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Is Shale Gas a Ponzi Scheme?

by Michael Levi
June 27, 2011

[Dear new readers: This post is part of a blog on energy and climate issues. Click here for the full blog.]

The New York Times’ war on shale gas continues with two more big stories by Ian Urbina. The front page of the Sunday paper featured “‘Enron Moment’: Insiders Sound Alarm amid a Natural Gas Rush”, complete with pullquote “Word in world of independents is that shale plays are just giant Ponzi schemes.” That was followed today by “Behind Veneer, Doubt on Future of Natural Gas”. Both articles are based primarily on piles of emails, the first from industry sources and the second from EIA staff. I hate to say it, but on the whole, both pieces are of pretty poor quality. That’s a shame, because both – particularly the first one – had the potential to raise some important issues for debate.

I can’t say that I’ve read through all of the hundreds of pages of documents that the Times has posted on its site. But I’ve gone through a good enough slice of them (including all the emails that the Times references in its articles) to get a feel for how Urbina went about using them in his stories. There’s a pattern: Urbina was clearly looking for negative views of shale gas, and had no problem finding them. Given the massize size of the industry, and the number of financial bets being placed upon the sector, that shouldn’t be a surprise. What is a surprise is that Urbina hasn’t done much to put them in context.

I’m going to focus on the Sunday story here, because it’s much more interesting, and because some of its sources raise some genuinely important issues, which I’ll get to in a few paragraphs. In contrast, today’s story is mostly a mix of some frustrated EIA analysts’ complaints and some healthy internal EIA debate taken wildly out of context.

Three Problems

Back to the Sunday story. The first bit of context worth noting is that the story relies heavily on geologists’ concerns about shale gas economics. That should be a red flag. There are very few emails from industry accountants or economists in the story. The geologists’ critiques follow an irritating pattern: most of them basically say that projected levels of gas production are implausible at current natural gas prices. This, of course, is beside the point: no one serious think that today’s gas prices are going to hold forever. (If this technique sounds familiar, that’s because it is: it’s the way that some of the more simplistic arguments for peak oil operate.) The question is whether production can continue at large volumes at reasonable prices. I don’t see anything in the emails that argues against that.

I should be clear: there are also emails from investors and a few non-geologists. Some of them even raise legitimate concerns (I’ll come to those in a moment). Others are more ridiculous: one investor, for example, notes that his emails to producers have gone unanswered, and concludes that they must have something to hide. But the guy also admits that he’s never invested in oil and gas. Perhaps the producers simply thought that he wasn’t worth their time.

My second problem is that the story conflates several issues. There’s an extended part that talks about how landowners in some parts of Texas have gotten hurt by falling prices for their mineral rights.  Indeed that is a real issue for those people who have been hurt. It is not clear what its relevance is to overall shale gas prospects. Heck, falling prices for mineral rights would help make the shale gas industry more stable (and gas prices lower) over the long haul.

The third problem is that many of the emails come from 2008 and 2009, when shale gas was still a much murkier industry. Lots of the technical debates that are played out in those emails have come a long way since. In particular, the steep initial decline rates for shale gas well were indeed surprising to many at the time. But they are not today – steep initial declines are standard in industry and analyst understanding of shale gas economics. The Times story implies that it’s got news on how these wells operate, that that this news might force a revision of analysts’ assessments. But what it presents isn’t news in 2011, and hence the impact on assessments of shale gas ought not be nearly as significant as one might superficially expect.

The Times descriptions of the emails (not just in the article, but in the document database)  also betray a serious lack of understanding of the industry. For example: UBS cautions gas investors to “not get excited”, which the Times takes as a warning against gas producers in general; if fact, it’s a warning against people who are betting on higher gas prices, which the analyst thinks are unlikely given the abundance of shale gas (i.e. completely contradicting Urbina’s thesis). Another great one: Dan Yergin is apparently a member of the news media, not the head of a large consulting firm.

