As you may be aware, over the past few weeks, much has been made of this unconventional source of energy. Some fine publications have even called shale gas a 'game changer' and most people are now convinced that shale gas has made 'Peak Oil' irrelevant. So, is shale gas really the miracle pill or is it yet another empty promise from a desperate industry?

Before we attempt to answer this question, we want to throw some light on shale gas, which is nothing more than natural gas trapped within shale (rock) formations, deep under the Earth's crust (Figure 1). In the past, due to limitations in drilling technology, shale gas was not accessible. However, with the advent of horizontal drilling and hydraulic fracturing (more on this below), the energy industry in the US has managed to release the gas from the shale formation.

Figure 1: Geology of natural gas resources

Source: EIA

It is worth noting that hydraulic fracturing is a process whereby water, sand and chemicals are injected at high pressure deep into the ground to break up the porous shale and allow for enhanced recovery of gas. Although this sounds simple enough, the problem is that this process of injecting chemicals close to the water table may pose a serious health risk. In order to get to the bottom of this matter, the US Environmental Protection Agency is moving forward with an investigation into the potential adverse effects of hydraulic fracturing on water quality and public health. So, it is still unclear as to whether this new technology is safe or if it will cause serious health problems for those who live close to the shales.

Apart from environmental and health concerns, shale gas may not turn out to be the 'game changer' due to geological realities. It is notable that despite the optimistic forecasts from the gas companies, shale gas wells are prone to extremely high depletion rates and after twelve months of production, the daily output has shown to plunge dramatically. Furthermore, the marginal cost of production in shale is around US$7-8 per thousand cubic feet (mcf). Therefore, in the current environment, whereby natural gas is trading around US$4 per mcf, shale gas is uneconomical.

The fact remains that this year the EIA expects total natural gas production in the US to decline by 2.7% to 58.7 billion cubic feet per day (bcf/d) and only increase by a modest 1.1% in 2011. So, if shale gas is such a big deal, why is total natural gas production not going through the roof?

The truth is that wishful thinking about the decline rates is the sole support for unrealistic expectations. Contrary to the rosy future being presented by the gas companies, recent studies carried out in the operating gas fields in Barnett Shale (Figure 2) confirm that the geological realities are very different.

Figure 2: Shale gas basins in the US

Source: USGS, ALL Consulting

You may want to note that Barnett in Texas is the first commercially developed shale play and it is a model for other areas such as Marcellus and Haynesville. Furthermore, the Barnett Shale currently contains approximately 12,000 gas wells and since 2002, most wells in this shale were drilled horizontally using hydraulic fracturing. It is estimated that so far, this shale has produced 5.64 trillion cubic feet (tcf) of gas, so it really is the poster-child for shale gas modeling.

Now, it is interesting to observe that although the operators in Barnett claim a gas bounty of 26 tcf, independent studies reveal that only 10 tcf of gas may ever be extracted. Moreover, even though the operating companies claim a gas recovery rate of 2.5-3.5 billion cubic feet per well, a recent decline-curve analysis of 2,000 wells shows a gas recovery rate of only 0.95 bcf per well! In other words, the economics of the Barnett Shale may not live up to its reputation; certainly not at today's depressed natural gas price. And if Barnett's economics are not favourable in today's environment, what chance do the other shales have?

Look. At this stage, nobody really knows how this will play out but the reality does not seem to be as pretty as the operators' claims. Now, we do not want to ruin the ongoing festivities but a recent study by Wood Mackenzie estimates that total natural gas production in the US is set to rise by only 15% over the next decade! This sluggish increase in output can be traced to the fact that the existing conventional natural gas fields are also depleting at a frantic pace. Therefore, much of the additional supply of shale gas will only offset the depletion of the existing conventional gas fields.

In any event, we do not believe that shale gas will solve our problems or fully compensate us for the ongoing depletion in the world's oil-fields. Remember, the world's transportation system is totally dependent on crude oil and an over-supply in natural gas will not make much difference. For instance, only 0.16% of the automobiles in the US are currently powered by natural gas and even if shale gas turned out to be a winner, the transition towards natural gas powered vehicles will take decades.

It is our conjecture that although the development of shale gas is a step in the right direction, it is not likely to be a 'game changer'. In a world where roughly 93% of the world's transportation runs on oil, an over-supply of natural gas will not quench our thirst for petroleum. So, instead of ushering in a new natural-gas economy, we should all be thinking in terms of oil conservation.

Our research confirms that unless we discover a lot of oil very promptly, the world will struggle to produce more than 89-90 million barrels per day of total liquids. Today, global usage is 86.5 million barrels per day and with demand rising by roughly 1% every year, aggregate consumption may surpass available supply within the next 3 years.

A few years ago, people used to scoff at 'Peak Oil', but now it is widely accepted that the world is losing roughly 4 million barrels per day of output every year due to the ongoing depletion. Fortunately, up until now, new capacity additions have been sufficient to offset this decline. However, as Figure 3 illustrates, the era of excess capacity is now coming to an end and from next year onwards, new projects will struggle to offset the ongoing depletion in the existing oil-fields. When that happens and supply becomes tight, the price of oil will surge and perhaps cause another super-spike.

Figure 3: Day of reckoning is around the corner

Source: Peak Oil Consulting

In summary, as long as the global economy is growing and demand for energy is on the increase, the price of oil will keep climbing and the energy industry will prosper. Accordingly, we have allocated about a third of our managed capital to outstanding companies in the energy sector and we are confident that these holdings will produce solid growth over the course of this business cycle.