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A RBN Energy Drill Down Report

Copyright 2015 RBN Energy

It Dont Come Easy:


Low Crude Prices, Producer Breakevens and Drilling Economics

oduction

The more than 50% fall in crude prices since June 2014 and
30% fall in natural gas since November 2014 have crushed
producer internal rates of return (IRRs) for typical wells in
U.S. shale plays.
Analysis of IRRs and crude breakevens provides insight into
what will happen to production as producers scramble to
respond.
Continued growth in shale production is related to IRR
economics, but with several caveats that affect producers
including high IRRs in drilling sweet spots, the impact of
hedging, HBP, lower services costs and the number of hold
over completions from last year.
This report includes results from IRR and breakeven
sensitivity analysis by basin and commodity using the RBN
Production Economics model and input well data from a
variety of sources.
Coming up with input variables that represent wells in
different plays is as much art as science. To fully understand
the significance of the analysis, it is important that you know
what you are looking at. We lay out our analysis for you so
you can make your own judgments about our methodology
and model input data.

In recent days the relentless fall in crude prices seems to have slowed, but a further decline is
certainly possible, if not likely. As everyone who watches the oil market knows by now the
price crash has resulted from an oversupply of crude in world markets, partially due to relentless
increases in production from U.S. shale plays which have pushed out almost 5 MMb/d of net
crude oil and petroleum product imports over the past five years. At this point there appears to
be little sign of enough short term demand increases to soak up excess barrels or cutbacks by
major producers including OPEC. Here is where we are today in a market still searching for
a bottom. The price of CME NYMEX crude futures for U.S. domestic benchmark West Texas
Intermediate (WTI) is down 57% from its high of $107/Bbl in June 2014 to $45.59/Bbl including
a fall of 14% so far in 2015. The price of international benchmark crude Brent ICE futures has
tumbled equally far and fast down 58% since June 2014 and 15% so far in 2015 to $48.79/Bbl
on January 23, 2015. Brent premiums to WTI have averaged less than $3/Bbl this year so far
compared to an average of $6.50/Bbl during 2014, removing some of the price advantage that
domestic crudes have held over international competitors for much of the past four years. On its

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own, this crude price carnage is enough to throw a curve ball at producer rates of return for U.S.
shale oil plays. To cite just one example, RBNs analysis indicates that producer internal rates of
return (IRRs calculated as the discounted cash flow rate of return) for a typical oil well in the
North Dakota Bakken shale play fell from 39% in the fall of 2014 with WTI priced at $90/Bbl to
just 1% in January 2015 with WTI at $45/Bbl. This is the first time since the onset of the shale
revolution in crude oil markets that prices, and thus rates of return have seen such declines.
These markets are now in uncharted territory.
As if the oil market free fall were not enough, a mild start to the 2014-15 winter and continued
high production of natural gas have combined to push prices for U.S. benchmark Henry Hub,
Louisiana CME NYMEX natural gas futures below $3/MMbtu for the first time since 2012. These
low prices are crushing the returns that producers make from dry natural gas shale plays
reducing typical IRRs in the Louisiana Haynesville dry gas shale play from 5% at $3.75/MMBtu
gas to -4% at $3.00/MMBtu. (Note that for emphasis we show negative returns in red.) And
despite falling natural gas prices, the ratio between WTI crude and Henry Hub natural gas is
languishing at 16X (meaning crude in $/Bbl is 16 times the price of natural gas in $/MMBtu). That
compares with a high ratio of 54X in 2012 and an average of 27X between 2009 and June 2014.
This narrowing in the ratio between crude and natural gas prices has a knock-on effect on shale
producer returns from wet gas plays. Prices for NGLs (the liquids extracted from wet or rich
gas at gas processing plants) are also at multi-year lows squeezed down by tumbling crude
prices. That means typical IRRs from drilling in wet gas plays no longer get an uplift from higher
NGL prices. As an example, previously healthy IRRs of 24% for typical wells in the South Texas
Eagle Ford play at $90/Bbl crude and $3.75/MMBtu natural gas have fallen to -3% in 2015 at
$45/Bbl crude and $3/MMbtu gas.
A somewhat counterintuitive point in all of this is that the immediate, short-term impact on the
production volumes of crude, natural gas and NGLs resulting from the price crash is likely to be
minimal. Existing wells that are currently flowing will continue to produce there is no value to
shutting in output because of falling prices. Even at todays prices, the per-unit revenues of
existing wells are significantly above operating costs. In fact, production is likely to increase in
the near term for at least four reasons: (a) Producers are cutting back drilling, but the rigs that
are left are focused on their highest yield sweet spots, the best, largest producing opportunities.
The producers goal is to maximize revenue, and that means maximize production volume. (b)
In recent years a number of leases signed by producers have HBP (held by production) clauses,
requiring drilling and production to hold leases that were acquired at significant costs. Some
wells will be drilled and produced to hold these leases, regardless of short-term economics. (c)
Some producers were wise enough to hedge their prices, and will continue to drill and produce
against those higher priced forward sales, and (d) producer economics will be improved by lower
drilling service costs, which are coming down fast in response to lower drilling activity.
However, there is no doubt that over time lower prices will result in producers cutting their
budgets for drilling new wells. This is already happening in shale plays across the country as
producers, small and large, review how much they will invest in new production during 2015 and
beyond. The analysis in this report lies at the heart of those investment decisions determining
which plays offer the best rates of return in a lower price environment.
Independent producers do not typically have the same deep pockets or access to bank finance
as major oil companies. Continued drilling programs require new financing that either has to be
borrowed or generated as cash flow from existing wells. The oil price crash has basically halved
the revenue from existing wells. We calculate that U.S. shale producers can expect to receive
about $66 billion less cash flow revenue from existing crude production with prices at year end
2014 levels ($53/Bbl) than at $100/Bbl. That revenue is not now available for new drilling budgets

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or to pay off existing bank loans. As a result producers need to be far more selective about where
and when to drill.
Those decisions how much to drill when to drill and where will determine the impact on
crude, natural gas and NGL production during 2015 and beyond. As the number of rigs deployed
to drill new wells declines, so will the rate of increase in production. As existing well flows decline,
overall production will eventually fall unless enough new wells are drilled to replace the resulting
drop in output or new wells are proportionately more productive. Whether enough new wells are
drilled to maintain an increase in overall crude production will depend on drilling economics and
the related appetite for new investment by producers. The latest Energy Information
Administration (EIA) forecast (January 2015) indicates that U.S. crude output will increase in
2015 by 600 Mb/d to 9.3MMb/d and by 200 Mb/d to 9.5MM b/d in 2016.
For the moment producers are reviewing drilling programs and making selective cutbacks.
Detailed information provided on rig deployment in North Dakota by the State Industrial
Commission indicates the drilling rig count in that State was down from 191 in October 2014 to
181 in December 2014 and 156 in mid-January 2015 a reduction of 35 rigs or 18% since
October. Weekly national drilling rig counts from Baker Hughes show the total rig count (for oil
and gas directed rigs) falling by 15% since mid-November 2014 with oil directed rigs down 17%
since then. While drilling rig counts are an obvious and important leading indicator of production
it should be noted that dramatic increases in rig productivity (output per rig) have been achieved
in the past four years. As a result new well production numbers are frequently higher than existing
wells slowing the production decline even as the rig count falls and as we have said allowing
for overall continued increases in production. In most cases we expect producers looking at
drilling program budgets today to concentrate their investment in the sweet spots of existing
plays where production and IRRs will be optimal. In such a lower price environment there are
few budget dollars available for experimental drilling at the fringes of established plays to discover
new opportunities. As stated above, expect instead to see reduced drilling, concentrated in sweet
spots.
The primary purpose of this RBN Drill Down report is to provide an explanation and summary of
analysis produced using RBN Energys Production Economics Model to indicate what we believe
are typical IRRs in different crude oil and natural gas price scenarios for major shale plays across
the U.S. The analysis segments wells as to whether they produce predominately oil, dry natural
gas or wet natural gas (containing NGLs) but incorporates the production of all three
hydrocarbons in basins were most wells are triple plays. We also provide data for sweet spots
in oil plays to demonstrate that new drilling will continue in some locations with high IRRs even
if prices continue to fall. In addition to IRRs we provide an analysis of breakeven prices for crude
oil plays calculated as the price that results in a zero % IRR in a given natural gas price
scenario.
We also provide a thorough description of the assumptions behind our analysis using the RBN
Production Economics model. We introduced the model in the fall of 2013 as part of our blog
series The Truth is Out There - Unconventional Production Economics. That first iteration
looked solely at one commodity natural gas. Last year (2014) we expanded the model to cover
all three drill-bit hydrocarbons crude oil, natural gas and NGLs. We used the expanded
version as part of our Drill Down report on growing production in the Permian Basin last May (see
Stacked Deck) and we provided a downloadable version of the spreadsheet model with that
report. This time we provide summary analysis based on running multiple sets of data and
scenarios through the model.