The Real Issues

But enough nitpicking: What are the legitimate issues raised in the emails? I see at least three. The first is that SEC rules for estimate reserves may lead to an overstating of some companies’ resources. I don’t understand this space well enough to comment on this particular issue, but I hope to read more from those who do.

The second is that the current spot price for natural gas is deceptively low because companies are hedged. Many companies sold much of their production forward when gas prices were much higher than they are today. That allows them to continue operating despite the fact that some of their wells might be uneconomical if they had to sell all their gas at the current spot price. (Of course, if those producers hasn’t sold so much gas forward, the spot price itself might be higher today.) Despite what the Times implies, this is not news to anyone who follows the sector. Many of us have believed for a long time that the natural gas price required to support the current level of production is a decent bit higher than the spot price is today. This doesn’t change the bottom line for serious analyses of policy implications.

The third issue is the one raised in the featured quote about “Ponzi schemes”. It is rather amazing that despite the Times’ focus on that quote, it never bothers to actually explain what the Ponzi scheme metaphor refers to. Here’s what it’s talking about: The shale gas industry contains many independent drillers. They often taken on a lot of debt to finance their activity. In particular, they take on a lot of debt in order to buy more leases. (My understanding is that leases tend to be the most expensive part of shale gas development these days.) But leases don’t help them service that debt – they need cash flow to do that. And to generate cash flow they often need to pump and sell natural gas. (They can also raise cash by selling some of their leases, which also feeds the Ponzi metaphor, but there is a limit to this.) What that means is that drillers have an incentive to produce gas even when, all in, it isn’t really economical at current prices. Alas, this feeds into a loop: gas floods the market, driving prices down even further, which creates an incentive for even more new drilling in order to meet cash flow needs. This is compounded by the fact that some operators are required to drill within a certain period of time in order to hold on to their leases.

This is obviously unsustainable: at some point, the cost of production – including leases and profit – needs to be less than the price of gas. That’s part of why many independents are trying to sell themselves to bigger players (who can finance development through their balance sheets rather than with debt, and which can wait more patiently for prices to rise a bit). It’s also part of why some of them are selling off assets. (Unless it’s only selling its lemons, this is not fundamentally different from any growing company selling off some of its equity in order to raise cash.) I have no doubt that some of these companies will fail to last long enough to either see higher gas prices or to sell themselves to entities that have the patience to hang on until the current gas glut gets worked through. Those companies will go bankrupt. (One might even be excused for referring to some of their business models — but not the whole industry — as Ponzi schemes.) So what? The Times repeatedly confuses the fortunes of various risk-hungry independents with the fortunes of the industry as a whole. Some investors will lose lots of money; some banks will regret having made loans. That’s life. It’s not clear why I should feel too sorry for them, or why the Times is so worried about saving their hides.

(Also: If shale gas is unsustainable at current prices, not only will prices rise, lease costs will drop, making production less expensive and allowing gas prices to settle lower than if lease costs were permanently fixed. Most land that’s being used for shale gas isn’t nearly as valuable for alternative uses; lease prices should thus be pretty elastic.)

At What Price Shale Gas?

Ultimately, the biggest issue that the piece raises concerns natural gas prices, not overall viability for the industry. (I say “raises” loosely, since the article doesn’t actually make clear that this is the real issue.) Do we have a world of four dollar gas in our future? Or will prices rise to six or seven or eight dollars in a few years, once acreage is consolidated under bigger players who can finance lease costs through their balance sheets and hence might have less incentive to pump out ever more gas in the short term? These questions matter: they have important implications for natural gas policy, climate policy, and for decisions regarding natural gas exports.

