by Fabio Herrero
In a previous article entitled, “US Natural Gas Export: A Sensible Move?” dated September 2014, I wrote about the nonsense surrounding the US gas export meme and debunked the frack gas miracle. Many arguments used for my case, which was that the gas boom was not a long lasting one and that the US should not export gas, hold true for the shale and tight oil industry as well. This updated and expanded article will describe how the fracked wells are not like the “old school” wells that we knew, and will add three more arguments about the frack oil industry in the US. First, the figures – the ones in the graph “Selling the Shale Boom” – reported by the US Securities and Exchange Commission, the SEC, and those from investors are very different; the investors’ are massively inflated. Second, the break-even cost of nonplateau oil assets deteriorated dramatically in the US, and if WTI Oil drops under $75/barrel the whole industry will go belly up. The third one is what I call the BOE, barrel of oil equivalent, deception, in which gas is considered as oil in mmbtu terms without being the same in dollar terms. Before concluding, I will explore how the Federal Reserve’s accommodating monetary policy has created this massive bubble.
This updated and expanded article will describe how the fracked wells are not like the “old school” wells that we knew, and will add three more arguments about the frack oil industry in the US.
1. Fracked wells are not like the old wells you are acquainted with
The sharp increase in production brought on by fracking has certainly been remarkable. However, even in their best case scenario, high and climbing oil prices, US shale producers will be pushed to maintain the high level of output they have achieved in recent years. This is because a shale well has a limited lifespan of around seven or eight years. According to Pete Stark, a geologist and analyst at IHS, the output of shale wells drops faster than conventional ones, falling by 50-80% after the first year, and one well, stated an article on Oilprice.com, in the Bakken fields dropped 69% in its first year. Traditional wells, according to a 2014 article in Bloomberg, take two years to fall by about 55% before flattening out. This forces companies to keep drilling new wells to make up for lost productivity. A conventional oil field produces crude at a level that wanes slowly over the course of decades. Saudi Arabia’s massive Ghawar field (biggest field ever), for example, began production in 1951 and is still pumping out around five million barrels a day. This is a well known fact.
2. Discrepancies between SEC reported and investor reported reserves and resources
It is not the purpose of this article to dissect the nuances about reserve, resources etc., let’s just be reminded that a mineral resource is an occurrence of material of intrinsic economic interest in such form, quality, and quantity that there are reasonable prospects for eventual economic extraction and a mineral reserve is a resource known to be economically feasible for extraction. What is important to understand is that reserves are more “real,” resources are just potential. It is mainly a function of price and technology.
One aspect not covered in my previous article were the massive discrepancies between the figures told to investors and the proved reserves reported to federal regulators. To illustrate this point, here is an excerpt from an article published in Bloomberg. “Lee Tillman, CEO of Marathon Oil Corp., told investors in September 2014 that the company was potentially sitting on the equivalent of 4.3 billion barrels in its U.S. shale acreage. That number was 5.5 times higher than the proved reserves Marathon reported to federal regulators, according to another 2014 Bloomberg Article. Such discrepancies are rife in the U.S. shale industry. Drillers use bigger forecasts to sell the hydraulic fracturing boom to investors and to persuade lawmakers to lift the 39-year-old ban on crude exports. 62 of 73 US shale drillers reported one estimate in mandatory filings with the SEC while citing higher potential figures to the public, according to data compiled by Bloomberg. Pioneer Natural Resources (PXD) Co.’s estimate was 13 times higher. Goodrich Petroleum Corp.’s was 19 times. For Rice Energy Inc., it was almost 27 times more (Bloomberg 2014b).”
“Drillers use bigger forecasts to sell the hydraulic fracturing boom to investors and to persuade lawmakers to lift the 39-year-old ban on crude exports.”
As a further example we have the case of “California’s Monterey Shale, which the U.S. Energy Information Agency thought contained 13.7 billion barrels of oil in 2011. Closer examination revealed the formation to be much more broken up underground than previously thought, so much so that only around 600 million barrels may ultimately be recovered with current technology.” This is highlighted in an article in zero-hedge entitled “Fracked Up: Don’t Believe in Miracles”. “That’s a 96% downgrade, and there is no guarantee that other predictions of shale oil riches both in the U.S. and elsewhere won’t have similar outcomes,” the article concludes.