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The report layout is as follows:


In Section 1 we provide background and detail on the price crash, crude-to-gas ratio and the
impact on producer revenues.
In Section 2 we review the basics of shale drilling technology and productivity enhancements
that continue to improve drilling efficiency.
In Section 3 we discuss the assumptions and input variables used in RBNs IRR and breakeven
analysis using the Production Economics model.
In Section 4 we present the results of our IRR and breakeven analysis
The U.S. oil and gas industry has entered a new phase in 2015, characterized by revolutionary
new technologies that reduce the per-unit cost of production, and now lower prices, that make
those lower costs essential to viable production economics. The only way to grasp how this
drama will play out over the next few years is to have a full appreciation of how those economics
will impact the behavior of U.S. producers. The goal of this RBN Drill Down report is to shed light
on some of the most important calculations that will impact that behavior.

This report is provided for the exclusive use of the Subscribing Customer. It is not
permissible to make copies of this report for distribution to anyone who is not a
Subscribing Customer.
The data and information in this report may be wrong. This report has been prepared
using publically available data and information sourced primarily from internet
websites including company presentations, press releases and media reports. The
topics covered are subject to continuous revision. Some of these revisions may not
be reported publically. Some of the reported information used in this report may be
erroneous. Accordingly, this report is subject to errors and inaccuracies. You should
not rely on any information provided in this report as the basis for any decision or
conclusion regarding the topics covered by this report.
The information and data in this report are provided on an as is basis. RBN Energy,
LLC makes no warranties as to the accuracy or completeness of any information or
data in the report. RBN Energy, LLC, shall be not be liable for any loss or damage
arising from any partys reliance on the contents of this report and the companies
disclaim any and all liability related to the use of this report to the full extent
permissible by law, whether based on warranty, contract, tort or any other legal
theory.

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Table of Contents
Introduction

..................................................................................................................... - 1 -

Section 1 Prices and Production ...................................................................................... - 7 1.1

Price Crash ........................................................................................................... - 7 -

1.2

Cash Flow Impact of the Price Crash .................................................................... - 8 -

1.3

Production Impact ................................................................................................. - 9 -

Section 2 Drilling Technology ........................................................................................ - 11 2.1

Background ......................................................................................................... - 11 -

2.2

Horizontal Drilling and Fracking 101 ................................................................... - 12 -

2.3

Evolution of Fracking ........................................................................................... - 13 -

2.4

Productivity Improvements .................................................................................. - 14 -

Section 3 Scenario Analysis Assumptions and Variables ........................................... - 14 3.1

Drilling and Completion Costs ............................................................................. - 15 -

3.2

Operating Expenses ............................................................................................ - 16 3.2.1 Production Taxes .................................................................................... - 16 3.2.2 Royalty Rates .......................................................................................... - 16 -

3.3

Initial Production, Decline Rates and Estimated Ultimate Recovery ................... - 16 -

3.4

RBN Production Economics Model Analysis ....................................................... - 18 3.4.1 Decline Rates and Decline Curves .......................................................... - 18 3.4.2 Estimated Ultimate Recovery .................................................................. - 18 3.4.3 Cost Inputs .............................................................................................. - 18 3.4.4 Production Inputs .................................................................................... - 19 3.4.5 Commodity Price Inputs .......................................................................... - 19 3.4.6 Model Outputs ......................................................................................... - 20 -

3.5

RBN IRR and Breakeven Analysis ...................................................................... - 21 3.5.1 Coverage and Categorization .................................................................. - 21 3.5.2 Premises ................................................................................................. - 22 -

Section 4 IRR and Breakeven Analysis Results ........................................................... - 23 4.1

Then and Now ..................................................................................................... - 23 -

4.2

Typical Oil Plays .................................................................................................. - 25 -

4.3

Sweet Spots in Oil Plays ..................................................................................... - 26 -

4.4

Breakeven Analysis of Crude Plays .................................................................... - 27 -

4.5

Gas Liquids Plays Alternative Crude Price Scenarios...................................... - 28 -

4.6

Gas Liquids Plays Gas Price Scenarios ........................................................... - 29 -

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4.6.1 Crude and Liquids Sensitivity to Oil Prices .............................................. - 30 4.6.2 Dry Gas Plays Gas Price Sensitivities .................................................. - 30 4.6.3 Gas and Liquids Sensitivity to Gas Prices ............................................... - 31 Conclusions

................................................................................................................... - 32 -

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Section 1 Prices and Production


1.1

Price Crash

Drill bit hydrocarbon prices (crude, natural gas and NGLs) have been in free fall. The price of
CME NYMEX crude futures for U.S. domestic benchmark West Texas Intermediate (WTI) is
down 57% from its high of $107/Bbl in June 2014 to $45.59/Bbl (January 23, 2015) including a
fall of 14% so far in 2015. The price of international benchmark crude Brent ICE futures has
tumbled equally far and fast down 58% since June 2014 and 15% so far in 2015 to $48.79 on
January 23, 2015. Brent premiums to WTI have averaged less than $3/Bbl this year so far
compared to an average of $6.50/Bbl during 2014, removing some of the price advantage that
domestic crudes have held over international competitors for much of the past four years. In
addition a mild 2014/2015 winter so far and continued record dry gas production in the Lower 48
has resulted in lower prices for natural gas since November 2014. Prices for CME NYMEX Henry
Hub natural gas futures delivered to the Henry Hub in Louisiana are down 30 % to $2.986/MMBtu
(January 23, 2015) since November 2014 and have averaged less than $3/MMBtu in recent
weeks. The chart in Figure 1 below shows Brent (red line) and WTI (blue line) in $/Bbl against
the left axis and Henry Hub futures (green line) in $/MMBtu against the right axis. All three
commodities have been headed in the same direction down (black dotted oval on the chart).

Figure 1 Crude & Natural Gas Prices; Source: CME Data from Morningstar

Despite falling natural gas prices, the ratio between WTI crude and Henry Hub natural gas is
languishing at 16.3X (meaning crude in $/Bbl is 16.3 times the price of natural gas in $/MMBtu).
That compares with an extremely high ratio of 54X in 2012 and an average of 27X between 2009

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and June 2014. The low crude to gas ratio has important implications for NGLs (the liquids
extracted from wet or rich gas at the wellhead). NGLs are also at multi-year lows squeezed
between tumbling crude and low natural gas. The Frac spread is an indicator of natural gas
processing margins the spread between the energy equivalent Btu price of a basket of NGLs
weighted by typical volume processing yields and the price of natural gas. The higher the Frac
spread, the more profitable it becomes to extract liquids from wet gas NGL plays. The Frac
spread was above $8MMbtu in February 2014, but as NGL prices fell it dropped below
$4.00/MMbtu in November and in January 2015 the spread fell below $2.00/MMbtu - indicating
that gas processing is uneconomic at many processing facilities. Lower Frac spread values
reduce drilling returns in wet gas NGL plays.
It is this triple price whammy that U.S. shale producers are scrambling to come to terms with in
developing their 2015 drilling programs.

1.2

Cash Flow Impact of the Price Crash

Funds for most producers to pay for continued drilling and increased production rely heavily on
cash flow generated from existing operations. That cash flow is either used to pay for new drilling
or to pay down borrowing for existing well development. With less operating cash or financing
available, new drilling will be curtailed. Because of this reality it is important to understand that
there has been a sea change in the fortunes of U.S. shale producers as a result of the price
crash. The following high-level estimate of the cash flow impact on crude oil production returns
illustrates the scale of the challenge for just one commodity.