So it’s a shame that the article obscures them, because it’s allowing industry officials to ignore the real issues. In a long Facebook post last night, Chesapeake CEO (and uber-shale gas impresario) Aubrey McClendon hits back at the article thusly:

“It is also ludicrous to allege that shale gas wells are underperforming as we sit awash in natural gas, with natural gas prices less than half of what they averaged in 2008.  I also note that CHK and other shale gas producers are routinely beating our production forecasts – how can shale wells be underperforming if shale gas companies are beating their production forecasts and as US nat gas production has recently surged to new record highs (in fact, in 2009, thanks to shale gas, the US passed Russia as the largest natural gas producer in the world). Also, isn’t it completely illogical when this reporter argues that shale gas wells are underperforming, yet acknowledges that gas prices are less than half the price they were three years ago. ”

A proper read of the evidence cited in the article might provide ready answers to these questions: Gas prices might be low because drillers have an incentive to produce even if their wells are underperforming; high production might be evidence for the article’s contentions (which rest on there being incentives to produce more gas in order to generate cash flow), rather than against them; and it’s totally consistent for wells to be underperforming and to have cheap gas at the same time, so long as there are plenty of wells operating for other reasons.

Let me be clear: I’m not saying that the entire industry is being propped up by the dynamics that the Times article is based on. I haven’t done the detailed economics: perhaps prices would be 5% higher; perhaps they’d by 50% higher. But the Times hasn’t done the economics either. And by choosing to indulge in hype rather than digging down into the real substance, it’s missed an opportunity to spark a useful debate too.

Post a Comment 17 Comments

  • Posted by Drew

    While I agree with much of what you say here, allowing price comparisons to be made versus 2008 prices is disingenuous. Gas price rose to over $14/MMBTU based on a speculative fervor that led to a crash. Those price levels were never hit before and have never been hit again.

    The real question/problem is that as baseload electricity generation moves from coal to gas over the next 25 years, will the supply keep prices in check, will the infrastructure be able to support it, and will international arbitrage in the global LNG market make high prices for power generation inevitable?

  • Posted by Nick Grealy

    A) many companies are now producing for <$2
    B) the complex economics surrounding shale oil make gas prices less important.

    The big story of the past year is not shale gas so much as shale oil. Using the same fracking and horizontal drilling used in shale gas is now working the shale magic on oil.

    Simply put, oil and gas often come out of the same hole in the ground. In those associated wells, one cannot produce oil without producing gas as well. Unlike in Russia, Nigeria etc, US gas cannot be flared off for environmental reasons.
    At $90+ a barrel, it makes perfect economic sense to literally give the gas away. In fact, some in Texas will be paying people to take it away and export it via LNG ifrom 2014. First US energy exports to Europe since the Marshall Plan!
    Keeping gas in the ground, means keeping oil in the ground and does the average American want to say "Fracking's nasty, let's ban it and keep on giving money to Saudi or Chavez or whomever? Most likely not. People are sometime irrational on shale. But they aren't mad.

  • Posted by Ray

    The NYT article was so biased that it bordered on the absurd. Trying to comment on it is far beyond the scope of shale gas and has more to do with the ethics of journalism.

    Drew: Not with what we know today. Another example of the US not having a practical energy policy. Although, probably better without one than let the cretins in Washington compile it.

  • Posted by george

    Yeah, corporate America has such a history of credibility (cough-subprime ‘securities’),
    especially the energy sector (cough-Enron).

    I am sure they would never prop up phony quarterly report ‘profits’ & then dump the wreckage on investors the way BP, Halliburton & Trans-Ocean have dumped the cleanup on the Gulf spill on taxpayers.

    Deregulated capitalism is such a rip-off & fraud, Law of the jungle, eat or be eaten.

    Cannibal corporate tyranny conspiring with the US government, to eat the American middle class alive.

    BTW Cornell University’s April (2011) report indicates that fracked natural gas creates more greenhouse warming than burning dirty coal.

  • Posted by Matt

    “And by choosing to indulge in hype rather than digging down into the real substance, it’s missed an opportunity to spark a useful debate too.”

