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Marcellus Shale: Back in Favor

By Peter Staas on November 30, 2010

Over the past few months the media has lavished a great deal of attention on the emerging Eagle Ford Shale in south Texas, an exciting unconventional play that boasts considerable amounts of oil, condensate and natural gas liquids (NGL).

As my colleague Elliott Gue explained in the April 28, 2010, installment of The Energy Letter, Why Some Natural Gas is Worth $7.28, the presence of oil and other high-value hydrocarbons substantially improve wellhead economics in the Eagle Ford. Several blockbuster deals over the past few months suggest that this emerging play has gained international renown.

In October Chinese oil giant CNOOC (HK: 0883, NYSE: CEO) paid $1.08 billion for a one-third stake in Chesapeake Energy Corp’s (NYSE: CHK) and indicated it will fund up to 75 percent of the operator’s drilling and completion costs up to another $1.08 billion. This deal was followed by a joint venture (JV) between Norwegian integrated energy company Statoil (Norway: STL, NYSE: STO) and Canadian outfit Talisman Energy (TSX: TSM, NYSE: TSM) to acquire 97,000 acres in the Eagle Ford for USD1.325 billion.

But investors shouldn’t overlook the massive Marcellus Shale, a sedimentary formation that occurs primarily beneath Pennsylvania, New York and West Virginia.

Source: Range Resources Corp

Although many of these regions have never been a hotbed for natural gas production, activity and output has ramped up quickly, particularly in Pennsylvania, which many in the industry currently regard as the heart of the Marcellus. Check out this animated graphic put together by Penn State’s Marcellus Center for Outreach and Research.

Source: Penn State’s Marcellus Center for Outreach and Research

As you can see, Pennsylvania in 2007 received about 100 requests for vertical wells, and permitting requests in 2008 increased to about 500 vertical and horizontal wells. Thus far in 2010 regulators have granted more than 2,700 well permits, primarily for horizontal wells.

Along with hydraulic fracturing, horizontal drilling is one of two key advances that have enabled producer to tap the massive reserves formerly locked in the Marcellus and other low-permeability formations.

A horizontal well branches off laterally from an initial vertical drill hole, exposing more of the productive layer to the well. Fracturing, or stimulation, increases the permeability of the reservoir rock, allowing natural gas to flow from the reserve rock into the well. This process involves pumping large quantities of water and a small percentage of chemicals into the rock formation at high pressure, producing a network of cracks. The inclusion of a proppant–typically sand, sand coated with ceramic material or ceramic material–ensures that these passages remain open.

Drilling at this fevered pace has rapidly increased the state’s natural gas output. According to the Pennsylvania Dept of Environmental Protection, the state’s 632 reported well s in the Marcellus Shale yielded 180 billion cubic feet of natural gas between July 1, 2009 and June 30, 2010. Statistics from the US Energy Information Administration indicate that the entire commonwealth produced about 200,000 million cubic feet of natural gas in all of 2008.

It’s also estimated that the volume of Marcellus gas in the pipeline system quadrupled from year-ago levels in the third quarter. These estimates reflect internal production growth posted by some of the play’s top operators. Over the next five years analysts and operators expect output in the region to reach at least 5 billion cubic feet per day, while more aggressive estimates call for production of 10 billion cubic feet per day.

Nevertheless, share prices of leading operators in the Marcellus Shale suffered this summer and through much of the fall, primarily because of persistenly low natural gas prices. This weakness stems from a decoupling of the market value of natural gas from drilling activity because of high-value liquids in certain plays, efforts to hold leases by production and huge capital flows from JVs with major oil companies. We discussed these trends at length in Pugh Clauses and Shale Gas Activity and Short-Term Outlook for Natural Gas Prices.

But Chevron’s (NYSE: CVX) acquisition of Atlas Energy (NasdaqGS: ATLS) for $3.2 billion, a producer with 486,000 net acres in the Marcellus, has changed investors’ sentiment regarding operators in the play. Chevron will also assume $1.1 billion of Atlas’ debt and will also receive a 49 percent stake in Laurel Mountain Midstream, a joint venture that owns over 1,000 miles of pipelines and gas gathering lines that service the Marcellus.

Most of the acquired wells in the Marcellus are part of a JV Atlas had inked  with India’s Reliance Industries (Bombay: 500325); in these areas, Chevron will assume Atlas’ 60 percent stake as well as its role as operator. Meanwhile, Reliance Industries will continue to cover 75 percent of the drilling costs, up to USD1.4 billion.

