The Problem of Price

From the moment the rush began to develop the vast untapped resources of gas trapped in the Marcellus Shale, economists and industry analysts warned that the massive explosion of cash that was pouring into the state—and in many cases right back out of it—would ebb and flow.

There would be times of expansion, when drillers would slather billions across the state, boosting regional economies, lifting the state’s tax revenues, and creating ancillary opportunities in industries both directly and indirectly involved in the business of exploiting shale gas. Boom times, they called them. But it is part of the cyclical nature of the gas business that lean times follow the fat, and there is little doubt that, at the moment, the state of Pennsylvania is staring down the barrel of what most analysts and industry officials agree is a deep and potentially long-lasting period of comparatively weak growth in the natural gas industry.

To a great degree, most analysts agree, the success of the Marcellus and other shale plays across the country are as much to blame for the current gas industry downturn as any other factor.

Advances in the combined techniques of hydraulic fracturing—the process used to blast open the rock that holds the natural gas—and horizontal drilling, and an improved understanding of how best to identify the richest deposits of natural gas, have flooded the market with natural gas. The supply is outstripping our ability to use it. Add to that the unseasonably warm winter of 2011–2012, and the conditions were ripe to drive the price of natural gas down to 10-year lows, about $2.15 per thousand cubic feet in April, with many analysts predicting that it could drop even lower.

As a result, over the past several months, some of the industry’s biggest players have begun to cut back operations. That reduction has not been as dramatic as it could be. Drillers in some areas have continued operating despite the low prices, in part because they have to or else the leases they hold will expire; and work is continuing on the infrastructure the industry will need to have in place when the downturn ends. But still, there has been a measurable effect from falling gas prices.

Talisman Energy, for example, has decided to trim its spending in the Marcellus by half a billion dollars for 2012—11 percent less than the company shelled out in 2011—reducing its rig count from 11 to seven this year. Chesapeake Energy, one of the largest leaseholders in the Marcellus, also plans to reduce its rig count by two-thirds across the U.S., from 75 to 24 by the second quarter of this year, with 12 of those rigs operating in the Marcellus.

Chesapeake also said it would cut back its production from dry gas wells by 8 percent. Like many in the industry, Chesapeake is shifting its attention to liquid-rich regions, including the western part of the Marcellus and the oil- and liquid-rich Utica Shale, which has begun to lure drillers across the border into neighboring Ohio.

There, the big prize is oil; geologists believe vast amounts of the stuff may be trapped in the Utica Shale, along with natural gas and natural gas liquids that can be stripped off and sold separately for a variety of uses, including the manufacture of plastics. That potential has attracted some investment. Earlier this year, Shell Oil Company announced that it plans to build a multibillion dollar ethylene cracker plant to refine natural gas liquids in Beaver County. The plant, still in the planning stages, is anticipated to create as many as 10,000 construction jobs. It’s still years from becoming a reality, but it does demonstrate the rising stock the industry is putting on the long-term prospects of the wet gas regions.

In fact, some in the industry are, at least at the moment, staking their future on wet gas.

Range Resources is a case in point. Range saw the handwriting on the wall more than a year ago. It predicted the fall in natural gas prices, anticipated that the so-called wet gas would throw it a lifeline, and changed its strategy accordingly, said company spokesman Matt Pitzarella.

“One of the core things we talk about this year is this idea of us being at an inflection point of sorts. If you think about it, everyone else for the last four to six months has been saying we’ve got to move out of dry gas for the time being. Really, our inflection point came last year. We started the sale of our Barnett Shale properties more than a year ago, and those were sold for a billion dollars. That was a huge deal for us because that was the largest asset in our company’s portfolio. We did that so that we could reinvest all that money.”

Range doubled down on its bet on the western edge of the Marcellus, an area that, while it may not produce the biggest shows of natural gas, does produce the wettest. “We always said the biggest gas wells aren’t going to be in southwest Pennsylvania; but we felt like this was the most economic place for us to be.”

At the moment, he said, that bet seems to be paying off for Range. “Our revenue, more than 50 percent of it comes from natural gas liquids, condensate and a little bit of oil, because we are in some oil plays. You just have to do that to make money.”

But those who don’t enjoy the luxury of being able to place all their chips on the wet gas regions of southwestern Pennsylvania are facing an economic headwind.

“The lower the price, the less it will be worth to market the gas out of the ground,” said Diana Furchtgott-Roth, an economist with the conservative Manhattan Institute. “Some major companies have already decreased their natural gas production,” she said, particularly in those areas in the northern and eastern parts of the Marcellus.

In Tioga County, for example, those landowners who were hoping to reap the benefits of royalty checks or lease payments are feeling the pinch, said Jackie Root of the Pennsylvania chapter of the National Association of Royalty Owners.

