Académique Documents
Professionnel Documents
Culture Documents
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Stephen J. Brown, New York University; Bruce D. Grundy University of Melbourne; Craig M. Lewis, Vanderbilt University;
and Patrick Verwijmeren, Erasmus University Rotterdam
74
87
97
in the first year of production. This means that a dependable supply of natural gas from shale formations requires a
sustained program of drilling, completion, and exploration.
Finally, there are serious environmental concerns
about the production of shale gas. The drilling techniques
used to extract shale gas require large volumes of water and
some chemicals that could result in ground water contamination. Potential environmental costs could seriously erode the
economic viability of producing gas from shale formations. 6
Ultimately all of these concerns impact the economics
of shale gas production. If shale gas reserves have been overestimated then this will result in reduced production and
possibly higher gas prices. Environmental concerns will likely
lead to regulatory changes that result in increased costs of
extracting shale gas.
In this paper we first develop a base case model to evaluate the economic viability of producing natural gas from shale
formations. To construct our base model we use data from a
shale gas well in the Haynesville shale region of North Louisiana.7 Our analysis explores the valuation of the predicted gas
volumes from that well using estimated production costs for
the region in conjunction with estimated natural gas prices.
To generalize the model we use both sensitivity analyses of the
key value drivers, as well as simulation analysis. We find most
shale gas wells are profitable under the assumed conditions of
our model data. However, the key driver of NPV is the price
of natural gas, which at the time of this writing is very nearly
equal to breakeven levels (assuming the current method used
to estimate production volume is correct).
The conventional view of a hydrocarbon accumulation
is that three things are required: a source rock, a reservoir,
rather than 100 year supply of natural gas, shale gas offers as little as seven years.
5. Natural gas has been produced from shale formations for over one hundred years
but recent technological advances have made the economics of its production much
more attractive.
6. Although fracking has been around since the 1940s its use has increased significantly since 2000 and become a focus of intense media scrutiny. Fracking fluid is 99.5%
sand and water and most of the injected water is later extracted during production. There
is always some risk, however, of ground water contamination, and objections to more
traffic and noise related to drilling. See John Walton and Arturo Woocay, Environmental
Issues Related to Enhanced Production of Natural Gas by Hydraulic Fracturing, Oil, Gas,
& Mining, Volume 1, Issue 1, (August 2013).
7. The Haynesville shale spans a 9,000 square mile area in North Louisiana. Although not as large geographically as the Marcellus shale which covers 95,000 square
miles, it has almost as much gas: an estimated 251 trillion cubic feet (Tcf) compared to
just 262 Tcf for the much larger Marcellus shale.
T
B
Fall 2013
87
8. This is a bit of an oversimplification for even with conventional wells the operator
might choose to frack the well after drilling should the well not flow. Thus, conventional
wells offer the operator the option to complete the well which may include fracking. In
contrast, shale wells must be fracked before their economic viability can be determined.
9. The severance tax is a tax imposed by states for the extraction of natural resources
such as natural gas which in the State of Louisiana is $0.0331 per Mcf. The ad valorem
tax is a tax levied on the difference between the price of natural gas and the cost of
production. In Louisiana this tax is levied for each well as follows: In the first year the tax
is $955 per month. In years two through twenty the tax declines by 4% per year and for
all years thereafter it is equal to the year 20 total.
