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UBS Shale Plays

UBS Shale Plays

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04/09/2013

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A great resource play possesses a combination of large size, easy access and a
good economic rate of return—not a particularly easy combination to achieve.
Clearly headline NYMEX natural gas prices are the most important economic
driver behind any play; however, beyond this element that is largely beyond
management control, there are a number of factors that clearly affect play
economics. We discuss some of them below.

1) Gas price realizations

There are remarkable differences in price realizations across natural gas resource
plays. Whereas resource plays in the US Northeast and the Utica shales in
Quebec can achieve a pricing premium of US$1/Mcf to NYMEX, plays in
Canada and the US Rockies tend to receive a US$1/Mcf discount from NYMEX
(or sometimes substantially less depending on takeaway capacity). Variance in
price realizations means that plays located closer to markets can tolerate
substantially higher F&D costs to deliver the same IRR as others; or, put another
way, they can deliver superior IRRs at similar F&D costs.

Overall, the Utica and Marcellus plays enjoy the greatest advantage when it
comes to price realizations. Canadian and US Rockies plays with the largest
pricing discounts must compensate either through lower costs or royalties in
order to enjoy similar margins as plays located in more central locations.

2) Royalties

Royalty rates vary considerably across resource plays. Many emerging US
resource plays are located on freehold lands where royalties are negotiated
directly with landholders. Companies that secured land early in the development
of plays are typically paying royalties of about 12%, compared with recently
negotiated royalties on “hot” plays ranging between 20-30%. Typically US
royalties are set at flat percentages, which do not increase with commodity
prices. In Canada, the vast majority of unconventional gas development is on
crown lands where royalties are set by provincial governments. The Utica shales
will be subject to a very attractive flat royalty of 12.5%, whereas in Alberta,
royalties escalate considerably with commodity prices. The BC government has
just tabled a very compelling royalty structure aimed at promoting
unconventional gas development in the province. This “net profits” royalty is
very similar in structure to the oil sands, where a 2% royalty is paid until the
entire project’s capital is recovered, after which point royalties begin to escalate.
Overall, the Utica and Horn River shale plays appear to have the lowest royalty
takes relative to the majority of other resource plays.

Utica and Marcellus enjoy the greatest
advantage when it comes to price
realizations

Overall, Utica and Horn River appear to
have the lowest royalty takes relative to
the majority of other resource plays

Q-Series®: North American Oil & Gas 3 September 2008

UBS 14

3) Operating costs

Operating costs vary considerably across play types, the most significant
differences being: 1) the stage of the development lifecycle—plays that are well
developed tend to have lower operating costs, as infrastructure is spread over
more wells; and, 2) well productivity—plays with higher productivity, such as
the Haynesville and Montney, will likely tend to have lower operating costs than
many other plays at a similar stage of the lifecycle. Wells in the Horn River
basin typically have high productivity, which may be offset somewhat by a
relatively high concentration of CO2 that will require additional processing. For
the majority of emerging plays, we are expecting operating costs to average
$1.00/Mcf, ranging from $0.75 to $1.25/Mcf.

4) Land tenure

There are substantial differences in land tenure across North America. In Alberta
and BC, lands are typically granted for a period of five years. In many parts of
the US such as Texas and Louisiana, land tenure is negotiated directly with the
landowner. Land tenures within the hot plays of the US are typically shorter in
length (i.e.: three years) and have more burdensome drilling obligations. Land
tenure is important because it dictates the development timeframe. Companies
paying large sums recently for lands in the Haynesville need to drill aggressively
over the coming years in order to keep their lands, whereas some resource plays
in western Canada and the US Rockies (government lands with longer tenure)
can be developed at a more relaxed pace.

5) Infrastructure

Infrastructure is a key factor when it comes to developing new resource plays.
While most of the emerging plays in this report have adequate gas-gathering
infrastructure in place to deal with initial drilling plans, there are differences
when it comes to the ability to deal with volumes from full commercial
development. Of all the plays examined, the Haynesville has the easiest access
to infrastructure with approximately 1 Bcf/d of excess takeaway capacity. While
this threshold will likely be reached in the next 12-18 months, we believe that is
adequate time for industry to plan and develop future capacity expansions.
Beyond the Haynesville, we believe each of the Marcellus, Utica, Montney and
Horn River are roughly equal in terms of infrastructure challenges—all have
immediate takeaway capacity, but face medium-term constraints.

