A Burning Question: Why is North Dakota s Natural Gas Going Up in Flames? By Merit Webster The Bakken story is a remarkable one that continues to evolve; it tells of a minor oil producing region that has skyrocketed to become one of the nation s leaders in only a few years. There are certainly some unique factors that have coalesced in the Williston Basin to create this exceptional growth. But in many ways, the dynamics at play represent a microcosm of the opportunities and challenges impacting the entire North American energy sector. We ran a feature article discussing crude oil production in the Bakken in Q2 2013. In this issue of the CMU, we explore the other side of that story: natural gas. 4 COMMODITY MARKETS UPDATE
WILLISTON BASIN, NORTH DAKOTA There are hundreds of fires burning across the western half of North Dakota, lighting up the night sky. They are not caused by wildfires or other natural disasters; the region is only sparsely inhabited. Observable from satellite data, the clusters of light emanating from the Bakken oil fields result from the flaring of natural gas a visual consequence of a rapidly growing energy industry and the region s insufficient infrastructure to move that gas to the end markets where it is needed. A View of the Bakken A quick flight in a propeller plane over the Williston Basin, which spans some 150,000 square miles into the northeast corner of Montana, and it is easy to tell that this is not Texas oil country. The basin is peppered with rock formations ( The Badlands ), rolling hills, and valleys, which today, during our trip in the rainsoaked month of June, are alive with several shades of green. Roads consisting of scoria, a thick burnt-red clay dirt, snake through the grasslands and up the slopes of the hills. Pumps sit atop red pads, where freshly-drilled oil wells churn out the light, sweet crude which has made the region famous as of late. This is all changing, however, and very quickly. It is no secret that North Dakota is currently undergoing an unprecedented crude oil boom. At 875,000 barrels/day (a 40-fold increase from the 18,000 bbls/day produced in May 2007), the state is now the second largest producer in the United States, behind only Texas. 1 New horizontal drilling techniques and high oil prices have facilitated a rapid growth in crude oil production extracted from the Bakken, the shale formation that lies below a 15,000-square mile portion of the Williston Basin. The primary hindrance to further drilling has been the absence of pipelines to transport the crude to end markets. Even that constraint has begun to ease, as marketers have adapted by increasingly using rail, truck and barge to transport product to refineries in the Gulf Coast and along the eastern seaboard. (For more information on this topic, refer to Q2 s CMU The New Logistics of Oil Transportation. ) Crude oil production in the basin is projected to top two million bbls/d by 2025. 2 In comparison, the country of Saudi Arabia produces 10 million bbls/d, according to the International Energy Agency. The landscape is breathtaking. But the very attributes that make the basin so beautiful have also historically made it among the most arduous terrain for oil and gas exploration and production. The harsh climate and severe cold weather create unfavorable working conditions throughout much of the year. The remote, rugged landscape has traditionally not been conducive to conventional drilling techniques; the dearth of pipeline and gathering infrastructure has long made the prairie a wildcatter s game. An Abundance of Natural Gas What is less discussed, however, is the abundance of rich natural gas that is being produced in conjunction with these oil wells. More than three-quarters of all gas in North Dakota is associated gas, which is gas that bubbles up as a byproduct of horizontal oil drilling and is not the primary revenue generator for the well operator. As unconventional oil production in the Bakken has experienced tremendous growth, soaring 40% in the past year alone, production of associated natural gas has kept pace. 3 According to an analysis by Bentek, an energy analytics company, the gas-to-oil ratio of a Bakken well will double over its lifetime, meaning that wherever oil is drilled, gas will not only just follow, but will significantly outpace oil production as the well matures. In the company s base case scenario, gas production in the Bakken will rise to 3.1 Bcf/day by 2025, a threefold increase over current production levels of 0.93 Bcf/d. 4 Based on these projections, the basin is on track to become a leading source of North American natural gas in the next few years. 1 Lynn Helms, NDIC Department of Mineral Resources, Director s Cut, 09/13/13. 2 Bentek Energy, The Williston Basin: Greasing the Gears for Growth in North Dakota, 2012. Flaring from Bakken oil fields is now visible by space, with light emitting from the region comparable to urban centers like Minneapolis and Chicago. Image Source: NASA 3 NDIC Department of Mineral Resources. 4 Bentek Williston Basin report. Fourth Quarter 2013 5
