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A Contrarian View on the Shale Oil and Gas Revolution

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If you've ever even briefly perused a financial publication, surely you must have run across at least a few mentions of shale oil and gas and how its growing production is revolutionizing the U.S. economy. Over the past few years, the phrase "shale gas revolution" has become commonplace, with the phenomenon attracting interest from all types of investors from all over the world.

The list of shale oil and gas proponents is long and varied. PIMCO's Mark Kiesel, recently named Morningstar's "Fixed-Income Fund Manager of the Year" for 2012, called advancements in oil and gas drilling technologies a potential "game changer" for the U.S. economy. Prominent energy expert Daniel Yergin has touted the positive impacts of the shale gas revolution on America's manufacturing sector, its balance of payments, and employment. Even Dylan Grice, former global strategist at Societe Generale and usually a go-to source of contrarian wisdom, is sold on the merits of shale gas, writing last year that "shale gas will be as disruptive to the global economy as the Internet was."

But despite an impressive array of advocates, there are also a fair amount of skeptics who argue that the quantity of recoverable shale oil and gas in the U.S. has been grossly overstated. They argue that shale wells suffer from steep decline rates in the first couple of years of production, followed by a sharp drop-off in output over their remaining lives. Do these skeptics have a point or have they been conducting their research a bit too close to the gas fumes?

The contrarian view on shale oil and gas
I don't think it would be a stretch to say that most commentators are sold on the future of shale gas. They expect it to yield tremendous benefits for the American economy, not the least of which is the ultimate goal of energy independence. But as with any topic, there are two sides to the coin.

Now meet the skeptics. In my research so far, I've come across Arthur Berman, who is a principal and consulting geologist at Houston-based Labyrinth Consulting Services, David Hughes, a Canadian geoscientist and a fellow at the Post Carbon Institute, and Bob Brackett, a senior research analyst at Bernstein Research.

Berman is probably one of the most prominent skeptics so, in the interest of time, let's assess his argument. His view, which has been shaped by meticulous analysis of thousands of individual oil wells in the U.S., is that Citigroup's and others' optimistic projections are far too rosy.

He argues that they fail to take into account the rapid decline rates of shale wells, a point he drove home in a presentation, "Oil-Prone Shale Plays – The Illusion of Energy Independence," given at an energy conference at the University of Texas last month.

Shale well decline rates and companies that would benefit
In illustrating how quickly shale wells can be exhausted, Berman used the Bakken as an example. Currently, the prolific formation boasts roughly 5,000 wells in North Dakota that are posting average production of around 143 barrels per day, which comes out to a little over 700,000 total barrels per day. While this level of production is an extraordinary achievement, he argues that it cannot be sustained for very long.

His case-by-case analysis of around 2,500 Bakken wells led him to conclude that, unless a lot more wells are drilled, output would fall by nearly 40% within a year. Assuming this rate of depletion, roughly 1,600 new wells will have to be drilled just for production to stay flat. If we extrapolate similar production profiles for other shale wells in the country, the end result for production by 2020 is strikingly lower – just 1 million-2 million barrels per day according to Berman's calculations.

If he is right, faster than expected declines in U.S. gas supply will likely have major implications for natural gas companies. The combination of falling supply and rising demand could put substantial upward pressure on gas prices, leading to higher profits for energy companies that derive the bulk of their revenues from gas sales. However, operating costs would also rise and could offset the benefits of higher gas prices to varying degrees.

Companies like Chesapeake Energy (NYSE: CHK  ) , as the nation's second-largest gas producer, and Encana (NYSE: ECA  ) and EOG Resources (NYSE: EOG  ) , which derive the bulk of their revenues from natural gas, would likely be affected. And companies like Ultra Petroleum (NASDAQOTH: UPLMQ  ) and Southwestern Energy (NYSE: SWN  ) , because they are low-cost producers of natural gas, may actually benefit from a faster than expected surge in gas prices.

Final thoughts
After assessing the arguments of both the shale bulls and bears, I have adopted a slightly more skeptical stance on the future of U.S. oil and gas production. While production has risen rapidly over the past five years, estimates of future production growth are clearly prone to huge biases.

In my opinion, there are so many variables involved, such as the effect of government policies and the rate of advancement in drilling technologies, that it becomes almost useless to project oil and gas production more than a few years into the future.

After all, I'm no geological expert and am forced to rely on experts' calculations. When they say that output from the Bakken shale will reach a certain number of barrels per day by 2020, all I can do is check their assumptions to the best of my ability. If they seem reasonable, I'm usually inclined to accept their calculations in good faith.

But isn't that the wrong thing to do? Isn't this type of blind faith exactly what prevented us from seeing one of the biggest housing bubbles in history? Shouldn't we question where the experts are getting their numbers from and meticulously analyze the fine print?

Just as most observers kept mum when banks created complex financial products that were supposed to diversify risk, hardly anybody questions the logistics of shale oil and gas production. Isn't it worrisome that some of the largest gas producers spend multiples of their operating cash flow to finance exploration and drilling ventures? Isn't it troubling that estimates of shale wells' economic lives and decline rates vary so drastically? Maybe, maybe not. I'm not sure. But I feel it would be disingenuous not to raise these questions.