Figure 2 WTI Prices 2013 & 2014; Source: CME Data from Morningstar

Between January 2009 and January 2015 U.S. monthly crude production increased by 3.8
MMb/d to 9.1 MMb/d according to the Energy Information Administration (EIA) weekly estimates.
Since this 3.8 MMb/d has primarily been an increase in shale production mostly from the
Bakken, Permian and Eagle Ford basins - we can use that number to estimate shale producer

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revenues before the price crash and after. Figure 2 shows crude prices for U.S. benchmark West
Texas Intermediate (WTI) during 2013 and 2014. Up until the high price of 2014 on June 7th
the average WTI price over this period was $99/Bbl (green dotted line). After the crash, prices
fell sharply for the rest of the year to end at $53/Bbl about 46% below the previous $99/Bbl
average (red arrow). At $99/Bbl the 3.8 MMb/d of shale crude production since 2009 would
generate about $0.38 billion per day or $139 billion per year. That means shale producers could
expect as much as $139 billion revenue from production during 2014. With crude prices falling
46% in the second half of 2014, the revenue from that shale production would fall to 3.8 MMb/d
* $54/Bbl = $0.2 billion per day. That is $73 billion on an annual basis. So in terms of drilling
budgets for 2015, U.S. shale producers can expect to receive about ($139 - $73) or $66 billion
less cash flow revenue from existing crude production with prices at year end 2014 levels
($53/Bbl).

1.3

Production Impact

Prior to the shale era, lower oil and gas prices would translate quickly into a visible reduction in
the number of drilling rigs operating and the curtailment of new production. But today the
response is much less predictable and a reduction in drilling rigs is frequently matched by an
increase in production at least in the short term. Figure #3 shows U.S. weekly drilling rig count
totals from the start of 2011 the period when oil shale production really took off. The green
shaded area is the total rig count (both oil and gas) including conventional vertical drilling where
the well is drilled straight down and horizontal drilling that is typically used with hydraulic
fracturing to extract hydrocarbons from shale. Note that the total rig count has remained range
bound between 1700 and 2000 over the entire period but was down to 1633 on January 23, 2015
- falling 15 % since November 2014. In the shale era, the number of rigs has had little or no
correlation with production volumes. For example total rig count was higher in 2011 than it is
today, yet crude and gas production volumes have increased dramatically since then. This
disparity is caused by dramatic improvements in rig productivity meaning fewer rigs are required
to extract more hydrocarbons. Also note that the gas-only rig count (red line in Figure #2) has
leveled off in the three hundred range since 2013 although gas production has continued to
increase - in part because oil drilling has produced more associated gas. The number of oil rigs
(blue line) has fallen by 261 since mid-November in response to falling crude prices (pink dashed
circle in Figure 3) but production is still increasing from existing wells coming online.

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Figure 3 Oil & Gas Rig Counts; Source: Baker Hughes


Regardless of drilling rig numbers, the immediate impact on the production of crude, natural gas
and NGLs resulting from the price crash is likely to be minimal. Existing wells that are currently
flowing will continue to produce there is no value to shutting in output because of falling prices.
Even at todays prices, the per-unit revenues of existing wells are significantly above operating
costs. In fact, production is likely to increase in the near term for at least four reasons: (a)
Producers are cutting back drilling, but the rigs that are left are focused on their highest yield
sweet spots, the best, largest producing opportunities. The producers goal is to maximize
revenue, and that means maximize production volume. (b) In recent years a number of leases
signed by producers have HBP (held by production) clauses, requiring drilling and production to
hold leases that were acquired at significant costs. Some wells will be drilled and produced to
hold these leases, regardless of short term economics. (c) Some producers were wise enough
to hedge their prices, and will continue to drill and produce against those higher priced forward
sales, and (d) producer economics will be improved by lower drilling services costs, which are
coming down fast in response to lower drilling activity.
However, there is no doubt that over time lower prices will result in producers cutting their
budgets for drilling new wells. This is already happening in shale plays across the country as
producers, small and large review how much they will invest in new production during 2015 and
beyond. For example, detailed information provided on rig deployment in North Dakota by the
State Industrial Commission indicates the drilling rig count in that State was down from 191 in
October 2014 to 181 in December 2014 and 156 in mid-January 2015 a reduction of 35 rigs or
18% since October.

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But even as the rig count is falling, many companies have announced that they expect 2015
production to be higher than 2014. For example spending at Oklahoma City-based Continental
will fall to $2.7 billion but the company will increase production by as much as 20 percent in 2015.
Midland, TX-based Concho Resources cut its 2015 capital spending plans by $1 billion but
projects 16-20% year-over-year production growth. Other producers are moving rigs to locations
where they expect higher production, and thus higher returns. Comstock Resources announced
plans to suspend its oil-directed drilling activity in shale plays in Texas and Mississippi and move
two rigs to Northeast Louisiana where it would start drilling for natural gas in the Haynesville
Shale in pursuit of higher returns. Analysis of a sample of company announcements compiled by
U.S. Capital Advisors on January 20, 2015 indicated that 15 out of 18 independent producers
who provided data expect 2015 production to stay level or increase over 2014. What is happening
is that the least productive rigs are being laid up, while the most productive rigs continue to drill
and yield increasing production volume.
In summary despite the price crash, RBN does not expect to see an immediate decline in crude
oil production. We expect that producers will drill fewer wells this year but that these wells will be
more productive targeting the sweet spots in existing plays. We expect production to continue
to increase in 2015 and potentially 2016 as well albeit at a slower pace. The more immediate
impact will be on producers dealing with lower cash flows from existing wells and deciding where
to target their future drilling programs to get the best returns on investment.

Section 2 Drilling Technology


What follows is based in part on our May 2014 Stacked Deck Drill Down report on RBNs view
of the outlook for Permian production. It is provided as a refresher and introduction for those less
familiar with shale drilling and economics.

2.1

Background

The conventional approach to oil and gas production that dominated the industry for decades
targets individual geologic "traps" of oil and gas, which are concentrated pools of hydrocarbons
sealed under a cap of impermeable rock. Over millions of years, these deposits seeped up to the
trap from a source rock below, often a shale formation. Such conventional reservoirs are
relatively straightforward to develop once discovered. Unfortunately, onshore U.S. conventional
fields have long been in decline and are largely tapped out. As a result, producers looking for
conventional plays increasingly resorted to inhospitable locations such as deep sea offshore and
northern Alaska that are expensive and challenging in which to operate.
In contrast with conventional plays, unconventional shale plays seek to exploit hydrocarbons
that have not migrated away from the source rock and are still embedded in relatively
impermeable, sedimentary geological formations such as tight sands and shale. Hydrocarbons
are extracted from these formations using an innovative combination of two technologies, namely
horizontal drilling and hydraulic fracturing that have been around for a long time.
What makes shale production viable is the presence of vast, continuous shale-rock formations
in several major plays around the U.S., together with (a) the ability to burrow across these long
formations horizontally, and (b) huge improvements in the ability to frack the rock to release
hydrocarbons to flow to the well bore and up to the surface. The result? Large initial production
(IP) flow rates of hydrocarbons in the first 30 days, and significant estimated ultimate recoveries
(EUR - total cumulative production) per well.
From an economic perspective, these
characteristics translate to more production per dollar spent drilling a well, which in turn means
higher rates of return on drilling investment.

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Much of the credit for the innovative techniques used in the shale revolution lies with the late
George Mitchell (1919 2013) and members of his Mitchell Energy shale gas team. Over more
than a decade of trial and error in the late 1990s and early 2000s, Mitchell and his team worked
to refine horizontal drilling and hydraulic fracturing (fracking) technologies to tap the vast supply
of shale hydrocarbon resources that unconventional drilling now provides.

2.2

Horizontal Drilling and Fracking 101

To drill a horizontal well, the operator first drills vertically to a depth just above the shale formation
called a kick-off point". Drilling is then continued horizontally through the shale formation to the
desired lateral length. During the process of drilling, several casings are installed--think of them
as metal sleeves. Casing is held in place by cement that isolates the well from the surrounding
geology (see Figure 4).

Figure 4 Shale Drilling Technologies; Source: Department of Energy

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The key to the large initial production rates and EURs exhibited by shale wells is that horizontal
orientation. Why? The entire length of the extended horizontal well bore after hitting shale comes
into direct contact with the pay zone. Think of it this way: vertically drilling into a conventional
reservoir allows only a few hundred feet of contact between a well and a formation, but drilling a
shale well horizontally allows several thousand feet of contact between the well and the
formation. Many of these horizontal wells in shale basins have horizontal laterals, extending
5,000 to 12,000 feet in length, or longer.
After drilling, the next stage is well completion. Operators progressively perforate the well in
stages, working back from the end of the horizontal lateral, using explosives to blow small holes
(perforations) through the casing. Then comes hydraulic fracturing, a technique used for decades
in both vertical and horizontal wells to create fissures in the rock to release gas and liquid
hydrocarbons.
Using heavy horsepower, the operator pumps a mixture of water and chemicals at very high
pressure into the well and out through the perforations. The resulting pressure cracks or fractures
the surrounding shale, creating permeable passages from the greater formation to the well bore.
However, once the water pressure is reduced the fractures would quickly close again, so to
prevent this, operators also add to the frack fluid a quantity of small crush-resistant particles,
usually sand, called proppants. These proppants move into the fractures and hold them open
after the pressure is reduced. The process of perforation and fracturing is conducted in stages
back from the end of the horizontal lateral with short lengths of the well bore being completed
one after another. Accordingly the cost of completion is somewhat proportional to the number of
frack stages performed.