... unlike crude oil, natural gas cannot be trucked or moved by rail. Individual wells must be connected to pipelines, which capture gas at the wellhead and send to processing facilities In the Bakken, with its mountainous terrain, long winters, and large distances between wells and processing plants, installing this infrastructure is particularly challenging. The problem is that, unlike crude oil, natural gas cannot be trucked or moved by rail. Individual wells must be connected to pipelines, which capture gas at the wellhead and send it to gas processing facilities. These fractionation facilities separate the wet gas (i.e. natural gas liquids such as propane, ethane, and butane) from the dry gas (i.e. methane) and ready the product for shipping on interstate pipelines. Comparable oil-rich shale plays, such as the Eagle Ford and Permian Basin (both in Texas), benefit from existing transportation infrastructure, making it less laborious for well operators to invest in pipelines to gather the associated natural gas and route it to processing plants. BCF/day 1.00 0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 - Jan-00 Sep-00 May-01 Jan-02 Sep-02 May-03 Natural Gas Flaring Jan-04 Sep-04 May-05 Jan-06 Sep-06 May-07 Jan-08 Sep-08 May-09 Jan-10 Sep-10 May-11 Jan-12 Sep-12 May-13 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Installing pipeline gathering systems in the Bakken, by contrast, with its mountainous terrain, long winters that shorten the working season, and large distances between wells and processing plants, is particularly challenging. As of July, there were 9,322 active wells dispersed across North Dakota, and the number keeps growing. Although drilling companies are connecting wells to gas infrastructure at an increasing rate, production with an average of 130 new wells coming online each month has far outpaced the installation of gathering and treatment facilities. 5 Even for wells that are connected to a pipeline, there can sometimes be additional hindrances to fully capturing gas production. After hydraulic fracturing techniques have cracked open the shale rock, Bakken wells typically have an initial flush of rapid oil and gas outflow for the first three to four months of operation. When one of these new, high-pressure wells comes online, it can sometimes kick older, low-pressure nearby wells off the gathering grid for an interim period, because there is not sufficient compression in the Bakken infrastructure to handle both the new and the old gas. A Reason for Flaring In any situation without the ability for adequate collection, the natural gas that is generated alongside oil production is burned at the wellhead flaring, in industry parlance. Roughly 30% of all gas produced in the Bakken is flared. This translates to 300 million cubic feet of natural gas squandered daily at current production levels, enough energy to heat 3,000 American homes for an entire year and foregone revenues to the tune of $35 million every month. 6 (In contrast, only 0.4% of all gas produced in Texas is flared.) 7 As with most other energy-producing states, North Dakota regulations allow flaring to occur during the first 12 months of operation without penalty. After that timeframe, producers must apply for an exemption that requires them to justify the economic feasibility of needing to flare, or pay royalties to the state. 8 5 Lynn Helms, NDIC Department of Mineral Resources, Director s Cut, 07/15/13. Natural Gas marketed Natural Gas NOT marketed % natural gas flared 6 American Gas Association. 7 Railroad Commission of Texas. Source: NDIC Department of Mineral Resources, BBH Analysis 8 ND Pipeline Authority, Natural Gas Facts, accessed July 2013. 6 COMMODITY MARKETS UPDATE
