Marcellus-Utica Shale Trends, Developments and Dynamics – 2023

The Marcellus-Utica shale oil and gas formations are situated in Pennsylvania, Ohio and West Virginia in the Appalachian Basin. It is now estimated that the region holds 214 Tcf (trillion cubic feet) of natural gas reserves – enough to fuel the US for almost seven years. Like other oil and gas-producing regions in the US, the Appalachian Basin is subject to the same global market conditions that settle supply and demand forces determining oil, gas, liquefied natural gas (LNG) and various natural gas liquid (NGL) prices. However, these forces manifest themselves in specific ways due to localised conditions unique to the Appalachian Basin.

You have come a long way Appalachia!

Shale gas development in Appalachia has come a long way since Range Resources drilled the first Marcellus well in 2004 in Washington County, Pennsylvania. The Marcellus-Utica shale now contributes 36 Bcf/day (billion cubic feet per day) to the United States’ total natural gas production of 119 Bcf/day. The road to reaching this point has not always been a smooth one. Oil and gas development began in Appalachia in the mid-1800s, as did ownership severance transactions where the ownership of oil and gas rights was transferred separately from the surface. This historic practice made establishing oil and gas title and ownership significantly more complex. Legal, regulatory and permitting frameworks also had to be developed to match the new industrial scale of the “Shale Era”. The region’s proximity to environmentally conscious populations and opposition to new fossil fuel development add to the complexity.

Big opportunities and challenges exist

With its abundant reserves and footprint proximate to about half of the nation’s population, the Marcellus-Utica shale formation is positioned to be a dominant force in the energy world. Companies have quickly turned shale gas development from an educated guessing exercise to a highly sophisticated and predictable energy production business. Producers now think of themselves as energy wholesalers focused on producing gas at as low a cost as possible and selling into markets with the best commodity prices. The real questions are not when the Appalachian Basin will reach its potential, but if, how and what it will take for the region to get there.

All companies face growing pains and challenges. Companies with differing geographic footprints will face different regulators, and will be subject to differing financial, social and community dynamics. Development near population centres is more challenging than in rural areas or brownfield sites ready for reclamation. Any substantial downstream project takes years of planning and socialising the project plan with regulators, taxing bodies and local communities. Public companies with access to public capital markets and privately owned companies with no such access will face different financial pressures.

Some of the conditions relevant to the development of the Marcellus-Utica include the following.

Northeast development challenges

The Appalachian Basin seems perfectly suited to foster the development of the largest shale reserve in the world. It has been home to the oil and gas industry for well over a century. Some of the world’s most successful industrial entrepreneurs such as John D Rockefeller, Andrew Carnegie, George Westinghouse and HJ Heinz called the region home. There is an abundance of water, which is essential for oil and gas operations. Barges and rail cars full of coal can still be seen travelling through cities and towns across the region. The growth of another industrial economic driver should fit perfectly in this part of the Rust Belt.

However, the shale gas revolution was not universally welcomed. Well organised and funded opposition groups sprung up. Documentary movies purporting to chronicle the harms caused by hydraulic fracturing (“fracking”) received worldwide attention and acclaim. The City of Pittsburgh banned fracking, notwithstanding that no company had proposed to drill a well in the city limits. There have been a number of legal and legislative efforts to limit hydraulic fracturing, as well as numerous private party lawsuits filed against the industry. This is a natural conflict that occurs when an industrial activity takes place near where people live, work and play. In light of these dynamics, some degree of opposition was expected – the full extent of it may not have been.

During the “gold rush” of the shale development, regional banks and financial institutions aggressively courted producers and other companies in the industry. That interest soured around 2016 when realised natural gas prices in the region fell below USD1.50/MMBtu (million British thermal units). The natural gas price crash led to hundreds of bankruptcies wiping out billions of dollars of debt and equity capital. Marcellus and Utica producers can break even when prices are below USD2.00/MMBtu but very few, if any, can sustain extended prices below break even. The fallout from the financial shake-up has been that many regional banks and financial institutions no longer provide traditional credit facilities to shale oil and gas companies.

