Lessons from North American Unconventional Gas Plays

Thoughts about ExxonMobil’s acquisition of XTO Energy

Ohio Oil & Gas Association March 2010

Acknowledgments
• Mike Bodell • Allen Brooks • Perry Fischer • Robert Gray • Jim Halloran • IHS • Lynn Pittinger • Keith Shanley

Lessons Learned from Unconventional Gas Plays
• Unconventional gas is increasingly important in global energy supply mix • Two play types for tight sandstone gas plays in Rocky Mountains (Shanley)  Widespread producing complexes (true resource plays) where trap definition is less important than focus on pilot development projects & establishing an economic threshold  Unconventional reservoir plays where trap definition is critical and development areas are more restricted (conventional trap plays) • Both involve large gas volumes & require a realistic assessment of charge potential but require different approaches for commercial success • Drilling and fracturing methods differ & are critically important • Seismic is fundamental • Geology matters!

Why There is a Problem

• Widespread belief that shale plays have ensured an abundant supply of inexpensive natural gas • Little is known about the plays on which this belief is based • While there is little doubt about the resource size, the cost to produce it is probably much higher than assumed • ExxonMobil acquisition of XTO Energy makes shale players feel they are on the right track

4

Exxon Mobil-XTO Energy Merger
• Most analysts believe acquisition represents a dramatic shift by premier global E&P company • Taken as a validation of shale plays • It is neither

Exxon Mobil-XTO Energy Merger
• It is mostly about reserves • Consistent with the company’s retreat from the international arena • A validation that natural gas is the short-term basis for North America’s energy future: shale gas is an important component • Gas price will increase • An act of quiet desperation

Energy Realities: the resource pyramid
• Unconventional gas plays became important as better plays were exhausted • Tight sandstone, coal-bed methane, & shale at the bottom •Economics are marginal • Mean & modal single-well performance need to be placed in context of Minimum Economic Threshold (MET)

Companies whose stated strategy is to find oil reserves onshore North America don’t understand the resource pyramid or history

Shanley’s synthesis of tight-gas experience in the U.S.
• Producing complexes like Piceance Basin Mesaverde (Williams Fork): true resource play • Conventional fields with low-quality reservoir like Green River Basin Almond: conventional trap play • Both have very large resource volumes

• Gas ubiquitous but only commercial where traps can be defined • High net-to-gross, low permeability, marine sandstone • Emphasis on discrete development areas • Petroleum system risk is important • 3-D seismic driven: pilots have limited value • Minimum Economic Threshold >> background resource

Green River basin: conventional fields, tight reservoirs

Piceance basin: tight sandstone producing complex
• Development across 100s-1000s of km2 • Non-marine, low net-to-gross sandstone—identification of traps not critical • Little petroleum-system risk • Reservoir characterization based on areas and pilots • Manufacturing model • Minimum Economic Threshold ~= background resource

From Shanley 2010

Shale Manufacturing Paradigm born in the Barnett Shale play: Shoot, ready, aim!
• Indiscriminate leasing in an acreage rush • Announce success & resource size • Lease-driven drilling campaign • Find the sweet spot by the Braille Method after 12,000 wells drilled • Do the hard science • CHK has spent $1.2 MM/well on acreage for shale plays (Bernstein Research, January 2010)
"There was a time you all were told that any of the 17 counties in the Barnett Shale play would be just as good as any other county," McClendon said. "We found out there are about two or two and a half counties where you really want to be.” --Bloomberg News October 14, 2009

Reserves are overstated

•It is unlikely that most operators will reach their claims for average well EUR in a time frame in which NPV10 is meaningful • Many operator EUR is based on assumption of 40-65 years of well life with terminal decline rates of 4-6% • The main difference between our EUR and the operators is the time required to reach that EUR • We do not feel there is much NPV in about ½ of operator EUR • We also suspect that liquid loading will limit well life to far less than 40-65 years!

