Rational Investment Decisions: Shale Gas Not Over-Drilled

by Jim Smith|

The oil and gas industry has received a bad wrap about drilling for shale gas. Since late 2008, when prices collapsed owing to demand destruction from the economic crisis and an abundance of supply, prices of natural gas have remained low. From an all-time high of $14 per MCF (thousand cubic foot) they have fallen to under $3 today. Critics have charged that too many gas wells have been drilled given the low prices, and that the gas boom is unsustainable. SMU Cox Finance Professor James Smith's new research says the facts do not support that claim.

A key to understanding the drilling boom lies in the impact of a special provision that is common to most gas leases. Smith's research estimates that this "hold by production" (HBP) provision has played a vital role in setting the pace and scope of drilling, and simultaneously increased the value of typical shale gas leases in the U.S. by 25%-250% in recent years. He notes, "The provision appears very likely to have increased drilling in certain areas, but even more likely to have decreased drilling elsewhere." In fact, firms that drill for gas are making rational choices based on the leases that they hold. According to Smith, the Maguire Chair of Oil and Gas Management, their decisions about when to drill a well, and how many, are taken to increase shareholder value.

The drilling decision

The decision of where and when to drill a shale gas well is not so straightforward. Several factors influence the decision such as the depth of the well, its cost, the expected production volumes of the resource, and the terms of the lease, among others. All leases are set to expire after a fixed term, and drilling must take place before the lease expires. However, most leases in the U.S. include a specific provision (HBP) that gives the operator (drilling firm) the right to extend the term by completing a single well. If a firm has a lease in a gas-oriented basin like the Haynesville, where wells are deep and average costs to drill are high, the operator may drill what appears to be a money-losing, sub-economic well to "hold" the lease and thereby retain the right to future development when a better price incentivizes drilling more wells. Obviously this creates tension for the landowner who wants their royalty checks flowing in immediately.

The incentives created by the HBP option are fundamental to understanding the rate and pattern of drilling in U.S. shale gas plays. "It is clear why the operator initiates drilling the sub-marginal well," notes Smith. "They would not have drilled that well if it did not give them the right to hang on for a better tomorrow." And by drilling it, they contribute to the appearance of a drilling boom. But the HPB provision is a two-sided sword: it may increase drilling on certain sub-marginal leases but decrease drilling elsewhere. For example, once the firm has extended the lease by drilling a single well, the drilling of additional wells can (and sometimes will) be delayed. "If the operator thought that four wells would be required to exploit the leaseholding, the HPB provision may result in three of those being delayed. "These are wells you would drill, and eventually will drill, but they may be pushed back in anticipation of a brighter tomorrow. "

Adding value

Smith’s research indicates that there has been no over-drilling of shale gas wells and the wells that have been drilled tend to contribute to shareholder value. Smith says it's a rational investment decision by firms, and one that maximizes two things: shareholder value and resource value. "The operator's net profit for shareholders is maximized, and also the value of the resource owned by the landowner," he notes. Although the HBP provision sometimes creates friction between the two sides, Smith suggests there may be no real conflict of interest. The landowner, perhaps a rancher, has a mineral asset to be monetized by a lease; he wants the lease to include provisions that will maximize the value of that asset so he can obtain a better price. Smith says landowners need to be patient and vigilant in negotiating royalty rates - monitoring and enforcing the terms of the lease.

Given the low-priced gas environment where many wells appear to be "out-of-the-money," the findings indicate that these questionable wells are still wise and prudent investments. "This is because those wells permit firms to avoid relinquishing what still has a potential future value, whether in the Marcellus, Barnett, or Haynesville Basins —all of these leases have quite a bit of value because of the volatility of gas prices," Smith explains. "From the operator’s and owner’s point of view, that market value is going to be tapped sooner or later." Under the HBP provision, an operator is willing to eat the cost of one well to hold the lease, after which more will follow if and when the market justifies it, Smith concludes.

Smith's holistic analysis more accurately describes what is literally happening in the field.

The paper "The Option to Hold a Petroleum Lease by Production: A User’s Guide to the Shale Gas Drilling Boom" by James Smith, Maguire Chair of Oil and Gas Management, Cox School of Business, Southern Methodist University, is under review.

Written by Jennifer Warren.