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Can oil save Chesapeake?

The US shale gas boom has the hallmarks of a technology bubble: firms need continual re-capitalization but their gas output is not demonstrably profitable. Value is instead based on reserves and technology.

The switch from gas to oil suggests shale gas can survive only through cross-subsidization not on its own merit. Perpetual expansion cannot forever disguise a serious problem with the bottom line.

Shale gas has been an extraordinary success in the United States, changing the country's gas balance from one of growing importer to potential exporter.

It has reversed the decline in US proved natural gas reserves and boosted production to such an extent that storage is close to capacity and prices have dropped significantly.

The claims made by the shale gas industry are that they have discovered sufficient gas reserves to supply the US with cheap natural gas for the next 100 years. Not only that, but they have now claimed that they can produce shale gas at prices below $1/MMBtu.

The US success story has not gone unnoticed around the world and major integrated oil and gas companies have spent billions buying into US shale reserves and accessing the relevant drilling technology.

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The mere possibility that what has happened in the US could be replicated in other parts of the world has changed perceptions of the future gas market and thus investments in all types of gas technologies from natural gas powered vehicles to Floating LNG.

In Europe, shale gas has met its skeptics. They argue that Europe's shale resources are unproven, that harsher environmental regulation, less amenable subsurface rights and more densely populated regions will all retard the industry's development.

Significantly, the barriers to shale gas development in Europe are all regionally specific. They take for granted that the fundamental economic case for shale gas production is sound. Unfortunately, there are some good reasons to think otherwise.

Where's the money?

Chesapeake Energy is probably the most well-known shale gas company in the US, and, as such, the entire world. It has expanded aggressively and holds large positions in the major US shale plays.

It can boast exceptional share price growth since its beginnings in 1992, backed by increasing production and an expanding resource base. The company is emblematic of the shale gas revolution.

In 2009, Chesapeake produced 835 Bcf of natural gas. Including oil and Natural Gas Liquids, the company produced 2.5 MMcf equivalent per day of hydrocarbons, more than five times its production in 2001.

Its proved reserves have grown from below 3 Tcfe in 2002 to about 14 Tcfe in 2009. It estimates its resource base at just less than 80 Tcfe.

Chesapeake has also pulled off a series of spectacular deals, feeding off the growing international interest in shale gas. In 2008, it sold Norway's Statoil 32.5% of its assets in the Marcellus shale for $3.375 billion in cash and drilling carries.

It sold 20% of its Haynesville assets for $3.2 billion in cash and drilling carries to US firm Plains Exploration and Production Company and, in September 2008, it divested 25% of its holdings in the Fayetteville shale to UK major BP for $1.9 billion.

The monetization spree continued in 2009, with Chesapeake selling 25% of its assets in the Barnett shale to French major Total for $2.25 billion in a deal that closed in January 2010.

Most recently, Chesapeake sold a 33.3% stake in its Eagle Ford shale project to the China National Offshore Oil Company for $1.08 billion in cash and a further $1.08 billion in carried drilling costs. This deal should fund 75% of Chesapeake's drilling on Eagle Ford until around 2012.

Chesapeake also reached a $1.15 billion production payment deal with UK investment bank Barclays in October, signing over 390 Bcf-equivalent of Barnett Shale reserves for the next five years.

The reserves are expected to produce the equivalent of 280 MMcfe next year.

This is Chesapeake's eighth VPP -- Volumetric Production Payment -- deal. The company has completed eight such transactions since December 2007, selling 1 Tcfe of proved reserves for about $4.7 billion.

The intention is to fund the gap between its aggressive liquids leasing and gas drilling plans in 2010 and its actual income.

However, despite the impressive expansion, growing production, the huge reserves, and the equally huge expenditures, Chesapeake does not appear to have created a base from which it can derive a steady and sustainable profit.

Chief executive officer Aubrey McClendon described 2009 as "a very successful year for Chesapeake," but the company saw a net income loss of $5.83 billion, which effectively wiped out all the net income reported by the company since its foundation.

Since 1992, the company has reported a cumulative net income of minus $368 million. And this is before the precipitous fall in US natural gas prices in 2010.

Chesapeake's operating costs have been growing faster than production since 1999, while the sales price of the gas produced has been falling since 2006. 1999 appeared to be a breakthrough year.

Excluding oil, in 1998, Chesapeake had spent $1.234 billion in operating costs to produce 94 Bcf of natural gas. In 1999, it spent just $247 million to produce 109 Bcf of gas, the equivalent of $2.266 million per Bcf of gas produced.

However, this figure has risen steadily since, hitting $7.86 million per Bcf of gas produced in 2007, $13.13 million in 2008 and $19.94 million in 2009.

Moreover, despite the multitude of deals that Chesapeake has struck, creating joint ventures with some of the world's biggest oil companies, and pulling down billions in funding, it has consistently increased its levels of long-term debt, only curbing them slightly in 2009.

Long-term debt, net of current maturities, as reported in the company's 2009 annual report, was $12,295 billion, down from $13,175 billion in 2008, but still four times what it was in 2004.

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