88
Net Gas
Production
(mcf)
Price of
Total Net Severance &
Depletion
Natural Gas Operating Ad Valorem
Allowance
per mcf
Expenses
Expenses
Corporate
Depletion
1+
Income Tax Rate
Allowance
(1)
Net gas production is equal to the owners proportionate
working interest in the well revenues (15.75%) multiplied by
the estimated gross annual gas production. Total net operating expenses include the owners share of the cash expenses
required to extract, transport and sell the gas production
from the well. Severance and Ad Valorem expenses are taxes
imposed on gas producers and the depletion allowance is a
non-cash expense available to gas producers to reflect the
depletion of the asset represented by the well.9
Energy firms have sometimes computed return on investments in gas wells on a before corporate tax basis. This practice
arose, in part, because their investments were often unprofitable. This has been much less true recently. For example,
Chesapeake Energy paid average tax rates of 38% and 39%
Fall 2013
Period
Estimated
Gross Gas
(Mcf)
Estimated Net
Price of
Gas
Natural Gas/
(15.75% of
Mcf
Gross Gas)
(Mcf)
Estimated
Total Net
Revenue
Estimated
Total Net
Operating
Expense
Estimated
Severance &
Ad Valorem
Expense
Estimated
Depletion
Allowance
Estimated
Equity
Investment
Estimated
After-tax Net
Cash Flow
Dec-09
Dec-10
1 2,405,443.0
378,857.3
$4.50
$1,704,858
$(13,568)
$(1,908)
$(483,695)
$(1,912,500) $(1,912,500)
Dec-11
773,147.5
121,770.7
4.50
547,968
(11,833)
(36,625)
$(155,467)
396,298
Dec-12
474,995.6
74,811.8
4.50
336,653
(9,747)
(25,794)
$(95,514)
239,432
Dec-13
343,838.1
54,154.5
4.50
243,695
(9,747)
(19,644)
$(69,140)
170,755
Dec-14
269,659.5
42,471.4
4.50
191,121
(9,747)
(15,791)
$(54,224)
132,176
Dec-15
221,876.7
34,945.6
4.50
157,255
(9,747)
(13,165)
$(44,616)
107,425
Dec-16
188,506.2
29,689.7
4.50
133,604
(9,747)
(11,265)
$(37,906)
90,186
Dec-17
163,873.9
25,810.1
4.50
116,146
(9,747)
(9,827)
$(32,952)
77,486
Dec-18
144,941.4
22,828.3
4.50
102,727
(9,747)
(8,701)
$(29,145)
67,739
Dec-19
10
129,934.0
20,464.6
4.50
92,091
(9,747)
(7,797)
$(26,128)
60,021
Dec-20
11
117,744.9
18,544.8
4.50
83,452
(9,747)
(7,054)
$(23,677)
53,759
Dec-21
12
107,647.8
16,954.5
4.50
76,295
(9,747)
(6,433)
$(21,646)
48,575
Dec-22
13
99,146.5
15,615.6
4.50
70,270
(9,747)
(5,906)
$(19,937)
44,213
Dec-23
14
91,890.3
14,472.7
4.50
65,127
(9,747)
(5,454)
$(18,478)
40,492
Dec-24
15
85,870.8
13,524.7
4.50
60,861
(9,747)
(5,076)
$(17,267)
37,406
Dec-25
16
80,858.5
12,735.2
4.50
57,308
(9,747)
(4,761)
$(16,259)
34,838
Dec-26
17
76,149.7
11,993.6
4.50
53,971
(9,747)
(4,463)
$(15,312)
32,426
Dec-27
18
71,715.1
11,295.1
4.50
50,828
(9,747)
(4,182)
$(14,421)
30,155
Dec-28
19
67,538.7
10,637.3
4.50
47,868
(9,747)
(3,916)
$(13,581)
28,017
Dec-29
20
63,605.6
10,017.9
4.50
45,080
(9,747)
(3,665)
$(12,790)
26,005
Dec-30
21
59,901.5
9,434.5
4.50
42,455
(9,747)
(3,428)
$(12,045)
24,109
Dec-31
22
56,413.1
8,885.1
4.50
39,983
(9,747)
(3,204)
$(11,344)
22,325
Dec-32
23
53,127.8
8,367.6
4.50
37,654
(9,747)
(2,993)
$(10,683)
20,645
Dec-33
24
50,033.9
7,880.3