“Certainly, if you’ve got a well in production, the depressed prices are not a good thing because once your gas is produced it’s gone, and it’s producing at the low price,” said Root, who owns 400 acres that are leased and held by production. The downturn has also dramatically curtailed leasing activity, she said. “Lease-wise, the downturn has caused companies to pretty much stop leasing other than where they need to fill in units.”

And while no one knows for sure how long the economic dry spell in much of the state will last, it is likely that the ratcheting-down of activity in the dry gas areas of the Marcellus will continue through the end of the year, probably through 2013 and perhaps into 2014, most economists and industry analysts say. As Tim Kelsey, a professor of rural economics at Penn State who has been studying the Marcellus for years, put it, “This downturn is perhaps not permanent but it very likely will be much longer-term than what we’ve experienced in the past.”

For the moment it seems as if other pressures on the drillers have softened the most severe impacts of the historic low price of natural gas. Even in those regions of the state where there aren’t enough liquids in the gas which the drillers could strip off and sell to compensate for low natural gas prices, many drillers are still contractually obligated to drill vast swaths of acreage within the next year or two or risk having their leases expire. And there is still a great deal of money being spent to develop the infrastructure needed to ship that gas to market.

But with so much of it headed to market—even the most conservative estimates are that the Marcellus contains a 30-year supply of gas at current consumption rates—analysts are starting to predict that natural gas prices could drop even further, perhaps to $1.50 per thousand cubic feet this year, before rebounding.

It is difficult to gauge precisely the effect that reduced gas-related activity is having on state tax revenues. But there are indications across the board that state tax revenues are falling below expectations—for the gas industry and the broader economy. In all categories—gas-related or not—state tax collections for the first seven months of the fiscal year (July 1 to Feb. 29) totaled $15.5 billion. That’s about three percent ($481.6 million) below estimates.

Sales tax figures for all business and enterprises in the state are still 0.6 percent above expectations for the first seven months of the fiscal year. However, the state’s sales tax collections in February dipped below estimates. The $623.7 million collected in February is $6.5 million lower than state Department of Revenue estimates and down dramatically from the $807.5 million collected in January. By comparison, in January and February, the gas industry generated $7.1 million in sales tax revenue.

The state’s overall personal income tax revenue in February 2012 totaled $812.2 million, down from an already disappointing $1.1 billion in January. That brings the total for the fiscal year for all personal income tax revenue so far to $6.5 billion. That’s $175.3 million or 2.6 percent below estimates for the fiscal year, the department reported.

Corporate net income tax revenue for gas-related activities is down—and dramatically so compared with 2011. In January and February, the state collected just $4.6 million in gas-related corporate net income tax revenue. By comparison, for all of 2011, gas-related activities brought the state $275.8 million in corporate net income tax revenue. Across all industries in February, the state collected $64.2 million in corporate net income tax revenues—about 17.8 percent ($9.7 million) below estimates.

While state officials caution that those numbers are a snapshot in time and are likely to change as the year progresses, they give a glimpse into what appears to be the initial impact of plummeting gas prices and reduced drilling activity in much of the Marcellus.

The state and many county governments have signed on to accept the controversial impact fee that will be paid by Marcellus drillers, with 60 percent going to participating counties and 40 percent retained by the state. Those counties and the state should feel less of a bite when that money is collected in September. The Pennsylvania Board of Public Utilities, which administers the program, expects to collect $180 million this year. But that’s based on a fee of $50,000 for every horizontal well drilled, a fee that is linked to the price of natural gas. For this year, the state based its fee schedule on a price of $4.01 per thousand cubic feet; a figure about 40 percent higher than the $2.36 natural gas was selling for in March. But next year, it could a different matter. While 729 wells were given permits in the first three months of the year, that’s more than 10 percent fewer Marcellus wells than the 823 permitted during the same period in 2011. With drillers shelling out $6 million on average to drill a well, that’s more than half a billion dollars that will not be finding its way into the national and regional economy.

If, as expected, drilling remains slow and gas prices continue to remain low, and perhaps drop further, that per-well fee would decline next year right along with them. If gas remains at its current price, the fee would be reduced by 10 percent for every well drilled, and if it stays below $2.25, that fee would drop to $40,000 for each new well. And by law, the amount paid per well declines each year it is in operation, so a well that is started this year would be assessed a fee of $45,000, which would drop to $35,000 next year, assuming prices remained steady, $30,000 the year after that, and then $15,000 through year 10, dropping to $5,000 for the next five years. Those fees could rise somewhat if natural gas prices increase, but in the charts the utilities board provides, the most optimistic scenario provides for gas at $4.99 per thousand cubic feet—a sign that few expect gas prices to rise significantly at any time in the near future.

For its part, the industry contends that the unusually low gas prices that have clouded the state’s economic forecast have something of a silver lining. Those low prices, together with a drive by federal regulators to reduce emissions from coal-fired power plants, have expanded the use of natural gas as the fuel of choice for electrical generation; nationally, the share of electricity generated using natural gas increased by 22.5 percent in the past year, according to the federal Energy Information Agency, while coal’s share of the market dropped by a comparable amount.