6) Site access

Ease of site access is an important consideration when evaluating resource plays.
Many western Canadian resource plays are constrained by winter-only access
properties due to muskeg-like surface conditions, a disadvantage relative to
many other regions where drilling and completion operations can run year-
around. Other considerations for ease-of-site access are road networks, surface
topography and population density. The Horn River and Montney are somewhat
disadvantaged in terms of underdeveloped road infrastructure, which leads to
higher upfront costs and slightly longer lead times to commercialization. The
Haynesville is well positioned from a site access perspective, with favourable
topography and good road infrastructure. The Marcellus can be drilled year-
round, but faces challenges from high population density, which can complicate
drilling operations.

For most emerging plays, we expect
operating costs to average $1.00/Mcf,
ranging from $0.75 to $1.25/Mcf

Land tenure dictates more aggressive
drilling in the Haynesville, for example,
compared with a more relaxed pace in
western Canada and the US Rockies

The Haynesville has the easiest access
to infrastructure, with about 1 Bcf/d of
excess takeaway capacity

The Haynesville is well positioned from
a site access perspective, with
favourable topography and good road
infrastructure

Q-Series®: North American Oil & Gas 3 September 2008

UBS 15

7) The cost of entry

Land costs have a large impact on unconventional gas economics because of the
large up-front investment that is required. On a company-specific basis, it is
important to give credit to those companies that are able to get into the right
plays early, as opposed to those that pay extremely high costs later to catch up
with their peers. The Haynesville is a classic example where a year ago, lands
were easily acquired for under $1,000/acre but have exceeded over $30,000/acre
in various, recent, large deals. We estimate that a company acquiring 100,000
acres of land in the Haynesville shale at $1,000/acre is capable of generating a
full cycle IRR of about 60%, whereas another company acquiring land at recent
prices of approximately $30,000/acre would yield a return of about 15%—still
acceptable, but a clear difference from the company with the lower cost base.
We also illustrate an example in the Horn River where early entrants into the
play at less than $1,100/acre would earn full cycle IRRs of 48% at $9/Mcf;
whereas late entrants paying up to $10,000/acre would generate full cycle IRRs
of 27%. While late entrants earn a noticeably lower IRR, these are still very
attractive rates of return.

We believe EnCana, Chesapeake and EOG Resources stand out as consistently
being the early entrants into the majority of emerging plays. Talisman, mainly
due to its pursuit of other plays, has found itself with high-quality land holdings
in many emerging plays at a very low cost.

Chart 3: Horn River full cycle IRR sensitivity on $/acre

Chart 4: Haynesville full cycle IRR sensitivity on $/acre

-20%

0%

20%

40%

60%

80%

$4

$5

$6

$7

$8

$9

$10$11

$12

Long-Term Gas Price (US$/mcfe oil converted to gas at 10:1)

IRR (a-tax)

$1,000

$5,000

$10,000

-20%

0%

20%

40%

60%

80%

100%

$4

$5

$6

$7

$8

$9

$10$11$12
Long-Term Gas Price (US$/mcfe oil converted to gas at 10:1)

IRR (a-tax)

$1,000

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

Source: UBS

Source: UBS

We believe EnCana, Chesapeake and
EOG stand out as consistently being
the early entrants into the majority of
emerging plays

Q-Series®: North American Oil & Gas 3 September 2008

UBS 16

Summary of key resource plays

Table 1 provides an overview of many of the key characteristics of each of the
key emerging resource plays. As is apparent from the previous discussion, there
is no one recipe for a successful resource play. The key takeaway from this
analysis is that virtually all of the emerging resource plays that we examined in
this report appear set to yield strong rates of return.

The highest IRR play that we see is the Bakken, both in the US and Canada.
Despite having different characteristics, they both yield ultra high rates of return
with very little in the way of surface obstacles or infrastructure constraints. The
second most promising play we see is the Haynesville with a typical IRR
expected at the 89% level (assuming commercial scale costs). The Haynesville
is also ideal in terms of relatively easy surface access and good infrastructure
access (at least for the next year).