    ML- you’re writing about it, so not sure this is the right conclusion?

    [ML: The Times has a few more readers than I do….]

  • Posted by Ona

    Nicely written, but Mr. Levi I think you really misunderstood the critique of well performance raised by the documents and emails in The Times. While both The Times and the industry agree that wells drop off sharply in the first year or two, the issue isn’t the steep initial declines, but how soon the wells will stop being productive. The debate isn’t about the initial declines, it’s about what happens over the long run.

    Though the emails use the word “ponzi,” the claims of potential illegality that are highlighted in the piece aren’t really the idea of the drilling treadmill that you describe – it’s the idea that companies may be over-stating their reserves.

    [ML: What does that have to do with a Ponzi scheme? A Ponzi scheme is one in which one is forced to generate cash flow in order to pay off early investors, even if that cash flow comes from unprofitable activities. That’s the treadmill thing. Overstating reserves is bad, but it doesn’t have anything to do with Ponzi schemes. In any case, whatever is highlighted in the piece, my point was that the emails highlight the treadmill issue. My complaint was that the article failed to discuss those even though they were a key focus of the emails — and an important issue.]

    That’s why the opinions of geologists matter so much. If shale gas wells don’t perform as advertised, a lot of companies, both big and small, will be in significant economic trouble – and it seems like the people with the most doubts about company claims are geologists not accountants (although, in their document archive, the Times does include a couple of reports by Argus Research, which criticize Chesapeake Energy for its aggressive financial accounting).

    To me the most convincing support for this are found in the document archive —
    It’s an October 2010 Society of Petroleum Engineers paper that concludes that “commonly used” models are “inappropriate” for shale gas well productivity. These models were designed for conventional gas fields, not for shale gas production.

    [ML: Take a look at the accompanying slides from the same author. The plot suggests that with his preferred method, reserves would be downgraded about 20%. That is a big deal for individual corporations, but it is not all that significant from a public policy standpoint. All it means is that instead of having $5 gas, you need $6 — well within the error bars in pretty much any careful study. This is interesting stuff, and important for some individual companies, but not nearly as big a deal as the Times makes it out to be. The fact that production drops quickly in the early years means that the shape of the curve in the later years can only have so much consequence.]

    Today, Chesapeake CEO Aubrey McClendon said in a letter to his employees “there is no reason to believe that shale gas wells will have shorter lives than our conventional wells – some 8,000 of which are 30 years old or older.” In this presentation however, John Lee, says that conventional models don’t work for shale gas, pointing to assumptions that “lead to unreasonably large reserves estimate” when used for shale gas wells. and

    So to the extent that there may a “ponzi” scheme going on, perhaps it’s not driven by the costs of production or leases, but by drilling new wells to cover for production from older wells that is falling faster than the industry predicted early on.

    [ML: You’re basically claiming that industry is drilling extra wells in order to look good. I don’t see the point. So long as that don’t make fraudulent claims about decline rates, it’s not clear how drilling more wells would cover anything up except to the most casual observer. Neither the emails nor the Times makes such claims of fraud. Of course, drilling more wells can fix cash flow problems, but then we’re back to the issue that I criticized the Times for failing to highlight.]

    Spend less time ranting about the reporter and more time actually reading the documents the Times published and you might see they are raising good questions.

    [ML: I’m approving this because it’s mostly substantive. For future reference, though, I don’t normally approve comments with personal attacks, even if they have a lot of good substance alongside that.]

  • Posted by David B. Benson

    Burning natgas causes excess CO2.

    Enough said.

  • Posted by Wilson

    Message for Ona.

    Very well written and thought through response.

  • Posted by StewartIII
  • Posted by darwin

    To David B. Benson: Compared to coal? Or are you proposing we go strictly solar and wind and return to the Middle Ages?
    Not enough thought before saying.

  • Posted by James S.