The state allows flaring for two reasons. The first is environmental: in any situation where excess natural gas (methane) could otherwise leak into the atmosphere, the alternative byproduct of burnt gas, CO 2, is generally considered preferable. There are some who have environmental concerns: a recent report published by Ceres, a non-profit environmental group, argued that flaring has increased the carbon footprint of Bakken oil, by emitting 4.5 million metric tons of carbon dioxide over the course of 2012, equivalent to the annual emissions of approximately one million cars. 9 Thus far, however, North Dakota health officials say that flaring has not produced any serious air pollution problems. 10 The second is economic: investing in the additional infrastructure required for natural gas collection can be an expensive alternative for independent drillers who could otherwise invest that capital into additional wells. In order to justify the upfront costs to connect its wells to gathering systems and to get an estimation of the size of pipeline needed, an operator must have a strong idea of how much associated gas is going to be generated from its well. As gas production is difficult to predict until oil production gets underway, some amount of flaring will therefore be necessary to bridge the gap between a well s completion and the time it takes to install gathering pipelines. natural gas in the Bakken trades at an even steeper discount to the Henry Hub benchmark because of the lack of pipeline infrastructure. For example, in September 2013, average price for delivery at the Northern Border hub in North Dakota was at $3.02/ mmbtu, compared to an average $3.64/mmbtu for the Henry Hub benchmark. 14 With the oil-to-gas price ratio (on an energy-equivalent basis) for the region at 30 to 1 and producers scrambling to overcome the logistical challenges in getting their ~$90/bbl crude to end markets, natural gas has thus far been little more than an afterthought for Bakken producers. That does not mean, however, that capturing natural gas is entirely uneconomical. The costs vary substantially depending on how easy it is to get to the well and how close the well is to a processing plant. While the price of gas is clearly a key driver of a well s economics, once the initial gathering pipeline infrastructure investment is made, a company will reap the additional income over the life of the well (25-30 years in some cases), with minimal additional maintenance expenses. With the vast amount of gas now expected as a byproduct of oil drilling, producers today have more incentive to connect their wells at an earlier stage in the drilling process. A Driller s Economics As with many other unconventional shale plays, oil production drives the economic incentive for companies to drill in the Williston Basin. Precisely because of the region s topography, a well in the Bakken is a huge upfront investment that can cost upwards of $10 million to complete (much higher than the average of roughly $6 million for shale drilling in other U.S. production regions). 11 $5.00 $4.00 $3.00 $2.00 Natural Gas Price Differential ($/mmbtu) ($/mmbtu) Natural Gas Price Differential Despite the costs, wells in the region produce some of the most attractive rates of return of any shale play across the country because of their high-quality oil production. Bentek s Internal Rate of Return (IRR) model (which compares expected returns over a well s lifetime factoring in natural gas liquids, crude, and natural gas production), rated the Bakken s IRR at 58%, in contrast to an average return of 36% across the 18 U.S. shale plays it analyzed. 12 Accordingly, the $2.1 billion in monthly revenue that producers generated in July from crude oil production dwarfs the $100 million earned from natural gas production in the same month. 13 As a glut of supply across the country continues to depress prices, $1.00 Price Received by Bakken Producers Henry Hub Benchmark Source: NDIC Department of Mineral Resources, Bloomberg 9 Ceres, Flaring Up: North Dakota Nautral Gas Flaring More Than Doubles in Two Years, 07/29/13. 10 NDIC Department of Mineral Resources. 11 According to Bentek, based on key 18 shale plays surveyed in report. 12 Bentek Williston Basin report. 13 NDIC Department of Mineral Resources. 14 Lynn Helms, NDIC Department of Mineral Resources, Director s Cut, 09/13/13. Fourth Quarter 2013 7
Processing Rich Natural Gas Raw Natural Gas NGL Applications: Methane: power generation, residential and commercial heating Ethane: petrochemical feedstock, plastic manufacturing Propane: residential and commercial heating, cooking fuel Butane: Natural Gasoline: petrochemical feedstock, synthetic rubber for tires, lighter fuel solvent, gasoline, polystyrene Consumer Quality Dry Natural Gas Processing Plant NGLs Fractioned Iso-Butane: petrochemical feedstock, refrigerant, aerosols Methane Ethane 42% Propane 28% Butane 7% Natural Gasoline 14% Iso-Butane 10% Product NGL spot price ($/gal) Conversion Factor (GAL/MMBTU) NGL spot price ($/MMBTU) % Processing Composition NGL $ Gross Margin per MMBTU Propane $1.03 11.010427 $11.34 28% $3.21 Iso-Butane $1.47 10.109895 $14.82 10% $1.42 Normal Butane $1.34 9.717323 $13.05 7% $0.91 Natural Gasoline $2.00 9.195064 $18.39 14% $2.48 * Prices - spot Conway, KS 09/30/13 **Estimated conversion factors and model provided by Bloomberg. % Product Breakdown by Bentek for Williston Basin region. ****Note that ethane, the fifth liquid processed from gas has been omitted for the purposes of this analysis. Typically it comprises ~42% of processing, but ethane is being rejected at the plant in the Bakken due to prices averaging under 30c/gal for much of the year, well below the cost of transportation. Therefore, we do not factor in the additional uplift a plant could theoretically earn from ethane production. Total - value of NGL basket in MMBTUs $8.02 Less: spot natural gas $3.56 Income "uplift" per MMBTU $4.47 8 COMMODITY MARKETS UPDATE