3. The break-even cost of non-plateau oil assets in the US is now $75/bl
An article submitted to zerohedge.com in October of 2014, entitled “If The Oil Plunge Continues, Now May be a Time to Panic for US Shale Companies”, summarizes the US shale boom and its associated costs:
“Over the past five years, the shale industry, fabricated or real reserves notwithstanding, has been a significant boon to the US economy for four main reasons: it has been the target of billions of dollars in fixed investment and CapEx spending, it has resulted in tens of thousands of high-paying jobs, its output has been a major tailwind for the US trade deficit, and has generally been a significant contributor to GDP (not to mention Warren Buffett controlled railway Co.’s). Most importantly, the cost curve of US shale is horizontal, with a massive ten million barrels per day available within dollars of $85/bl. In a recent report by Goldman Sachs in 2014, the investment bank states that the vast reserves that have been opened for development through shale oil in the US have flattened the cost curve meaningfully, at around a $85/bl Brent oil price. Goldman’s analysts estimate shale reserves from the top three fields in the US onshore (the Permian, Bakken and Eagle Ford) at around 91bn boe, which to put it in context, is equivalent to roughly one third of Saudi Arabia’s current stated reserves (the Saudi Arabian number “may” be vastly overstated, but this is completely another story. For more about the overstating of Saudi reserves see: “Twilight in the Desert” by Matthew Simmons). Most of this resource has become available in the past five years, with few barriers to exploiting the reserves. Production in the US, as a result, is growing strongly at a yearly rate of more than one million barrels per day currently, and we expect this pace of growth to continue over the coming three years as capital continues to be drawn into these developments. The consequence is that costs of production and E&P CapEx/bl should stabilize as the marginal cost of production remains stable. Goldman Sachs (2014) believes that shale oil has become effectively the marginal source of supply, providing the bulk of non-OPEC production growth…With US shale oil profitable only above its virtually horizontal cost curve, it means that eleven million barrels per day are available as long as Brent is above $85, a clear “red line” for most OPEC producers. The red line is conveniently shown on the chart:”
What is obvious to me is that if we combine the knowledge derived from these charts and the known fact that at any time the best marginal fields are used first, leaving the less productive and expensive for the future, we (as a civilized society) are on a collision crash course. But how about cost reductions? If the oil price goes down, and the oil industry reduces CapEx “at a time of material expansion of oil service capacity, it could lead to a potential 5-15% cost deflation across oil developments, after a decade of 10% inflation,” according to an article published on zerohedge.com in October 2014 entitled “Why ‘75’ Is The Most Important Number for US Economic Hope.” It is a reasonable scenario.
Let’s look at the chart with $5-10/bl of cost reduction:
Looking at this data, we can assess that the shale oil boom would be severely damaged if the oil price falls and stays under $75/bl. If we look at these numbers from a financial point of view, and incorporate some cost reductions as Goldman Sachs (2014) did in this next chart, it would appear evident that only some fields provide some meaningful return, the others needing a much higher oil price.
The Barrels of Oil equivalents deceitful practice
Marin Katusa, an energy investment strategist at Casey Research, exposed the deception US energy companies use to enhance their value in an article called “Three Energy Sector Investment Traps.”:
“The BOE is a unit of energy, defined as the amount of energy released when one barrel of crude oil is consumed. Most oil wells produce some natural gas and most natural gas wells produce some oil, so energy companies generally produce both kinds of fuel. Producers have long lumped quantities of the two into one calculation in order to simplify reporting: the “barrel of oil equivalent” (BOE). Since different grades of oil burn at different rates, the value is an approximation, set at 5.8 x 106 BTU or 6.12 x 109 joules. The BOE concept then lets us combine different fuels according to energy equivalence. Barrels of oil equivalent are most commonly used to combine oil and natural gas: one barrel of oil is equivalent to 5,800 cubic feet of natural gas because both produce approximately the same amount of energy on combustion. The problem is that details are lost during the conversion, important details. One barrel of oil is equivalent to 5,800 cubic feet of natural gas in terms of energy, but the difference in value is very significant, and that is the trap.”
Marin Katusa provides us with this handy calculation to understand the matter:
“Using an oil price of $80 per barrel and a natural gas price of $3.50 per thousand cubic feet we can calculate the value of a BOE of natural gas priced as gas: $20.30. However, a barrel of oil is not worth $20.30, but rather is currently worth more than $75 per barrel. Yet a BOE with 100% gas is worth only $20.30. The barrel of oil is actually worth almost four times more than the supposedly equivalent “barrel” of natural gas. Certain companies purposely use this concept because they want to value their gas reserves at more than seven times their actual value.
