Technology, entry, and uncertainties: Analysis of the U.S. shale gas industry development

1. Technology, entry, and uncertainties: Analysis of the U.S. shale gas industry development Svetlana Ikonnikova Scott W. Tinker Bureau of Economic GeologyJackson School of GeosciencesThe University of Texas at Austin IAEE, Stockholm June 21, 2011

2. History • In 2000 virtually no shale gas production vs. over 20 % of the U.S. total production in 2010. • Conventional market producers are capacity constrained; new fields are hard to discover and expensive to develop. • Over the past decades, new players came to the market, investing in technology to make unconventional production economical • Chesapeake Energy - the second largest producer of natural gas in the United States, began with 10 employees and $50,000

3. The U.S. has ~1000 Tcf (28 Trillion cm) of technically recoverable resources.

4. Researchquestions • What has driven shale gas development? • Why are big producers followers, adopting technology, and small new comers are leaders? • What can explain overproduction? • What can we infer about the future?

5. Literature • Reinganum (‘81, ‘85), Gilbert&Newbery (‘85), Fudenberg&Tirol (‘85) – look at investments in production cost reduction, technology races and technology diffusion. • A limited number of works studies investments in entry cost reduction, e.g. Argenziano & Schmidt-Dengler (‘06). • We enrich the past models adding uncertainty on R&D success and private information about costs.

6. Analytical approach • Multi stage repeated market game • Before resource can be used a technology to be developed to produce it profitably at costs below market price. entrant wins or is bankrupt; incumbents may adopt entrant invests; incumbents wait new resource incumbents & entrant invest entrant wins or is bankrupt; incumbents winor may adopt

7. Key assumptions • R&D is a stochastic process: success date is uncertain: Pr{τi(Ii)≤ τ} • Success is determined by production cost ci, which is private information: F(ci) • Market price is determined exogenously, expected price is a common knowledge pτi • Incumbents have size parameter αi ≥ 1, that is to do the same job it costs them more. • Investments are observable.

8. Solution • Solve the game backwards to find the optimal incumbent & entrant strategy. • Players are risk neutral and maximize flow of expected profits , where hi– aggregate rival hazard rate and πdepends on Pr{ci≤piτ}

9. Results I • Depending on the uncertainty parameters, incumbents will choose not to invest, but wait to observe whether entrant’s efforts are successful and what is F(ci). • Incumbents adopts the technology when marginal cost of technology adoption are equal to expected gain, that depends on the market price as well as expected cost reduction.

10. Results II • Key determinants of the industry dynamics are price vs. costs and uncertainty about when technology improvement will happen. • When entrant succeeds, he becomes incumbent and game starts over. Under high uncertainty and depending on price, multiple entry can be expected. • Hence, industry may grow and when the price is also affected by the industry size, lower prices and increased output are to be expected.

11. Thank you! Questions?