Sunday, May 13, 2012

The Economics of Drilling in the Marcellus Shale

For those of you who like taking risks for the chance of high returns on investment, the Marcellus Shale is a great place to make or to lose a lot of money.
The economic viability of drilling in the Marcellus Shale is highly dependent on the amount of C3+ hydrocarbons, such as propane, butane and higher hydrocarbons.
Using the following estimates for drilling costs and drilling production, one can estimate the rate of return on investment for drilling at different locations in the Marcellus Shale.

Upfront drilling cost = $3.5 million
Land Lease = $100 thousand
Initial gas flow rate = 3.5 million scf/day which is roughly 50 mole/sec   (Note that there is significant variability in this value in relation to the $3.5 million upfront drilling cost. Rough estimates would be $1 per 1 scf/day initial production plus or minus 30%, depending on the location.)
Monthly decline in production = 10%    i.e. Production in month X = 90% times Production in month (X-1)    (Once again, there is significant variability in the drop in gas production, but 10% per month is a rough estimate.)
Re-fracturing Cost = $1 million at the start of month 13
Lifetime = 30 months  (Note:  you could also re-fracture a second or a third time and make the lifetime >30 months, but this doesn't effect your monthly rate of return on investment significantly.)
Royalties = 10% of sales   (Depends on the agreement with the local landowners)

If the gas composition if ~95% methane and if the price of natural gas is $2.5/mscf, then the monthly rate of return on investment is approximately -4%/month or a yearly rate of return on investment of -40%/yr. This would be a huge waste of money.
However, the key is to chose a location in the Marcellus Shale that is high in higher hydrocarbons. For example, there are locations in the Marcellus Shale in which the gas composition is more like the following:
74% methane, 15% ethane, 5% propane, 2% butane, 1% pentane, 1% hexane+, and ~2% CO2/N2. On an energy basis, this gas is only ~50% methane. When there's this much propane/butane, the drilling company can make a significant amount of money by selling the natural gas liquids (NGL). The net effect is that the effective '$ per mscf of gas flow' is around $6.60/mscf rather than $2.5/mscf    (note mscf=thousand cubic feet at standard pressure and temperature.  0.8 scf of gas is approximately 1 mole of gas.)
When there is significant amounts of higher hydrocarbons, the rate of return on investment is approximately 7%/month or ~130%/yr. You can double your money is less than a year if you find a location in the Marcellus Shale that is high in higher hydrocarbons.
That's a huge different in rates of return on investment:   -40%/yr to +130%/yr.   (And this range of RROI didn't even account for the variability in normalized initial production,  $/scf/day.)

So, for those of you that are interested in investing in the Marcellus Shale. Make sure you do your homework before investing in a company. Drilling just for methane is a losing proposition right now. It's the higher hydrocarbons that makes drilling economically viable, not the methane.

Note also that the the Marcellus Shale regions that are ~95% methane would be economically viable (i.e. IRR = 15%/yr) using the assumptions listed above at a price of natural gas of $4.25/mscf  (~$4.25/MMBTU...$4.25/GJ). Therefore, one would expect that the price of natural gas would stay below $5/GJ for quite some time. It is likely that there are a lot of site in Ohio, WV, PA, and NY in which the economic assumptions above are valid. So, don't bet on the price of gas going above $4.5/GJ for quite awhile.
Interestingly, the price of natural gas at which building new natural gas and coal power plants are equally viable economically is $6/GJ or higher. So, it would be unlikely that we would have seen new coal power plants built in the US in the next decade, even if the EPA didn't decide to regulate CO2 emissions.

Here's some additional information that might be useful in making investment decisions.

Map of US Shale Plays

Map of the Marcellus Shale Play

Map of the 'Wet Gas' and 'Dry Gas' regions of the Marcellus Shale
Note that the 'Wet Gas' is the region high in hydrocarbons, and some of this area is due to the amount of higher hydrocarbon also found in parts of the Utica Shale. (Note that the dividing line in the picture below is indicative of where the gas is higher in ethane, propane, and butane, but it's not always higher in these gas species in this locations. There is still a lot of variability, as one would expect because there occurrence of a large source of natural gas requires a lot of things: correct prior geological history, thick shale seam, and a shale that is high in organic content.

Number of Drill Rigs in the US over the last few years
From this WSJ article  (The number of natural gas rigs has dropped recently, but there are still parts of the Marcellus Shale that can earn very large rates of return on investment due to the propane, butane, and higher hydrocarbons.)

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