Could U.S. Crude Oil Reserves Be Grossly Exaggerated?

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.

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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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 24, 2014, at 3:20 PM, Dutchman61 wrote:

    The formula was based on vertical wells drilled in a pattern so many feet apart. The introduction of horizontal drilling is what has throw the formula out of whack, not so much the shale issues. The formula was based in data from vertical wells over 80 years in the US. It has never been accurate since every oil field it has been applied to has produced 10-20 times the forecast.

  • Report this Comment On August 24, 2014, at 3:50 PM, jimmychurch wrote:

    Would obama and his crack team in his Office of MUN (Make Up Numbers) lie to you...

  • Report this Comment On August 24, 2014, at 5:07 PM, westexas wrote:

    Based on EIA estimates for Bakken + Eagle Ford oil production decline rates (and assuming a decline rate of about 7%/year for existing oil wells outside of the Bakken and Eagle Ford, and based on a Citi Research report for gas, I estimate the industry would has to replace 100% of current US oil and gas production in about four years, just to maintain current levels of production for four years.

    I estimate that US oil and gas wells completed in 2014 and in earlier years will show about a 24% gross decline in production from 2014 to 2015. This would be the percentage decline in production if no new wells were completed in 2015.

    For an example of why this is a reasonable estimate, consider the fact that the EIA shows that Louisiana' marketed natural gas production fell by 20% from 2012 to 2013 (note this was the net decline, after new wells were added). The gross decline in production from wells completed in 2012, and earlier, would be even higher.

  • Report this Comment On August 24, 2014, at 11:12 PM, kennyhobo wrote:

    Unfortunately, we live in the Era of Obama. Competence, truthfulness, and honesty are no longer required to be a lead Administration Person. We can't trust anything that the Obama Administration says! All statements are politically managed - lies to meet the needs of Barack! That should scare you. We have a President who became a proven liar and it is never ending.

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Arjun Sreekumar

Arjun is a value-oriented investor focusing primarily on the oil and gas sector, with an emphasis on E&Ps and integrated majors. He also occasionally writes about the US housing market and China’s economy.

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