Shale: This Time It's Different

 |  Includes: CHK, CRR
by: Akram's Razor

"This one will really take you back," said the Great Winfield. Sheldon's Western Oil Shale has gone from 3 to 30. "Sir!" said Sheldon the kid. The United States is sitting on a pool of oil 5x as big as all the known reserves in the world- shale oil. Technology is coming along fast. When it comes, Equity Oil can earn seven hundred and fifty dollars a share. It is selling at twenty-four dollars. [Excerpted from The Money Game, Adam Smith, 1967]

From a 1968 Department of the Interior Bureau of Land Management brief:

If there had been no technological and economic problems preventing the production of shale oil, and if shale oil could have completely supplanted natural petroleum and captured the entire market in the United States in 1920, then (1) eighty 160-acre mining claims covering mediocre deposits of oil shale could have supplied the total consumption of the United States for 1920, and (2) the estimated 55 plus billion barrels of potential shale oil in a portion of the Green River formation in Colorado could have supplied the total consumption of the United States in 1920 for over 100 years.

From President Obama's recent State of the Union address:

We have a supply of natural gas that can last America nearly 100 years. [Applause] And my administration will take every possible action to safely develop this energy. Experts believe this will support more than 600,000 jobs by the end of the decade.

While I don't know where the 1920 shale oil estimates in the brief came from, I do know that the President's natural gas estimates come from an April 2011 report by the Potential Gas Committee. And who is behind this Committee? Well, Chairman and President Larry Gring works for Third Day Energy, an Austin based company that is focused on acquiring oil and gas claims along the Texas Gulf Coast. The chairman of the board, Darrell Pierce, works as a VP for DCP Midstream, a natural gas company based in Denver.

Furthermore, go through the report and you will find that the contributors are all from the industry backed Colorado School of Mines. Another industry sponsored source of independent research. But this isn't the first time the Colorado School of Mines has been involved in Shale mania.

In 1964 the Colorado School of Mines was Instrumental In Initiating the first of a series of annual Oil Shale Symposiums. The fifth annual Oil Shale Symposium was held in May of 1968. The Rocky Mountain News on May 4, 1968, reported on the symposium as follows:

Production of crude oil alone from shale probably can not now compete commercially with oil from wells. However, increased demand for oil, decreasing production, and the enhanced price will be met by an almost inexhaustible supply of oil shale, cheap mining. Improved methods of distillation and valuable by-products, which will un-doubtedly. In the very near future, make the oil shale industry a strong competitor for the oil well and, in the not too distant future, its successor.

These annual symposiums, as with much of the oil shale story are a repetition of the 1920 era. Six national oil shale conferences were held each year from 1919 to 1924 as a convenient vehicle for promotional propaganda. With the collapse of the speculative bubble following 1920, the conferences went out of existence. I think this quote from the 1960s sums it up:

The major participants in the oil shale activity of the 1920 era were the individual speculators or promotors who hoped to make a fast dollar through the acquisition and disposition of interests in oil shale claims or through the sale of stock in newly formed oil shale corporations. In addition, there were a small number who showed some interest in acquiring oil shale lands as an insurance program or a hedge for the long-term future against a possible oil scarcity and a few who actually constructed experimental plants. It is difficult to ascertain whether the experimental operations were conducted by handyman tinkerers who had dreams of Inventing a commercially feasible process that would convert the tremendous deposits of worthless oil shale into marketable products or by promotors seeking to impress investors that they were working on the only retort that promised to be successful.

Now compare this to what Chesapeake (NYSE:CHK) Ceo Aubrey McClendon told some analysts on a 2008 conference call:

I can assure you that buying leases for X and selling them for 5X or 10X is a lot more profitable than trying to produce gas for $5 or $6 mcf.

Or to this anonymous email from a Schlumberger (NYSE:SLB) employee:

All about making money. I'm working on a shale gas well that was just drilled in Europe. Looks like crap, but the operator will flip it based on 'potential' and make some money on it. Always a greater sucker.

Or to this one from an Anglo-European geologist:

After buying production for over 20 years, hopefully I know the characteristics of great wells (flat decline curves, low operating costs, large production), and as you know, the shale plays have none of these. The herd mentality into the shale will eventually end possibly like the sub-prime mortgage did. In the meantime it is very difficult to sell any kind of prospect that is not a shale play.

Though personally I really liked this quote from the 1968 brief:

The test or standard for determining whether a valid discovery has been made on a mining claim, i.e., whether a valuable mineral deposit has been found, is whether a person of ordinary prudence would be Justified in the further expenditure of his labor and means in actually working the property with a reasonable prospect of success in developing a valuable or paying mine. In other words, the test is simply whether the property is valuable for mining pur- poses. The test is not whether a person of ordinary prudence might be Justified in the expenditure of time and money in an effort to ascertain whether the property might be valuable at sometime in the future for mining purposes.

But at least nobody is saying this yet:

Twenty-five years ago, we ware told that oil from shale would be a reality in five years. Twenty years ago we were told It would be In five years. And today we hear oil from shale will be a reality in the next five years. I'm beginning to doubt that It will ever be a reality.

That last one's from Michael Halbouty, geologist and independent oil producer, in 1968.

But if Shale is more hype than anything else, how is this all transpiring? Why are major energy companies making acquisitions? Surely, these behemoths wouldn't get involved just to speculate. There is a one-word answer to this question: Reserves.

Big energy is in the reserve replacement game, and in Shale that game is very lucrative right now, because the history of production is limited. Who's to say what is probable and proved right now? (Though based on the data on the Barnett it would appear the problem is more denial then lack of accurate information for somewhat reliable EUR projections.) A better question might be what has allowed the game to go on for so long.

The answer to that has a lot more to do with the financial markets. Hedging has allowed producers like Chesapeake to sell their production forward for closer to $6 or $7 for Nymex Henry Hub. This eventually goosed production, which then pressured the spot market. Now, why would a producer do this? Simple, real estate speculation. With Shale related land values soaring, there was a huge incentive to develop/promote regardless of the future economics of production.

The hedging shields earnings and buys time to play the much more financially rewarding real estate flipping game. If you can drill a couple wells in a sweet spot (you should know where that is, based on all your seismic surveys), show some production, and then sell the land around it for 10x what you paid for it, why would you worry about long-term prices? Basically, for everybody other than the drillers and drill equipment providers, Shale is about real estate speculation.

But like contractors and cement companies after a real estate boom, they too will be casualties of war once the land flipping game ends. Though with shale gas one does wonder if we are still in the early stages and simply shifting to Argentina, China, Poland, and other regions will be easy enough for these companies. One might consider shorting russian natural gas producers and buying into any shale plays leveraged to European plays in France and Poland. Though by my understanding the land flipping game is nowhere near as easy in Europe, and thus the room for smaller operators to speculate is much more limited. So, maybe China and South America are better suited for this game.

Anyway, my point was not to predict a shale gas bubble pop, as I've already touched on that topic a few times over the past six months. Right now the evidence is clear that North American producers are already slowing down on shale gas. Carbo Ceramics (NYSE:CRR), the king of shale proppant, recently warned of "challenges beyond typical seasonality" as sales volumes fell 70% sequentially in the Haynesville shale. Chesapeake has also started to drastically cut drilling and production now that it has just about milked the land sale game for all that it is worth.

You are also hearing other operators talk about how they are shifting all focus to liquid-only plays for now. This of course will last until oil prices fall again, at which point the liquid-only plays will probably feel some pain too. Rinse and repeat. No, what I really wanted to accomplish here was to show that the same type of game is being played over and over again. 1920, 1960, 2012 - land speculation and promotion driving the entire shale industry.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.