Ponzi Baby Ponzi!
The March 15, 2012 issue of Rolling Stone features a story by Jeff Goodell called The Fracking Bubble (see #1) that documents numerous issues of interest to citizens and investors alike.
Everyone has seen the ads run by "America's Natural Gas Alliance" which present new technologies for natural gas drilling as the solution to America's problems... At least for the next 100 years.
This RS story sheds light on the man behind that "Alliance", Aubrey McClendon, the CEO of Chesapeake Energy, interestingly located in Oklahoma City and one of the firms profiting the most from the gas boom (no pun intended) in America.
There's certainly nothing wrong with a CEO talking his book and funding ads to sell his side of the story to the public. However, the RS article points out major problems with that story, many of which are already familiar to people who understand what fracking is and what it has done to water quality where it has been pursued.
But that's not what's interesting about the RS story. The real eye openers involve an analysis of how many of the firms in this modern "energy" industry are actually making money and what the real energy results are from the drilling.
ENERGY OR LAND?
Per the RS story, Chesapeake Energy is making the vast majority of its profits not from selling the oil and gas it drills, but from the process of flipping the land on which the wells are drilled while nailing down the rights to what's underneath. The RS story quotes a comment McClendon made on a call with Wall Street analysts a few years ago: I can assure you that buying leases for x and selling them for 5x or 10x is a lot more profitable than trying to produce gas at $5 or $6 per million cubic feet.
Virtually everyone except Mr. Short Term Memory can likely spot the problems likely to occur with a firm establishing a blizzard of paper partnerships funded with a blizzard of SIVs and similar financial wizardry that served us so well in the past decade.
REAL OR IMAGINED RESERVES?
A key selling point of the new horizontal drilling technology is that a single well on the surface can more economically drill in any direction underground, reducing up front expenses and reducing the financial risk of a "dry" well. It turns out there may be a strong need to be able to drill in "any direction" because the amount of oil and gas actually recoverable is turning out to be far less than the "100 years" amounts previously touted.
This is one area where the RS story crosses some wires. It cites a 70% reduction in reserve estimates issued by the DOE and a reduction from 100 years to 23 years by an industry trade group (the Potential Gas Committee or PGC) associated with the Colorado School of Mines. Actually, it was the US Geological Survey who announced an 80% drop in reserves in August 2011 and a sub-department of the Department of Energy called the Energy Information Administration (EIA) that announced the 23 year reserve estimate.
Despite those crossed wires, there are clearly multiple perspectives on the true reserves available. Who do you believe? Maybe talk to people with wells in their yard and flaming water in their faucet whose monthly production royalties have dropped from $1400 in 2008 to $70 in November 2011.
A SELF-INDUCED QUEEZE PLAY ON STEROIDS
Spiking oil prices and the desire to "do something" to "solve" our energy problem have now combined to produce a near optimal economic and political Petri dish for a new type of potentially colossal business failure. The RS story has drawn quite a bit of flack from the energy industry for its use of the dreaded "P" word (Ponzi) in conjunction with an explanation of two opposing economic pressures created by this model of exploiting shale gas reserves.
The story cites a crucial requirement that many parties leasing drilling rights to firms like Chesapeake attach to lease deals -- you have to drill on the land within 3-5 years of signing the lease. You can't simply lock up a bunch of leases all over to keep them out of the hands of competing energy producers (or competing speculators) then drill when you want or when market prices make it viable to do so.
When that requirement combines with the strategy of gobbling up huge swaths of land to flip to the next sucker, it "starts the meter" on when production must begin and produces a spike in land prices (an input) while accelerating the eventual delivery of gas (the output) which might flood the market, depress prices and destroy the viability of all those wells being drilled with borrowed money. Anyone remember what happened to Houston in the 1980s after the collapse in oil prices then?