    Excellent article. Personally, I would eagerly read even more thorough analysis and push-back against what appears to be a full scale assault on NG by the NY Times.

    One thing. Your article, well written, does include a few grammatical errors:
    – no one serious think
    – if those producers hasn’t sold
    – So long as that don’t make fraudulent claims


    [ML: Thanks. I’ll fire the editor.]

  • Posted by dahcredyns


    Last night Chesapeake CEO Aubrey McClendon was on MadMoney, and was asked directly about many of the points raised in this piece. McClendon basically called the entire NYTimes article nonsense, and said that the data collected from the government alone contradicts the NYTimes.

    Ultimately, if the NYTimes is correct, McClendon and others are in clear violation of securities law and digging themselves a deeper hole that will lead to massive lawsuits and possible SEC investigations.

    Somehow, I doubt that is the case, especially based on the latest research coming out of many US and European studies regarding both shale supplies and the dangers or fracking.

    Instead, it appears it is the NYTimes that is digging the hole.

  • Posted by dahcredyns

    David Benson-

    So, what’s your point? Greater coal use?

    Natural gas is far cleaner than coal, and excess methane, for instance, could quite easily be converted into methanol.

    If your point is renewables, on the other hand, the economics simply don’t support your case.

    Natural gas is not the future, but it can be an important bridge fuel, especially when one considers the legacy effect of the auto industry for instance.

    Waiting for perfect solutions to ripen, on the other hand, is the sure path to failure.

  • Posted by Vangel

    Here are my problems with the shale gas industry.

    We begin with the fact that the companies are using estimates of EUR that are not supported by the production data. As example let us point out Chesapeake, which announced that it had increased the EUR for its Fayetteville wells from 2.4 bcf to 2.6 bcf. Can the change be justified? According to Bill Powers, “Of the company’s 742 operated wells completed in the Fayetteville shale over the past five years, only 66 (9 percent) have produced more than 1 bcf and none have produced more than 1.7 bcf. CHK’s average Fayetteville well has produced only 541 million cubic feet (mmcf). On its Q4 2010 earnings conference call, Southwestern Energy upped its EUR for its proven undeveloped drilling locations from 2.2 bcf per well at the end of 2009 to 2.4 bcf per well at the end of 2010. The third largest operator in the Fayetteville, Petrohawk Energy (NYSE:HK), which recently sold its Fayetteville acreage to ExxonMobil for $650 million, has not publicly disclosed its EUR for the Fayetteville for some time, likely due to the poor performance of its wells. However, given that it locked in a huge loss in its sale of Fayetteville assets, I expect HK’s Fayetteville shale well EUR to be far lower then either of its two competitors. (More on HK’s sale later.) Based on information I found on the Arkansas Oil and Gas Commission’s website on 4/11/2011, there is strong evidence to suggest that CHK and SWN are overstating their EURs per Fayetteville well. Here are some of the highlights of my data mining efforts:

    Only 11 wells of the 3,110 wells drilled into the Fayetteville since 2005 have produced more than 2 bcf. In other words, slightly more than a third of one percent of all wells to date have produced more than 2 bcf.

    79 wells (2.5 percent) have produced more than 1.5 bcf

    1,552 wells (49.9 percent) have produced less than 500 mmcf of gas.”

    I am sorry but this is very specific information that is damaging to the shale gas story. It needs to be addressed with real production data that justifies the depletion and EUR estimates given by the companies. Unless the estimates are supportable the earning reports cannot be justified and the companies, or those that buy their properties, will have to write down the value of their reported assets some time in the future. Obviously if you have to amortize costs over 5 years rather than 20 years the reported profits will look very different and may actually turn out to be losses.