2.3

Evolution of Fracking

When shale gas grabbed the public consciousness in the late 2000s, companies initially
targeted dry gas (gas which is mostly methane; minimal NGL content) wells in the Barnett shale
near Fort Worth and Dallas, the Haynesville shale of Louisiana, the Fayetteville shale of
Arkansas, and the Marcellus shale of Northeast Pennsylvania. Gas flowed out of fractured rock
so well that the ensuing oversupply depressed domestic gas prices. Those lower prices
discouraged more drilling, and eventually the natural decline rate of the wells overtook volumes
from the fewer new wells, resulting in decreasing production in some of these plays. One major
exception to this trend has been dry gas in the particularly prolific and profitable gas wells in the
Marcellus and Utica plays near Northeast consumers.
Fortunately those same technologies worked equally well for wet natural gas plays where the
gas has a high British Thermal Unit (BTU a common measure of energy) content which, when
processed, yields significant quantities of NGLs valued by (among others) petrochemical, refining
and retail propane markets. As liquids, NGLs are generally priced closer to crude oil than to
natural gas and so when the crude to gas price ratio is wide (as it was between 2009 and June
2014), NGLs were priced considerably higher on a BTU basis than dry (predominately
methane) natural gas. The higher value of NGLs encouraged gas drillers to move away from dry
gas basins and towards wet gas liquids plays, and that was a big factor in continued increases
in natural gas production. But there are a limited number of those wet gas plays. Eventually
producers turned the focus of shale technologies to crude oil. The price of oil, set on international
markets, more than doubled after the Great Recession, returning to pre-crisis levels of over
$100/Bbl and dramatically diverging on an energy-equivalent basis from gas prices. This
divergence of crude and natural gas prices provided the impetus for shale producers to begin
exploiting oil plays such as the big three - the Bakken, Eagle Ford and Permian Basins using
horizontal drilling and hydraulic fracturing. The result was a shift in focus by producers with the

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option to move their drilling budgets and activities away from dry gas and towards crude oil and
liquids-rich gas plays.

2.4

Productivity Improvements

The evolution of fracking technology has been characterized by continuous improvement in


drilling productivity bringing down the costs of drilling and completing wells at the same time
as increasing well IPs and EURs. Two of the more important techniques developed are:

Multiple Well Drilling Pads: many laterals can be drilled in several directions from one
drilling site. The same horizontal drilling rig can be moved slightly to extend a new lateral
instead of packing up and moving to a new location to drill a new well.
Stacked Plays: as fracking technology has improved, operators have learned how to
crack the code in more complex formations with multiple layers of shale such as the
Niobrara in the Rockies, the Bakken in North Dakota and Wyoming, and Permian basin
in Texas and New Mexico. Wells in these stacked plays produce a combination of oil,
gas and NGLs - increasing producer IRRs. By obtaining a lease with optionality,
producers can drill wells over and over on the same stretch of land, targeting different
geological levels in stacked pay zones.

All this is good for the management of costs. Producers keep their infrastructure, crews,
subcontractors and materials in roughly the same area over a longer time, and do not have to
relocate to reinvent the wheel as often. Even moving rigs is getting more efficient with walking
rigs that can mechanically move a short distance to their next location.
These productivity improvements have been achieved at a time of higher oil prices when rates
of return for drilling were high permitting experimentation. In the coming period of lower oil and
gas prices we expect to see productivity improvements continue under the incentive of lower
revenue streams. Other service costs provided by drilling support companies should also be
pressured downward in a period of lower demand.

Section 3 Scenario Analysis Assumptions and Variables


Methodologies for calculating the economics of oil and gas producing wells are quite complex,
requiring sophisticated models, considerable technical expertise and more data than is usually
available to analysts. However, it is possible to approximate the results from these sophisticated
models using a simple spreadsheet model and a few critical input variables. That is the intent of
the RBN Production Economics Model, which uses only seven input factors. These factors are:

Drilling and Completion Costs what it costs to drill the well and ready it for
production
Operating Expenses the ongoing cost of operating and maintaining the well
Production Taxes- taxes due to government entities based on oil and gas
production
Royalty Rates the amount owed to the owner of the mineral rights where the
well is located
Initial Production Rate the rate of flow for the well when it first goes into
production
Decline Curves the rate of production decline over the life of the well
Commodity prices the price at which the oil, NGLs and gas are sold

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The analysis in Section 4 was generated using the RBN Production Economics Model to compute
returns (IRRs) for both typical and sweet spot wells in oil, gas and NGL shale plays. In this section
we provide details and explanations of the model inputs.
Note that the cost of acquiring the lease and any exploration costs are not included in our list of
variables. We confine our analysis to half cycle economics - a term that means we compute the
rate of return based on the incremental cost of drilling the well, offset by the revenues from
products from that well. Since any exploration costs and the cost of acquiring the lease are for
the most part already sunk, they are not included in our analysis.

3.1

Drilling and Completion Costs

Developing a well is a two-part process. The first is drilling: putting roads in to the well site,
leveling dirt for the drilling pad and platform, prepping the site, mobilizing the rig, drilling the well,
and cementing the casing. The second part is completion: hydraulic fracturing to stimulate flow
from the well and putting the infrastructure in place to get the wells production to market. The
two pie charts in Figure 5 give an idea of the relative proportions of drilling and completion costs
spent at each stage.
The actual cost of drilling a single unconventional horizontal well is chiefly a function of the depth
of the formation and the lateral length drilled through it. A short lateral (horizontal) may have a
length of 5,000 ft. Longer laterals get up to 12,000 feet and are considerably more expensive.

Figure 5 Breakdown of Representative Horizontal Well Costs; Source: RBN

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By far the largest part of completion cost is fracking (hydraulic fracturing), or well stimulation.
Other costs include perforation of the well casing, handling of flowback water, tubing and surface
equipment, and facilities costs.
The number of fracturing stages is a primary determinant of completion costs. In each fracturing
stage the well casing is perforated and water, chemicals and proppant are injected under high
pressures into the shale to cause fractures. When the water recedes the proppant (usually silica
sand) holds open the fractures so that the hydrocarbons can flow into the well bore.
The drilling and completion costs for wells used in our analysis ranged from less than $1 million
to $12 million.

3.2

Operating Expenses

Well drilling and completion can be considered the fixed costs of production. Once the well is
producing hydrocarbons, there are a number of variable operating costs. These variable costs
may be broadly grouped into two buckets - operating expenses and royalties and taxes.
Operating expenses are direct costs associated with operating each individual well together with
the gathering system that connects the wells to a processing plant or pipeline interconnect. They
are generally split between lease operating expenses and gathering and transportation costs.
3.2.1

Production Taxes

In most U.S. oil and gas fields, producers are required to pay a production or severance tax
based on the gross production revenue generated at the wellhead. The gross production
revenue - the final sale price of the oil and gas at the wellhead, less the transportation cost to
get it to market. When dealing with severance tax it is important to remember that the mineral
rights owner usually must pay his/her portion of the severance tax out of their royalty payment.
3.2.2

Royalty Rates

The royalty is an agreed upon percentage of the gross production revenue, before production
costs, paid to the owner of the mineral rights. Usually producers do not directly own either the
land or the mineral rights for drilling locations and must lease those mineral rights from the
owner. The owner of the mineral rights may or may not be the surface owner. The minerals
lease will typically include a bonus, paid up front (and ignored in our analysis since we are
computing half cycle economics, as described previously) and a royalty rate.

3.3

Initial Production, Decline Rates and Estimated Ultimate Recovery

The relationships between three critical variables determine a wells production over time. Those three
variables are; the initial production rate (IP the production rate during the first month), the decline rate
(meaning the rate at which production declines over time) and the estimated ultimate recovery, or EUR
(meaning the total well lifetime production).
Figure 6 plots the relationship between the daily crude oil production curve (blue line, left axis) and the
cumulative crude oil production curve (red line, right axis) for the 25-year lifetime of a representative well
in the Permian basin.

