Drill Watch

All told, the department says recoverable world shale oil resources stand at 345bn barrels while recoverable world shale gas resources total 7,299 trillion cubic feet (Tcf). This is 10 per cent higher than the previous estimate compiled in 2011.

Sceptics nevertheless point out that not a single shale gas well drilled and fracked outside of the US has yielded commercial flow rates yet, apart from in Canada and perhaps China (where data is limited and suspect). Angelos Damaskos, fund manager of the Junior Oils Trust, also notes the Department of Energy disregarded the costs of production when compiling its "technically recoverable" resource estimates. "Most of the North American shale gas projects have marginal cost in excess of $4 per mbtu (million British thermal units), which is above the current market price, while shale oil is deemed economic at well above $80 per barrel. Energy prices will have to stay above $100 per barrel and $5 per mbtu to incentivise the exploitation of such reserves."

With this in mind, the June edition of Drill Watch will look at the recent fracking activities of several companies listed on London's Alternative Investment Market (Aim) and compares the vastly differing effects it can have on flow rates.

As usual, we provide a summary of drill results released by companies we profiled in the May edition of Drill Watch at the bottom of the article.

Northcote Energy – Big Hill #1

Tiny Northcote Energy (NCT) operates in one of America's rapidly emerging shale plays, the Mississippi Lime formation in Oklahoma. The company released positive initial results on 28 May from the first frack at its Horizon project, in which Northcote holds a 51.75 per cent working interest (but only a 41 per cent net revenue interest). It is carrying out hydraulic fracturing on four to six previously drilled – but unfracked – horizontal and vertical wells there this year. The wells are thought to contain multiple potential new pay zones for oil and liquids-rich natural gas.

Chief executive Randy Connally told Investors Chronicle a few months ago that fracking at Horizon could potentially increase initial production by up to 32 times or as little as two times, depending on how the reservoir reacts. And it looks like he was right. The first well, Big Hill #1, saw gas production immediately increase by 12 times after fracking at an open flow rate of up to 1.21m cubic feet of gas per day (or 215.5 boepd gross, 88.4 net to Northcote). The program also unlocked 16 barrels (gross) of oil production per day, where previously the well had not been an oil producer, "providing further encouragement that the fracture stimulation has enabled the well bore to open up unexploited reservoir".

Fracking at the Big Hill #2 well unfortunately run into some technical difficulties. Northcote discovered a tubing leak mid-way through testing, so the release of any production flow test results will have to be delayed until the problem is fixed and testing restarted. In the meantime, preparations for fracking the next two wells are under way. The company says further information will be provided on anticipated timings when finalised.

IC view: Clearly, fracking has the potential to dramatically boost both gas and oil production from the underperforming wells at Horizon. At open flow, Northcote says the well has "demonstrated the potential to produce up to 231.5 boepd (95 boepd net to Northcote)". Granted, the steep natural decline curves associated with fracking for shale gas mean this rate won't last for long. But provided the company can get the required mechanisms in place to capitalise on the increased gas volumes, the Big Hill #1 well should contribute significantly towards Northcote's 2013 year-end production target exit rate of 100 boepd. As of mid-April, the company had already increased production by 75 per cent since listing in January, from 28 barrels of oil equivalent per day (boepd) to 49 boepd. While it's difficult to estimate what impact this will have on Northcote's bottom line, we continue to see value in Northcote's shares based on other metrics and reiterate our speculative buy recommendation. Last IC view: Buy, 1.50p, 11 Apr 2013

Magnolia Petroleum – Roger Swartz #1

Aim tiddler Magnolia Petroleum (MAGP) is also drilling in Oklahoma's up-and-coming Mississippi Lime formation. While the company's usual business plan involves acquiring very small interests in wells about to be drilled by experienced operators, this year it decided to drill its own, 100-per-cent-owned vertical well, Roger Swartz #1.

Hydraulic fracturing was carried out on the well in May and Magnolia released preliminary production figures on 5 June: an initial production rate of 17 barrels of oil per day was recorded, which management says is roughly in line with its expectations. Still, this is much lower than the 231.5 boepd rate that fracking yielded at Northcote's Big Hill #1 well.

