Much has been made of the technology-driven shale revolution that has sent U.S. crude oil production to levels not seen since the 1980s and boosted its crude oil reserves to the highest level since the 1970s. But the misuse of a formula that few outside the industry know about could seriously jeopardize the accuracy of reserve estimates and the length of time we have before our shale oil wells run dry.

Eagle Ford Shale Anadarko Petroleum

Photo credit: Anadarko Petroleum

The formula that changed the game
In 1945, a petroleum engineer by the name of Jan Arps published a formula for the rate at which crude oil production from a well declines. Using decline analysis, his formula attempted to determine a well's future production rates and the amount of oil that could ultimately be recovered from it, known as the estimated ultimate recovery (EUR).

Though a number of experts have attempted to improve the Arps equation, his original formula remains widely used throughout the oil and gas industry today. Virtually all upstream oil and gas companies rely on it or one of its close variants to extrapolate trends about a well's oil production rates, determine the economics of drilling, and -- perhaps most importantly -- estimate reserves.

But the problem is that the oil and gas industry has changed radically since Arps' time. Monumental advances in drilling techniques like horizontal drilling and hydraulic fracturing have allowed companies to exploit previously inaccessible shale reservoirs. Yet despite these shale plays' unique challenges, companies continue to rely on the decades-old Arps formula to gauge their potential.

According to University of Houston engineering professor John Lee, this practice may be problematic since many shale plays have extremely limited production histories, leading companies to make unfounded assumptions that may end up grossly overstating the reserves and long-term production potential of these shale wells.

Arps' limitations
Like any formula, the Arps equation is only as good as the assumptions it makes. That's why using it to extrapolate future production and reserves for shale plays with limited drilling histories may result in inflated figures. EURs for shale plays may also be exaggerated depending on the decline rates companies assume and depending on whether or not they cherry-pick data from their best-performing wells.

The latter practice proved a major hurdle for SandRidge Energy, an Oklahoma City-based energy producer that operates primarily in the Mississippi Lime formation of Oklahoma and Kansas. In April of last year, the company slashed its EUR estimates from 422,000 barrels per well to 369,000 barrels per well after recognizing that its earlier forecasts were flawed because it had used data from a small number of high-performing wells to extrapolate the potential across the rest of its acreage.

SandRidge wasn't an isolated case. A number of other companies relying on the Arps formula or its variants have also cut their initial EUR and reserve estimates for relatively immature plays. Indeed, reserve estimates for an entire shale play -- California's Monterey -- were recently slashed by a whopping 96% from 13.7 billion barrels to just 600 million barrels because the play turned out to be much more difficult to drill than previously believed.

The bottom line
It's possible that U.S. oil reserves may be overstated, especially if decline rates for shale wells turn out to be higher than companies believe -- a strong possibility according to some geologists and industry experts. But that, by itself, doesn't fault the Arps formula in any way, and it doesn't suggest that companies are deliberately overstating their reserves.

Instead, it simply reflects the inherently dubious assumptions used by companies who are forced to rely on limited and incomplete data for immature shale plays. For investors, this means taking reserve and future production estimates for emerging plays with a grain of salt and being especially cautious about companies operating exclusively in untested plays.

Risk-averse investors would be wise to instead focus on companies operating in tried-and-tested formations with extensive production histories and acreage that has been properly delineated and derisked, which makes future drilling repeatable and a whole lot less risky.

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