(Editor’s note: This is the first of two parts, the second to be published in the P&GJ November edition.)
Ten years after the shale revolution first took off in the North Texas Barnett Shale formation, large-scale shale development primarily remains a phenomenon unique to the United States.
This has many U.S. and foreign companies, investors and policymakers asking a lot of questions about the American experience with shale development. What made the U.S. shale revolution possible? How did it accelerate so quickly? Is it replicable elsewhere in the world?
Before making any predictions regarding the future, it is necessary to first examine the factors that enabled the unparalleled success of the shale revolution in the U.S. The explanation for the U.S.’s experience is more complex than the presence of available or easily accessible shale resources. In fact, in June, the U.S. Energy Information Administration (EIA) estimated that only 9.1% of total worldwide technically recoverable shale gas resources and only 16.8% of total worldwide technically recoverable “tight oil” resources (crude oil embedded in low-permeable sandstone, carbonate, and shale formations) are located inside the U.S.
While numerous factors influenced shale development in the U.S. and around the world, in our view, the five most responsible for the shale revolution are: (1) a legal framework that encourages technological innovation and development; (2) the innovative and entrepreneurial players involved in the U.S. oil and gas industry; (3) the presence of favorable market forces; (4) the American system of private mineral ownership; and (5) a judicial and regulatory system that, while not perfect, provides certainty and has not yet made shale development cost-prohibitive.
Positive Legal Framework
Many people, both in the U.S. and abroad, do not realize the U.S. shale revolution was essentially a technological revolution. Like the effects of other “disruptive” technological advances throughout history, the shale revolution started small, expanded rapidly and ended up changing what we thought we knew about energy production.
Surprising to many people is how humble the origins of the U.S. shale revolution are. For decades, geologists in the industry knew where shale formations were and that they contained vast amounts of natural gas and other hydrocarbons. The problem was not locating the shale; the problem was finding a way to extract hydrocarbons trapped in the dense lateral (horizontal) shale formations that were buried thousands of feet beneath the surface. With seemingly insurmountable technical barriers, the industry essentially ignored shale for the life span of the industry.
That all changed in the late 1990s. Mitchell Energy, a relatively small, independent Texas exploration and production company (led by the legendary wildcatter, George P. Mitchell), did what nearly everyone at the time thought was impossible – it developed a way to economically tap into the natural gas-rich Barnett Shale in North Texas. The game-changing moment occurred when Mitchell Energy successfully pioneered a multistage “slickwater” hydraulic fracturing process and paired it with horizontal drilling technology.
The pairing of these two advanced technologies made the commercial exploitation of shale plays possible for the first time. In the following years, American energy companies advanced the technology further, adapting it to the unique geologies of numerous shale plays across the U.S. In fact, between 2003-2012, energy companies drilled 102,264 horizontal wells, including an estimated 45,500 in 2012 alone.
In terms of production, these advanced technologies have pushed annual U.S. natural gas production from 24.2 Tcf in 2000 to 29.8 Tcf in 2012. During that same time period, natural gas produced from shale grew from only 2% of total U.S. natural gas production to 35%. Moreover, shale gas production is expected to grow by over 113% between 2011-2040. At this rate, domestic natural gas production will outpace domestic consumption by 2020. Today, conservative estimates have the U.S. technically recoverable natural gas supply at more than 90 years with some estimates claiming the U.S. has enough gas to last more than 200 years.
In addition to shale gas production, advanced hydraulic fracturing and horizontal drilling technologies have led to a 43% increase in U.S. oil production since 2008 to 6.5 MMbopd. The EIA estimates tight oil production will exceed 2.5 MMbopd in 2013. As a result of rising tight oil production, some experts assert total U.S. crude oil production could eventually reach 10 MMbopd (by comparison, Saudi Arabia produced 9.8 MMbopd in 2012).
The total economic impact attributable to the shale development in the U.S. has been substantial. A recent report by McKinsey & Company suggests the shale revolution could boost the country’s GDP 2-4% a year, or as much as $690 billion annually, thus creating up to 1.7 million jobs by 2020.
What ultimately made the development and adoption of these advanced hydraulic fracturing and horizontal drilling technologies possible was a legal and regulatory framework that encourages private innovation, experimentation and risk-taking. Additionally, clearly defined and enforceable patent and intellectual property protection laws have ensured that investors who take risks on new technologies can enjoy the economic fruits of their ingenuity, which in turn helps the market keeps innovating.
Among the top concerns cited by U.S. companies operating abroad is the lack of clearly defined and enforceable patent and intellectual property protection laws. Schlumberger and Halliburton, leaders in U.S. oil field services market, have repeatedly voiced this concern about operating in China. The stakes are high. The development of technologies that make production – even marginally – more efficient on a well can confer a distinct market advantage worth millions or even billions.
The U.S. is unique in that it has a robust, highly diversified and competitive oil and gas industry with thousands of different market players, big and small, active in the upstream, midstream and downstream sectors. Of all the players in the oil and gas industry, entrepreneurial independent exploration and production companies and oilfield service companies deserve the most credit for driving the shale revolution.
