Shale Gas – The game changer

It should have been a time to reflect, but Mukesh

Ambani wanted to paint the future. It was October
2009. Earlier that year, Reliance Industries had
commissioned India’s largest oil refinery at
Jamnagar and had started pumping natural gas
from the Krishna-Godavari basin, but the chairman
was looking ahead. He sunk into the sofa in his
fourth-floor office at Maker Chambers IV in
downtown Mumbai, and drew the contours of the
next big thing for Reliance, one that would catapult it to the next level in the energy
space.

“It has to be non-conventional and green. It has to be commercial and outside India,”
he had told ET then during a 90-minute conversation.

Over the past five months, Reliance has articulated Ambani’s vision through a blitz of
buys in shale gas — the newest form of natural gas that is gaining currency. The
company has spent $2 billion, in three acquisitions, to buy fields of shale gas in the US.
In terms of cost per acre, the last of the three deals was the priciest shale-gas deal
struck there.

Shale gas is the future, agrees David Morrison, chairman,

Wood Mackenzie, an Edinburgh-based research and
consultancy in energy, mines and metals. “It’s a game
changer that has caught most markets by surprise,” he said
while speaking at the Asian gas summit in the capital in
March. “We do our projections for 5-10 years, but the
growth of shale gas could throw even the best of
projections out of gear.”

The size of global shale-gas reserves is not known. Potentially, every rock formation,
above and under the ground, can have shale gas, but only the US has really tapped this
resource. China is said to have the second largest deposits of shale, after the US.
Geologists have also identified deposits in Poland and Australia. Elsewhere, including
India, the work has barely begun. But, says a senior Reliance official: “As a natural
resource, it is more democratic and is found in several countries.”
It’s why, in the decades to come, shale gas can affect countries, companies and
consumers. It can alter the energy consumption-patterns of economies: how much oil
and how much gas? In 2009, shale gas accounted for 13% of US energy consumption;
this is projected to increase to 25-30% in three years. It can change their energy
production-patterns: how much tapped at home and how much imported? It can trim
the clout of oligarchic oil producers by being a natural counter to rising oil prices.

About the time that Ambani was plotting his move into shale gas, in the Qatar capital of
Doha, another man was pondering the business strategy of the oil and gas state.
Abdullah Bin Hamad Al-Attiyah has been the Qatar minister of energy and industry since
1992 and its deputy prime minister since 2007. It was under his watch that Qatar
became the second largest producer of natural gas in the world, after Russia.

Qatar has invested about $90 billion in natural gas: on drilling equipment, on ships that
transport gas in liquid form (liquefied natural gas, or LNG), and on plants in other
countries that convert that liquid gas back into gaseous form. Its production capacity of
gas is projected to increase to 77 million tonnes per year in 2011, against 22 million
tonnes in 2004. With every expansion of shale gas, a substitute for LNG, Doha is staring
at a lower return on its $90 billion investment.

Al-Attiyah’s gas strategy was oriented around selling to the two big markets: US and
Europe. So, Qatar invested $3.5 billion on 35 ships to ferry gas to these two markets.
Its two LNG companies, Rasgas and Qatar Petroleum, invested another $6-7 billion in
re-gasification projects in Europe and US. These remain big gas markets, but their need
for natural gas from Qatar is reducing.

In the US, shale gas is the spoiler. The US is beginning to replace LNG with shale gas,
which it has plenty of. In Europe, the drop in demand is primarily due to Russia and
Algeria increasing supplies to Spain and Italy. Gazprom (the Russian gas company) has
a pipeline to Europe, while Qatar has to move gas via ships, increasing its cost.

Qatar’s dominant position in natural gas is being challenged, bit by bit. Al-Attiyah is
being forced to do things he doesn’t want to. He is diverting some LNG ships meant for
the US and Europe to Japan, South Korea and China. Or, at times, he is dumping LNG
into the spot market. Or, at times, he is simply sitting tight. “The situation is such now
that Qatar is being forced to hold some of its LNG in ships,” says P Dasgupta, former
CEO of Petronet LNG , India’s largest LNG company, who heads ArcelorMittal’s power
venture in India and tracks the gas economy closely.

Qatar has deep pockets and a low cost of production due to its location. Says Dasgupta:
“While oil wells in the Gulf of Mexico are found at a depth of 2,500 metres, in Qatar, it’s
just 90 metres.” Yet, it has temporarily stopped production at some wells, lowering its
peak capacity to 52 million tonnes, against 77 million tonnes previously. Qatar is waiting
for the needle of demand and prices to turn its way.
It might turn out to be a long, even futile, wait. At Henry Hub, where US gas prices are
set, gas is at $3-4 per mmbtu (million metric British thermal unit) — a far cry from the
$10-12 in 2007-08. The fall is due to energy prices cooling off, the economic slowdown
and the spurt in gas finds and production, especially shale, in US and Europe. According
to the latest edition of the BP Statistical Review, between 2004 and 2009, global gas
production increased by 14%, against 3% in crude. “The glut in the gas market is here
to stay,” says Morrison.

Till early-2009, prices of crude oil and natural gas moved in tandem, irrespective of
differences in demand-supply fundamentals. With growing supply of gas, such price
behaviour is in for a change. Even as crude has bounced back to $75-80 a barrel, gas
prices remain soft (See graphic: Growing Apart). “The decoupling of the crude oil and
gas market is here to stay,” says BC Tripathi, chairman of GAIL India , India’s nodal gas
pipeline company.