Luckily, we live in a world with plenty of independent thinkers and contrarians. While we may lack the expertise and data to calculate our own decline rates, we have access to a wealth of information that can help us separate hype from reality.

While I have been very bullish on the prospects for U.S. oil and gas production – as evidenced by my previous articles – I will be sure to pay closer attention to new research that presents a different view. After all, getting both sides of the story is crucial to becoming a better investor.

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Read/Post Comments (3) | Recommend This Article (20)

Comments from our Foolish Readers

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  • Report this Comment On January 12, 2013, at 1:21 PM, TheRealRacc wrote:

    Arjun, I suggest you watch the documentary 'GasLand' (2010). It is important to compare the impacts of LNG drilling to other types of environmental pollution. There is a chance natural gas production does not live up to its potential.

  • Report this Comment On January 12, 2013, at 5:38 PM, BB1946 wrote:

    The myth of energy independence is based on a continuation of the growth curves in fracking-derived oil and natural gas production. What the optimists don't consider is the growing demand curve in natural gas due to massive switching out of coal for electricity generation, the switching of many truck fleets to natural gas, and the imminent exportation of LNG (liquified natural gas) as new export facilities are created. The second thing that the optimists miss is the decline rates as mentioned above. The Barnett Shale in Texas has been around for about 20 years and production has started to fall. That is not a long time for an oil field of the traditional variety.

    I agree with the sentiment of this article. The shale plays bear close watching.

  • Report this Comment On February 08, 2013, at 12:15 PM, MarkOfBeast wrote:

    Arjun Sreekumar:

    Arthur Berman is not the only shale gas skeptism. I am probably the most outspoken critic Shale Gas among all people who wrote on Seeking Alpha. They have now imposed worse censorship on me because I spoke out on the truth of shale gas. Not only they banned me from writting any article or instablog on Seeking Alpha. They banned me from making any comment or even communicate privately with any Seeking Alpha readers. In communist countries at least people are free to communicate privately.

    This tells you that they feared people to hear the truth on shale gas. I intend to complaint to SEC about Seeking Alpha's blatant market manipulation by supressing truthful information. Some vested interest group played a dirty hand in getting me, Mark Anthony, completely banned on Seeking Alpha. My previous articles are still there. But I bet they will ultimately remove all traces of them eventually.

    Now, Arthur Berman first got my attention to the potential scam in the US shale gas industry. But unlike most people, I do not take Arthur Berman's words on face value. I dig out data myself and do my own data analysis.

    Here is what I find out by studying data from several thousand Bakken wells. Bakken is a good study candicate thanks for excellent public data release by North Dakota Department of Mineral Resources. They have month by month production statistics of ALL Bakken shale wells. So you can track each well and see how the production declines.

    My study shows that Bakken well declines MUCH FASTER than even Arthur Berman claimed. For example I summed up production from 3062 Bakken wells that has been continuously producing in all the months from May to Nov 2012, including 128 wells that only started in May 2012. That's the entirety of all wells I can find that has been producing continuously, but excluding a few that produced for a while and then shut down.

    In May 2012, those existing wells produced at average of 506869 Barrels per day (BOE), with gas and oil production lumped together as Barrel of Oil Equivalence (BOE).

    In Nov 2012, only six months later, these same 3062 wells produced at 353040 BOE/day. That's a drop of -30.35% in merely six months. That's averaging at -0.2% drop per day, or -5.9% drop per month, or -51.5% drop per year.

    That's how fast the collective group of existing wells drop, with newest and oldest wells all included. That's losing slightly more than half of production rate in a year.

    Identifying only the newest 128 wells which only started in May 2012. These 128 wells dropped from 62067.67 BOE/day to 27950.77 BOE/day, or losing -55.0% in six months. That's a -0.436% drop per day, or -12.5% loss per month, or losing 80% in a year. Here are just some of the well numbers in this group:




    Now looking at the oldest wells within this group. There are 1244 Bakken wells that has been producing continuously since Dec., 2009. These wells produced at 111911 BOE/day in Dec. 2009. They dropped to 54539 BOE/day in May 2012 and further dropped to 50234 BOE/day in Nov 2012. So these vintage wells more than three years old were dropping at -7.9% every half year, or losing -15.2% per year. These wells show that even after more than three years, the well decline is still very steep.

    Singling out wells first started in Jan. 2010, no early and no later. There are 31 of them:





    These wells that started in Jan 2010 produced at 8052.68 BOE/day in that month, dropped to 2433.77 BOE in May 2012 and then to 2007.77 in Dec. 2012. So these three year old wells dropped at losing -17.5% in half a year, or losing -32% per year, or losing 0.1% per day.

    At such steep decline, even Bakken shale, perceived as most profitable due to its high content of oil and high oil price, is NOT profitable currently. They need $20 or $30/barrel higher oil price to break even.

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    stockology . blogspot . com

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