The Horn River, Marcellus and Montney all group together quite closely in
terms of rate of return and therefore we are reluctant to label one as better than
the other as there is high variability within each of these plays. One
differentiating factor, though, is that there is much greater well control on the
Montney and therefore lower risk versus both the Marcellus and Horn River
plays. Overall, though, we believe each of these plays is poised for significant
growth and will deliver investors very strong returns.

Due to its early stage of exploration, it is difficult to truly define Utica’s IRR,
and with it, the highest margin of error. Our type curve for Utica, which
assumes 1.75 MMcf/d of initial production (IP) and 1.6 Bcf of estimated
ultimate recovery (EUR) would deliver a rate of return comparable to the Horn
River, Montney and Marcellus. This appears to be a pretty achievable threshold,
but will not be known until more wells are drilled and tested this fall. It is
important to note that due to its high gas price realization and low royalties, if
the Utica does realize higher IPs and recoveries, it could also compete with the
Haynesville for IRRs.

Table 1: Emerging resource play comparables

Fayetteville

Woodford

Marcellus

Bossier /
Haynesville

Horn River

Utica

Montney

Canadian
Bakken

US Bakken

Depth (feet)

1,500-7,000

6,000-12,000

2,500-8,50010,500-13,5006,500-8,500

2,300-6,000

6,000-10,0005,000-6,0008,000-10,000

Thickness (feet)

20-200

120-220

50-200

200-240

500

300-6,500

160-1,000

32-40

20-50

GIP (bcfe/section)

25-65

40-120

20-150

150-250

130-250

75-350

70-300

27

30

TOC Weight (%)

4.0-9.5

3-10

1.0-12

0.5-4

3.1-5.9

0.1-2.5

1.5-6.0

7.0-12.0

12.1

Silica Weight (%)

20-60

60-80

20-50

na

70

30-35

20-60

90-95

na

Pressure Gradient (psi/ft)

0.435

0.52

0.45-0.60

0.7-0.9

0.65

0.60-0.76

0.44-0.70

0.43

0.5-0.8

Gas-Filled Porosity (%)

2.0-8.0

3.0-6.5

1.6-7.0

8.0-15.0

3.2-6.2

1.2-3.7

1.0-6.0

10-14 (oil)

8-12 (oil)

Maturity (Ro)

1.4->4

1.1-3.0

1.5-3

0.9-2.6

2.2-2.6

1.1-4.0

0.8-2.5

Immature

Immature

DCT Costs ($mm) - Commercial Scale Drilling

$3,000

$4,850

$4,000

$6,500

$7,500

$3,000

$6,285

$1,900

$5,000

Avg. EURBcfe

2.3

3.1

2.4

6.3

5.3

1.6

4.4

0.7

2.2

F&DCost ($/mcfe)

$1.30

$1.55

$1.67

$1.03

$1.43

$1.89

$1.42

$2.70

$2.28

Typical IP (mmcf/d)

2,250

3,500

2,500

8,000

5,400

1,750

4,500

190

500

Price Realization (US$9/mcf & $90/bbl benchmark)

$8.10

$8.10

$9.45

$8.55

$7.76

$9.45

$7.84

$87.30

$87.30

Avg. Royalty

17%

19%

13%

25%

19%

10%

20%

18%

20%

IRR A-Tax (excluding land costs)

54%

37%

65%

89%

52%

50%

57%

105%

95%

NPV / Well ($ million)

$2,698

$2,805

$3,893

$8,422

$5,046

$2,398

$4,632

$1,727

$5,843

NPV / Mcfe

$1.17

$0.89

$1.62

$1.33

$0.96

$1.51

$1.05

$2.45

$2.67

Above Ground Challenges

Medium

Medium

High

Low

High

Low

High

Low

Low

Level of Delineation

High

High

Medium

Low

Low

Low

High

High

High

Source: Company reports, UBS

The highest IRR play that we see is the
Bakken, both in the US and Canada,
followed by the Haynesville

The Horn River, Marcellus and Montney
all group together quite closely in terms
of rate of return

Utica’s IRR is more difficult to define at
this early stage, but with high gas price
realization and low royalties, it could
compete with Haynesville’s IRR

Q-Series®: North American Oil & Gas 3 September 2008

UBS 17

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