4.50
35,462
(9,747)
(2,793)
$(10,061)
19,063
Dec-34
25
47,120.2
7,421.4
4.50
33,396
(9,747)
(2,605)
$(9,475)
17,574
Dec-35
26
44,376.1
6,989.2
4.50
31,452
(9,747)
(2,427)
$(8,923)
16,171
Dec-36
27
41,791.8
6,582.2
4.50
29,620
(9,747)
(2,259)
$(8,404)
14,851
Dec-37
28
39,358.1
6,198.9
4.50
27,895
(9,747)
(2,101)
$(7,914)
13,607
Dec-38
29
37,066.0
5,837.9
4.50
26,271
(9,747)
(1,952)
$(7,453)
12,436
Dec-39
30
34,907.5
5,497.9
4.50
24,741
(9,747)
(1,811)
$(7,019)
11,334
Dec-40
31
32,874.6
5,177.8
4.50
23,300
(9,747)
(1,678)
$(6,611)
10,296
Dec-41
32
30,960.1
4,876.2
4.50
21,943
(9,747)
(1,553)
$(6,226)
9,318
Dec-42
33
29,157.2
4,592.3
4.50
20,665
(9,747)
(1,434)
$(5,863)
8,398
Dec-43
34
27,459.2
4,324.8
4.50
19,462
(9,747)
(1,323)
$(5,522)
7,531
Dec-44
35
25,860.1
4,073.0
4.50
18,328
(9,747)
(1,218)
$(5,200)
6,714
Dec-45
36
24,354.1
3,835.8
4.50
17,261
(9,747)
(1,119)
$(4,897)
5,946
Dec-46
37
22,935.8
3,612.4
4.50
16,256
(9,747)
(1,025)
$(4,612)
5,222
Dec-47
38
21,600.2
3,402.0
4.50
15,309
(9,747)
(937)
$(4,343)
4,540
1,327,676
30
NPV, $
309,201
893,995
IRR, %
16.47
30.86
Fall 2013
89
10. Based on a study published in April 2009 and prepared for the U.S. Department
of Energy Office of Fossil Energy and National Energy Technology Laboratory titled Modern Shale Gas Development in the United States: A Primer, p. 17.
11 Larry Benedetto, Unconventional Gas and its Impact on Domestic Supply, a report issued by Howard Weil (http://www.ocsbbs.com/hottopics/2008/PLANO_Larry_
May2008.pdf)
12. This is the cost estimate of our example well. However, the average cost of shale
wells in the Haynesville shale has been reported to be somewhat higher. In 2010 both
Petrohawk (HK) (Enercom Oil & Gas Conference: August 24, 2010) and EXCO (XCO)
(Fourth Quarter and Full Year 2009 Review: February 2010) reported an average cost of
their shale gas wells in the Haynesville Shale of $9.5 million.
13. R.E. Allen is credited with mentioning four types of decline curves in 1931 and
that J.J. Arps later expounded upon. See R. E. Allen, Control of California Oil Curtail-
ment, Trans. A.I.M.E., 92, 47, 1931 and J. J. Arps, Estimation of Primary Oil Reserves in Petroleum Transactions, AIME, Vol. 207, 1956.
14. The method we use to estimate production volumes follows industry practice;
however, new methods have been proposed that claim to improve the accuracy of volume projections. These include the one mentioned in the M.S. thesis of A.J. Clark. See
A. J. Clark, Decline Curve Analysis in Unconventional Resource Plays using Logistic
Growth Models, M.S. thesis, University of Texas at Austin, 2011; A. J. Clark, Larry W.
Lake, and Tad Patzel, Production Forecasting with Logistic Growth Models, SPE
144790, presented at the 2011 Annual Technical Conference and Exhibition of the Society of Petroleum Engineers, Denver, Colorado; and Peter Valko and W. John Lee, A
Better Way to Forecast Production from Unconventional Gas Wells, SPE134231, presented at the 2010 E Annual Technical Conference and Exhibition of the Society of Petroleum Engineers, Florence, Italy.