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Figure 6 Daily Oil Production Curve & Cumulative Production Curve; Source: RBN

The well has a high crude oil IP rate of 475 b/d (blue line, first month of production). The rate of
production falls off a steep 55% in the first year, 30% the second year, and a declining percentage
each year thereafter until the decline curve comes close to flattening out (numbers detailed in
Table 1). But by the end of the fifth year (60 months), the well is still producing about 93 Mb/d.
Even after 300 months (25 years) the well is still expected to be producing 36 Mb/d.

Table 1 Production Decline Rates; Source: RBN

The red line in Figure 6 is cumulative production over the life of the well. Because of the high IP
rate the cumulative production builds quickly in the early years then continues to grow at a slower
rate over the entire life of the well, eventually reaching an EUR of about 700 Mbbls (cumulative
production in year 25). Almost half of the wells EUR is produced in the first five years. From an
economic perspective, this front-end loaded cash flow is good news. In effect, the producers
well costs are recovered sooner, which improves the discounted cash flow rate of return (IRR)
for the well.
Ideally producers want a high initial rate of production (IP) and a slow rate of decline, so that they
can get as much of the wells cash flow in the early years as possible (this greatly improves the
wells net present value), so that revenues dont fall off a cliff soon thereafter.

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3.4

RBN Production Economics Model Analysis

RBNs IRR analysis was produced by running published well datasets with values for the seven
inputs described above through our spreadsheet model in different price scenarios We use a
variety of published sources for the data including investor presentations and analyst reports.
Our goal is to include a range of input values for different wells from multiple sources for each
basin and in some cases for wells having different economics to do with transportation or
commodity prices within basins. Each set of well inputs is categorized as being oil, gas or NGL
directed and identified with a particular basin or sub-basin. The summary scenario IRR and
breakeven analysis in Section 4 is based on aggregated data for each basin category, calculated
by averaging multiple datasets to identify a typical well.
3.4.1

Decline Rates and Decline Curves

The decline rate inputs to our model are monthly or annual decline curve percentages
provided by our various data sources. We apply a smoothing technique called the Arps curve
to these decline rates to produce smooth decline curves. A mining engineer named J.J. Arps
in his 1945 paper Analysis of Decline Curves developed this method. Effectively the Arps
equation fits a hyperbolic curve to a series of decline rates to achieve a curve generally
representative of actual well declines.
3.4.2

Estimated Ultimate Recovery

The EUR is an estimate of the total volume of hydrocarbons that can be recovered over the
well life. The EUR is simply the cumulative production forecast for the well and in the RBN
model is calculated using decline rates and assuming a standard 25-year well life. For a
multiple commodity well, we calculate the EUR for each commodity.
The following cost and revenue inputs and assumptions are supplied to the model for each
well case to produce RBN IRR and breakeven analysis:
3.4.3

Cost Inputs

Drilling and Completion Cost: the total cost of drilling and completion
Royalty Interest: This is an agreed upon percentage of the gross production revenue paid
to the owner of the mineral rights. The royalty interest varies according to lease terms.
Discount Factor: The discount factor is the interest rate used to calculate the cumulative
Discounted Cash Flow for all three commodities: oil, natural gas and NGLs. The sum of
the discounted cash flows is the net present value (NPV). The model calculates the value
of the discount factor when the NPV is zero as the internal rate of return (IRR), or
discounted cash flow rate of return. Theoretically the discount factor represents a
companys internal cost of capital. We set the discount rate in the model to 10% because
operators often calculate a wells break-even price on a before tax basis using a flat 10%
discount rate. This facilitates an apples to apples comparison both between wells and
across basins.
Production Taxes (%): the production tax is levied on the final sale price of the oil and
gas at the wellhead. Production taxes apply to net revenue less royalty payments.
Operating Costs: in $/Bbl for oil and liquids or $/Mcf for gas. Variable costs associated
with the production of oil, gas and the processing cost for NGLs.
Operating Cost Escalator (%/yr): expected annual escalator for operating costs defined
above. The escalator is assumed to be zero in our analysis

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3.4.4

Production Inputs

Initial Production [Oil/Gas/NGL]: the first years daily production rate (measuring volume
in b/d for oil and NGLs, Mcf/d for gas). Production is multiplied by the assumed commodity
price to calculate gross revenue. After the first year, production is calculated using the
production decline rate.
Gas GPM content (Gal/Mcf): the typical volume of gas liquids extracted from wet gas at
a processing plant for a given well.
NGL Production Volumes: The IP rate and decline curve inputs for natural gas are used
to compute gross gas production. Then the liquids content of the gas (GPM) is used to
compute the NGL volumes. For example, using a value of 6.5 GPM value and a 1100
Mcf/d IP rate for gas, the initial production rate for NGLs is calculated as
1100*6.5/42=170.24 (where 42 is the number of gallons in a barrel).
1,100 MCF
1 day

6.5 gallons
1 MCF

1 barrel
=
42 gallons

170.24 barrels
day

Shrinkage: When NGLs are extracted in a processing plant, the volume of gas remaining
is naturally going to be less than the original wellhead production. The model computes
shrinkage based on the percentage mix of NGL products.
3.4.5

Commodity Price Inputs

Crude Prices and Discounts: crude prices for each well used in our IRR and breakeven
analysis have three components. The first is the Cushing WTI benchmark price in our
analysis of pricing scenarios this is the default crude price used for each well (e.g. $90/Bbl,
$75/Bbl, $60/Bbl or $45/Bbl). There are also two crude discount variables that can be
assigned a value for each well analyzed. The first is quality e.g. in the Eagle Ford some
crude is actually condensate that is typically discounted by refiners who do not value the
lighter components in condensate. The second discount component is transport cost to
market - typically borne by producers. The transport costs reduce producer crude netbacks
(a netback is the crude sales price less transportation costs).
We include the two crude price discount components in our analysis in order to calculate
IRRs for both actual crude values at the wellhead (default crude price less quality and
transport components) and the WTI equivalent price (just the default crude price).
Calculating a WTI equivalent IRR allows direct comparison of well performance between
basins and an easy reference to WTI - the U.S. benchmark crude price.
Natural Gas Price Discounts: natural gas prices are assumed by default to equal the
benchmark CME NYMEX Henry Hub futures price. In a similar way to that explained above
for crude we also include price discounts for natural gas. Gas price discounts represent
typical basis differentials that represent the price spread between the nearest gas trading
hub price point to the well and Henry Hub, LA. Each well producing gas in our analysis is
assigned a gas trading hub and each hub has an assigned discount value equal to the
most recent yearly average basis spread to Henry. The gas price discount factor is
subtracted from the scenario price (e.g. $4.50/MMBtu, $4.00/MMBtu etc.) for each well
when calculating IRRs.
Marcellus and Utica Natural Gas: as a general rule in the model, because they are based
on nearby gas trading hubs, all the wells in a gas play use the same basis discount. There
is one important exception to this assumption. Currently there is a wide disparity in basis

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differentials in the Marcellus and Utica regions, depending on availability of take-away


capacity. In some areas of constrained take-away capacity, basis has been very wide with
corresponding low natural gas prices. Other areas, generally those further west, have not
been subject to such wide differentials. Furthermore, some producers have acquired
pipeline capacity to move their gas from the constrained areas to the unconstrained areas.
Thus there is a big price difference between natural gas production subject to wide
differentials and production that is not. For that reason, two natural gas cases are
calculated in the region, one based on the price at Columbia Gas TCO and the other based
on the Dominion South trading hub. Dominion South, in West Virginia on the Dominion
Transmission (DTI) pipeline system, is usually subject to significant take-away constraints,
and as a result, prices at Dominion South (DOM) trade well below Henry Hub. In contrast
the Columbia Gas TCO pool hub (TCO) has the capacity to replace incoming supplies from
the southeast (on Columbia Gulf) with Marcellus gas. The result is that TCO is less
congested than DOM and gas prices at TCO are typically higher by more than $1/MMBtu.
To reflect the fact that these two pricing hubs are mismatched, we split Utica and Marcellus
well analysis into separate categories for our IRR analysis with wells associated with
TCO pricing having a lower gas price discount.
NGL to Crude Ratios in the Northeast: as explained above, we use a lower NGL ratio to
crude (29%) for liquids plays in the Marcellus and Utica because the latter produce a lighter
slate of NGLs and are subject to NGL pricing discounts, particularly during the summer
season. For liquids plays outside the Northeast we use a 37% NGL to crude ratio.
3.4.6

Model Outputs

Cash Flows: are calculated for each commodity over the 25-year assumed life of the well
by multiplying annual production volumes by the net commodity price (price less discounts
and transport) and subtracting the variable operating costs and taxes.
Discounted Cash Flows: using the annual cash flows and the discount factor the model
calculates a discounted cash flow for the well. Table 3 shows the discounted cash flow
calculation results for a well that cost $7.5 million to drill and complete (investment cost
cell B17). Cash flows for each of the three hydrocarbon products are summed with total
investment costs to yield annual cash flows (column B in Table 3) and cumulative cash
flows (column C in Table 3). Discounted cash flows are then computed using the 10%
discount factor (column D in Table 3).