ESG and the rise of renewable energy alternatives

The modern movement towards the adoption of renewable energy rose from people’s desire for energy independence. The 1997 Kyoto Protocol was one of the first multinational efforts to reduce greenhouse gases and curb climate change. Since that time, there has been a growing movement to reduce the use of fossil fuels as a fuel source. Many companies, including traditional energy companies, banks and financial institutions, have adopted ESG (environmental, social and governance) standards that evaluate a company on a number of measures important to socially conscious investors. Activist investors have targeted certain companies to place their desired representatives on such companies’ boards of directors. As a result of these pressures, many traditional lenders and capital providers are no longer willing to finance companies that develop fossil fuels. The Inflation Reduction Act of 2022 accelerated the focus on developing renewables by providing an array of meaningful incentives to promote climate and clean energy programmes with bonus incentives for development in traditional “energy communities” such as in the Appalachian Basin. The net result of this movement is that investment dollars have shifted from traditional energy sources toward renewables and green technologies.

New infrastructure and downstream projects are needed

The Appalachian Basin is the largest natural gas-producing basin in the United States. Daily production has doubled in the last several years now approximating 35 Bcf/day. As of the beginning of 2023, total pipeline takeaway capacity from the region was around 24 Bcf/day. Many existing long-haul interstate pipelines out of the Appalachian Basin are at or near capacity. To accommodate further growth, additional takeaway capacity, additional local demand or both are needed.

Additional infrastructure projects have been proposed for the basin, but many have either been cancelled or have not got off the ground. The 1.5Bcf/Day, USD8B Atlantic Coast pipeline was cancelled in 2020, the 1.1 Bcf/day PennEast pipeline (which received a favourable US Supreme Court ruling) was cancelled in 2021, the 0.5 Bcf/day Northern Access pipeline did not make it into service, and the 0.65 Bcf/day Constitution pipeline was cancelled in 2020.

The lack of new infrastructure to service additional production growth has resulted in a growing basis differential. The basis differential is the difference between the natural gas prices received in the local markets and Henry Hub in Louisiana. In the early 2010s, as Marcellus production began to take off, the Appalachian basis differential hovered around or above USD1.00. During the 2014–2020 period, pipeline takeaway capacity grew by almost 500%. As pipeline capacity and access to demand markets outside the region grew, the basis differential fell and, in some cases (depending on the producer), went to zero. With a dearth of new infrastructure projects on the horizon, the basis differential is heading back to its prior higher levels. So, while producers delivering into Henry Hub may realise prices approximating USD2.50, producers selling to local Northeastern markets would likely see prices closer to the USD1.25–1.30 range.

Not all basins face comparable impediments to midstream and downstream development. A number of LNG, petrochemical complexes, cracker facilities and refineries are in various stages of planning and/or development on the Gulf Coast of Texas and Louisiana. The Gulf Coast will be positioned to supply the LNG and other hydrocarbons needed to satisfy global demand. Thus, unless the Appalachian Basin gets access to additional demand domestically or abroad, its growth prospects will be constrained.

Alternative development options and operating capital sources are growing

The oil and gas business is capital intensive. Publicly trading companies access capital via public debt and equity markets. Smaller, independent oil and gas producers have to rely on traditional forms of debt and equity. Following the latest wave of oil and gas bankruptcies, many institutions have changed the manner in which they are willing to deploy capital. Rather than extending credit in traditional forms, many capital providers now provide capital in exchange for the right to gas production or their corresponding revenue streams. These funding vehicles come in a variety of forms including:

• Drillcos – these are drilling joint venture arrangements where an investor provides an agreed amount of capital for the development of a specific well or wells in exchange for a working interest in the wells. Once the capital and the investment return are achieved, some or all of the working interest held by the investor can revert to the producer.
• Overriding royalty interests (ORRI) – these are investment vehicles where the investor provides an agreed amount of capital in exchange for a minority, non-operating interest in the production from one or more wells. The investor receives a return on its investment from production. Some or all of the ORRI may revert to the producer once the investor’s desired return on investment is achieved.
• Prepaid gas sales – these are purchase transactions where an investor purchases certain advance quantities of gas from a producer. The investor is entitled to market the purchased production and retain the proceeds or receive the proceeds from a sale by the producer on the investor’s behalf. Once the investor is repaid its capital with a return, the prepaid gas sale transaction is complete.
• Asset-backed securities (ABS) – these are investment instruments sold to investors in offerings using promissory notes issued by a special purpose vehicle that are backed by the wellbores and production from the wellbores. ABS investors minimise their risk by having the securities investment graded and backstopped by mortgages on the wellbores.
• Volumetric production payments (VPPs) – these are non-operating and non-expense bearing royalty interests in a producer’s leases and wells. The VPP investor makes an upfront payment in exchange for a specified volume of production. VPPs are typically structured for tax-efficient treatment for the producer and the investor.
• Farmounts – these are transactions whereby the owner of oil and gas conveys certain development rights to a third party in exchange for an upfront or deferred payment. Companies are willing to farm out oil and gas properties if they do not have the capital to develop the acreage or if it is no longer part of their core development position but they would like to retain some economic benefits from the development.

