Fracking and China’s quest for natural gas

You have probably seen the headlines on the natural gas accident in Pennsylvania. Chesapeake Energy, the largest natgas driller reported on Tuesday that one of its wells in Bradford County, Pennsylvania was uncontrollably spilling thousands of gallons of chemical-laced salt water into freshwater streams that ultimately feed into the Chesapeake Bay. Chesapeake Energy was using the controversial drilling method known as fracking which was examined in an Academy-Award nominated film Gasland. A Chesapeake spokesman said, "We have put all well completion operations on hold." But, scrutiny of the drilling practice is now heightened.

Andy Lees writes about this:

US inventories are down 9% y/y (+ 1.4% vs 5 year average). Chesapeake has halted all fracking operations in Pennsylvania after Tuesday’s blowout that spilt hydraulic fracturing fluid into the environment. This is in conjunction to the 6 month moratorium in Arkansas on drilling new injection wells after the series of earthquakes. It also follows the 11% fall in the US rotary rig count since September last year. Well productivity is still up 71% vs the average of 2007 or the first half of 2008 when the shale started to kick in but it is also down 24.5% since it peaked in November 2009.

We saw in February Chesapeake selling assets to raise USD5bn at a 17% discount to where they bought the assets only a few years earlier which led to its debt being put on +’ve watch by S&P. The sector is trying to run as fast as it can to service mountains of debt but the operating costs are rising with each successive fracture such that in February Lazards said "We believe 2011 will be the breaking point where producers run out of assets to sell to fund growth that is driven by spending 80% more than the discretionary cash flow. Natural gas E&Ps are running on borrowed time". Gas focussed E&P, necessary to maintain or grow reserves, are outstripping cash flow by 50%. Both gas and oil focussed E&P’s raised more than USD20bn in each of the past 2 years but this has been used to fuel their "excess spending".

This overhang should limit new exploration. With oil prices at exceedingly high levels, fuel switching should make natural gas poised for higher prices. Andy sees $6 per cubic meter as a reasonable medium term target. That represents at 36% premium to spot.

China, soon to be the world’s largest energy user ahead of the United States, is concerned about access to resources and is going full bore into fracking despite environmental concerns we see in the US. I should note that despite natural gas’ claim to being cleaner than oil or coal on which China is heavily dependent, there are the environmental concerns from greenhouse gases like methane and water contamination.

Reuters had a good report on the situation which I put in the links today. A key part of the report reads:

Once deemed too costly to extract, shale gas has turned around U.S. dependence on foreign gas imports. Just a few years ago, the United States was building scores of expensive facilities to import liquefied natural gas (LNG), looking at booming long-term demand forecasts and wondering which countries would supply the huge volume of imports it needed.

Instead, the United States is turning import facilities into export terminals, because its shale gas reserves are estimated to be big enough to meet domestic demand for 30 years. This is an American dream that China wants to emulate.

"America’s shale gas production alone has exceeded that of total Chinese gas output. That gives us a lot of confidence," said Zhang Dawei, deputy director of the Strategic Research Center for Oil and Gas in the Ministry of Land and Resources(MLR).

China’s confidence has been bolstered by a new report of its estimated reserves of shale gas, which shows them to be, by far, the largest in the world.

The U.S. Energy Information Agency in a report last month estimates China holds 36.1 trillion cubic meters (1,275 trillion cubic feet) of technically recoverable shale gas reserves — significantly higher than the 24.4 tcm (862 trillion cubic feet) in the United States, which has the second-most.

Industry estimates in China peg shale gas resources slightly lower — but still huge — at 26 trillion cubic meters (tcm), although they have yet to give their own forecasts of how much of that is recoverable.

The background to this is a recent report that state-owned Sinopec has halted the export out of China of refined oil because of increased domestic demand.

My takeaway is fourfold:

• China wants to continue its growth. Therefore, it will have to increase energy consumption and/or reduce its energy intensity. With reports of coal shortages rising, China is going to want to find other domestic sources of energy.
• Fossil fuels are not about to run out. However, their price is becoming more dear. In an environment of dwindling natural resources, that puts China at conflict with the United States, the world’s largest energy consumer, and other growing economies like India.
• Likely, China will be less concerned about domestic environmental factors than the US in its quest for resources.  That means it will turn to fracking, nuclear, and continue heavy coal use. But, ultimately, the US and China will look to lock up contracts with third parties in Latin America and Africa to ensure energy supplies.
• That is where conflict will arise. How intense any conflict will be depends on how quickly world oil supplies decline.