by David Huck
Recent experiences in the fragility of our financial system and the ease with which irrational exuberance gives way to bubble mania should encourage us to take any “this time is different” story with a grain of salt.
Remember the internet boom when any company that ended in .com was worth something extraordinary? Or Enron, which used fraudulent accounting to cover up the fact they didn’t own much and were basically glorified commodity traders? Or the housing bubble when even dead people managed to get loans without any verification of their ability to pay them back? Bubbles frequently usher in phrases like “new paradigm” a “higher plateau” or something to the effect of “this time is different.”1 The current shale boom (1 billion cubic feet per day in 2003 to 20 bcfd in 2011) exhibits many of these same characteristics. An increasingly large cadre of energy writers and financial market observers are sounding the alarm that the shale gas drilling boom is just one more bubble that will eventually pop leaving communities with polluted water, abandoned drill pads and no more jobs than they started with in exchange for exponentially declining royalties as the gas peters out.
Writers at theoildrum.com have been expressing concern over the shale boom for years, much like they questioned the sustainability of the biofuel/ethanol boom that is now petering out (complete with abandoned plants, layoffs and bankruptcies)2. As recently as August 2011 Arthur Berman, a Houston-based petroleum geologist and energy sector consultant, and petroleum engineer Lynn Pittinger built a detailed model of shale gas development using mature regions (Barnett and Fayetteville) to compare industry hype with history. I encourage you to read their analysis but will summarize the key points here.
• Despite impressive production growth, it is not yet clear that these plays are commercial at current prices because of the high capital costs of land and drilling and completion.
• Reserves and economics depend on estimated ultimate recoveries based on hyperbolic, or increasingly flattening, decline profiles that predict decades of commercial production. With only a few years of production history in most of these plays, this model has not been shown to be correct, and may be overly optimistic.
Berman and Pittinger go on to analyze the existing skimpy data to develop their own model of future production. As seen in one of the charts reproduced here, drilling by a major gas producer, XTO lead to sharply decreasing marginal returns after the initial honeymoon period expired in the Barnett shale. With so little experience in the Marcellus (the shale formation underlying PA, WV, NY and OH) we must make assumptions based on historical data. If communities wait until the numbers are in the drillers will have mostly packed up and whatever damage will be done.
After extensive efforts to model depletion curves the authors conclude “the true structural cost of shale gas production is higher than present prices can support ($4.15/mcf average price for the year ending July 30, 2011), and that per-well reserves are about one-half of the volumes claimed by operators. Relatively long-lived production history data in the Barnett and Fayetteville shale plays is compelling. A shorter production history for the Haynesville Shale play permits more latitude in forecasting projections. There is, however, sufficient data to conclude that results for the play are disappointing… Decline rates indicate that a decrease in drilling by any of the major producers in the shale gas plays would reveal the insecurity of supply. This is especially true in the case of the Haynesville Shale play where initial rates are about three times higher than in the Barnett or Fayetteville.”
Unlike the vertical integration so common in the oil industry, shale gas producers are mostly specialized drillers that have more in common with real estate speculators and hedge funds than they do with the traditional refining and marketing functions of multinational oil companies. The shale boom that is driving land values up and environmental quality down began with a couple companies like Chesapeake Energy (CHK) drilling in the Barnett Shale in Texas. They are the second largest producer of natural gas in the United States and the most active driller of new wells. Like most of the rest of the shale industry they have extensive hedging operations in the financial markets to ensure they get a predictable price for their product. According to CNBC, CHK has booked $5 billion in profits by betting that gas will stay below $8 in the coming decade. For a producer of natural gas this is an attractive position because any increase in the gas price translates into profits at the wellhead.3 For this to work a firm cannot sell too many more long-dated options than it expects to produce in actual natural gas. Put another way, for every option to buy gas at cheap price in the future, CHK should have an equivalent amount of production to sell in the future should the price rise. If not, this begins to look very much like a Ponzi scheme where the buy-in of new entrants (or in this case the new wells) offsets payouts to existing players/contract holders.