Most Likely Horizontal Barnett EUR is 1.1 Bcf (0.09 P75 -1.1 P50 - 1.4 P25 )
Barnett Shale Horizontal Well P50 EUR Histogram
Frequency 160 Cumulative % 120%

140 100% 120 Frequency (Number of Wells)

80

60

Based on individual declinecurve analysis of 1977 horizontal wells

60%

40%

40 20% 20

0 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2 2.2 2.4 2.6 2.8 3 3.2 3.4 3.6 3.8 4 4.2 4.4 4.6 4.8 5 5.2 5.4 5.6 5.8 6 6.2 6.4 6.6 6.8 7 7.2 7.4 7.6 7.8 8

0%

Bins of EUR

Cumulative Percent

100

Mean EUR = 1.1 Bcf Mode = 0.40 Bcf MET = 1.5 Bcf @ $6.50 gas

80%

How Important Is Assumed Well Life?
Barnett Type Well—Incremental Net Present Value Added by Time Periods of Production—10% Discount Rate

• • • • • • •

Used the CHK Type Curve for the Barnett Play IP 2 MMscfd D = 2.974/yr, b = 1.61 70% of Value produced in 1st 5 yrs 85% in 1st 10 yrs Negligible value added after 20 yrs (<4%) but operators claim significant EUR after 20 yrs Valueless volumes being used to dilute F&D numbers

How are we doing in the Barnett Shale?

• Devon is the leading operator in the Barnett Shale with almost 4,000 wells (1/3 of all producing wells & dominates mid-stream) • Devon was “first mover” with Mitchell acquisition & later Chief acquisition "2009 was a pivotal year for Devon as we began repositioning the company to focus entirely on our high-return, North American onshore natural gas and oil portfolio." --Larry Nichols, chairman and CEO of Devon Energy

How are we doing in the Haynesville Shale?

MET

• Mean EUR = 2.6 Bcf, Mode = 2.0 Bcf

• Minimum Economic Threshold = 5.0 Bcf: 10% of wells
• Best wells are 8-9.5 Bcf EUR • A conventional trap play • Not a manufacturing play

14,000 wells to Cotton Valley before Haynesville Play began

• Traps well defined by legacy production • Where to buy leases?

Fallacy of the Manufacturing Model—traps matter!

Haynesville Shale Fayetteville Shale structure map structure map •Traps are critical and best production is in discreet areas • Similar to Green River Basin Almond • Pilots appropriate to characterize reservoir and best-practice completion methods • Southwestern Energy did extensive pilot work in Fayetteville Shale

Fallacy of the Manufacturing Model.
• • • • Operators represent shale plays as low- to no-risk ventures Gas is ubiquitous & success can be achieved and repeated thru horizontal drilling & fracture stimulation Pilot programs were few and late in Barnett Play, were used in Fayetteville, not in Haynesville Fundamental elements of petroleum geology—trap, reservoir, charge, seal—are not critical An appealing model not supported by results to date Over-riding problem with shale plays is lack of reservoir—no effective porosity & permeabilities 100s-1000s times lower than tight gas plays Artifical reservoirs—must be created by engineering brute force Much progress with completion methods, but long-term production is elusive

• •
• •

Fallacy of the Manufacturing Model: Barnett Shale
• Barnett may be a true manufacturing play • Problem: Minimum Economic Threshold is above most wells • Mode is 0.4 Bcf, Median is 0.8 Bcf, Median is 1.1 Bcf • Late results are better but a lot of capital has been destroyed in the process • Early pilot programs might have been a good idea!
Barnett Shale Horizontal Well EUR by Order of First Production
9.0 8.5 8.0 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

Estimated Ultimate Recovery (Bcfg)

Minimum Economic Threshold (MET) = 1.5 Bcf Mean EUR = 1.1 Bcf Mode = 0.4 Bcf Median = 0.8 Bcf MET

Barnett Shale Structure Map Showing Horizontal Wells Above MET (< 30% of total)

1 61 121 181 241 301 361 421 481 541 601 661 721 781 841 901 961 1021 1081 1141 1201 1261 1321 1381 1441 1501 1561 1621 1681 1741 1801 1861 1921 Order of First Production

Pitfall: non-comparable analogues with dissimilar permeabilities (0.00005-0.0003 millidarcies) & completion methods
Shale that produces from natural fractures, drilled vertically & not fracture-stimulated. Permeability range is 200-15,000 times greater than current shale plays.

