ShalePlaysandLowerNaturalGasPrices

ATimeForCriticalThinking

ArthurE.Berman OhioOilandGasAssociation March2009

PremiseofthePresentation
NaturalgaspriceshavecollapsedsinceJuly2008 Theforecastforlowerdemandsuggeststhatlowpriceswillpersist In2008,domesticU.S.gasproductionreachedahistoricalhighandan oversupplyofnaturalgasnowexists ThereisanirrationaltendencyintheE&Pindustrytopursueshaleplays despiteoversupplyofnaturalgasandlowerprices AdetailedevaluationofBarnettShalerates&reservesindicatesthat productionwasmarginallycommercialathighergasprices,andthatonly afractionofwellsarecommercialatcurrentprices AnearlyevaluationoftheHaynesvilleShaleplaysuggeststhatwells havesimilarrates&reservesastheBarnettShale,butattwicethecost ItispossiblethatU.S.naturalgaspricesmayfallaslowas$2.00/Mcfby September2009,andthatthegasrigcountmayapproach500 ThedropingaswelldrillingcombinedwiththehighdeclineratesofU.S. wellssuggestapricereboundinthelastquarterof2009 Thereisabrightfuturefornaturalgasingeneral,andpossiblyforsome shaleplays TheShaleplaymanufacturingparadigmmustchange:abetter businessmodelisneeded geology&geophysicsmatter!

In mid-July the U.S. unexpectedly discovered it had an over-supply of natural gas

20052006 Hurricanes KatrinaRita Supply Interruption

2008Price Anomaly

Yet, there is an irrational tendency to continue pursue shale gas plays

U.S.gasproductionhasreachedanewhigh
2008OverSupply

2001OverSupply

6.7%Increaseindomesticproduction,muchfromconventionalsourcesin GulfofMexico(ThunderHorse,MadDog,IndependenceHub,Tahiti)

Butarespectableamounthasalsocomefromshaleplays

Butreserveshaveflattened
Andthesearequestionablebecause unconventionalreservesbookedat highergaspricesmaynowbenon commercial

Result:Reserves/Production(R/P)hasfallen
Thisisthebasicrealitythatisbeing ignoredatthemoment

HighdeclineratesarethereasonthatR/Pisstatic:newreservesarebeing producedasquicklyastheyarefound

TheNorthAmericanGaspictureisworse:recentgainsaremarginal
NorthAmericanReserves/Production(R/P)
20 18 18.7 17.0 16.1 16 15.3 14 YearsofSupply 12 10 8 6 4 2 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 18.118.4 17.6 17.3 15.615.3 14.914.7 14.2 13.0 12.012.011.7 11.3

10.610.610.3 9.7 9.8 9.9 9.9 9.7 9.7 10.0

CanadaandMexicoreservesandproductionaredeclining Thisbroaderperspectivemeansthatthefuturefornaturalgasisbetterthanmost peoplethink! LNGwillbecomemoreimportant:thismeansthatdomesticoperatorsmustwork smarter:shaleplayersmustlearntobasetheirprogramsongeology&geophysics!

TheShalePlayParadigm
Theresourceplay:thereisnorisk Source&charge:100%Ps Trap:100%Ps (thereisnotrap,or thereservoiristhetrap) Reservoir:100%Ps(bruteforce engineeringtakescareofthat) Amanufacturingprocesswhere drillingandcompletionareprimary, andgeology&geophysicsare secondaryatbest Investmentcommunitylovesthis concept:norisk,highrewardthe samethinkingthatproducedtheglobal financialcrisis!

...andwhataboutongoingdemand& pricesupportwhileeveryoneis rushingtoproduceallofthisnorisk gas?

