The “Lottery Economics” of Shale – Why only smaller companies are successful in the Shale Revolution

By Henrik Vorloeper

The revolution of shale has been a revolution from below. Not Chevron, ExxonMobil or Shell – major oil and gas companies who share the majority of the market and have overwhelmingly large financial assets, – were the leaders amongst the development of unconventional hydrocarbon extraction. Predominantly smaller and mid-sized independent companies, those who have limited or no share in the energy sector led the shale revolution and remained there up until its peak. Smaller companies, such as the pioneer amongst shale drillers Mitchell Energy & Development Corp., followed by Devon Energy, Chesapeake Energy and Continental Resources have been the developer of drilling techniques and the driver of the shale extraction in the 1980s and 1990s. In the 2000s the number of producers increased, but amongst them the number of large and renowned companies remains limited and their success modest until today.

Why have smaller companies been more successful in the shale revolution and why do they continue to dominate the shale industry? While analysts provide several explanations for this phenomenon, one of the more feasible answering both questions is provided by Russell Braziel in his book “The Domino Effect” (2016)[2]. The common understanding is that the strength of smaller companies is flexibility, an asset that is less developed in larger companies. But where does this flexibility comes from? Basically there are four major drivers behind the success of small companies, the regulatory framework, the geology of shale and the remaining two are linked to the quality of risk assessment exceptional in small companies.

  1. Regulatory Framework

The shale revolution took place in the United States only and this for two good reasons. First, in general the liberal economic system of the United States provides fertile ground for independent and start-up companies to acquire access to markets barriers to competition are rather limited. The second reason is more specific for energy companies. Below ground minerals are owned by the individual who owns the land above. The state traditionally does thus have a limited if any opportunity influence extraction activities. The right to extract these minerals are provided by the private owner only. This makes it tremendously easy for companies to launch drilling activity. This distinguishes the United States from most other countries, where mineral extraction rights are in most cases licensed by the state.

  1. Geology

The second driver that benefits small companies is the geology of shale. Shale has four specific attributes that distinguishes it from the nature of conventionally extracted hydrocarbons. First, shale formations can be found very deep below ground. Drilling is possible up to depths of 15 000 feet, but it becomes very expensive and the chances to find shale formation less likely, thus more risky. Shale formations in depths lower than 3 000 feet are easier to find, but their hydrocarbon content can be low to zero. Second, shale formations are very different one from another. It is not only the depths, but also the composition of shale formations so that drilling methods used in one hole may not be suitable for a different shale rock composition. For example, if a company was successful extracting hydrocarbons from one field, the same method does not guarantee to be successful at any other field. Third, shale formations are different in their size. Where drilling and eventual extraction of shale hydrocarbon is possible, there is no guaranty if the project is successful as such. In order to achieve an investment return, the tapped shale field must surpass a specific size. The fourth factor is the amount of hydrocarbons found in shale (so called: Total Organic Carbon, or TOC), which makes some shale formations more attractive to extract independent of their size and location, while for others the TOC can be so low that any extension of extraction does not return the costs of drilling. With these four factors in mind, it becomes clear that shale exploration and extraction is still an undertaking of high risk, almost like a lottery. Equally important, it has a low tolerance of risk reduction, which means that any new drilling project has a very similar high risk of complete failure, while at the same time the learning effect of the continuously exercised trial-and-error is significantly low. This is of course a disadvantage for any energy company operating in the shale business.

  1. Tolerance for Uncertainty

However, small companies tend to have a comparative advantage over large companies in the form of tolerance for uncertainty.

The risk factor in shale is an advantage for small companies over large companies for the fact that small companies are willing to take more risk. The chances for small and large companies to fail are equally high, while the perceived benefit of success is relatively high for smaller companies. Braziel explains the occurrence, using the viewpoint of a manager in a large company and the viewpoint of an owner of a small company. While an unsuccessful project in a shale formation will have a detrimental effect on the career of a large company’s manager, the owner of a small company will risk the survival of his company. But the sole reason for a small company is taking the whole risk, as this is the purpose of the company, while the large company has a rather large number of projects. However, a better understanding provides the view on the case of a potential success in the project. If the large company is successful in its exploration of a shale formation, the manager of the large company is likely to receive a bonus. However, his incentive is lower than incentive of his colleague in the small company. For the small company, a successful exploration can be compared with a lottery win for the owner, as he has to share his financial gains with a smaller number of shareholders. The idea of “all-or-nothing” plays the major role for independent companies, and this is what defines their flexibility. However, the explanation is not sufficient to answer the financial risk of small companies. Companies do not know at the beginning, how much exploration will cost and how much return the project will provide, so that the risk of having huge losses is high, and the return extremely uncertain. Large companies are unwilling to deal with the uncertainties, as those uncertainties do not fit into a large companies risk assessment strategy. Therefore their attitude towards investment in highly uncertain shale projects is diminished.

  1. Tolerance for Repeated Failure

Why exactly do small companies have a higher tolerance for uncertainties?

First of all, it is easier for smaller companies to get access to drilling rights, because they can be the owner of minerals if they own the land. It is a precondition for a small company to establish one or more opportunities to drill in shale. But, as mentioned, the undertaking bares a large financial risk. One company might have enough financial assets and willingness to take one attempt in which it either fails or wins. Again, if it wins, the return is a fortune for the small company. The possibility of both failure and success is perceived by private investors as an opportunity to make positive return, if it spreads its investment to several smaller companies with each having one or a few attempts to drill, the chances to make a positive return is higher. For example, if two out of three companies fail in extraction, the third company still can provide a larger return to cover the costs for all three investments and make an additional win. The problems for large companies remain the same; the failure in one project neither reduces, nor increases the likelihood of success in the other project.

In conclusion, it should be stated that it needs pioneers, those operators who take risk and whose incentive is driven by the prospect of success rather than fear of losses. This is greatly supported by the U.S. economic system. However, much in the shale sector suggests that it is still a maturing sector in which technologies to reduce the uncertainties of the geology of shale is in development. Combined with the falling global price of oil, the question for the future of shale has to be asked, whether it will be the renowned large oil companies that will find their way into shale, or a few of the most efficient shale companies will come out as new major companies.

[1] Wang, Zhongmin, and Xue, Qing, The Market Structure of Shale Gas Drilling in the United States, in: Resources For The Future Discussion Paper 14-31, (Washington D.C., 2014)

[2] Braziel, Russell, The Domino Effect – How the Shale Revolution is Transforming Energy Markets, Industries and Economics, (NTA Press, 2016)

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