A Source of Profit in Liquid Form There is another, potentially more lucrative incentive for producers in the Bakken to capture natural gas, which lies in the embedded natural gas liquids ( NGLs, which include products like ethane and butane). Associated gas is rich in these liquids, which currently command higher prices on the market and are valuable resources that producers would prefer to sell rather than flare. For years, energy companies favored dry gas (pure methane) for its pipeline-ready purity; many of the originally-discovered unconventional shale plays produce mainly dry gas. However, as dry gas prices have plummeted due to the supply glut, drillers have become increasingly willing to shoulder the additional cost of wet gas processing, in order to capture the higher value of the NGLs. The table to the left shows a rough indication of the value differential among various NGLs and pure methane gas, based on September 30th prices at the Conway, KS hub and the percentage output of a barrel of NGLs in the Bakken. The current pricing premiums of NGLs over methane translate into a material uplift for an oil producer facing the discounted wellhead prices for gas that have persisted in the Bakken due to its logistical constraints. As such, producers are not choosing to flare off these NGLs because of a lack of value. Rather, the primary factor holding back further NGL production in the region has been, unsurprisingly, an infrastructure shortage to process the raw natural gas into liquids and transport them to market. A Changing Infrastructure Landscape Several midstream energy companies are now taking note of this need and are investing heavily. Roughly $4 billion has gone into natural gas infrastructure developments since 2009 in the Williston Basin, according to the ND Pipeline Authority. Bakken NGL processing capacity is currently 50,000 bbls/day, up from 20,000 bbls/day just two years ago. With new processing capacity coming on stream in 2013, the EIA predicts NGL production will double in the Williston Basin by the end of the year. The investments of two companies in particular will provide a significant outlet for the region s gas production. Hess Corporation expects to complete a major expansion of its Tioga Gas Plant later this year, which produces propane, butane, and natural gasoline. 15 ONEOK has completed two projects in 2013, $30 $25 $20 $15 $10 $5 $0 Aug-07 Nov-07 Feb-08 May-08 Aug-08 Crude Oil, Dry Gas, and NGL prices, Crude Oil, Dry Gas, and NGL Prices, in in $/mmbtu $/mmbtu equivalent equivalent Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 as well: an NGL pipeline that transports unfractionated NGLs to the Conway, KS hub and a Stateline II processing facility. 16 According to Justin Kringstad, director of the North Dakota Pipeline Authority, the improvements will increase processing capacity to 1.2 bcf/d by the end of this year and 1.4 bcf/d by the end of 2015. Based on baseline projections, North Dakota could have enough processing capacity for all of the gas it produces by the end of the year. 17 (Current production as of June was 0.93 Bcf/d; June 2011 production was 0.39 Bcf/d). Furthermore, once drilling companies do connect their wells to a gathering grid, there is considerable dry gas takeaway capacity on pipelines that flow through the region (Alliance, WBI Energy, NBPL) and provide delivery access to Midwest markets such as the Chicago hub. Though the space has historically been allocated primarily to Canadian producers, Bakken producers have an opportunity to gain market share as the firm pipeline transportation contracts roll off in the next few years, according to Bentek. As gas is not their primary revenue generator, Bakken operators have a competitive advantage in the region over traditional Canadian producers: they can accept lower prices for their gas without negatively impacting well returns. These developments could challenge the conventional wisdom that flaring is inevitable. Yet keeping pace with the growing 15 Michael Lutz, Hess: A Bakken Producer s Regional View on Gas & NGL Markets, Platts Rockies Oil & Gas Conference, April 15-16, 2013. 16 ONEOK Annual Report, 2013. 17 Justin Kringstad, North Dakota Pipeline Authority, Bakken Investor Conference, 04/25/13. Aug-10 NGL Basket Natural Gas (Henry Hub) Crude Oil (WTI) Source: Bloomberg As the EIA points out, for production implications, a higher crude oil-to-natural gas ratio incentivizes drilling for oil in preference to natural gas, and makes NGLs relatively more attractive than the development of dry gas resources. Nov-10 Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12 Feb-13 May-13 Aug-13 Fourth Quarter 2013 9