Anirrationalbeliefthatgaspriceswouldcontinuetorise

andafailuretorecognizethesignsofaslowingeconomy,andaloomingfinancialcrisisbyatleast thesummerof2007 someoftherisingpriceisbecauseofsupplydemandconcerns,butmostisbecauseofrisingcost

BarnettShaleHorizontalEUREvaluation
Isallacreage equal? Isntitreasonable toassumethatthere isageologicalreason fortheobserved distributionof productiontrends? Howmuchcapital hasbeendestroyed becauseofthe manufacturing approach? Thisisthemodelforother shaleplays About10,000wells Mostwellsdrilled horizontallywithfracture stimulationssince2003 Wellcosts$3.25MMfrom published10Kand conferencecalldata StandardNRI(75%)& severancetax(7.5%)values LOEG&A($1.25/Mcf) frompublished10Kand consortiumdata Leasecosts($1,250/acre) frompublisheddata

BarnettShale:operatingcosts&salesprice
Carrizoisarelativelysmall,independentE&Pcompany MostcurrentoperationsareintheBarnettShale Companyhasareasonablytransparenthistoryofprovidingcosts In2007,capex was$231.4MM&drilled96gross/68netwells

CarrizoOil&GasCompany LeaseOperatingExpense General&Administrative InterestExpense TOTAL Cost/Mcfe $ 1.32 $ 0.57 $ 0.33 $ 2.22

EastTexasSales HoustonShipChannel Katy TennesseeTexas,Zone0

CashEquiv $3.60 $3.67 $3.64

Itcostsalmost$2.50/Mcfto operateawell,inadditiontocapex (leasing,drilling&completion)! Costsshownarenotcommonly consideredinevaluationsofshale playsandoperatorsbymany analysts(industryoutsiders) becausecriticalthinkingrequires insideknowledge&experience Truenetbackpricerarelyused Thisphenomenoncreatesincorrect perceptionsaboutthesuccessof shaleplays,andthelikely continuationofoversupply

BarnettShale:naturalgasprice
NaturalGasPrice
$16.00 $15.00 $14.00 $13.00 $12.00 HenryHubSpotGasPrice($/MMBtu) $11.00 $10.00 $9.00 $8.00 $7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 01/07/00 01/07/01 01/07/02 01/07/03 01/07/04 01/07/05 01/07/06 01/07/07 01/07/08 01/07/09

Howcanacompanyhedgepricesintheseperiods?

$7.50/Mcf

Theupsidetothehedgeislessthanthe producedcost.Whoisontheotherside?

Ifthecosttoproducegasis~$7.50/Mcf,whendoesacompanymakemoney?

BarnettShaleHorizontalEURHistogram(1966wells)
BarnettShaleEURHistogram
700

Economicthreshold@ $6.25/MMBtunet

Frequency

Cumulative% 120%

600

500 Frequency(NumberofWells)

400 54% 300

200

32%

Modeldoesnotincludetransportation&gathering 100% 99% 99% 100% 100% 100% 100% 100% 100% 100% 96% 98% 98% fees,interestexpense,refracs,DD&A,etc. 93% 89% CarrizosLOE+G&AforQ42008were$1.89/Mcfvs. 82% $1.25inthisevaluation <30%ofwellspayoutormake 71% CHKsproducedcostis$7.25/Mcf EUR) money(~1,500MMcf Modelusedleasecostof$1250/acrevs.core TheaverageEURforhorizontalBarnett areacostsin2008of$10,000+/acre Shalewellsis1.2Bcfe Atcurrentprices,11%ofwellsmeetthreshold 54%ofwells0.51.0BcfeEUR 71%ofwells<1.5Bcfe Usingcurrentnetbackprices(nohedging),2%of wellsmeetthreshold

100%

80% CumulativeFrequency

60%

40%

100

20%

0 500 1000 1500 2000 2500 3000 3500 4000 4500 5000 5500 6000 6500 7000 7500 8000 8500 9000 More EURBins(MMCFG)

0%

BarnettShaleCoreArea(TarrantCounty)Evaluation

Overall,successratesaresimilartoaveragereservesintheplay,thoughcertainoperatorsinthe coreareahaveapparentlylearnedhowtoimproveontheaverage(thoughthesuccessratesarestill unacceptablylow) Sensitivitiesarealsosomewhattypicaloftheoverallplay,andtheyindicatewhyaminimumgas priceof$7.508.00isnecessarygiventhecurrentstateofreservepredictability

