Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.
This piece provides a brief discussion about the shale gas industry and how investors can seek to gain exposure to a theme that we only expect to grow in importance.
To the untrained ear or for the reader unaccustomed to our series of occasional thematic pieces, the term fracking sounds distinctly unedifying and perhaps even a little impolite. However, hydraulic fracturing – to give it its full term rather than its more memorable, but less appealing abbreviation – is a major development occurring in the energy industry globally, even here in the UK close to the seaside resort of Blackpool. If, as is often suggested, fracking can help mitigate potential energy demand: supply imbalances, then it is a topic that clearly matters both for players in the energy industry and for equity investors.
It is well-understood that the world’s energy needs are increasing, driven both by population change and industrialisation, particularly in emerging economies. Global energy major, Shell, for example, predicts that worldwide energy demands will rise by two-thirds between now and 2050. At the same time, several other factors are influencing the equation: first, there is a declining supply of conventional energy sources (think oil, coal); second, countries are increasingly seeking ‘energy independence,’ rebalancing towards domestic sources of supply wherever possible; and, third, environmental concerns are re-orienting energy debates towards greener sources of power.
For many, gas – in its various forms – provides the answers to several of these conundrums, and it was a topic we first discussed in April’s piece on liquefied natural gas (“A ‘natural’ solution to the world’s energy needs”). In broad terms, according to BP, there currently exist 187 trillion cubic feet of proved reserves of gas, equivalent to a reserves: production ratio of more than 60 years. Gas currently sells for just over $4.00 per million cubic feet, making it almost equivalent in cost to coal, and as more supplies become available, the cost should correspondingly fall. Furthermore, natural gas advocates also highlight that it can contain less than 50% of the carbon content of oil. Over the medium-term, many within the energy industry therefore suggest that gas could overtake oil as the world’s dominant energy source.
Where fracking fits into the equation is as follows: in a nutshell, it is the process that makes it economical for energy companies to tunnel at least 5,000 feet below ground to remove gas; rocks are fractured and gas is released. The technology of hydraulic fracturing was developed in the United States in 1947 and was first used commercially in 1949 by Halliburton, a US energy company. With advances in directional drilling (i.e. the ability to, and the practice of, drilling non-vertical wells), fracking has become of meaningful commercial value in the last five years and it is now used in thousands of sites worldwide.
Its major appeal is that fracking allows natural gas (and oil) to be recovered safely from deep shale formations, allowing countries rich in this basic resource to reduce their reliance of foreign fuel imports dramatically. Geologically, shale is a fine-grained sedimentary rock composed of mud that is a mix of flakes of clay minerals and tiny fragments of other minerals. Gas is formed within shale as a consequence of heat and pressure from dead algae that are mixed with mud from ancient seas. In the absence of fracking, there would be insufficient porosity and permeability to allow natural gas to flow from the rock to the surface at economic rates.
According to the Energy Information Administration (EIA), the US Government’s energy body, there are 48 major shale gas basins globally, located in 32 different countries. These basins contain at least 6,000 billion cubic feet of reserves. Although the industry is still highly nascent, China has the greatest level of potential shale reserves, followed by the US, with Argentina, Australia, Brazil and Poland also offering rich resources. Meanwhile, in the UK, as mentioned earlier, Cuadrilla Resources (a US private equity backed firm) started fracking an onshore shale gas reservoir near Blackpool in March.
The global shale gas market is already worth $26.6bn based on calculations by Vision Gain, an independent American consultancy. The EIA believes that the US shale industry has grown at a compound annual rate of 29% in the last ten years (albeit from a very low base) and in its Annual Energy Outlook for 2011, it predicts that by 2035, shale gas production may account for over 40% of US natural gas production. Meanwhile in China, the government has set companies the medium-term target of producing 30 billion cubic feet from shale, equivalent to almost half the country’s 2008 level of gas consumption. The Beijing Government issued in June its first tender offer for four shale gas blocks in southern China to six local companies.
In order for these goals to be reached, we should expect a lot more fracking. The fracturing of rock (known in the industry as a ‘frack job’) is done from a wellbore drilled into the rock formation. These bores typically extend for at least 5,000 feet – equivalent to the depth of the Grand Canyon, or 16 football pitches laid end-to-end – below the surface. A mix of water, sand and chemicals is then injected at high pressure through the bore, and it is the pressurized mixture that causes the rock layer to crack, hence releasing gas up the well.