Table 3 Cash Flows and Discounted Cash Flows; Source: RBN

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Net Present Value: the discounted cash flow (DCF) for a well is the sum of the discounted
cash flows (column E in Table 3). The sum of the discounted cash flows is also known as
the Net Present Value (NPV).
Internal Rate of Return: the Discounted Internal Rate of Return (IRR) is calculated using
the ExcelTM function =IRR() to calculate the rate which discounts the series of before tax
net cash flows (column E in Table 3) to zero. The calculated IRR represents the rate of
return a producer can expect for a well with the given input characteristics.
Breakeven Price: for a well is calculated by reducing the input value for the crude price
(for example by using the ExcelTM solver function or by trial-and-error), until the rate of
return is zero. At that price the DCF will pay back the investment exactly over the 25-year
well life. The breakeven price can only be calculated for one commodity at a time meaning
that the price of natural gas must remain static when calculating a crude oil breakeven. In
our analysis we calculated breakeven values for crude at various natural gas prices. (NGLs
are priced as a percentage of crude.)

3.5 RBN IRR and Breakeven Analysis


3.5.1

Coverage and Categorization

For our analysis we used well data from the shale basins and plays listed in Table 4.

Table 4 Basin Coverage; Source: RBN

As stated earlier we analyzed data from a range of wells for each of these basins and
aggregated the results to provide summary values for the categories in Table 4 oil, liquids
(NGLs) and natural gas. Wells are placed into these categories based on the commodity
that provides the greatest contribution to total well revenues. For example, natural gas
plays are usually the easiest to categorize as such since they do not produce meaningful
liquids outputs. It is more difficult to determine whether a well is primarily producing oil or
NGLs since they both typically produce both. For our analysis we categorized wells in the
liquids (NGL) category if more than 40% of the first years output was in the form of NGLs.
The exception to this rule was wells identified as located in the liquids (wet gas) window of
the Eagle Ford in South Texas.
As explained above Marcellus and Utica liquids and gas wells are categorized as DOM
or TCO depending on their natural gas market price delivery hub.
For each of the fourteen plays used in our analysis (shown in Table 4) we aggregated
results reflecting representative wells. These representative wells were not simple
averages of all well results. Rather we focused on wells drilled over the past two years
which appeared to be representative in terms of cost and well performance of the typical
well drilled in each play. We eliminated outliers from the analysis to arrive at a
representative sample across multiple sources.

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3.5.2

Premises

Table 5 lists the most important input variables used for each play more detail on each of
these below. We provide this level of data to improve the readers understanding of how to
interpret our IRR and breakeven results.
OilIP
Drillingand RateFirst OilPrice
Oil GasIPRate GasPrice
Gas
GPM
Completion
30
Differential Decline First30 Differential Decline
Costs(MM) (Bbl/day) ($/bbl)
Y1
(Mcf/Day)
($/Mcf)
Y1
Content
$3.0
200
(1.50)
57% 600
0.09
63%
4.4
$8.0
750
(4.00)
73% 1,000
0.01
75%
4.2
$7.0
500
(2.50)
73% 1,200
0.03
70%
4.6
$9.0
700
(6.50)
68% 450
0.04
73%
6.3
$4.4
325
(1.50)
79% 800
0.03
79%
4.2

OilPlays
Anadarko
EagleFord
Permian
Bakken
Niobrara
LiquidsPlays
Utica
$10.0
0
(1.50)
EagleFord
$8.0
300
(6.00)
GraniteWash
$7.0
100
(1.50)
Marcellus
$7.0
0
(1.50)
GasPlays
Marcellus
$5.5
NA
NA
Utica
$10.0
NA
NA
Haynesville
$8.0
NA
NA
Fayetteville
$2.7
NA
NA
Piceance
$1.7
NA
NA
*Variesdependingonlocationandtakeawaycapacity

50%
71%
74%
53%

6,000
4,000
6,000
5,000

*
0.01
0.09
*

50%
71%
74%
53%

8.2
5.2
5.2
5.5

NA
NA
NA
NA
NA

8,000
9,000
12,000
2,800
1,700

*
*
0.00
0.09
0.03

65%
52%
70%
69%
72%

NA
NA
NA
NA
NA

Table 5 Analysis Premises; Source: RBN

Drilling and Completion Costs: half-cycle costs as described above that exclude certain
costs such as exploration and leasing. Per well drilling and completion costs range from a
low of $3.0 million in the Piceance Basin to $10 million in the Utica. Note that these costs
are based on inputs derived from wells drilled before the crude price crash and
consequently are biased high. These costs are coming down quickly as services providers
reduce fees to remain competitive in todays low crude price environment.
Oil IP Rate: crude oil initial production rate in barrels of oil per day. Gas-only and NGLonly wells do not have oil IPs. Note that these IPs are in some cases considerably above
the average well in each play. For example, we use an IP of 700 Mb/d in the Bakken when
the average well over the past two years may be 200 Mb/d below that level. In this analysis
we are focused on the wells that are targeted by producers today, not necessarily historical
experience.
Oil Price Differential: The differential applied to WTI prices to reduce prices to the field
level. The higher differential for Bakken crude is reflective of a geographic differential while
the differentials for the Eagle Ford is reflective of a quality differential (about half of the
crude oil is priced as condensate).
Oil Decline: This is the first year decline rate applied to the oil stream. Like other factors,
these decline rates are for representative wells and vary significantly within basins and
from well to well.
Gas IP Rate: natural gas initial production rate in Mcf/d.

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Gas Price Differential: These differentials are based on the average basis between these
points and Henry Hub during 2014.
Gas Decline: This is the first year decline rate applied to the gas stream.
GPM Content: This is the assumed liquids content of the gas as measured by gallons per
thousand cubic feet (GPM). NGL volume is developed using the gas production rate and
the gas production rate is reduced by NGL shrinkage. The GPM for dry gas plays is omitted
since it is assumed that no NGLs are extracted from the dry gas plays.
Typical Wells and Sweet Spot Wells: We then extracted from each typical well set a
super set of sweet spot wells having the highest IP rates that produce the highest IRRs.
We used these wells to identify sweet spot well characteristics.

Section 4 IRR and Breakeven Analysis Results


4.1

Then and Now

We start with overall results from our analysis beginning with two overviews of typical IRRs seen
in oil, wet gas (NGLs) and dry gas plays in different price scenarios. The first of these scenarios
is with oil at $90/Bbl and gas at $3.75/MMbtu as experienced in the fall of 2014. We compared
those results to the situation in January 2015 with oil at about $45/Bbl and gas at about
$3/MMBtu. Figure 7 shows typical IRRs for the fall of 2014. Black circles are oil plays, red circles
are dry gas and green circles are wet gas plays.
With oil at $90/Bbl the oil plays easily show the best returns with the Anadarko at 41% followed
by Permian at 40%, Bakken at 39%, Eagle Ford at 40% and Niobrara at 37%. Next highest
returns are for the wet gas NGL plays with the Eagle Ford yielding 25% IRR and the Granite
Wash 23%. In the Utica and Marcellus recall that we provide separate scenarios for dry gas and
liquids based on market delivery to Dominion South Point (where congestion is increasing market
price discounts to Henry Hub thus reducing IRRs) and Columbia Gas TCO where there is less
congestion and price discounts are lower. Typical wet gas wells delivering to the Utica TCO hub
produce 32% IRRs compared to 24% for Dominion South. In the Marcellus the wet gas typical
IRRs delivered to TCO are 22% and to Dominion South 13%. Finally typical dry gas returns at
$3.75/MMBtu (oil prices are not applicable to dry gas wells) are 6% for the Fayetteville and 5%
for the Haynesville and -2% for the Piceance. Far higher IP rates in the Utica and Marcellus dry
gas plays produce higher IRRs for wells delivering into TCO at 16% for Marcellus and 15% for
Utica. These higher IRRs are reduced considerably by lower market prices for wells delivering to
Dominion South that have an IRR of -1% in the Marcellus and 1% in the Utica. Note that these
returns, while attractive, still are not as good as the returns seen during the summer of 2014
when crude oil was above $100/Bbl and natural gas exceeded $4.50/MMbtu.