BarnettShaledrillinghasdecreased

ManyoperatorshaveshiftedemphasistotheHaynesvilleShale

IPs impressive,upto24 MMcfd HKclaims160MMcfd/3wells Probablynotreallyashale play Mostproductionfromsandy siltyintervalswithinHaynesville Shale Apparentlowerunitcost/Mcf thanBarnettbecauseofhigh rates Overpressured&deeperthan othershaleplays Costsareveryhigh$7.5MM D&Ccostperwell Acreageishighupto $30k/acre,average$15k/acre

20wellsstudiedwithenoughproductionhistorytoevaluate

PennVirginiaFogle Unit5H HarrisonCounty,TX 1.25BcfEUR

ChesapeakeBledsoeProperties1 CaddoParish,LA 1.03BcfEUR

Standardratevs.timedeclinecurvemethod Hyperbolicapproachwith20%terminaldecline Economiclimitof1MMcf/month(33,000cfg/day)tocoverleaseoperating costs($5,000/month@$5gas&8/8) verygeneroussincethenotional LOE+G&Acostfor1MMcf/mo=$12,500 Generousapproachtodeclinewithlimiteddata

Declineratesareveryhigh
Average monthly decline rate is 25% (a 10 MMcf/d well produces 300 Mcf/d after 1 yr) 57% of wells decline 20-35% per month

IPsarehigherthanactualdailyrates(usingmaximum30dayperiod)
HaynesvileActualDailyRatevs.IPHistogram Average maximum producing rate is 80% of IP Discrepancy is greater in 50% of wells Frequency Cumulative%
6 120%

100% 5 100%

Frequency(NumberofWells)

4 70% 65% 3 50% 45% 2 35% 55%

75%

80% CumulativePercent

60%

40%

20% 1 5% 0% 0 35% 40% 45% 50% 55% 60% 5% 15% 15%

20% 20%

0% 65% 70% 75% 80% 85% 90% 95% 100% More

BinsRatioofActualDailyProduction(Max30days)vs.IP(Percent)

15wellshaveenoughproductiondatatodecline:reservesaredisappointing
EUR averaged 1.5 Bcf HaynesvilleShaleReserveHistogram 67% of wells had reserves from 0.5-1.5 Bcf Frequency Cumulative% Haynesville reserves similar to Barnett at twice the capital expenditure
6 6 93% 5 73% 4 3 3 40% 2 1 7% 0 0% 0 0.0 0.5 1.0 1.5 2.0 2.5 0 3.0 0 3.5 0 4.0 0 4.5 0 5.0 5.5 0 More 0% 27% 1 1 20% 67% 60% 3 80% CumulativePercent 93% 93% 93% 93% 93% 100% 100% 100%

120%

Frequency(NumberofWells)

BinsEstimatedUltimatelyRecoverableReserves(BCFGas)

Whatistheneartermoutlookfornaturalgasprices?

Mostforecastsarebearish Buttherearebroaddifferences inestimates Thetruthisthatnooneknows Whatisthebalancebetween decreaseddemand,oversupply, andthemarkeddropinrigrates? EIAestimatesanaverage2009 gaspriceof$5.01/MMBtu

2009 HHub Bloomberg NYMEX Futures HHub RaymondJames

Q109E $6.13 $4.81 $4.90

Q209E $5.66 $4.03 $3.25

Q309E $6.04 $4.36 $2.50

Q409E $7.00 $5.03 $4.25

2009E $6.21 $4.56 $3.73

Thecurrentoversupply&recession

$13.10/MMBtuinearlyJuly2008$4.23today 1,606gasrigsinSeptember2008867today

Thecontext: U.S.Vintaged DailyGasProductionContributiontoDecember2007Volume

Halfthegasconsumedin2007wasproducedfrom wellsdrilledwithintheprior40months!

