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Upstream faces pressure to cut emissions, go green

Highlights

Producer consolidation pressure likely to grow

Investor environmental stewardship demands increase

The transition to a low-carbon energy future raises tough questions for the US upstream natural gas industry over its environmental impacts and what measures should be taken to mitigate them. It also threatens to end nearly 20 years of growth in gas production.

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In earnings calls, investor presentations and at conferences, the low-carbon narrative has become a recurring theme among upstream companies and their investors as the energy transition grows in prominence. In the 2020s and beyond, that narrative promises to dramatically alter the shale gas producer business model.

ADDITIONAL COVERAGE: Natural Gas in Transition

Throughout the early 2000s, the stunning success of shale drilling was determined largely by institutional investors and politicians directing capital and tax incentives to the upstream sector. Those investments allowed US producers to nearly triple domestic output since the early 2000s to more than 90 Bcf/d currently.

As boardrooms and legislatures scrutinize the carbon costs of drilling, their mandate for the 2020s is one of discipline and stewardship. First and foremost, low-cost, maintenance-level production will remain critical to the survival of individual producers. Beyond that, though, intensive carbon-tracking and emissions reductions will also become vital in the years ahead.

Low prices, narrow margins

Over the past decade, the price of benchmark Henry Hub gas has averaged just $3.01/MMBtu, according to S&P Global Platts data. Consistently low prices have long been the hallmark of shale drilling and will remain a major selling point for gas as a residential-commercial and industrial fuel.

Through 2030, the real, inflation-adjusted, price of benchmark Henry Hub gas will average just $2.85/MMBtu, according to a forecast from S&P Global Platts Analytics. Through the decade that follows, prices will likely rise by less than 45 cents.

In the US, low prices – and the high cost to overhaul or repurpose midstream and downstream infrastructure – will make gas a fierce competitor to alternative fuels, even in a low-carbon world. While the push toward renewable power will erode market share for gas in the generation sector, the fuel is forecast to remain critical to both the residential-commercial and industrial markets over the next 30 years.

For the upstream industry, low prices will require further improvements in efficiency and cost-control.

Over the past 10 years, low gas prices have rendered obsolete some of the most prolific early-era shale basins, such as the Fayetteville in Arkansas and the Barnett in Texas. In the decades to come, that trend will only accelerate as producers focus on a narrowing pool of profitable resources in a handful of plays. These are likely to include the Delaware and Midland sub-basins of the Permian in Texas and New Mexico; the Bakken, largely in North Dakota; the Marcellus in Appalachia; and the Haynesville in Texas and Louisiana.

As of first-quarter 2021, an average shale producer in the Delaware Basin – currently the most profitable in North America – sees an internal rate of return close to 34%, based on a half-cycle, post-tax analysis. Across Appalachia, the average producer sees closer to 14% to 19% – just enough to remain profitable.

In recent years, average IRRs in even the most prolific basins have at times dipped lower – into the single digits, sometime for months. Generally, producers require a return of at least 10% to achieve breakeven, making margins below that level unsustainable longer term, according to Platts Analytics.

Consolidation

Over the next decade, thin margins and a growing focus of investors on profitability will likely narrow the field by way of bankruptcies, mergers and acquisitions, leaving only the most efficient standing.

In Q1 2021, bankruptcies among US exploration and production companies totaled eight, according to recent data published by Haynes and Boone. It was the most for any first-quarter period since 2016, but still down from peak levels in Q2 2020 when 18 E&Ps filed, and Q3 when 17 bankruptcies were filed. Even for producers that have weathered the recent storms, consolidation pressures in the 2020s are only likely to grow. During a recent earnings call, EQT President and CEO Toby Rice told analysts that scale will become increasingly critical to producers' survival in a low-price commodity environment.

"In Appalachia, we've got 30 teams running around 30 rigs; you may have very efficient companies, but when you look at that, it could be more efficient than that," he said. "You've got a lot of service providers that are running at, call it 50% utilization. And you've got multiple gathering infrastructures."

Carbon costs

Cost, efficiency and consolidation pressures are just half of the equation for E&Ps, though. In the 2020s and beyond, discerning investors and tighter regulations will demand environmental stewardship, too.

For natural gas producers, emissions detection, tracking and certification at the wellhead and on gathering lines will become an indispensable, routine component of environmental stewardship. Beyond that, investors will look to E&Ps for leadership in the adoption of low- or zero-carbon business models and emissions-cutting technologies.

This spring, the US' largest gas producer, EQT, already took its first step in that direction, saying its Marcellus output would undergo an independent assessment of its environmental impact. Its certification will include quantified assessments for methane detection and intensity, along with an overall score based on other factors, including the company's record on corporate governance, ethics, social impacts, human rights, community engagement, biodiversity and climate change.

The push for greater environmental stewardship comes, not just from investors but from end-user customers, too. Earlier this year, Pavilion Energy signed a six-year LNG sales and purchase agreement with Chevron for the supply of some 500,000 mt/year of LNG to Singapore starting in 2023. Under the agreement, cargoes delivered will be accompanied by a statement of GHG emissions measured from the wellhead to the discharge port. At a recent climate summit, Chevron's general manager of ESG and Sustainability said he anticipates many future commercial deals will include such agreements.

For some companies, the push to meet environmental goals will be met early on by aggressive emissions cuts. Last year, BP, for instance, announced an ambitious goal to achieve carbon neutrality across its global operation by mid-century.

For other E&Ps, the pressure has intensified just in recent weeks. At ExxonMobil – which has announced its own plan to reduce GHG emissions some 30% by 2025, with reductions coming in part from carbon capture and sequestration technology – an activist hedge fund managed to get three nominees on to the ExxonMobil board. The same day, Chevron investors voted for stringent targets to cut emissions from the company's products, and Royal Dutch Shell was handed a court decision in the Netherlands ordering the company to accelerate emissions reductions and cut its carbon footprint 45% globally by 2030.

Environmental initiatives are already becoming business-critical for E&Ps as they look to attract both investor dollars and end-user customers. The sector can expect more of the same into the mid-2020s and beyond.