Sandstone that is drilled vertically & fracturestimulated. Permeability range is 100-167 times greater than current shale plays.

Limestone that is drilled vertically & not fracture-stimulated. Permeability range is 1,000-1,667 times greater than current shale plays.

Chalk that is drilled horizontally & not fracture-stimulated. Permeability range is 200-333 times greater than current shale plays.

•And all have orders of magnitude better reservoir quality than current shale-play reservoirs: range of permeability for shale plays is 0.00005-0.0003 md! • Few wells with > 10 years of production, none with 40-65 years, & few total wells • Water-free production characterizes these examples but is a rare phenomenon

Pitfall: Costs are understated

• Operators claim that shale plays are “low cost” compared to conventional plays • Costs stated in investor presentations are less than those in public filings • Typically exclude “sunk costs” like land expense & geophysics, interest expense • Don’t include dry holes (15% according to Bernstein)

Unit costs are understated
Company PetroHawk Range Chesapeake Devon XTO Southwestern Market Cap $B $7 $8 $17 $30 $28 $15 EV $B $9 $10 $30 $37 $38 $16 Debt to Total Cap Capex to Cashflow 44% 385% 42% 163% 50% 161% 32% 78% 38% 52% 30% 42%

Companies state shale profitability at less than $5/Mcf gas price, but their average unit cost is more than that Hedging has helped minimize losses since price collapse, but difficult to find attractive hedge prices for significant volumes in low-cost environment If the plays are so profitable, why can’t the companies pay for drilling & leasing out of cash flow? What about paying down debt? We’re losing money but making it up on volume!

Pitfall: Higher gas prices will save the day
• Average inflation-adjusted gas price since 1995 is $5.50/Mcf • Gas prices necessary to make shale plays profitable have only existed for brief periods since deregulation • All previous gas price spikes because of storage shortfalls/decreased gasdirected drilling • Opposite is occurring now: storage surplus • If shale gas development continues at current pace, unlikely to get a new spike to save the day • Why should the market reward the lack of drilling discipline by the shale operators?

What is the premise of 100 years of natural gas supply?

• Potential gas committee report: 1,836 Tcf technically recoverable resources (P3) + 238 (P1) Tcf proved (~90 years supply @ current demand of 23 Tcf/year) • 616 Tcf (about 1/3) is shale gas (27 years of supply @ current demand) •The probable component (P2) of total resource is 441 Tcf (~ 19 years supply) • About 147 Tcf (1/3) of that is shale gas • Approximately 6.5 years of P2 shale gas supply at current consumption rates • That’s a lot of gas from shale, but not what is generally perceived • Operators claim more than that in both the Haynesville and Marcellus plays • Shale gas is 15-20% of total U.S. supply

Reserve Category Definitions Proved P1 - reasonable certainty Probable P2 - more likely than not Possible P3 - less likely than probable

ExxonMobil Acquisition of XTO Energy
• $31 billion in stock & assumption of $10 billion of debt--25% premium above XTO stock price (XTO P/E ratio =12.8) • Condition that Congress does not restrict hydraulic fracturing • Viewed as a dramatic shift by premier IOC to bet on U.S. unconventional gas • Taken as a validation of shale gas plays

Acquisition driven by XOM’s need to add reserves
• 2007, 2008, & 2009 were the company’s worst years ever for reserve additions • 2008 additions reported as 103% • Without Canadian oil sands, replacement would have been less than 100% • 2/3 of 2009 reserve additions are from gas discovered in Australia & Papua New Guinea years ago • Just added because processing facilities completed in 2009 • Unconventional gas represents the only remaining scalable resource • SEC revisions more liberal & allow “appropriate technology” for proved reserves

XTO has gas production and positions in many plays

XTO has great representation in the shale plays, but 83% of production is from tight gas, conventional gas, and coal-bed methane

Long-term natural gas price will rise
• Price will accommodate marginal cost of production eventually • Energy demand will grow & natural gas will fill a larger proportion of energy mix • Percent of unconventional gas will increase compared to conventional • Shale gas the best of a bad lot for majors • XOM is betting that technology, efficiency, & increased demand & price will lead to commercial success

XTO acquisition only a dramatic shift to those not paying attention • ExxonMobil’s portfolio has reflected growing importance of unconventional oil and gas for at least a decade • Company has been “bullish” on shale plays since 2003 (Tim Cejka, President Exxon Mobil Exploration Company) • Has XOM considered impact of competitors who will over-produce gas as long as undisciplined capital markets provide funding?