This has major implications on how countries meet their energy needs and how much
they pay, more so since oil and gas is a major cost head for economies. Most gas
guzzling countries — US and Europe, and now, China, India, Japan and South Korea —
have relatively low reserves of their own and depend on imports.

In most applications where oil is used, gas is being substituted. For instance, in
automobiles, CNG (compressed natural gas) is replacing petrol and diesel. In industries
like petrochemicals, power and fertilisers, gas is replacing oil-based naphtha as the
feedstock.

The share of gas in India’s energy consumption is 10-12%; this is expected to increase
to 25% by 2020. A lot of the incremental gas will come from Reliance’s fields in the
Krishna-Godavari basin. “It will reduce India’s oil import bill by 10%, or $9 billion a
year, during peak production, at current prices,” former secretary RS Pandey had said
in Ap RIL 2009, when Reliance commissioned its KG basin gas project.

Increasingly, prices will be determined by the complex interplay of the two resources.
The greater demand for gas, some of which will come at the expense of oil, will counter
inflationary tendencies in oil prices. Yet, oil prices are unlikely to crash, as oil itself is
becoming elusive. Companies, increasingly, have to go far into the sea and drill deep
for oil. This increases their complexity of operations and cost of production, and sets a
floor for oil prices.

Into all this comes shale gas. If it does turn to be the ‘democratic resource’ it is thought
to be, it can do wonders for the energy self-sufficiency of economies. Given its higher
cost of production — $2.5-3 per mmbtu, against $1-1.5 per mmbtu for conventional gas
found on land — the price of shale gas will be attractive to consumers only if it is not
transported long distances or, worse, liquefied. That calls for a sweeping pipeline
infrastructure, which India presently does not have.
The US, by comparison, has gas pipes covering almost every part of the country. With
shale gas finding viability and gaining momentum, Big Oil – notably, British Petroleum,
ExxonMobil and Shell — is moving in to grab the baton from the small early-birds. In
the US, shale gas goes back to the early-eighties, when it was the preserve of small,
niche players like Cheasapake, Pioneer and Atlas, who were referred to as ‘super-
independents’. Shale gas was first produced in the US in 1989.

Big Oil started getting interested in early-2000, when it started becoming clear that the
era of easy oil was over and non-conventional fuels would be the future. They have
been buying super-independents, who are increasingly finding it difficult to raise capital
to expand, and so are either selling stakes or selling out. With a difference: they, not
Big Oil, are the ones driving a hard bargain.

In December 2009, Exxon paid $42 billion to buy XTO, a shale gas operator. “The price
was stiff,” says RS Butola, managing director of ONGC Videsh, the overseas investment
arm of ONGC. “Exxon has always believed they are the best, but they knew what XTO
was offering.” Today, ExxonMobil is the world’s largest producer of shale gas.

Today, 48 of the 50 states in the US have reserves of shale, the exploration and
production of which has become a mainstream activity there. Rick Bott, chief operating
officer of Cairn India , was at Devon, a shale gas producer in the US. “The US
government took some key decisions in the early years, which helped commercialise
shale,” says Bott. It promoted competition by deregulating gas markets, it provided
generous tax credits for geological and technology efforts. “The idea was to establish a
feasible technology and the government went all out to promote such efforts,” he adds.

The breakthrough came when ‘horizontal drilling’ was established as a commercially

feasible technology. In conventional gas fields, one drills vertically, into the ground. In
shale fields, which are essentially tight rock formations, the drill first goes down and
then sideways, along with water sprays. Shale gas is found in tight reservoirs that have
poor permeability. “It is like sourcing the gas from the kitchen itself,” says Butola.

But shale throws up its unique challenges. Butola says shale producers need to have a
“manufacturer’s mindset”. In conventional gas, one can dig a well and cap it for later
extraction. Shale gas requires large number of wells as the volume per well is small.
Further, the wells have to be drilled in quick succession to maintain continuous
production. One also has to dig deeper in shale – 8,000-12,000 feet, compared to
3,000-5,000 feet for conventional gas.

After all this, the success rate is not too great. In a paper by John D Wright of Norwest
Corporation titled ‘Economic Evolution of Shale Gas Reserves’, 226 of the 389 wells
(69%) studied for this paper generated an internal rate of return (IRR) of less than
10%.

That, in a sense, captures the challenges that shale gas presents. Many aspects of it are
still a work-in-progress in their early stages. Expertise is not widely shared. It’s why
Reliance, a newcomer to shale, has chosen to buy large stakes in fields in the US. It
pumps in the cash, but leaves the running to its US partner and watches from up close.
“We have to acquire the technological edge, which we can then bring back to India,”
says PMS Prasad, an oil sector veteran and a director on RIL board.

The rush by Reliance to corner shale resources shows a keenness to strike early, more
so when it has abundant cash and gas prices are low. Says Prasad: “Even as we
consolidate in conventional sources, we have to move into new areas. Shale gas is one
such area that will give us the technological edge if we move in fast.” If the shale story
unfolds the way Reliance is seeing it, and early evidence suggests it might, the energy
landscape will never be the same again.