90
q t = q i (1+nDi t) n (2)
Fall 2013
3,000,000
2,500,000
2,000,000
1,500,000
1,000,000
y = 2,015,779.16x
R
500,000
-1.19
= 0.99
0
0
10
15
qt =qt-1 e .06
The switch from the hyperbolic to the exponential decline
function occurs between years 13 and 14 for Haynesville #1.17
Figure 1 contains the estimated production volumes for
2010 through 2047.18 Note the initial steep production rate
decline as noted above. Using estimates based on this hyperbolic decline curve in the model we can later consider the
effects of deviations from the estimated parameters on the
value of the shale gas well.
Multiplying the annual production volumes by the $4.50/
Mcf price for natural gas provides an estimate of the gross
gas revenues from the well. Adjusting these estimates for the
working interest of the investor produces the net gas revenue.
There are three categories of annual operating expenses
(see Equation 1). These are Total Net Operating Expense;
Severance and Ad Valorem Expense; and Depletion Allowance. Based on the estimates provided for Haynesville #1 we
15. The slope term, n, being equal to one indicates that the hyperbolic decline function reduces to the special case of a harmonic decline function, which is discussed in the
appendix.
16. Given the relatively brief time that horizontal, hydraulically fractured gas wells
have been producing, the productive life of these wells is still unknown. Although conventional wells have produced for 30 years and longer, the initial evidence from the
Barnett Shale is that the average productive life of a well is 7.5 years and the early evidence from the Marcellus suggests its wells also might have similar (short) lifespans (see
www.marcellus-shale.us/Marcellus-production.htm). A short life span does not mean
these wells are not economic, but to be profitable the volumes of initial production have
to carry the investment.
17. This switch to the exponential decline function is important because a hyperbolic
curve with value of n greater than one implies an infinite recovery amount, (i.e., commonly referred to as the wells estimated ultimate recovery or EUR).
20
25
30
35
40
Fall 2013
91
(5,000)
100,000
200,000
300,000
400,000
500,000
600,000
(10,000)
y = 0.00x2 - 0.13x - 1,654.88
(15,000)
R 2 = 0.99
(20,000)
(25,000)
(30,000)
(35,000)
(40,000)
Net Gas Revenues
Model Estimates
NPV, $
308,222
309,201
IRR, %
16.45
16.47
20. Recall that the production decline function used to model Haynesville #1 is a
hybrid model containing a mixture of a hyperbolic and exponential function. In the sensitivity analysis used here we do not alter the exponential portion of the decline curve,
which describes the tail of the curve. In the initial estimates we found that the exponential function is used between 13 and 14 years in to the productive life of the well.
21. Recall from equation (2) that there is a third variable in the hyperbolic decline
curve equation. This variable determines the rate of change in the annual decline rate in
production and was designated by n. When we evaluated the sensitivity of NPV to this
variable we found that there was no positive value for n for which NPV was equal to zero.
NPV declined with smaller values of n, but it reached a minimum near $100,000 as n
92
Table 3
Parameter
Initial
Production
Rate (qi)
Initial Decline
in Production
in Year 1 (Di)
Break-even
Parameter
Value
Percent
Change in
Parameter
Value
Percent
Change in
Estimated
Ultimate
Recovery
(EUR)
19,500 Mcf/
day
16,551 Mcf/
day
-15.12%
-15.12%
85%
87.7%
3.15%
-13.2%
Clearly, the NPV of the project is very sensitive to production volumes. An increase in the initial rate of decline in
production for year one from 85% to 87.7% (an increase of
just 3.15%) leads to a zero NPV estimate. Furthermore, a
drop of 15.12% in the initial rate of production from 19,500
Mcf/day to 16,551 Mcf/day can also result in a zero NPV.21
Although we have used the same hyperbolic decline
function (as in equation 2) widely used with conventional
gas wells,22 to estimate the output of our shale gas well, we
do not yet know whether this or some other function is more
appropriate for unconventional shale gas wells. Some geoscientists suggest that a more rapid exponential function would
be more appropriate. Only time will tell as we gain more
production experience.23
approached zero. Remember that we were only allowing n to vary while holding all other
variables constant so that estimates of this variable are important even though in this
example this variable was not able to drive the NPV to zero.