“It's not a strategic shift.”
David Rosenthal, Exxon Mobil VP Investor Relations

Only a dramatic shift to those not paying attention
•Winner’s Curse speech by Kurt Rudolf at AAPG Annual Meeting in Long Beach, 2007-- few new opportunities not already captured in international arena • XOM applied petroleum system/basin analysis methods to North American basins • XTO positions were a good fit • Opposite approach to Gold Rush • Showcased Piceance Basin tight gas sand play: Multi-zone stimulation technology • Most resources currently in Americas

Only a dramatic shift to those not paying attention
• Tight gas play in Hungary (Pannonian Basin Mako Trough) • Shale play in Horn River Basin (Canada) • Leased 20,000 acres in Pennsylvania Marcellus in August, 2008 • 290,000 acres in Marcellus with Pennsylvania General Energy • Ongoing commitment to Canada oil sands

Unlocking Tight Gas

•Use technology to “crack the code” first with tight sandstone reservoirs, then with shale • Use the Multi-zone stimulation technology to produce shale in vertical wells that cost less

Conclusions
• Approach to shale plays in U.S destroys capital • Reserves are overstated • Costs are understated • Why it is important

Implications
• Shale gas plays will be a permanent & important part of the E&P landscape • They require “peak” market conditions to be commercial based on historical gas prices • Companies that bet everything on shale plays (or any single play-type) will have a competitive disadvantage through 80% of the price cycle • Tight sandstone plays are preferable because of better reservoir & matrix storage capacity: shale players should learn from 3 decades of experience • Focus on trap definition (seismic) and best fracture technology for the play • Seismic attribute mapping to define optimum reservoirs

Troubling implications
• Massive capital investment & debt load in projects that have not yet demonstrated sustainable value • Undisciplined drilling & resulting over-supply keeps prices low • Ongoing asset sales, share offerings & new debt: present level of drilling & leasing cannot be paid from cash flow • High decline rates mean the drilling treadmill must continue • A potential bubble when the music stops: tighter credit, higher interest rates
Horizontal Barnett Wells Completed
3000 Number of Wells Completed 2669

2500
2000 1500 1000 500 4 0 2000 2001 2002 2003 2004 2005 2006 16 44 392 185 769 1325

2330

2007

2008

Closing thoughts
• XTO approached XOM about merger— implications about cost, competitiveness, environmental & legal battles pending • Hungary play failed & XOM exited • Piceance basin play is non-commercial to date • XOM feels that it needs to learn from XTO, but may not be able to retain employees • ExxonMobil came late to the shale party & paid a high price of admission (diluted shareholders) • May have overvalued high-decline rate wells • XOM overhead structure and cost may not fit with operating 1000s of low-rate gas wells

Closing thoughts
• ExxonMobil understands the technical risks & uncertainties in unconventional plays • Made realistic projections about reserves and costs • XOM bet is that efficiency, science & technology will bring commercial success • Bring abundant capital and little debt to plays dominated by highly leveraged companies • Bet is based on assumption that price will rise • Less clear that XOM appreciates the business risks from undisciplined competitors who overproduce and keep prices low as long as the market provides capital
“We are awash in gas today because the market continues to distribute funds to companies that destroy the capital they are given. There is no type of skillful way to differentiate a positive shale well from a negative one. I believe this is the dilemma you should focus on.“ CEO of a public gas E&P company, personal communication (January 2010)

Lessons from North American Unconventional Gas Plays
Thoughts about ExxonMobil’s acquisition of XTO Energy

Ohio Oil & Gas Association March 2010

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