Unsurprisingly, fracking is not without its critics. Concerns focus on cost, resource use, environmental safety and health risks. Taking each in turn, shale gas tends to cost more to produce than gas from conventional sources. This is owing to the significant expense attached to horizontal drilling combined with the hydraulic fracturing treatment itself. Proponents justify the expense in arguing – correctly on this count – that the economic risk of drilling unsuitable shale gas wells is relatively low (lower than, for example, drilling an oil well off-shore). However, more contentious is the fact that between 9,000 and 29,000 cubic metres of water are required for fracking operations on a single well, according to Greenpeace, an environmental group. This could cause problems with regard to the sustainability of water resources even in temperate countries, and add to consumption pressures on supplies in more arid areas.
A related problem concerns the subsequent potential contamination of ground water and the mishandling of fracking waste. Data from Greenpeace show that anywhere between 15% and 80% of the injected fracturing fluid returns to the surface as flow-back water. This water contains fracturing additives and their transformation products, namely substances dissolved from the shale that include heavy metals, hydrocarbons and naturally occurring radioactive elements. The US Environmental Protection Agency (EPA) has been sufficiently concerned over these developments that it announced in June that it would examine claims of water pollution related to fracking in five US states, while a 2010 report by the EPA also showed elements of arsenic, copper and methane in drinking water adjacent to drilling operations.
Despite these issues and the threat of increased regulation and/or growing public criticism, fracking is currently big business. Spears & Associates, another American consultancy, forecasts 90,000 land-based oil/gas wells to be drilled in 2011, rising to 100,000 by 2015. According to Spears, a majority of these are expected to be stimulated by hydraulic fracturing. The optimism of Spears is shared by a number of listed US companies, with Chesapeake Energy, for example, stating at its July results that “natural gas can meet growing demand for power; unconventional development [i.e. fracking] will spread worldwide.” Peers Baker Hughes and Schlumberger have made similarly positive statements in recent months.
A wide range of equipment is used at natural gas (and oil) fields where fracking technology is employed. This includes a slurry blender, one or more high-pressure, high-volume fracturing pumps and a monitoring unit. Associated equipment includes fracturing tanks, high-pressure treating irons, a chemical additive unit (used to accurately monitor chemical addition) low-pressure pipes and gauges for flow rate, fluid density, and treating pressure.
From an investment perspective, it is the pumping market that is potentially the most attractive. While investors can gain exposure to the fracking theme via either listed exploration and production companies (BP, Chesapeake, Encana, Exxon, Reliance, Shell and Statoil among others are all active in fracking) or via service companies such as Baker Hughes, Halliburton, Schlumberger or Weatherford, the pumping market benefits from an oligopolistic structure and hence high returns.
Calculations from Spears & Associates suggest that the combined directional drilling and pressure pumping market will be worth $42bn on a global basis in 2011, rising to $62bn in 2015 (these figures relate to market value across all industries, not just shale). Demand for pumps is being driven not just by the development of new fracking sites, but also by the replacement/ upgrade cycle relating to existing pumps currently working at higher pressure levels and with less down-time than in the past. Industry sources now put an average asset life on a frack pump of four-five years, versus assumptions of six-seven years that were made when the industry first began to develop.
Three players dominate the frack pump market: UK-listed Weir Group has around a 30% share, double that of its nearest competitor, FMC Technologies. Gardner Denver occupies another 10% of the market, with the remainder controlled by a range of smaller, more diversified players. Weir’s dominant position is a result of its 2007 purchase of Texas-based SPM. Since acquisition, Weir has increased capacity at SPM by more than 30% and in its last reported results, SPM’s order book showed year-on-year growth of more than 80%. While oil & gas comprises just over 30% of Weir’s revenues, it is responsible for the majority of the company’s current earnings growth. Weir represents one of the best organic growth stories within the capital goods sector and owing to its business mix (the company is also present in the mining and power sectors), tends to trade on closer to a multiple comparable to other UK-listed engineers rather than the growth/energy related premium it potentially deserves.
Fracking, in literal terms, is a dirty business. More importantly, however, it looks as if it is set to stay, with the industry in clear growth mode on a global basis. As we have discussed previously, governments need to construct their energy portfolios in a fashion similar to how investors structure theirs, namely with an appropriate and tactical balance of resources. Shale gas will almost certainly feature in this equation. On the assumption that shale will remain important, so will fracking, as will those who make the equipment with which to frack.
Alexander Gunz, Fund Manager, Heptagon Capital
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