Did Shell Just Fail To Get Lucky, Or Are Eagle Ford, Other Shale Oil Plays Potential Money Pits?

Aug.12.13 | About: Royal Dutch (RDS.A)

In January of this year, I wrote an article on my personal blog, entitled; "Eagle Ford: An Unconventional Fantasy". I pointed out then, that given reports of $150 billion dollars being spent collectively by investors on developing the field by 2015, we have to start questioning whether there will be a net collective profit on bringing the field's proven reserves of 7.3 billion barrels in oil, NGL and natural gas to market. I argued that there will be many companies, which will suffer heavy losses there, even though some may do alright. I expected to start seeing loses announced some years later, but in less than a year, we already have Shell's (RDS.A, RDS.B) report of a $2.1 billion in shale liquids write down, which many tried to immediately downplay as Shell just being "unlucky", rather than raising some important questions in regards to the overall viability of some of these shale oil plays.

Basic Facts on Eagle Ford:

-Proven oil & NGL reserves amount to about 3.5 billion barrels. At current market prices, worth about $280 billion.

-Natural gas reserves amount to about 4 billion barrels of oil equivalent. At current market prices worth about $60 billion, (I am assuming a much higher price of $7/MCF, because current prices do not provide an attractive level for pure gas plays in Eagle Ford).

-Amount of money invested or scheduled by 2015 is $150 billion, mostly spent on liquid hydrocarbons ($116 billion between 2012-15).

-Society of Petroleum Engineers (SPE) estimates per/well recovery rates at about 206,800 barrels of oil and NGL's.

-Estimates of price of drilling a well range between $7-10 million.

What could have gone wrong with Shell's projects?

Taking an average price of oil and various NGL's, the average well in Eagle Ford would cost about $8.5 million to drill and would return about $16.5 million, assuming an average sale price of liquids produced to be $80 dollars a barrel. There are of course, other costs involved, including paying for the land lease, building additional infrastructure, management costs, royalties and so on. It is possible that Shell's lease contained more NGL's, which fetch a lower average price, but that on its own would not cause such a huge asset write-down. There is only one possible explanation, and that is that well flow rates in their part of the field did not match the average 207 thousand barrel ultimate flow rate estimated by the SPE, in fact they may have encountered significantly lower flow rates than that.

Lessons we need to learn:

Defenders of the industry, quickly came out on the same day Shell released its report (August 1'st), to point out that while Shell hit a snag in its shale oil adventure, many companies are doing just fine and should continue to make a hefty profit. They are right of course, but we need to fit in this new information in the overall picture of this still relatively new large-scale oil producing industry, especially if one is looking to invest.

Going back to the SPE study of Eagle Ford, we see a great deal of difference between median & mean production per well from county to county. For instance; companies exploiting in McMullen County have a median of 126,000 barrels (172,000 mean), which means that half of all wells producing there can be expected to ultimately produce $10 million or less, at current prices, so in other words, there will be significant losses on some projects. On the other end of the spectrum, we have DeWitt County, where median production was 391,000 barrels, which means that significant profits should be expected for most companies operating in the area. Pioneer and Petrohawk are the main producers there. I should point out however, that there seems to be less oil and more NGL's, which do fetch a lower price on average.

In McMullen County, we have companies such as Chesapeake, Swift Energy and Petrohawk, figuring as major producers. As the SPE paper tells us, some of them will likely do all right, others not so much. Here, one needs to be careful, because while Shell's loss of $2.1 billion may have been a tolerable hit, given its diverse global portfolio, some of the other producers will not be able to sustain large losses, and it is increasingly clear that some companies will suffer major losses on their shale oil projects in Eagle Ford and elsewhere. Incidentally, Shell is heavily invested in Dimmit County, where median well production was estimated at 129,000 barrels by the SPE report. Shell did not disclose details about where their losses occurred, but if this was it, perhaps we have our answer of why it happened.

What about future Shale Oil adventures?

When investing in shale oil producers, one needs to realize the magnitude of the gamble, and not only the potential for profits. The main risk involved is that companies, will hit many of the areas, which turn out not to be much-coveted production sweet spots. Therefore, if one is looking to invest in companies, which are trying to adventure outside currently well-established sweet spots, in places like the Bakken and Eagle Ford, they are running a much higher chance of failure than companies that established themselves early on, on top of the already identified sweet spots. As far as the sweet spots go, they are already approaching the point of well saturation, so companies that are not looking to expand beyond currently lucrative frontiers, are also facing the risk of production shrinkage in the not too distant future.

As far as tapping new fields, Uttica has already been declared a disappointment for oil production. The field thought to have most potential in the US for oil production is the Monterey field in California. The main reason production from this field has been slow to materialize, is because it presents many technical challenges, including the fact that it is in a highly, geologically unstable region, given all the earthquakes. Fracking for oil in areas already known to be unstable might not be such a good idea. These challenges may be overcome and some companies may reap the benefits, or perhaps, they will fare as well as Shell did in its shale oil adventure.

There is a reason why certain areas within Bakken and Eagle Ford were first to be developed in the shale oil rush. The risk/reward ratio was the most favorable. We are now reaching the point however when these companies have to either accept shrinking production, or venture out into the less attractive parts of shale oil deposits, and while for some, these new adventures may bring more profit, it needs to be recognized that the level of risk will be much higher.

I hope people realize that Shell's recent $2.1 billion write down stemming from its shale oil investments, has more lessons to offer than what it seems most people wanted us to get out of it, which was that "Shell just failed to get lucky"(WSJ). If people fail to realize the wider implications, they may increase their own chances of also being unlucky, especially if they invest in shale oil producers, without subjecting them to very close scrutiny, and without understanding the nature of shale oil.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.