventually started to raise the costs of exploration and production, leading to higher commodity prices, increasing price volatility and creating a supply-shortage mentality. Not until these problems hit a fever pitch in the summer of 2008 did a change occur that no one expected.

New Technologies

The revolutionary process of releasing natural gas from the tiny pores within source rock was made possible by the combination of two key technologies. First, horizontal drilling enabled producers to access an unprecedented range of resources. The process entails drilling down thousands of feet to reach the shale formation and maneuvering the drill bit sideways to bore horizontally through the target rock. But drilling a horizontal well is only half of the process. Hydraulic fracturing—pumping water mixed with sand and other liquids at high pressure into the well—creates tiny fissures in the brittle rock and props them open, unleashing the vast reserves of gas trapped within the shale. The combination of these two technologies has allowed producers to significantly increase the amount of gas recovered from a single well. The high probabilities associated with the drilling and discovery of shale gas has led its production to be likened to a manufacturing process, akin to the achievements of Henry Ford.

Shale gas has transformed natural gas economics in the U.S. Though figures differ by basin and producer, unconventional shale gas production is clearly profitable with gas prices in the range of $4 to $6 per million Btu (MMBtu). Conventional gas production, on the other hand, generally falls into a price range of $6 to $8 per MMBtu. Lower production costs foster lower natural gas prices. 

Although on the radar for only a few years, shale gas has already made a significant impact on the U.S. natural gas supply-demand balance. The latest statistics from the U.S. DOE show domestic natural gas production at the highest level since the early 1970s, despite Gulf of Mexico production at less than half of what it was only 10 years ago. The impact of shale has been even more evident in the assessment of the nation’s gas resources. The Potential Gas Committee is an independent organization of industry experts and is the nation’s foremost authority on the natural gas resource base. In its latest report, the PGC increased its assessment of potential gas resources by 39 percent, driven in large part by the reevaluation of production from shale. Similarly, when the U.S. Energy Information Administration made an upward revision to its latest estimate of net proved reserves of natural gas, it was the biggest upward revision on record (See Figure 1).

Price Impacts

What does this mean for natural gas prices? The answer can be drawn from recent history. U.S. natural gas usage was about the same in 2008 and 2010, yet gas prices at Henry Hub—the benchmark pricing index for the U.S. natural gas market—fell by a whopping 50 percent. 

As natural gas production experienced a revolution, the natural gas pipeline network was going through one as well. In recent years, the U.S. has undergone the largest build up in pipeline infrastructure since the 1950s. Nearly $50 billion worth of new projects and expansions will add more than 100 billion cubic feet per day (Bcf/d) of additional pipeline capacity during this building cycle. Projects of note include Rockies Express (REX), Bison, Ruby and the CenterPoint Energy Carthage-to-Perryville Pipeline (Line CP). Bolstering this trend, some of the most lucrative shale gas production areas are located far from traditional supply basins. New pipeline capacity will be needed to bring that gas to market. Hence, the U.S. is not only benefitting from a growing natural gas supply, but also an increasingly robust and integrated pipeline network.

Ethanol Industry Impacts

The combination of a growing, geographically diverse shale supply and an increasingly integrated pipeline network has had a chilling effect on the value of pipeline capacity. Historically, holding pipeline capacity has served as an insurance policy for ethanol producers, protecting them from price spikes and local supply shortages. But a surplus of supply and pipeline capacity makes a price spike less likely. A region like the Midwest, which is now supplied by gas from the Rockies, the Midcontinent, the Gulf of Mexico, exports from Canada, and potentially surplus Marcellus Shale gas production from the Northeast, has already seen both prices and volatility subside.

Here’s one quick example looking at the group of pipelines running from the Texas and Oklahoma panhandles in the Midcontinent region to Chicago that illustrates the shift in pipeline capacity value. It compares the cost of purchasing gas at a market price (Chicago) to purchasing gas in the production area (Midcontinent) and paying the fees to transport it to the Chicago market.

The difference between the price of natural gas at the market (Chicago) and the production area (Midcontinent) is the price spread. Subtracting the charges associated with utilizing pipeline capacity from the price spread yields the historical capacity value. While the capacity value was $1.05 in 2008, market conditions caused it to turn negative in 2010. An 8,000 Mcf/d segment of capacity (a typical daily usage rate of a modern biorefining facility) was worth over $3 million in 2008. Only two years later, the capacity value was a loss of more than $600,000.   

After feedstock, energy is the most significant input cost in ethanol production. Changing gas prices can have a tremendous impact on biorefiners. Recent developments—shale gas production and pipeline capacity additions—will have a positive impact for ethanol producers, providing them with an abundant, inexpensive and reliable gas supply, but certain risks exist even in this type of environment. Potential regulation of hydraulic fracturing and tighter pipeline safety standards may increase production and transportation costs. Pipeline tariff revisions also have the potential to collectively increase the price of gas. And as always, unforeseen changes will materialize. No matter how small, they will have the potential to greatly impact the energy industry.

Author: Michael Trakhtenberg
Business Development, CenterPoint Energy Services
(713) 207-5931