These are the companies that made big bets on shale early on and have been the primary drivers of the innovations responsible for bringing down production costs and improving ultimate recovery for unconventional wells. While all of the major international oil and gas companies, such as ExxonMobil and Chevron, now have assets in the U.S. shale plays, they have acquired these assets largely through purchase. For example, ExxonMobil acquired XTO Energy, a Texas independent producer active in the Barnett Shale, for $41 billion in 2010.
Overseas, the oil and gas industry is not as highly diversified or competitive. National oil companies (NOCs) dominate exploration and production around the rest of the world, controlling 85% of world reserves and 55% of its production in 2010, according to the EIA. International oil companies (IOCs) are involved, to varying degrees, in exploration and production overseas; however, their equity access is generally limited.
In many places, the NOC have sole access to reserves, no foreign ownership of hydrocarbon resources is permitted, and if there is any outside participation by an IOC, that involvement is limited to operation through a domestic affiliate – examples include Mexico, Saudi Arabia and Iran.
In some other large oil-producing countries, NOCs are given priority access. While IOCs generally have some equity access to the country’s petroleum resources, that access is often limited through minimum domestic ownership requirements or shared production with the NOC – examples include China, Russia and Angola. Without ownership rights, many private companies simply lack the financial incentive to participate. Even in places where competition is allowed, such as most of Europe, the barriers to entry remain high, and the oil and gas industry is dominated by a limited number of large international oil and gas companies.
Another significant obstacle to increased shale development is that most NOCs have limited experience in developing unconventional shale resources, although this appears to be changing in some places. NOCs tend to be more risk averse and, to date, have been hesitant about investing in unproven shale formations. In some countries, NOCs have a monopoly on the exploitation of all hydrocarbons. As a result, there is less competitive pressure to be the first to develop the resources. Many NOCs have adopted a “wait-and-see” approach.
Another obstacle is that some state-owned energy companies do not have the same incentives to develop their shale resources. Gazprom, for example, reiterated that it has no plans to develop shale gas for at least 10 years due, in part, to the size of Russia’s conventional natural gas reserves.
The knowledge and experience necessary to exploit shale resources is centered in the U.S. To evaluate whether the shale revolution can go global, the question remains: What incentives exist to convince the independent producers and service companies – the companies that drove the shale revolution in the U.S. – to take their knowledge and experience abroad?
Developing shale and other onshore unconventional formations involves considerably higher production costs and more risk than developing conventional oil and gas resources. On the high end, the cost to drill and complete an unconventional well averages $10 million in North Dakota’s oil-bearing Bakken Shale, while on the low end, the cost averages $3 million in the natural gas-rich Barnett Shale. A $7.7 million well in the Marcellus Shale, for example, has the following production costs:
• Land acquisition and leasing: $2.1 million
• Permitting: $10,000
• Vertical drilling: $663,000
• Horizontal drilling: $1.2 million
• Hydraulic fracturing: $2.5 million
• Completion: $200,000
• Production to gathering: $472,000
Because the cost for unconventional wells is comparatively higher and the margin is lower, the success of shale exploitation rests, in large part, on keeping the various costs of production low.
Shale development overseas has been negatively affected by comparatively higher production costs and uncertainty about the market for produced oil and gas. Outside the U.S., there are several forces affecting the cost of production, including:
• Limited availability of experienced management teams, drilling crews, petroleum engineers and geologists.
• Limited availability of drilling and completion equipment, particularly drilling with active drilling rigs standing at: U.S., 1,776; Latin America, 423; Asia, 639; Europe, 138.
• Lack of a well-established supply chain for parts and equipment.
• Limited access to capital markets, important for raising capital and providing exit strategies.
• Limited tools for hedging risk.
• Challenging tax burden (VAT, corporate income tax, resource tax, royalties).
• Limited availability of geologic information.
• Lack of access to sufficient water supplies – an unconventional well typically requires several million gallons of water; limited access to water has been a particularly significant obstacle to large-scale shale development in parts of China.
• Limited transportation infrastructure and high treatment costs.
As an example, despite lower labor costs, Apache has found it to be twice as expensive to drill an unconventional well in Argentina as in the U.S., and four times as expensive to fracture it.
Once produced, oil and gas has to be transported to a place where it can be refined or treated and then sold. The U.S. has the most developed and interconnected pipeline network in the world as well as an extensive interstate highway system and rail network.
Dallas Parker is a partner in Mayer Brown’s Houston office and is co-head of the firm’s Global Oil and Gas Practice Group. He represents U.S. and other clients in corporate and securities law matters, with extensive experience in the areas of mergers, acquisitions, dispositions and public and private offerings of securities. He earned his law degree from University of Texas School of Law and his bachelor’s degree from Vanderbilt University.
John D. Furlow is an associate in Mayer Brown’s Global Oil and Gas Practice Group in the Houston office. He earned his law degree from University of Texas School of Law and his bachelor’s degree from Vanderbilt University.