Russia Forgoes Shale Gas

Published in Investing on 13 April 2012

This world energy giant doesn't need to bother with unconventional sources.

A version of this article initially appeared on our US site, Fool.com.

Unlike the rest of the world right now, Russia isn't scrambling to develop its shale gas assets. The country is the world's second-largest natural-gas producer, and its production story affects much of the world and many of our investments.

Sticking to conventional gas

Gazprom, Russia's state-owned natural-gas producer, has stated that turnoffs to shale drilling and hydraulic fracturing include numerous environmental hazards and the reality that pipeline infrastructure in Europe does not have the capacity for a Russian gas boom.

But let's be serious -- Russia doesn't need shale gas. The country's natural-gas reserves are the largest in the world, and these conventional resources are much cheaper to develop than shale gas reserves. Gazprom's stance is to stick to conventional reserves for now and revisit the possibility of drilling shale in 50 to 70 years.

The delicate balance of gas production

There may be more reasons to hold back on shale gas production. Russia supplies the European Union with 25% of its natural gas needs. Demand in Europe is currently outpacing supply, keeping prices up. The price of natural gas on the continent is about $12.50 per MMBtu. If Russia went after shale gas, the influx of more product would likely drive that price down, cannibalising profits and creating a situation much like the one we see in the US right now, where natural gas prices are closer to $2.03 per MMBtu. For those keeping score, that's a new 10-year low.

Europe's energy pinch

This past winter was unseasonably cold in Europe and Russia. To compensate for increased demand in the face of colder temperatures, Russia kept more of its gas for its citizens, letting demand outstrip supply in Europe. In some cases, supplies were cut by as much as 30%.

This isn't the first time Europe has felt the effect of a Russian gas pullback. In 2006, and most recently in 2009, disputes with Russia caused gas-shortage crises that affected some European countries for weeks. As a result, countries in the EU have improved their storage facilities and re-engineered pipelines to flow east-west and west-east. Additionally, EU gas companies must be able to guarantee they can supply customers for 30 days in the face of exceptional demand or a disruption of service.

In the meantime, demand will continue to rise. Germany is looking to offset its shift away from nuclear power with an increased dependency on renewables and natural gas from Russia. To prevent another crisis, the EU will continue to look for new sources to diversify gas imports. Enter, Poland.

Poland's hero potential

Right now, Europe's hopes of escaping Russian energy dependency are all on Poland. Recent research shows that Poland is home to Europe's third-largest reserves of recoverable gas, and there are a few companies trying to make the most of them. But Poland's natural-gas future is undecided right now, its exploration and production story a mix of hits and misses.

In February, ExxonMobil (NYSE: XOM.US) announced that two exploratory wells failed to produce at commercial levels. The news struck a blow to those who had pinned their hopes on a Polish gas boom, but some companies have been able to get commercially viable wells up and running.

FX Energy (NYSE: FXEN.US) has had great success in Poland. The company has increased production in the country from 10 million cubic feet of equivalent per day in 2010 to its current rate of 14 MMcfe. If everything goes according to plan, that number will rise to 17 MMcfe by the third quarter of this year.

Marathon Oil (NYSE: MORE.US) is also throwing its hat in the ring. The company is evaluating data from its first drilled well and plans to drill six or seven more this year. Marathon has control of about 1.2 million net acres, with shale gas potential in Poland.

Russia's next move

For the time being, Russia can count on Europe as a top customer, but the country is looking to diversify its customer base, just as Europe is looking to diversify suppliers.

One immediate problem is that Russia has lost a large potential market in the US. The country planned to export liquefied natural gas (LNG) to the Americas before its shale gas boom. Now that the US no longer needs Russian gas, Russia must reassess its export plan going forward.

Evidence of these decisions will come from the development of the Shtokman gas field. Located under the Barents Sea, the Shtokman is estimated to contain 137 trillion cubic feet of natural gas. Initial development plans called for 50% of gas produced to be routed to Europe via pipeline and the other 50% converted to LNG and shipped to the US.

Now Russia will seek markets for its LNG in Europe, the Middle East and Asia. Energy consultancy Wood MacKenzie predicts that the current tax environment in Russia will ultimately transform Shtokman into a project that produces mostly LNG, as the economics of LNG are superior to pipelines right now.

Foolish takeaway

Russia will not develop shale gas any time soon, but its production story remains a complicated one as markets shift and European demand grows. The most intriguing play for investors may be in this European side story, in which companies move into Poland to develop reserves and try to steal Russian market share.

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