The fires scattered throughout the North Dakota prairie illustrate the enormous challenges facing energy companies as they work to reduce wastefulness and instead harness this valuable energy source into productive (and revenue-generating) end uses... In a way, however, flaring also offers a visual representation of the opportunities that the region has been given. solution to the flaring problem will necessarily be a mixture of several initiatives, and it is not an issue that can be resolved overnight. In a way, however, flaring also offers a visual representation of the opportunities that the region has been given. The Bakken is a story of exceptional growth, propelling the North Dakota economy into one of the nation s leaders: the state has the lowest unemployment rate in the country at 3.0%, and it reported the highest annual increase in GDP per capita of any state in both 2011 and 2012. 19 A revitalized energy industry is now engaging with other sectors, spurring further investment in the region. For example, two new fertilizer plants are in the process of being constructed to utilize natural gas in the manufacture of nitrogen fertilizer, which will boost productivity in the state s legacy agriculture industry. The North Dakota regulatory body continues to see a wave of enthusiasm from production is going to be a continual struggle: projections by companies interested in finding alternative uses for natural gas Continental Resources, a major operator in the region, have the and has already commissioned several studies, including an evaluation of its use in motor vehicles. number of Bakken wells approaching 52,000 by 2025 (+400% increase over today). The rural, rugged terrain and the severe winter weather that shortens the drilling season will only further complicate the process of well connection. dented hurdles, and how it will capitalize on these unprecedented Much about how the energy industry will tackle these unprece- opportunities, remains up in the air. For natural gas, a relatively A Future of Challenges and Opportunities clean-burning fuel that is currently being wasted in excess, the With such exceptionally high flaring levels, the situation has hope is that with the right balance of encouragement from the raised the attention of the Environmental Protection Agency, North Dakota state legislature and the economic incentives to and the state could increasingly come under scrutiny from environmental groups if flaring does not decrease. North Dakota s valuable energy source will no longer be going up in flames. develop adequate gathering and processing infrastructure, this legislature is targeting a 10% flaring rate, though it has not yet published a specific timeline for that goal to be met. It also Much of the data for this article was sourced from Bentek Energy s July recently passed legislation to provide tax incentives for companies that find an alternative source for otherwise flared gas. Dakota. The study was commissioned by the North Dakota Pipeline 2012 report, The Williston Basin: Greasing the Gears for Growth in North Authority and the North Dakota Industrial Commission to forecast natural Major players in the Bakken, such as Continental Resources and gas production growth through 2025 and to determine if adequate natural Whiting Petroleum Corp, have vocally expressed a more ambitious goal of reducing flaring to as close to zero as possible. gas pipeline infrastructure exists. 18 The fires scattered throughout the North Dakota prairie illustrate the enormous challenges facing energy companies as they work to reduce wastefulness and instead harness this valuable energy source into productive (and revenue-generating) end uses. The 18 As per 10-K company presentations. Also sourced from: Saqib Rahim, EnergyWire, Bakken s top producer wants to snuff out natural gas flaring, 03/04/2013. 19 EIA.gov, North Dakota sees increases in real GDP per capita following Bakken production, 07/12/13. 10 COMMODITY MARKETS UPDATE
Fourth Quarter 2013 11