Another aspect impacting this issue and something the mainstream media are totally missing is the glut, or oversupply, of so-called “wet” gas the industry in North America is currently experiencing. Gas is called wet when natural gas liquids, or NGLs, and condensates can be separated from the natural gas. NGLs are ethane (C2), propane (C3), and butane (C4). Condensates are pentanes plus (C5 and higher).”
“There’s such a glut of ethane that we now see ethane rejection, where the companies leave the ethane in the gas stream and sell it as natural gas. They don’t even bother separating it. It’s like flaring the gas at the oil well, it’s not worth the hassle right now.”
Some firms separate the NGLs by category and break down the pricing. But the majority is less transparent, explains Casey. “Since wet gas was worth so much more than dry gas, the exploration and production (E&P) sector has focused on wet gas formations, and now there is a glut of NGLs in North America. In fact, there’s such a glut of ethane that we now see ethane rejection, where the companies leave the ethane in the gas stream and sell it as natural gas. They don’t even bother separating it. It’s like flaring the gas at the oil well, it’s not worth the hassle right now.”
What it means is that the value of NGL is also going down, reducing even more the overall profitability of the BOE.
The impact of the FED’s low rates policy on the oil economy.
The oil and gas sector is capital intensive. As discussed in my previous article, the “fracking miracle” may not be all that it is believed to be due to fast production decline rates and massive amounts of leverage. The energy sector is the largest single industry component of the USD DM HY index. Drillers have borrowed huge amounts of capital to acquire leases, drill wells, and install processing equipment and infrastructure. Even as debt piled up, the decline rates of fracked wells forced drillers to drill new wells to make up for the dropping production from old ones (remember, the decline can be as high as 70% after just one year), and to drill even more to show some kind of growth. All this was funded in part by High Yield debt, called junk debt. Wolf Richter wrote in October 2014 in ‘Wolf Street”, a blog about business and finance, that “junk bond issuance has been soaring as the FED repressed interest rates and caused yield-hungry investors to take on more risk” to earn some meaningful return. “Demand for junk debt soared and pushed down yields further….The proportion issued by oil and gas companies jumped from 9.7% at the end of 2007 to 15% now, an all-time record.” An article in Bloomberg explained further: “Shale debt has almost doubled over the last four years while revenue has gained just 5.6%, according to an analysis of 61 shale drillers published in Bloomberg. A dozen of the surveyed companies are spending at least 10% of their sales on interest compared with Exxon Mobil Corp.’s 0.1%.” (Bloomberg 2014c) “Interest expenses are rising,” Virendra Chauhan, an oil analyst with Energy Aspects in London, was quoted as saying in Bloomberg. “The risk for shale producers is that because of the production decline rates, you constantly have elevated capital expenditures.” In a world of falling interest rates, the newcomers have a competitive advantage over the old ones, paying less and less for capital, and having less debt to pay on.
Below, I have included sections from an article published in November of 2014 on zerohedge.com entitled “If WTI Drops to $60, It Will Trigger a Broader HY Market Default Cycle, says Deutsche.” What impact should we expect from the move in oil price so far and where is the true tipping point for the sector? Analysts at Deutsche Bank have calculated a scenario with WTI at $60 for the single B/CCC segment. “At the moment, average debt/enterprise (D/EV) value metric is 55%, up from 43% in late June, before the 26% move lower in oil. About 28% of energy B/CCC names are trading at 65%+ D/EV, implying an 8.5% default rate among them, assuming historical 1/3rd default probability holds. This would translate into a 4.3% default rate for the overall US HY energy sector (including BBs), and 0.7% across the US HY bond market.”
A November 2014 article in Forbes weighs in, “Within energy, the oil exploration and production (E&P) and the oilfield services companies have been hit particularly hard. The median spread of bonds in those industries is currently in the 5.5% to 6.5% range.”
“A 25% drop in oil price so far has pushed D/EV valuations among US energy B/CCC names to a point suggesting 8.5% future default probability, while their bonds are pricing in a 9.5% default probability.” Deutsche Bank’s stress test shows “that a further 20% drop in WTI to $60/bbl is likely to push the whole sector into distress, a scenario where average B/CCC energy name will start trading at 65% D/EV, implying a 30% default rate for the whole segment. A shock of that magnitude could be sufficient to trigger a broader HY market default cycle, if materialized.” (Zerohedge/Deutsche Bank 2014).
Clearly the shale O&G revolution is a major misallocation of capital, and this is without accounting for the massive investments in LNG export plants. Low US gas prices have hindered the development of renewable energy sources, directly by making them more uneconomic, and indirectly, giving the impression that the US is sitting on a sea of cheap and infinitely abundant gas.