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Figure 7 Fall 2014 IRR Results; Source: RBN

Our second scenarios are with oil at $45/Bbl and gas at $3.00/MMbtu as experienced during
much of January 2015 (see Figure 8). With oil at $45/Bbl and gas at $3/MMBtu pretty much all
the plays show negative IRRs except for three oil basins - the Anadarko at 3% (down from 41%
at $90/Bbl), the Permian at 3% (down from 40%), and the Bakken at 1% (down from 39%). Eagle
Ford oil is down to breakeven (0%) from 40% at $90/Bbl oil and the Niobrara is also at breakeven
(down from 37%). All the wet gas NGL plays are underwater in this scenario with the Eagle Ford
producing -3% IRR (down from 24%) and the Granite Wash -2% (down from 23%). Typical wet
gas wells delivering to the Utica TCO hub produce 1% (down from 32%) IRRs compared to -4%
(down from 24%) for Dominion South. In the Marcellus the wet gas typical IRRs delivered to TCO
are -2% (down from 22%) and to Dominion South -9% (down from 13%). Typical dry gas returns
at $3.00/MMBtu are -8% (down from 2%) for the Piceance, -2% (down from 6%) for the
Fayetteville and -4% (down from 5%) for the Haynesville. In the Utica and Marcellus dry gas
plays produce higher IRRs for wells delivering into TCO at 3% (down from 16%) for Marcellus
and 4% (down from 15%) for Utica. Those just positive IRRs are turned negative by lower market
prices at Dominion South with IRRs of -11% (down from -1%) in the Marcellus and -8% (down
from 1%) in the Utica.

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Figure 8 January 2015 IRR Results; Source: RBN

The unsurprising take-away from this analysis is that from Fall 2014 to January 2015, unhedged
producer returns have declined from quite healthy levels in most plays down to marginal or
negative returns today. The representative well in most plays is under water, with marginal
profitability demonstrated in only the very best plays. Clearly returns are quite sensitive to prices.

4.2

Typical Oil Plays

To show exactly how sensitive returns are to prices, we next summarize representative IRR
results for oil plays at different price levels.

Table 6 Oil Play Sensitivity to Oil Prices; Source: RBN

Table 6 provides a summary of the IRR analysis results for oil plays at 4 different crude prices:
$90/Bbl, $75/Bbl, $60/Bbl and $45/Bbl in columns 2 through 5 respectively. All of these scenarios
used an NGL ratio of 37% and assume a $3/MMBtu price for gas at Henry Hub. To the right of
the IRR percentages are the same input factors as described above: drilling and completion
costs in millions of dollars per well, the oil IP rate for the 1st 30 days, oil price differentials to WTI
(transport and quality differentials by basin) as well as the first year production decline rate. The

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top oil plays all produce both natural gas and NGLs, so the final columns in the table indicate gas
IP rate, gas price differential to Henry and gas year 1 production decline percentage. The final
column indicates gas liquids GPM. All of these oil plays produce IRRs just below 40% at $90/Bbl
oil, around 25% at $75/Bbl oil and around 13% for $60/Bbl oil. At $45/Bbl typical Eagle Ford and
Niobrara wells are at breakeven (0% IRR), the Anadarko and Permian return 3% and the Bakken
1% - suggesting that if oil prices stay at that level for a long period, shale drilling in these plays
will eventually be reduced significantly.
Note that regardless of the wide variances in well cost, the IRRs are clustered rather tightly. For
example, the IRR range for the $90/bbl crude case is from a low of 36% to a high of 39%. We
believe this is basically a manifestation of natural selection. In other words, in the various plays
producers only drill wells that generate attractive returns. In basins with higher drilling and
completion costs that means wells need to have higher IP rates.

Figure 9 IRR Sensitivity to Oil Prices; Source: RBN

Also note that using our modeling methodology, the sensitivity results are linear. For example,
Figure 9 shows average IRRs for typical wells in all crude plays (left axis in %) plotted against
crude price (bottom axis, $/Bbl) with gas prices as $3/MMbtu. Since the only input variable
changing is oil price, the IRR has a linear relationship to the crude price.

4.3

Sweet Spots in Oil Plays

As we have pointed out, our typical wells are representative of each basin as a whole. We also
identified those wells within basins with higher oil IP rates that produce optimum IRRs. These
sweet spot results are summarized in Table 7. As for the typical well results in Table 6 we present
four price scenarios for the sweet spot wells at $90, $75, $60 and $45/Bbl oil respectively. You
can compare the oil IP rates in column 6 of Table 6 to the same numbers in Table 7 to see how
much better the sweet spot wells perform. The rightmost column in Table 7 indicates the
percentage spread between IRRs for typical and sweet spot wells at $60/Bbl oil. The data shows
that IRRs improved the most for sweet spot wells in the Permian Basin up 24% from the 14%
typical well with IP oil output increasing from 500 to 800 b/d. Next best improvement was in the

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Anadarko with the IRR improved by 20% in sweet spot wells to 34%, followed by the Niobraraup 10% from 11% at $60/Bbl oil. Eagle Ford typical IRRs at 12% increased to 21% in the sweet
spots and Bakken sweet spots produced 6% higher IRRs than the 12% in typical wells.

OilPlaysSweet
Spot
$90Crude $75Crude $60Crude $45Crude
Anadarko
73%
53%
34%
16%
EagleFord
57%
39%
21%
7%
Permian
79%
58%
38%
19%
Bakken
49%
33%
18%
5%
Niobrara
52%
36%
21%
11%

OilIP
RateFirst
30
(Bbl/day)
300
950
800
800
400

Average
toSweet
Spot
Spread
($60)
20%
9%
24%
6%
10%

Table 7 Oil Sweet Spot Well IRRs; Source: RBN

The oil play sweet spot analysis illustrates that at $60/Bbl oil, producers can find better IRRs by
concentrating on sweet spots in the plays particularly in the Permian, Niobrara and Anadarko.
And of course these sweet spot plays produce even better IRRs at higher oil prices.

4.4

Breakeven Analysis of Crude Plays

Table 8 Breakeven Crude Prices; Source: RBN

The data in Table 8 shows RBNs breakeven analysis for the major crude plays we included in
the study. As stated earlier, the breakeven is calculated by using the ExcelTM solver function to
identify the crude price at which the IRR is 0% - indicating the price at which a producer would
simply get their money back (including a standard 10% cost of capital) on the drilling investment
over the 25 year life of the well. The analysis assumes gas prices are $3/MMBtu. For each play
we calculated four breakeven prices. Column 1 in Table 8 is the breakeven for a typical well in
each play with the crude price including differentials to WTI based on crude quality and

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transportation (see Table 6). These values reinforce the IRR results by showing how close to
breakeven typical wells are in these plays at $45/Bbl crude. In column 2 we show the breakeven
values (including differentials to WTI) for our sweet spot wells in the plays. As expected, these
breakeven crude prices are lower than typical wells the actual spread is indicated in column 3.
In columns 4 and 5 we list the breakeven equivalent WTI values for typical and sweet spot wells
respectively.

Figure 10 Typical Well Breakeven vs Sweet Spot Breakeven by Basin; Source: RBN

While the breakevens for typical wells are unattractive at $45/Bbl oil, the sweet spots will continue
to provide a return on investment at that price. This indicates that producers who have the
available lease acreage can hunker down and concentrate on sweet spots even with prices at
recent lows near $45/Bbl. It should also be noted that the sweet spot wells have higher IP rates
and will therefore actually increase production compared to typical wells. Although producers
may decide to wait on better prices to drill in sweet spots in order to maximize their IRR, the need
for cash flow in the short term could dictate migration to the sweet spots. Figure 10 shows the
breakeven data by play for typical well values (red bars) and sweet spots (blue bars).
Typical IRR and breakeven analysis for specific wells is based on crude and natural gas prices
realized at the wellhead. Our analysis sticks to this convention but by isolating the price and
quality differentials to benchmarks we are able to provide IRRs and breakevens for oil plays on
a WTI basis. While this is less meaningful to the individual producer in a particular basin it is
valuable for comparison across basins and makes it easier to understand the impact of changes
in the far more visible WTI price on the viability of drilling in particular basins. The WTI
breakevens for typical wells in Table 8 show that for the Eagle Ford and the Bakken, WTI needs
to be closer to $50/Bbl for breakeven and in the case of the Bakken even sweet spot wells barely
breakeven at $45/Bbl WTI prices.