GasProductionbyVintageYear

SlidecourtesyofIHS

Oildemandisanexcellentindicatorofeconomicconditions

ThecurrentrecessionwasevidentatleastasearlyasQ12008 Oildemandhasdeclined7.42%(1.6MMbopd)sinceJanuary2008 Demandappearstobestabilizing

In2001,therewasanoversupplyofgas&arecession

Analysisofthe20002002Cycle

Pricecycleapproximately60%longerthanrigcycle 6monthlagforrigdeclineafterpricedeclinebegan Pricerecoverybeganhalfwaythroughtherigdeclinecycle

Ascenarioforthe20082009HalfCycle

~550rigsbySept ~$2.00/MMBtu Pricedecreasesameas in2000 Rigdecreasegreater (66%vs.44%)

Pricecycleapproximately15%longer(vs.60%in2000)thanrigcycle 3monthlag(vs.6monthsin2000)forrigdeclineafterpricedeclinebegins Pricerecoverynotincorporatedinthemodel

Anotherscenarioforthe20082009HalfCycle

~470rigsbyAugust ~$4.00/MMBtu Pricedecreaselessthan in2000(70%vs.84%) Rigdecreasegreater (71%vs.44%)

Pricecycleapproximately20%shorter(vs.60%longerin2000)thanrigcycle 3monthlag(vs.6monthsin2000)forrigdeclineafterpricedeclinebegins Pricerecovery60%intorigdeclinecycle(vs.50%in2000)

Causeofoversupply:anirrationalbeliefthatgaspriceswouldcontinuetorise

Despitethecyclicity ofnaturalgasmarketsoverthepast8years

PlankRoadFeverandShalePlays:apossibleanalogy
Inthelate1840s,thousandsofmilesoftoll roadswerebuiltwithwoodenplanksurfacesto connectfrontierareastonewlybuiltcanals& railroads Plankroadswerebetter:smoother,faster,all weather,allowedheavierloads,higherspeeds, fewerbreakdowns Demandwassogreatthattheconstruction explosionwascalledplankroadfever Economicswerebasedonplankinglifeof8 years Itsoonbecameevidentthatplanklifewas muchshorter,34years Plankroadfeverendedabruptlybythe mid1850sandbecamepartof transportationhistory ShalePlayshavesimilarpatternof explosivegrowthbasedonquestionable economicassumptions,followedbyreality

ObservationsandConclusions
The20082009naturalgaspricecollapseis morecomplexthanrecentreversalsbecause oftheglobalrecession/depression Oversupplywasinevitablebecauseofnew productionintheGulfofMexico&from onshoreunconventionalplays Theoversupplyresultedinpartfroman irrationalbeliefthatgaspriceswould continuetorise,perceptionofnorisk,and plentifulspeculativecapitalatlowinterest rates

Therewasalsoafailuretorecognize underlyingfundamentalsofgasprice formation:supply,demand,storage E&Pexecutivesdidnotseetheunderlying weaknessoftheU.S.economyatthesame timethatnaturalgaspriceswererising Itisstilltooearlytobecertain,butearly productiondatafromtheHaynesvilleShale doesnotsuggestthatthisplaywillbemore commercialthantheBarnett;theMarcellus Shaleismorespeculative

ObservationsandConclusions
ItremainsunclearwhytheE&Pindustry continuestopursueshaleplaysdespitelower gasprices Perhapstheyareoutofotherideas&need torefocustheireffortsonthetechnicalside ofthebusiness:areturntomore conventionalreservoirs&risktolerance Itispossiblethatnaturalgasprices&rig countswillcontinuetofallforawhile PriceswillprobablyreboundinQ42009,and Thereisabrightfuturefornaturalgasin willbestrongerin2010 general,andpossiblyforsomeshaleplays Rigorousapplicationoffullcycle economics&adisciplinedapproachto investmentarerequired Abusinessmodelbasedonrealisticcosts &profitmargins,loweroverhead,fewer promoters&moretechnicalevaluators TheShaleplaymanufacturing paradigmmustchange:geology& Criticalthinkingisthekey! geophysicsmatter!

ShalePlaysandLowerNaturalGasPrices

ATimeForCriticalThinking

ArthurE.Berman OhioOilandGasAssociation March2009