Natural Gas Overview In many ways, the unprecedented challenges and opportunities confronting producers and marketers in the Williston Basin reflect what is happening on the national scale. The North American natural gas sector has undergone, and continues to undergo, several dramatic changes that have caused a rapid increase in gas production and disrupted traditional forms of supply. Total U.S. production has climbed 45% since 2005, from an average 47.5 Bcf/d to 70.6 Bcf/d as of July 2013, according to the EIA. Key Themes Oversupply Leading to Low Prices: Horizontal drilling technologies (known as unconventional vs. traditional vertical drilling) have unlocked a prolific new source of natural gas. Demand has stayed relatively constant over the past few years; the glut of production has depressed prices, causing several ramifications. Ironically, many of the unconventional shale play discoveries that initially created such vast supplies of gas (Haynesville, Barnett) are facing reduced production in favor of wells that have more lucrative liquid streams. Drilling in Oil and Wet-Gas Rich Shale Plays: Producers are now incentivized to shift drilling rigs to oil and liquids-rich ( wet gas) plays, because oil and NGL prices remain high relative to dry gas on an mmbtu basis. Wet gas plays currently dominate rig activity, allowing producers to earn favorable returns despite low dry gas prices. Changing Supply Dynamics: Less efficient, more expensive producing areas, such as the Southeast, are being priced out of the markets they once served. There has been a massive infrastructure development of pipelines and gas gathering systems across the continent; some pipelines have even begun shipping gas in the opposite direction of traditional flows, as discoveries like the Marcellus in Pennsylvania can now more easily send product to northeast end markets. Imports from Canada have declined 40% and will continue to be negatively affected by increased U.S. production, particularly in North Dakota s Williston Basin, which shares similar pipeline routes. Transition from Regional to National Pricing: Once a regionally based-market, the flood of natural gas in unconventional areas of the country has caused geographic price spreads to collapse. Now that the U.S. market is much more interconnected through a developed natural gas pipeline system, traditional trading strategies that profited from geographic basis arbitrage are no longer lucrative. Increased Gas Production: The surge in oil and NGLs drilling nationwide is, in turn, helping to foster continued natural gas production growth. Dry gas drilling has fallen to ten year lows, but national production has held steady because wet gas is recovered alongside crude production in the shale regions ( associated gas). While 54% of 2014 natural gas is predicted to come from 12 COMMODITY MARKETS UPDATE
these wet gas wells, U.S. natural gas production is still expected to grow 22% between 2011 and 2017. Surging NGL Production: As drillers continue to reallocate capital to drilling in wet shale plays with greater rates of return, and as midstream companies race to build more liquids processing infrastructure, NGL production is growing considerably. The new abundant supply of liquids has driven down their prices to some extent, but this has also created a global cost advantage. For example, since NGLs are key feedstocks in petrochemical production, the readily available supply has reinvigorated the U.S. manufacturing industry. Companies have also begun to export propane and butane to Latin America and East Asia, with exports expected to exceed one million bbl/d by 2018. Gas-Fired Power Generation Projected to Increase: Low gas prices, and a continued focus on environmental regulations, are causing a shift from coal-burning to natural gas-burning power plants. Bentek, an energy consulting agency, estimates 14% gas demand growth from the power sector between 2011 and 2017. The company also projects a 43% increase in gas demand from Mexico during that same time period, as the country is currently investing in a gas distribution network to take advantage of cheap supply from the U.S. In the long-run, approval to export LNG (liquefied natural gas) to Europe and Asia, where average netback prices (gas price at import destination less shipping costs) average $8.60 and $13.68, respectively, could also expand distribution channels for domestic natural gas. 1 1 Bloomberg Top U.S. Unconventional Shale Gas Plays Location Bcf/d Haynesville AK, LA 6.99 Barnett TX 5.85 Marcellus PA 4.96 Fayetteville OK 2.81 Eagle Ford TX 2.14 Woodford OK 1.13 Granite Wash OK/TX 0.95 Source: EIA 6/1/13 Historical Natural Gas Price Historical Natural Gas Price Henry Henry Hub Hub Benchmark $16 $14 $12 $10 $8 $6 $4 $2 $- Source: Bloomberg Fourth Quarter 2013 13
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