Big projects are happening but need help (sometimes a lot)

The Appalachian Basin is a paradox of sorts. On the one hand, it contains a world-class resource that is within a few hundred miles of the majority of the US population. The Marcellus-Utica could provide an abundant, domestic source of inexpensive fuel for decades. On the other hand, there are vocal constituencies and interest groups operating in the region that oppose new fossil fuel projects even if the development is displacing higher-carbon emissions. The legal challenges and political pressure raised by opponents can delay projects for extended periods or indefinitely. If uncertainty over obtaining permits or approvals for a project is created, companies will have difficulty predicting if and/or when a project will be approved, much less put into service. This uncertainty can make informed investment decisions difficult.

This is not to say that significant projects are not being developed. In 2014, the Mountain Valley Pipeline (MVP) was proposed as a USD3.5 billion, 300 mile, 2 Bcf/day pipeline traversing Northwestern West Virginia to Southern Virginia. The MVP encountered aggressive, organised and well-funded opposition. Several of the MVP’s permits and approvals faced repeated legal challenges, which ultimately ended up in front of the US Supreme Court. These challenges delayed the completion date for years. In June 2023, as part of the US debt ceiling suspension approval by Congress, Democratic Party Senator Manchin of West Virginia secured the final federal permits needed for the pipeline to proceed to completion. Thus, while additional legal challenges are possible, it took an act of Congress for the project to proceed, and the updated cost estimate for the pipeline is now USD6.6B.

The Shell ethane cracker in Southwestern Pennsylvania is another substantial project that has recently been put into service. In 2011, Shell began discussions with state and local leaders in Pennsylvania, Ohio and West Virginia on potential locations for the proposed USD6 billion facility. Some three years later, after receiving USD1.7 billion in tax incentives from Pennsylvania, Shell announced that it would proceed with the project. In late 2022, over a decade after it had been proposed, the cracker became operational. Thus, in this case, it took almost a USD2 billion investment and full support from the state, for this project to be brought to reality.

Basin and state-level trends and developments

Global commodity markets and local supply and demand forces combine to create a unique set of circumstances for the Marcellus-Utica resource basin. Some basin-wide trends expected from these factors include:

• M&A – these are expected to be focused on asset optimisation where acquisition targets are selected if they are accretive to the acquirer’s existing assets or operations. For example, if a company needs to replace depleted assets on its balance sheet, it may look to acquire targeted assets. Similarly, if a company has additional takeaway capacity that can be filled with additional volumes, it may look to acquire producing properties.
• Distress – natural gas prices continue to hover around the USD2.50/MMBtu range. Realised prices for many Marcellus-Utica producers is lower (and, in some cases, lower than break-even). Unless companies can access capital to cover operating deficits, they will have difficulty restructuring their operations and/or remaining going concerns.
• Patriotic to produce – over the last few years, there has been considerable disruption of energy markets with natural gas prices soaring in 2022. As prices rose, there was a growing sentiment that we had an obligation to help produce hydrocarbons for our economy and for our allies in Europe. Basically, it became patriotic to produce oil and gas domestically. If this trend continues, there should be support for additional energy projects, including infrastructure and downstream developments.

Many of the same national political, cultural and societal trade winds that exist in other basins also affect the Appalachian Basin, but perhaps differently, or at least to a different degree, than elsewhere. Considering that local developments are driven by local considerations, each of Pennsylvania, Ohio and West Virginia have their own internal dynamics as well. Some trends that may affect each state include:

Pennsylvania

Pennsylvania ranks second in the US for natural gas production. Production more than doubled from just under 10 Bcf/day to over 20 Bcf/day in a decade. As reflected by its expansive production growth, Marcellus-Utica wells are being permitted, drilled and completed with regularity. Infield gathering and small-scale infrastructure (eg, compressors, processing facilities) are also regularly being built and put into service. There is some expected conflict between operators and regulators along the way, but many of the gating impediments have been resolved and have not materially impeded the growth of the industry. Large infrastructure and downstream projects, on the other hand, especially closer to population centres, struggle to reach completion in the absence of significant support from government officials, regulators and the community.

