Thoughts on the Shale Boom

The shale boom in the US is a highly controversial topic. There are the enthusiasts forecasting US energy independence and even net exports to Europe and the rest of the world. Sceptics argue that the boom is fake, by which they mean that while production in the US has indeed risen substantially, it is not sustainable due to the high depletion rates of shale sources. I have the feeling that many people in Europe are sceptical about the US shale boom and by that I do not mean usual suspects such as environmentalists. Acquaintances of mine whom I deem to have a better understanding of the relevant variables (geologists, engineers…) forecast – in no uncertain terms – a bitter end to the shale boom. Since I found it difficult to weigh the contradictory information properly, I had a neutral opinion on the topic – until now.

Shale Requires Constant High Levels of Capex

I am by no means an energy expert and not at all in a position to make definitive statements on this issue, but I took away one thing by reading about the topic over the years: both camps agree on the fact that in order to keep shale output constant, continuous capex for drilling is required. For instance, Daniel Yergin – an shale enthusiast as far as I can tell – in his recent FT-piece makes this point again:

How low will prices go? The US holds the key. Unlike conventional oilfields, the tight oil being produced there requires continuing investment in new wells to maintain production. Lower prices make such investment less attractive – but the effect may be smaller, and slower, than many people think. Some new fields become uneconomic if the oil price falls much below $90 – higher than it is today. But most of them are economic at $75 or well below that. Of course, if oil prices fall further, the impact will be greater.

Now, every business has to spend money on capex or R&D to stay afloat in the long-term – this is true for major oil companies as well. It just seems to be the case that due to shales high depletion rates (again an uncontroversial fact) capex needs are even more pressing, relatively speaking. I generally do not like business models that need to dedicate a substantial amount of their resources just to stay in the game. Too much depends on management skills and luck, if you have to redeploy a large part of your resources over and over again. And if constant drilling is the name of the game then surely the amount of reserves in the ground matter a lot.

And it was this chart on zerohedge which changed my position from neutral to sceptic,

Shale Reserves
Optimistic Management

The chart shows the reserves of the main shale players in the US. Note that there is a huge difference between estimated reserves presented to the SEC and those that are shown to investors – they differ by a factor of 6 on average! A Bloomberg article explains,

The SEC requires drillers to provide an annual accounting of how much oil and gas their properties will produce, a measurement called proved reserves, and company executives must certify that the reports are accurate.

No such rules apply to appraisals that drillers pitch to the public, sometimes called resource potential. In public presentations, unregulated estimates included wells that would lose money, prospects that have never been drilled, acreage that won’t be tapped for decades and projects whose likelihood of success is less than 10 percent ……..

Many of the companies use their own variation of resource potential, often with little explanation of what the number includes, how long it will take to drill or how much it will cost. The average estimate of resource potential was 6.6 times higher than the proved reserves reported to the SEC, the data compiled by Bloomberg News show.

So the executives are liable for the SEC figures, whereas there is no such constraint with respect to what they can tell investors in the presentations? Hmm…

This reminds me of the GAAP vs. “adjusted” earnings debate, where the first is figure is produced following general accounting rules and the latter is calculated by management as it deems fit. I am not aware of any case where, in the long-term, the GAAP figure has not been a better indicator of a company’s economic position than management earnings – none. How could it be different? It is simply the incentives at work: management has a tendency to be overly optimistic about their business. Some say they have to be that way, yes, but I am not so sure about that. IMHO it helps to be a cool, sober calculator if you have redeploy large resources year in and year out.

Oh, and before I forget it: a lot of managers out there are crooks…

Conclusion

Now, to be fair it is possible that management is just overly cautious as it fears the sometimes very harsh legal punishment in the US. Maybe the definition of what constitute probable reserves for  SEC purposes is suited for conventional oil fields and not for shale reserves? This is absolutely possible – as I am no expert, I do not know. But before I become convinced I would like somebody to explain this discrepancy to me. Until then, count me sceptical…

 

PS.

This does not mean I am bullish on the oil price. I believe the reduced demand from China far outweighs any supply side counter effects.

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3 comments

  1. thanks for the post; I’m of a similar view with regards to oil (companies) but am still working through China demand? Sure, China is ~10% of world demand but can’t seem to get the same level of conviction as say iron ore (2/3+ of world demand) with respect to a decrease.

    Perhaps it’s the product of a sharply steep supply curve?

  2. Thank you,
    I would also consider iron ore more vulnerable. energy consumption is less cyclical than steel consumption. Further, iron ore basically is infinitely available at cheap cost. which is not the case for oil. at the current price a lot of countries are operating below their cost curve, if I understand correctly.

    Iron ore is much easier to understand I find, whereas with oil I find there are good arguments for both bulls and bears, difficult to get a final handle on this…

    1. Agreed – oil bulls cite breakeven cost of product >$60 for bakken etc., but if I understand correctly that is the all in cost, not the marginal cost. Iron ore’s marginal cost is ~ 40 for vale, $20-30 for rio (I believe)?, but oil has marginal costs far lower (clr’s 10-k shows ~5+5 for direct & 20$ of d&a).

      So new projects may be put on hold, which can reduce supply & hurt the bear view. However, given that most of the cost is upfront & that many E&P’s have issued much HY debt, do they have a choice? If there is even a chance of oil upside would think that the normal route is to keep on drilling & satisfy debtors…(institutional imperative?).

      Also, psychology may actually a stronger factor for oil here, it seems like many lay people do not believe oil can fall below $x and will always come back… (didn’t hear that from the layman for iron ore).

      Trying to invert my thinking to support the bull view, but inevitably go bear – hope I’m not getting too biased!

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