4.5

Gas Liquids Plays Alternative Crude Price Scenarios

Table 9 shows a summary of typical IRR results for gas liquids plays at different crude price
levels with the Henry Hub natural gas price pegged at $3/MMBtu.

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Table 9 Gas Liquids Plays Sensitivity to Crude Prices; Source: RBN

As with the crude play analysis (Table 6) we provide a summary of the IRR analysis results for
wet gas/NGL plays at 4 different crude prices: $90/Bbl, $75/Bbl, $60/Bbl and $45/Bbl in columns
2 through 5 respectively. There are 6 liquids play scenarios in the table recall that liquids plays
are defined by more than 40% of first year revenues coming from NGLs except for the Eagle
Ford where we selected wells in the wet gas window of the play. For the Eagle Ford and Granite
Wash plays our assumption is that NGL production is valued at 37% of the crude price. For the
Northeast Utica and Marcellus plays we assumed a lower NGL value of 29% of crude because
of the higher ethane content in NGL production from these plays combined with lower realized
prices due to oversupply problems in the region, particularly during the summer.
The IRRs shown represent typical wells for each play. To the right of the IRR percentages for
each crude price level are the input factors referenced earlier, including drilling and completion
costs in millions of dollars per well. For the Eagle Ford and Granite Wash there is crude
production so we provide the oil IP rate for the 1st 30 days, oil price differentials to WTI (transport
and quality differentials by basin) as well as the first year oil production decline rate. These liquids
plays produce both natural gas and NGLs, so the final columns in the table indicate gas IP rate,
the gas price differential to Henry Hub, gas year 1 production decline percentage, and gas liquids
GPM.
First consider the IRR results for the Eagle Ford and Granite Wash. Eagle Ford IRRs are 21%
at $90/Bbl crude falling to 4% at $60/Bbl crude and -3% at $45/Bbl. Results for the Granite Wash
are similar starting at 18% for $90 oil, down to 4% at $60 and underwater at -2% for $45/Bbl
crude. With todays lower gas liquids prices compared to crude, the IRRs for liquids plays are
predictably lower than for crude plays. Comparing the results for the Eagle Ford oil versus liquids
provides a direct comparison indicating that typical Eagle Ford oil wells produce nearly double
the IRR for representative liquids wells at $90 and $75/Bbl crude and three times the return at
$60/Bbl. At $45/Bbl crude all our liquids play scenarios are underwater with negative IRRs except
for Utica TCO at 1%.
Turning to the Northeast plays, Utica TCO liquids wells are the top performers in the category
with positive returns at all crude price levels. Remember that TCO well liquid output is only valued
at 29% of crude prices (versus 39% for Eagle Ford or Granite Wash), so Utica TCOs top billing
illustrates how prolific the liquids output is in this region. In contrast, Marcellus liquids wells fare
worst in this category with TCO market delivery producing a reasonable 15% IRR at $90/Bbl
down to -2% at $45/Bbl oil and DOM market delivery producing a meager 7% IRR at $90/Bbl
down to -9% at $45/Bbl.

4.6

Gas Liquids Plays Gas Price Scenarios

To better understand the sensitivity of IRRs from liquids plays to gas prices as well as crude we
provide a summary of results for 4 different natural gas prices at both $60/Bbl crude and $45/Bbl
crude in Table 10. The data indicates that typical wells in liquids plays are more sensitive to lower
crude prices than they are to falling gas prices, since at $3.75/MMBtu gas prices (yellow columns)

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most plays have very low or negative IRRs at $45/Bbl oil and more reasonable IRRs (except for
Marcellus DOM) at $60/Bbl oil. Higher gas prices really do not help in a low oil price environment
for example at $45/Bbl oil the liquids plays produce dismal returns even at $4.50/MMBtu gas
prices.

Table 10 Gas Liquids Plays Sensitivity to Crude Prices; Source: RBN

4.6.1

Crude and Liquids Sensitivity to Oil Prices

Figure 11 is a summary chart showing IRR sensitivity to different oil prices for both the oil
plays (left side of the chart) and the gas liquids (right side) with gas prices at $3/MMBtu.

Figure 11 IRR Sensitivity to Oil Price; Source: RBN

Higher oil prices ($90/Bbl green bars) produce better IRR rates in oil plays than liquids plays
and that pattern is repeated at $75/Bbl oil as well as $60/Bbl oil. Predictably the picture looks
worse at $45/Bbl with the typical wells in oil plays at or just above breakeven (0% IRR) and
liquids plays are underwater except for the Utica TCO.
4.6.2

Dry Gas Plays Gas Price Sensitivities

Table 11 summarizes IRRs for typical wells in dry gas plays at four different gas price levels
- $4.50/MMBtu (grey column), $3.75/MMBtu (yellow), $3.00/MMBtu (green) and $2.25/MMBtu

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(purple). Since dry gas plays produce no liquids, crude prices have no bearing on well
performance. In addition to IRRs at different price levels Table 11 repeats the model input
data reviewed earlier, showing drilling costs per well, gas IP rate, gas price differentials to
Henry Hub and the first year gas production decline rate.

Table 11 Gas Play Sensitivity to Gas Prices; Source: RBN

The IRRs for these gas plays are predictably dependent on the gas price with the majority
producing positive IRRs at $3.75 and $4.50/MMBtu. If gas prices drop to $2.25/MMBtu then
all these plays would be underwater with negative IRRs. Aside from commodity price for a dry
gas well the drilling and completion cost plays a big part in performance with typical wells in
the Fayetteville and Piceance having lower representative per well costs of $2.7 MM and $1.7
MM respectively. Higher gas IP rates in the Utica and Haynesville are offset by higher
representative well costs of $10 MM and $8 MM respectively. Marcellus TCO wells produce
the best IRRs from a relatively low $5MM well cost and high IP rate (8000 Mcf/d). The Utica
and Marcellus DOM wells delivering into Dominion South are penalized by a $1/Mcf price
differential (discount) to Henry Hub. At $2.25/MMBtu gas that differential is squeezed to only
$.25/MMbtu based on an expectation that outright prices will decline, limiting the absolute
floor for prices in the region to no less than $2.00/MMbtu.
4.6.3

Gas and Liquids Sensitivity to Gas Prices

The chart in Figure 12 is a summary of IRR sensitivities for both liquids (left side) and dry gas
(right side) plays at different gas price levels. All of the scenarios in this chart are at $60/Bbl
oil prices only impacting the liquids (left side of the chart). Because the gas price is the only
parameter changed in this chart, higher (green bars) and lower (purple bars) gas prices have
a bigger impact on dry gas plays (right side of the chart) than on the liquids.

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Figure 12 Gas and Liquids Sensitivity to Gas Prices; Source: RBN

Conclusions

The more than 50% fall in crude prices since June 2014 and 30% fall in natural gas since
November 2014 have crushed producer internal rates of return (IRRs) for typical wells in U.S.
shale plays.

Analysis of IRRs and crude breakevens provides insight into what may happen to production
going forward as producers scramble to respond

Continued growth in shale production is related to IRR economics, but with several caveats
that affect producers including high IRRs in drilling sweet spots, the impact of hedging, HBP,
lower services costs and the number of hold over completions from last year.

This report includes results from IRR and breakeven sensitivity analysis by basin and
commodity using the RBN Production Economics model and input well data from a variety of
sources

Coming up with representative input variables for the model is as much art as science but the
main goal is to understand how the numbers relate to each other. Most analysts make you
guess what the input variables are, so you really dont know what you are looking at. In the
pages above, we lay it out for you so you can make your own judgments about whether or not
our data is representative.

Expected lower drilling, completion and operating costs due to budget pressure on services
providers are not factored into this analysis yet. Costs may be 25% lower in our next iteration
and that will improve these returns.

Our conclusions are hardly surprising - crude oil wells perform better than gas and natural gas
liquids (NGLs) except in the direst crude price scenarios. The lower oil and gas prices get the worse the return. Sweet spots make a difference sometimes a big difference.

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