And remember that in during the 2007-8 “subprime” crisis prices of oil wend in the $30s they didn’t stop at $60. We can only imagine what the consequences for the shale oil sector would be if this happens.
While Saudi Arabia’s strategy of dumping oil in the market and lowering the price is not completely clear and beyond the scope of this article, “very
soon there will be a very vocal, very insolvent, and very domestic shale community”, as is written in zerohedge, “demanding answers from the Obama administration”, as once again “hope” and “change” will have trumped farsighted statesmanship.
An article in zerohedge “Houston, We have a Fracking Problem” sums up the situation well: “With oil prices and demand falling at a time when production is strongly rising, the risk of a supply/demand imbalance has significantly increased. This puts the prices and valuations of energy companies, particularly drillers and service suppliers, at risk as well.” The whole ecosystem will be under stress. As the Danish Physicist Niels Bohr once said, “Prediction is very difficult, especially about the future”, so I will not predict a catastrophic end for the shale industry in the next years. However, the survival of the frack industry is a function of high Oil&Gas prices, and nobody knows what these prices will be one month or five years down the road or what the real floor price for the survival of the frack industry as we know it today is. Hitherto we know that the sector didn’t make profits in the last years of relatively elevated prices and minimal regulation. Also during this period it used the best fields available. In the meantime it accumulated enormous debts in an environment with the lowest interest rates in recorded history. Will the frack industry survive a possible less favourable future?
It seems we are at Peak Shale right now. The very best of the best wells are being drilled, and they are new and at peak production, interest rates are near zero, they can’t go lower. So shale is in its golden age. It can only go down from today UNLESS oil prices spike again. In that case, even shale could last for decades. It demands a high price, though, to keep going.
Fabio Herrero is a student in the ENERPO program at European University at St. Petersburg.
Bloomberg (2014a) “Dream of U.S. Oil Independence
Slams Against Shale Costs”, Retrieved 14.11.2014
Bloomberg (2014b) “We’re Sitting on 10 Billion Barrels of Oil! OK, Two.” Retrieved 14.11.2014
Bloomberg (2014c) “Shakeout Threatens Shale Patch as Frackers Go for Broke.” Retrieved 14.11.2014
Bloomberg (2014d) Oil and Junk Don’t Mix as Worst Bonds Sink as Much as 19%, Retrieved 14.11.2014
Forbes (2014), Falling Oil Prices Take A Toll On Energy Sector Junk Bonds, Retrieved 14.11.2014
Katusa, Marin (2014) “Is US Shale Oil a Ponzi Scheme at $75 per Barrel?” Retrieved 04.11.2014, http://www.caseyresearch.com/cdd/is-us-shale-oil-a-ponzi-scheme-at-75-per-barrel
Isaac Arnsdorf, Retrieved 27.10.2014
Los Angeles Times (2014) “U.S. officials cut esti-mate of recoverable Monterey Shale oil by 96%” Retrieved 04.11.2014
McCarthy, Niall (2014) “The Oil and Gas Industry in the United States”, Retrieved 10.11.2014
North Dakota Industrial Commission Department of Mineral Resources (2014), Retrieved 14.11.2014
Simmons, Matthew R. (2006), Twilight in the Desert: The Coming Saudi Oil Shock and the World Econo-my
Zerohedge.com (2014) “Fracked Up: Don’t Believe in Miracles.” http://www.zerohedge.com/news/2014-09-25/fracked-dont-believe-miracles
Zerohedge.com (2014) “If WTI Drops To $60, It Will “Trigger A Broader HY Market Default Cycle”, Says Deutsche.” Retrieved 14.11.2014 http://www.zerohedge.com/news/2014-11-13/if-wti-drops-60-deutsche-expects-one-third-high-yield-energy-space-default
Zerohedge.com (2014) “Houston, We Have a Fracking Problem.” http://www.zerohedge.com/news/2014-10-20/houston-we-have-fracking-problem
Zerohedge.com (2014) “Why ‘75’ is the Most Im-portant Number for US Economic Hope.” http://www.zerohedge.com/news/2014-10-29/why-75-most-important-number-us-economic-hope
Wiley, Dajahi. (2014) ‘The Questionable Staying Power of the US Shale Boom.” http://oilprice.com/Energy/Energy-General/The-Questionable-Staying-Power-Of-The-U.S.-Shale-Boom.html