About a year ago, private-equity firm KKR struck a $350 million deal to invest in East Resources, a natural gas exploration and development company focused on an area called the Marcellus Shale, which stretches from Ohio and Virginia to New York. At the time, the transaction got little fanfare.
Well, now it's getting lots of attention. On Friday, Royal Dutch Shell (RDS) announced it had agreed $4.7 billion in cash for most of the assets of East Resources.
Even for a company of Shell's massive size, this deal is substantial and will be a drain on resources. After all, Shell is also in the process of ramping up its investments across its global portfolio. But the transaction will also be a key part of the oils company's strategy to boost growth and diversify away from the challenges of the petroleum market.
Drilling Down on East Resources
In 1983, Terrence Pegula borrowed $7,500 from his parents and started East Resources. It was a gutsy move, but he saw the potential of extracting natural gas from shale.
Today, East Resources is one of the largest independent oil and natural gas companies in the Appalachian Basin. With about 1.05 million acres of land, the company's energy production is the equivalent of about 10,000 barrels of oil per day, mostly from natural gas.
The problem is, it's expensive to extract natural gas from shale. The process requires a large number of wells, which can easily cost more than $1 million apiece. In other words, this opportunity is really best-suited to companies that have enormous balance sheets.
Making that an even larger problem, lately, is that the industry has seen a brutal decline in pricing, in part due to the recession, and in part to an oversupply of natural gas. Further, natural gas extraction carries environmental risks, primary among them the possibility that the shale-extraction process called hydraulic fracturing (or "fracing") might contaminate local water supplies.
Yet the Marcellus Shale has remained attractive, because it's relatively cheaper to develop the energy resources in the region.
Catching Up With the Competition
Over the past year, other major oil companies have moved aggressively into natural gas. Recent deals include Exxon's (XOM) $41 billion purchase of XTO and Total SA's (TOT) $2.25 billion purchase of assets from Chesapeake Energy (CHK).
No doubt, natural gas prices will eventually improve again. A report from the U.S. Energy Information Administration forecasts that unconventional sources of natural gas -- which include shale -- will account for 26% of gas production in the U.S. by 2035, and a whopping 56% in China.
Moreover, in the wake of BP's (BP) tragic Gulf of Mexico oil spill, there may even be more emphasis on unconventional energy sources. Consider that U.S. Interior Secretary Ken Salazar said he would postpone consideration of Shell's request for permission to drill five exploratory wells in the Arctic.
Shell already has a decent footprint in the natural gas business. But with the deal for East Resources, it will expand that footprint substantially, and diversify its portfolio.
Introduction to Value Investing
Are you the next Warren Buffett?View Course »