But few analysts believe that the production of electricity alone will create enough of a spark to blast the sagging natural gas prices out of the doldrums.

“Energy markets are by their nature boom-bust markets. And there are so many different phenomena that can impact supply-and-demand conditions and, more importantly, speculation in the market,” said Dr. Ray Perryman, a Texas-based economist who has spent his career studying the cycles of the oil and gas industries. “The perceived supply is extremely high right now, and the fact is that the various ways we could use it in an environmentally sensitive manner are by and large left undeveloped. I mean, utilities are not going to use that much, really.”

If the state has, as it appears, been spared the worst effect of the typical boom-and-bust cycle this time, thanks in part to the drive to develop those leases that drillers need to develop in the next few years because of their contractual obligations and the drive to develop the infrastructure required to support the industry, there’s no guarantee that we will be as lucky next time, economists say.

“I’m not sure there’s anything you can do in terms of ameliorating these cycles,” said Perryman. “In terms of creating a permanently higher demand for natural gas—obviously it’s going

to take a lot of investment but moving toward using it for more things.”

To some degree the drillers and their related industries already recognize that challenge and are taking steps to face it, says Kathryn Klaber, executive director of the Marcellus Shale Coalition, an organization that represents many of the key players in the natural gas business in the region. “I believe a lot of companies are still moving forward… the technological change has created a whole different set of rules. And those rules are affecting the downstream options for using this fuel…. Electricity generation is affected, manufacturing is affected, the whole petrochemical industry is affected, and we’re seeing some pretty swift transportation changes that literally didn’t seem so likely to happen so quickly.”

But the unprecedented low price for natural gas has also created a powerful temptation among many in the industry to cast covetous glances at the markets in Asia—in places like Japan where gas was hovering around the $14 mark this spring— and in Europe, where $13 per thousand cubic feet is common. Energy analysts and industry officials contend that up to 10 percent of America’s natural gas reserves could be shipped overseas. While that is not yet technically feasible—the U.S. does not yet have the infrastructure to liquefy vast amounts of gas for intercontinental shipment, and the arduous regulatory process just to get that ball rolling takes years—a number of proposals are on the table.

In the short run, says Furchtgott-Roth of the Manhattan Institute, the drive to develop export capacity could benefit the industry by helping to bolster the confidence of commodity brokers and drive up the price of natural gas, if only slightly. “It’s expectations about the future that drive the current price,” she said.

But there are economists who warn that too much focus on export could actually undermine the industry’s long-term prospects. In fact there is good reason to suspect that those high overseas prices that seem so alluring to U.S. drillers now might not be there when Marcellus and other U.S. shale gas is finally able to be transported in quantity.

Over the past several years, major multinational corporations such as Shell, and foreign-held companies such as Norway’s Statoil Hydro, have bought significant stakes in American shale plays, not necessarily to get the gas, but to get the technology and know-how to exploit the vast resources in large shale plays around the world. In other words, they may well have their own gas in the future and won’t need ours. If that happens, the glut, which is now a purely domestic phenomenon, could be worldwide.

As Penn State economist Tim Kelsey puts it, there is a serious risk that the industry and its supporters may focus the bulk of their attention in coming years to developing the export infrastructure in pursuit of big bucks that may not be there when they’re finished, while neglecting the development of the infrastructure here that would expand the market for national gas and thus drive up demand and prices.

And even if the overseas market does remain lucrative, Kelsey says, too much focus on export and not enough on domestic consumption could limit the amount of economic benefit that the state, the region or the nation could derive from the Marcellus and other shale plays.

“When I do presentations I use a farming analogy: corn flakes and corn,” Kelsey says. “The dollars in agriculture are not in the farmer growing the corn, it’s in Kellogg’s taking that corn from the farmer and converting it into corn flakes. The dollar amount going to the farmer is a very small share. Gas is the same thing. If we’re in Pennsylvania focusing on taking it out of the ground and selling it to New York, New Jersey or Tokyo, we’re getting some dollars, but that’s not where the value added is—it’s not where the big dollars are. That’s in fashioning the other use of gas. And to the extent that we can capture users of that gas, that’s where the big economic impacts are going to be.”

For now, the lure of the potential profits in the wet gas regions of the Marcellus and the residual activity in the dry gas regions—the slower but still-continuing development of leased land and infrastructure—has softened the blow of the collapse in natural gas prices, Kelsey said. It has built a kind of “bridge” over the worst effects of the downturn this time. The question is, he says, are we doing all we can to make sure that it’s not a bridge to nowhere?

“It’s a bridge, but on the other side it’s not just that $14 gas might not be $14 when we get there; we’re also focusing on the wrong thing. We’re focusing on pulling the gas out of the ground and selling it for the highest prices, versus let’s pull the gas out of the ground and find other kinds of economic activity that gas can help spur here in the commonwealth.”