Why the big difference? The most basic conclusion one could draw is that Northcote's licence is of a better vintage than Magnolia's; perhaps Big Hill #1 was drilled in a sweet spot, or Roger Swartz was drilled on the outskirts of the play where the quality of the formation isn't as good. But it isn't as simple as that. Production from this play, like many of its American peers, is inherently heterogeneous. There is no average production profile that fits most wells; rather, some outperform and others underperform.

One key difference between these two wells, however, is that Magnolia drilled a vertical well while Northcote's is a horizontal well. Vertical wells are much cheaper to drill, but they are usually less productive because they offer less exposure to the main producing reservoir. Fracking can have a much greater effect on horizontal well production because it can target a much larger area of shale rock, potentially releasing more gas.

IC view: While Magnolia's 17 bopd initial production rate is clearly a bit lacklustre, the well should still be profitable. Management hasn't released an estimated payback period for the well but we would guess it to be about two years using an oil price of $90 to $95 a barrel. Granted, the well will have a relatively hyperbolic natural decline rate. But Magnolia estimates it can eventually recover a total of 51,000 barrels of oil-equivalent from the well, representing potential revenues of $4.8m at current oil prices. We don't want to speculate as to operating costs or bottom-line profit just yet, but drilling costs came in at $730,000. We have no current recommendation on Magnolia.

Leyshon Resources – Well ZJS5

Junior explorer Leyshon Resources (LRL) is one of the few western companies trying to exploit unconventional gas licences in China, which the US Energy Department says has some of the largest and most prospective shale gas basins in the world.

But rather than focus on the more difficult shale plays, Leyshon is targeting lower-hanging fruit in the form of 'tight gas'. Like shale gas, tight gas is difficult to extract because the rock formations are typically impermeable – for example, sandstone or limestone formations where the gas cannot move very easily through the rock. But whereas shale formations are often large and uniform, tight gas deposits typically form in smaller, more concentrated pockets. Fracking is the key to unlocking gas in both deposit types, and that is exactly what Leyshon is currently trying to do after discovering a significant tight gas reservoir at its Zijinshan project last year.

The company fracked its first well, ZJS5, in May and it flowed at a rate of 160,000 cubic feet per day (approximately 29 boepd) over an eight-hour testing period (which, it should be noted, is a fairly short and unreliable test period). Management was encouraged by the flow rate, saying it represented a commercial rate and that it was from just one pay zone; further flow may be possible from other, untested pay zones later on. Moreover, their internal cut-off for commercial flows was 125,000 cubic feet per day.

Unfortunately, fracking at a second well, ZJS6, failed to yield similar results. Whereas the first well was drilled right in the heart of the target area, the second well is located about eight km to the southeast, on the southern border of the licence area. Leyshon tested several zones but they were all found to be water-bearing. The company says it doesn't know if this is a well-specific issue or if the pay zone from the central area is simply water-logged in the southern area. Leyshon has decided to abandon the well and focus on the central and northern areas of the licence for the time being.

A map of Leyshon's Zinjinshan licence showing well locations. Note: this image was taken from a company presentation dated 7 June 2013, so it was compiled before the flow test results were released from ZJS6

IC VIEW:

Admittedly, we were a bit discouraged by the relatively low flow rates from the first well, and then the failure of the second well to produce anything but water has seriously hurt sentiment. But we think Leyshon's licence still has potential. This area of China benefits from very high gas prices – between $9 and $12 per mscf, or three to four times higher than the current price in the US – so production could still be economic despite lower flow rates.

Moreover, the drilling and fracking of a third well, ZJS7, should provide a clearer view of the production potential of the central part of the licence. That's because the well is being drilled just 3km north of well ZJS5, still close to the heart of the licence. Assuming that well is successful, Leyshon would then test wider-flung targets around the licence. Managing director Paul Atherley says drilling should begin in early to mid-July, with drilling taking approximately four weeks. Should the well encounter hydrocarbons, the company would then conduct flow testing and fracking. Leyshon’s shares sold off harshly following the results of the second well and are now trading near cash backing at 11p; the company currently has around $40m in its treasury, worth about 10p per share. We therefore keep our speculative buy recommendation while awaiting the next drill results. Last IC view: Buy, 19.75p, 14 Mar 2013