    And we cannot avoid the reserve booking issue. The SEC no longer requires that companies have test well data that uses flow rates to justify the booking of reserves. this leaves a lot of room for the most ‘optimistic’ and bold individuals to wind up making the calls and to see companies overstate reserves. Arthur Berman used the production data in the Barnett Shale area to question the company reserves. His analysis was showing XTO overstating reserves by around 125% or so while Encana and Chesapeake were overestimating their shale reserves by around 70% or so. As an investor that makes me quite worried and would like something better than opinion as a counter argument.

    These are serious issues and require serious analysis that goes back to the original per well production data, not opinion pieces by the companies or those analysts who have hyped the shale gas stocks.

  • Posted by Steve Rogers

    I find it fascinating that so few of the critics that cite the environmental impact of shale gas production are willing to compare those impacts with those of the oil-based fuels that gas has the potential to displace, at least partially. Of course there are environmental impacts from gas production, as there will be with any mode of energy production: there is no free lunch. Why not look at which fuels have lower comparative impact, both in production and across the production – consumption cycle?

    The difference, of course, is that the environmental impact of domestic production is here, and we see it, which makes it less acceptable to some than the far greater environmental impact of oil production in, say, Nigeria or Venezuela. As long as we insist on exporting environmental impact, we will have to import energy. Imported oil may not be a free lunch, but it’s an underpriced lunch for us, because the environmental impacts are borne by others.

  • Posted by Bill Wolfe

    I think you ignore the most important technical factor underlying the Ponzi scheme metaphor: decay curves for production.

    Driller get huge cash flow early, but step declines soon follow.

    To sustain the cash flow xpectations, more wells must be drilled.

    But the financing is mid to long term –

    The well production curves don’t meet the cash flow finance schedule.

    Vicious circle – more uneconomic wells to geenrate cash flow to feed the debt service.

  • Posted by Magic

    Hi there,

    That was an interesting read and admittedly I didn’t read all the comments yet as i working through them.

    Firstly I would like to say that i am from a drilling background, water wells, exploration and Directional Drilling.

    Now in answer to the title of your Article. I believe that Shale based Oil or Gas are both scams. Reason being is this.

    Shale oil – We will start with shale oil and the things that don’t seem to commonly known. Shale Oil has been in use for at least 100 years. The oil is extracted through a heating process whihc causes a de-polymerization of the molecules and in turn this is seen as a releases the oil. Non saying this it is not a replacement for all oils. It has not the same lubricating abilities as crude oil.
    So it is not a replacement to crude in the first place. It must be mined and heated also so basically it is like an open mine.

    Shale gas – Now here is another thing that they don’t tell you, A well is drilled pretty much in the same fashion as the Coal Bed Methane wells all good. The bit they miss out is that hydro-fracturing the seam is only to assist recovery of the gas first the gas must be released from the rock and that is done by injecting basically and acid like hydrochloric acid into the seams. It should be noted that only around 60% of that can be retrieved to be re-injected for further gas release. Does that sound good to anyone. In my career i have through thousands a dollars in hole but i never have injected acids and would refuse if someone asked me. Oil based drilling muds are bad enough.

    Not back to the Ponzi scheme thing.You shouldn’t believe that it is the drilling contractors that are running the ponzi scheme even if there is potential to do it.

    I believe the Ponzi scheme will start much higher up the chain such as the derivative markets by the greedy bankers. The same one who have stirred up the interest in something that is so environmentally challenged a 5 year old would not do this. Check out the real financial collapse that recently happened in 2008-9. If you believe it was due to the banks over lending money on houses alone then you don’t need to worry.If you understand that derivatives have a big part to play in that collapse then you will understand this point of view.

    As far as you imports go yes the US imports a lot of gas and oil. Canada however would be your biggest single supplier yet it is always portrayed as the middle east. this is a fallacy and i would suggest that people download OPEC’s oil reports whihc are readily available online.

    It is hard to explain all in one blog post. The thing is you can only believe what you are informed of. I bet most of your readers have no idea what it takes to recover the shale oil or gas. It is not a miracle free resource as the US gov is stating. It has dire consequences attached to its recovery.


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