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Financial Times - Is shale a miracle, revolution – or bandwagon?

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Investors are far from certain to make money from shale

Unless you have been in hibernation for the past few years you will have heard that there is a shale hydrocarbon “revolution” or “miracle” under way. Barack Obama, the US president, pledged support for shale gas development in his 2012 State of the Union speech. David Cameron has urged opponents of fracking to “get on board”.

“Fracking” has passed into the vernacular. The term was added to the Oxford English Dictionary last June. It involves releasing a high-pressure mix of water, sand and chemicals to crack rocks and release oil and gas from shale. Environmentalists have all sorts of objections to this practice. And there are other problems with the concept of shale as a saviour – either in terms of cheap energy or as an investment.

The first is the concept of “energy return on energy investment” or Eroei. This is the ratio of the amount of energy generated from an energy source to the amount of energy expended to obtain that energy. It is an important and mostly ignored ratio which determines both the efficiency of our economies – how much of our resources have to be expended into getting our energy – and the economics of energy exploration and generation.

The oil discoveries which took place a century or more ago were mostly in onshore locations, often in politically stable countries and close to key consumer markets. However, there is a natural tendency to pick the low hanging fruit first, and over time, oil and gas exploration and production has, out of necessity, moved to less hospitable and remote locations, which place logistical barriers between oil and gas and the markets.

Shale gas/oil and fracking are just an extension of this trend. US oil production had an Eroei of 100:1 in the 1930s – every hundred units produced required one unit to be expended. By 2000, despite huge technological advances, that had dropped to 11:1. The ratio for shale oil is about 5:1. This is a critical difference. 

There is also the issue of depletion. An old trick in investment analysis is to ask whether an annual return of £20 for an investment of £100 is good or bad. Most people will say it is a good return. But you lack other vital information necessary to assess the investment: the asset life and maturity value. If the asset only lasts for three years and is then worthless, it is a bad investment, as you will only recoup £60 in total from £100 invested. If it lasts for 20 years, it’s a good investment, as you will recoup £400.

Asset life is critical to assess all investments. In the case of oil and gas exploration and production, it is the period until the well or field is no longer economically viable and has to be abandoned.

The steepness of decline in production rates for shale oil wells has been a surprise. A typical well in the Bakken Formation, North Dakota, drilled in 2012 is likely to be producing at less than 30 per cent of its initial production rate today. Recent disappointing performance relative to expectations at the newer Utica shale play in the northeast US and Canada mirrors this.

Investor returns on shale gas investments have broadly come in two main periods. From the discovery of most shale gas in 2002 until 2007, share prices of shale companies rose rapidly. Once the newly discovered gas came on stream, natural gas prices fell – and so did returns and share prices. The largest shale player in the UK is Cuadrilla Resources, which was founded in 2007 and is owned by AJ Lucas, Riverstone Holdings and Carlyle and is exploring for shale gas deposits in Lancashire. AJ Lucas, a quoted Australian company, owns 42 per cent of Cuadrilla. Its own shares are just a quarter of what they were worth in 2009.

Nor is this disappointing performance limited to small companies. BP wrote off $1bn on shale in July 2012 whilst the Canadian company Encana said it lost almost $2bn on its shale gas assets in recent years. Shell is selling its stake in the Eagle Ford shale reserve in Texas, having written off more than $2bn on its assets there. It claims more than 200 wells are incapable of reaching their production target. Peter Voser, the former Shell chief executive, has said the rhetoric about the US shale revolution being exported to other countries was “hyped”, and that the rest of the world was in an early “exploration phase” which could yield “negative surprises”.

As the late Jimmy Goldsmith was fond of saying: “If you see a bandwagon, it’s too late.” The shale bandwagon may already have passed.

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Terry Smith

Financial Times