The real question for Pennsylvania is to what degree it will support the ongoing growth of the Marcellus-Utica. In January 2023, Democrats took over the House of Representatives and Democrat Attorney General Josh Shapiro was sworn in as the new Governor of Pennsylvania. As Attorney General, Shapiro aggressively investigated oil and gas companies. As a candidate and thus far as Governor, Shapiro has struck a more conciliatory rhetorical tone and taken a seemingly more pragmatic approach to the industry. A few things to watch include:

• Climate and Energy Policy Working Group – Governor Shapiro has empanelled a private working group to create a comprehensive climate and energy policy that is supposed to balance energy jobs and climate change while ensuring that Pennsylvania has access to affordable clean energy. The recommendations of this group will likely shape Pennsylvania energy policy and its approach to the production of shale gas.
• Regional Greenhouse Gas Initiative (RGGI) – under Shapiro’s predecessor, Pennsylvania joined the RGGI along with a dozen other Northeastern and Mid-Atlantic states. RGGI is intended to limit carbon dioxide emissions from fossil fuel power plants. RGGI places caps on plant emissions, allows for the trading of carbon credits and charges fees for additional emission allowances. Shapiro has not committed to fully participate or withdraw from the RGGI.
• Severance Tax – in June 2023, the Democrat-led House of Representatives voted to study a severance tax as compared to Pennsylvania’s current impact fee system. Typically, severance tax assessments are higher than those of Pennsylvania’s impact fee. The Republican-led Senate is not expected to support a proposed severance tax.

Ohio

Ohio is the sixth-largest producer of natural gas and the 12th-largest producer of oil in the US. Ohio has its own storied history in the oil and gas world as the home of John D Rockefeller’s Standard Oil. For anti-trust reasons, Standard Oil was split into 34 companies that evolved into industry juggernauts such as Exxon-Mobil, Chevron, BP and Marathon. Notionally, Ohio is generally supportive of oil and gas development in the state and has a fairly easy and predictable permitting process. There have been almost 3,000 shale wells drilled in 19 of Ohio’s 88 counties, leading to in excess of USD100 billion in investment in the state. To build off that progress, Governor DeWine has made a point of communicating that Ohio is “open for business” for upstream, midstream and downstream companies. Some steps that Ohio has taken and to look out for include the following.

• Gas is green – in January 2023, Governor DeWine signed legislation declaring natural gas to be “green energy”. While the full implications of the move are still being assessed, at a minimum, it is considered to be a statement that Ohio encourages additional development of its shale resources.
• Leasing state parks – building off the “gas is green energy” declaration, Governor DeWine is also requiring that state parks be leased for oil and gas development. Legal challenges to the legislation are likely.

West Virginia

West Virginia is the fifth-largest oil and gas producer in the US. Like Ohio, West Virginia is generally supportive of oil and gas development and has a predictable permitting process. Unlike many other states, it has an Office of Energy that is responsible for the development and use of fossil fuels, renewables and energy-efficiency initiatives, as well as a State Energy Plan (covering 2018–2022). The development of its oil and gas resources has resulted in approximately USD13 billion being contributed to the annual state economy in the form of jobs, investment, royalties to landowners, and severance taxes. 

In addition to the historic contributions to the state, West Virginia has had recent successes, including MVP, which is considered to be one of the bigger (and most hard fought) developments in the basin. It also has its challenges. West Virginia still produces approximately 90% of its power from coal and only about 5% from natural gas. A few items to watch for include:

• Power plant legislation – to encourage the use of natural gas, West Virginia has been considering legislation to encourage the siting of new gas-fired combined cycle power plants.
• Weirton zoning case – the city of Weirton denied a producer’s request to locate a well pad in the city limits. The producer appealed to the Brooke County Circuit Court and lost. The case is now before the Intermediate Court of Appeals.

Appalachian basin – will its full potential be realised? Time will tell

The Appalachian Basin is home to a world-class oil and gas resource. It is positioned to substantially contribute to a low-cost, abundant energy future for the United States and beyond. However, the Marcellus and Utica shale formations produce far more hydrocarbons than can be utilised in the basin. As a result, substantial interstate pipeline infrastructure and/or downstream projects will be needed, or new production growth will be curtailed. Such projects will require support from investors, government officials, regulators and the community at large. Only time will tell if there will be the collective will to achieve these results.