22. We used a switching model that is initially a hyperbolic function and then converts to an exponential function where the rate of decline in production falls to 6%.
23. John Dizard of the Financial Times described the dissention within the petroleum
engineering profession in 2010 regarding the amount of natural gas that will ultimately
be recovered from shale formations and at what cost. See Debate over Shale Gas Decline Fires Up, FT.com (October 10, 2010).
Fall 2013
Minimum Value
Most-Likely Value
Maximum Value
4,053
19,500
31,616
Initial Decline in
Production in Year 1
(Di), %
76.5
85
93.5
0.50
1.0
1.5
Initial Production
Rate (Mcf/day) (qi)
Fall 2013
93
29. See J. McCormack and Gordon Sick, Valuing PUD Reserves: A Practical Application of Real Option Techniques, Journal of Applied Corporate Finance, 13, 4 (Winter
2001), 110-115.
30. Some shale plays, such as the Haynesville shale, produce only dry gas, whereas
the northern most region of the Eagle Ford Shale in South Texas produces oil, the middle
region produces wet gas (some liquids) and the southernmost region is dry gas only.
94
Fall 2013
Sheridan Titman holds the McAllister Chair in Finance at the University of Texas at Austin.
31. We are grateful to John McCormack for pointing out this second type of shut-in
option to us. See J. McCormack and Gordon Sick, Valuing PUD Reserves: A Practical
Application of Real Option Techniques, Journal of Applied Corporate Finance, 13, 4
(Winter 2001), 110-115.
Fall 2013
95
(2A)
-1
(3A)
1 -Desi
n
-n -1
for n 0
(4A)
32. R.E. Allen described four types of production decline curves in 1931. J.J. Arps
later expounded upon three of these (the exception being the first, the constant decline
curve).
33. W.W. Cutler, Jr., Estimation of Underground Oil Reserves by Well Production
Curves, USBM Bull, 228 (1924).
96
9.00
8.60
(1A)
10.00
8.00
Estimated Mmcf/Day
7.00
6.00
5.00
4.30
4.00
3.00
2.82
2.00
1.13
1.00
0.36
.0
0
10
15
20
25
30
35
40
Year
34. Petrohawk Energy Corporation, Enercom Oil & Gas Conference presentation (April
24, 2010).
35. A. J. Clark, Decline Curve Analysis in Unconventional Resource Plays using Logistic Growth Models, M.S. thesis, University of Texas at Austin, 2011.
Fall 2013
ADVISORY BOARD
EDITORIAL
Yakov Amihud
New York University
Robert Eccles
Harvard Business School
Martin Leibowitz
Morgan Stanley
Charles Smithson
Rutter Associates
Editor-in-Chief
Donald H. Chew, Jr.
Mary Barth
Stanford University
Carl Ferenbach
Berkshire Partners
Donald Lessard
Massachusetts Institute of
Technology
Joel M. Stern
Stern Stewart & Co.
Associate Editor
John L. McCormack
Amar Bhid
Tufts University
Kenneth French
Dartmouth College
G. Bennett Stewart
EVA Dimensions
Michael Bradley
Duke University
Stuart L. Gillan
University of Georgia
Richard Brealey
London Business School
Richard Greco
Filangieri Capital Partners
Stewart Myers
Massachusetts Institute of
Technology
Alex Triantis
University of Maryland
Michael Brennan
University of California,
Los Angeles
Trevor Harris
Columbia University
Richard Ruback
Harvard Business School
Glenn Hubbard
Columbia University
G. William Schwert
University of Rochester
Michael Jensen
Harvard University
Alan Shapiro
University of Southern
California
Robert Bruner
University of Virginia
Christopher Culp
University of Chicago
Howard Davies
Institut dtudes Politiques
de Paris
Steven Kaplan
University of Chicago
Robert Merton
Massachusetts Institute of
Technology
Ren Stulz
The Ohio State University
Ross Watts
Massachusetts Institute
of Technology
Jerold Zimmerman
University of Rochester
David Larcker
Stanford University
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