For many, the deal came as a bit of a surprise. That’s not to suggest that the play hasn’t spawned its fair share of mergers and acquisitions activity. From 2008 to the end of the third quarter, roughly 65 transactions have taken place, including several blockbuster deals.

For example, Statoil in 2008 forked over USD3.38 billion for a 32.5 percent stake in Chesapeake Energy’s 1.8 million net acres in the Appalachian Basin, and in May 2010 Royal Dutch Shell (NYSE: RDS.A) announced it would pay $4.7 billion to buy East Resources, producer with substantial acreage in the prolific Marcellus Shale.

What’s striking about Chevron’s purchase is that in some ways it represented a bit of an about-face. The company was conspicuously absent from the wave of deals occurring in US shale plays, though it does hold acreage in Colorado’s Piceance Basin and the east Texas portion of the Haynesville Shale.

Why hasn’t Chevron made a bigger splash in North American shale gas? During last year’s third-quarter conference call Vice Chairman George Kirkland indicated that an oversupply of natural gas had prompted management to curtail its drilling activity in the Lower 48 states.

Kirkland elaborated on this decision during a conference call to discuss this year’s second-quarter results:

We like unconventional gas where we can make reasonable returns…[Our US holdings] don’t presently make development sense because the gas price and the market conditions with oversupply in the US just doesn’t make it attractive. We don’t see in the US in most cases, an opportunity to pay the land rentals, the royalty rates that you see in the US and make a competitive investment.

What changed? As Chevron Vice Chairman George Kirkland noted in a Nov. 9 press release announcing the deal, the opportunistic investment offered a value proposition that was too good to pass up:

We are acquiring a company that has one of the premier acreage positions in the prolific Marcellus. The high quality resource, competitive cost structure in the Marcellus, strong growth potential of the asset base and its proximity to premier natural gas markets make this targeted acquisition a compelling investment for Chevron.

Chevron’s management wasn’t the only one to pick up on the attractive valuations among leading natural gas drillers in the Marcellus; Elliott Gue noted in the Aug. 18, 2010, installment of The Energy Strategist, “A Tale of Two Industries,” that shares of his favorite Marcellus operator were undervalued relative to the company’s long-term growth opportunities.

Elliott’s investment thesis closely followed that of Chevron’s brass. Both noted that drillers in the Marcellus shale enjoy relatively attractive margins, even in the dry-gas portions of the play located in northeast Pennsylvania. Margins are even better in the prime southwestern portion of the Marcellus fairway, where Atlas was able to eke out a 58 percent internal rate of return on its second-quarter production. These results are on par with some early returns in the popular Eagle Ford Shale. Returns are better still in the play’s NGL-rich window.

Chevron CEO and Chairman John Watson recently put widespread concerns about depressed US natural gas prices into perspective in his comments at the Bank of America Merrill Lynch Global Energy Conference in Miami.

Watson noted that despite the much-vaunted shale gas revolution, conventional resources still account for the majority of US natural gas production–and very few of these traditional plays are economic with gas prices at current levels. Though Watson abstained from making a call about the timing or magnitude of a turnaround in natural gas prices, he further justified the transaction’s value by noting that “$4 [per million British thermal units] gas does not support sustained replacement of the decline curve in the business, and prices will rise in due course.”

Readers interested in learning more about Elliott Gue’s favorite long-term plays on accelerating development in the Marcellus Shale can sign up for a risk-free trial of his paid advisory, The Energy Strategist. Click here for more details on this offer.

Winter Warmer

Winter’s Coming, Let’s Fly South

For me, winter hasn’t truly arrived until I set a fire in the fireplace. I guess there’s just something about that smell of burning wood that reminds me of wintertime, or perhaps it’s the taste of the traditional cognac I pour while enjoying the first fire of the season. Winter finally came this week with just enough of a chill in the air to justify buying a small bundle of wood from my local grocery store for the exorbitant price of $10.

The first few months of winter are always a welcome change of pace, and I always enjoy that first fire. But winter gets old quickly. By early January I’m usually yearning for spring.

But this year I won’t have to wait long–I’m headed to sunny Orlando, Florida for the World MoneyShow, which will take place Feb. 9-12. Better yet, immediately thereafter I’m sailing to even warmer climes on the Money Answers Investment cruise

I’d like to extend a special invitation to all Personal Finance Weekly readers to join me in Orlando in February. I also hope you’ll all decide to make a longer trip of it and follow me south for the cruise. To sign up for the World MoneyShow as my guest (it’s free of charge), click here. And for more information about the Money Answers Investment cruise, including a detailed itinerary, or call 1-800-707-1634.

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