Because Chesapeake Energy did most of the original seismic surveying4 in many of these early basins they could choose to drill in the “sweet spot” while also quickly snapping up drilling rights (leases) before the “mania” caught on. Companies like Exxon Mobil, investors from wall street (including many pension funds) and national oil companies (Chinese, Saudi) eager to get in on the action were presented with the data from the initial wells in the best locations in the first couple years and convinced to overpay for more unpredictable real estate. Especially for small companies trading on the stock exchange it was important to keep stating high reserves to prevent the collapse of their share price. And once they have bought those leases, they are typically required to drill within 3-5 years or lose the lease, ostensibly to benefit the states and individuals that would collect royalties. In another analysis by Berman, increasing debt levels at shale drillers are being used to mask the lack of profitability. Once the cost of the debt used to acquire leases is included they continue to fail to break even and must keep racing forward on the treadmill of expanding probable reserves.
Like other regulatory agencies5, the SEC is frequently co-opted by the industries it supposedly regulates for the protection of consumers. In a recent rule change the SEC essentially gave a green light to the kind of suspicious modeling assumptions that brought us the housing bubble. Shale gas companies are now allowed to use their own assumptions to include gas further away from the well in reserve estimates. They are not required to reveal these assumptions or explain what new technology they have that allows them to book these higher reserve numbers.6 With no one watching over their shoulders it will be hard to resist the temptation to state higher reserve numbers and thus receive higher stock prices.
While the SEC still requires that only proved reserves are used for reporting purposes, it is instructive to understand how different probability ranges can produce wildly different reserves. The following graphic from slate.com displays the difference between proved (95% confidence of economic exploitation), probable (50% confidence) and possible (5%) reserves.
Historical production data from the Barnett, Fayetteville and Haynesville shales is useful but it will be important for activists in the Appalachian region to have local information as the case is made for the poor economic prospects (some people seem to only care about jobs jobs jobs, which won’t last if this analysis proves applicable to all shale plays). Luckily the website fractracker.com provides data and analysis on hydraulic fracturing in the United States. This report on the Marcellus indicates that average daily volumes continue to fall and that horizontal drilling may not actually increase the total recoverable volumes but simply shift the curve closer to the present day, putting shale drillers on a treadmill and jeopardizing projections about future revenues for state and local governments to benefit short term profit objectives. http://www.fractracker.org/?p=940
In another article, one of the commentators brings up a two pronged approach to how shale gas operators scam investors and perpetuate a ponzi. After drilling a $2 million well one of two scenarios unfolds….
Option 1: Sell $6 million in working interest/net revenue interest to investors. Well comes in and pays back 5% of the money and drops dead. Rework costs $500,000 and the Operator charges $750,000. Investor pony up because this is sure to fix the problem. Reworked well comes back at half of what it did and drops dead. Time for more work overs and a great big new frac by a different service company that really has their shit together. Frac fails to do much and a well continues to drizzel out some gas or oil and earns $1200 a month before taking out state tax, operating costs and the operators $700 per month fee. This goes on and on until operator can’t squeeze any more cash out of the deal and abandon’s the well. After a year or two the lease is picked up by a new Operator who is going to re work the well with some newly developed technology that is sure to make it produce like crazy and sells the deal to new set of What Ever You Want to Call Them’s. And things move along in the oil patch as usual.
Option 2. Drill with money earned from selling stock at inflated prices and company owned production. Drill shale well. Add huge reserves to company assets. Stock sells for more than ever. Drill another well, add reserves to assets, stock goes up. Rinse and repeat until you are mega rich then sell out keeping enough stock so people think you believe in the company and so the stock will go up while you do nothing. Then after a year or two of full time decadence, relentless debauchery, constant streams of awesome Russian babes, daily world travel, and fantastic food you start all over. But then you are in the oil business mostly in name only. You are really in the Wall Street Business.
As Bruce points out, “and things move along in the oil patch as usual.”
1Ȁ Also the title of Rogoff and Reinhart’s book “This Time is Different” which investigates financial bubbles and attendant banking and/or currency collapses going back to Tulipmania in 15th century Holland.
2Ȁ Chemical Engineer Robert Rapier has a long series of articles predating the ethanol boom that explain why it is folly: You barely get any more energy out than you put in to grow the corn. Here’s a recent one: http://www.theoildrum.com/node/7128
5Ȁ Notable examples include the Minerals Management Service, responsible for preventing disasters like the BP Deepwater horizon and the US Forest Service, which frequently spends more money building logging roads than it receives for logging permits, effectively subsidizing the extraction of national forest land with taxpayer money.