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Zedi Part 3 – The Plague of Fracking

October 8th, 2013 | Posted by Torin in ZED

If you are already familiar with how fracking has changed the North American natural gas industry, you can skip this post and wait for the next one. If you aren’t, here is a primer:

In the 1990s, a few U.S. natural gas producers began experimenting with horizontal, rather than vertical, gas drilling. Sending a drill a mile down into the ground and then turning it 90 degrees and drilling horizontally allowed U.S. gas producers to tap vast stores of gas that were inaccessible by traditional vertical drilling methods. By the mid-to-late 2000s, many U.S. gas producers had become proficient in this new drilling method, and soon thereafter North America was awash with natural gas.

The problem with all this gas is that it had nowhere to go. The natural choice for producers would have been to export the gas to whichever foreign market offered the highest price, but natural gas cannot be transported oversea except in liquefied form, and facilities that can liquefy natural gas A) cost enormous sums of money to build (Petronas recently stated it expects to spend $16 billion on one facility in Vancouver), and B) require five years or more to construct. The permitting process for such a facility, which must be built on a coast and connected to a regional pipeline network from which it is to draw gas, is not a walk in the park either.

So the gas had nowhere to go, and no prospects for export any time soon. But for a while gas producers continued to drill anyway, because doing so allowed them to report increased earnings and resource reserves to their investors. In addition, fractured wells in some shales produce both dry gas and “natural gas liquids” (in industry parlance these are “wet” wells), and with these wells, often the liquids alone are valuable enough to make drilling the wells profitable.

For the owners of those wet wells, the liquids were the point of drilling; the gas produced was just a byproduct to be sold off into a pipeline at whatever price was offered. This burdened the gas distribution and storage system with even more supply, creating a persistent weakening in the price of natural gas in North America: in 2008 the price of natural gas here was above $8; in 2012 it was below $3. Today it is still below $4.

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The price of gas is now so low that almost nobody is drilling pure (“dry”) natural gas wells anymore, unless the well are incredibly prolific, and proximate to pre-existing collection pipelines.

In the long run, this problem will more than likely take care of itself. Right now gas prices in the rest the world are multiples of the current North American price. In most of Europe, the price of gas is about $10, and in much of Asia and Latin America the price is $15. A number of parties are racing to arbitrage this price differential by building LNG export facilities on the Western coast of Canada and in the U.S., with a view to sending excess North American gas to Asia and Europe once the facilities are up and running. At that point it will be open season for gas producers in Canada. In fact, many of them are already undertaking extensive exploratory drilling in order to prove out their resources and position themselves to win long-term supply agreements with the LNG facility owners. Zedi CEO Matt Heffernan had this to say about the subject on the second quarter earnings call:

Questioner:

In terms of the shut-in activity, are you expecting that higher level of shut-in activity to continue in Q3?

Zedi CEO Matt Heffernan:

It’s hard to tell. We experienced a lot in Q2, but meanwhile we’re watching a lot of growth activity [in Canadian natural gas drilling] starting to happen in Northern B.C. as well. We’re watching that very carefully. We think the bigger players are coming in and starting to take positions in B.C., I think awaiting both some transportation—in-province pipelines to the coast—as well as LNG approvals. So based on all of that we are seeing a lot of both land activity and preliminary drilling activity taking place in B.C.”

Is this the seed of a long-awaited recovery in Canadian natural gas production? It is hard to tell. In the meantime, the producers seem finally to have gotten religion, and they have dramatically slowed their natural gas drilling. Many are now focusing on oil prospects almost to the exclusion of natural gas. With much less gas now being produced, domestic stores will eventually be depleted by typical usage, and the oversupply of gas will gradually reach equilibrium, or turn into an undersupply. At that point the price of gas will rise, and when it gets above $5 or so, producers will start drilling again. That might happen soon on its own, or it might not. If it doesn’t, eventually the commencement of liquefaction at LNG facilities in Vancouver will make it happen.

How Zedi has managed to prosper in the face of such an awful end market is the subject of the next post…

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