On January 23, 2013, Linc Energy (LNCGY.PK) confirmed the existence of a potentially massive shale oil discovery in the Arckaringa Basin. Two reputable independent consulting firms have estimated these shale oil reservoirs to contain between 103 and 233 billion BOE (barrels of oil equivalent). Media outlets jumped on the story, heralding it as a $20 trillion find that will allow Australia to achieve energy independence and become a net exporter of oil, thereby transforming the entire economy of the country. Peter Bond, the CEO of Linc Energy, cautioned against extreme optimism and offered a "worst case scenario" in which the discovery would yield 3.5 billion BOE. He expects early well production by the end of 2014.
Whether we're talking about $20 trillion or several billion dollars worth of oil, that's still a significant amount of value for a company which at the time of this writing has a market cap of less than $1.5 billion.
A Closer Look
In order to understand what this discovery is worth, we need to examine the information presented in the prospective research reports by the consulting firms. Let's choose DeGolyer and MacNaughton (D&M)'s report, because it provides the lower estimate of 103 billion BOE. This estimate classifies the asset as an "unrisked prospective resource" - the lowest category of certainty. As such, it carries the burden of three major categories of risk - recoverability, discovery, and commercial viability. Recoverability refers to the technical capacity to extract the oil, discovery refers to actually finding the oil, and commercial viability refers to whether a firm can make a profit from selling the oil after the cost of discovery, development, production, and transport, are factored in.
D&M estimated the volume of "unrisked prospective resources" for unconventional reservoirs in the Arckaringa Basin:
As you can see, they outline Low, Best, High, and Mean estimates. These terms are intended to reflect the range of uncertainty, and are defined as the following:
The low estimate reported herein is the P90 quantity derived from probabilistic analysis. This means that there is at least a 90-percent probability that, assuming the prospect is discovered and developed, the quantities actually recovered will equal or exceed the low estimate. The best (median) estimate is the P50 quantity derived from probabilistic analysis. This means that there is at least a 50-percent probability that, assuming the prospect is discovered and developed, the quantities actually recovered will equal or exceed the best (median) estimate. The high estimate is the P10 quantity derived from probabilistic analysis. This means that there is at least a 10-percent probability that, assuming the prospect is discovered and developed, the quantities actually recovered will equal or exceed the high estimate. The expected value* (EV), an outcome of the probabilistic analysis, is the mean estimate.
So basically the "Low" estimate removes almost all of the technical recoverability risk, whereas the mean estimate is the expected value of the resources after discounting for recoverability but without discounting for discovery or commercial viability.
D&M also does discount for discovery by calculating the "Risked Mean." They do this by applying Pg, which is defined as the probability of discovering reservoirs that flow petroleum at a measurable rate. To put it another way, risked mean resources are calculated by multiplying the unrisked mean resources by the geological chance of success to account for the risk of drilling an unsuccessful exploration well.
So after discounting for both recoverability and discovery, D&M's best estimate is that there are still 3.5 billion BOE that will actually come out of these reservoirs, assuming commercial viability. This is where Peter Bond's "worst case" scenario figure comes from. Once a project demonstrates commercial viability, the resources will become classified as "reserves," which are much more valuable than their current classification as "unrisked prospective resources." It is generally more costly to extract oil from shale than from conventional deposits due to the need for fracking, and so it remains to be seen whether it will be cost-effective to extract oil from the shale in the Arckaringa Basin.
All this attention to the shale oil reservoirs has ignored the fact that Gustavson and Associates, the other consulting firm, "conducted a preliminary assessment of resource potential in conventional reservoirs in portions of the Arckaringa Basin, amounting to a separate 125 billion BOE on an unrisked basis." Which means that there might be as much oil in the conventional reservoirs as there is in the shale reservoirs. Yet thus far, not a single news article has even mentioned the comparably massive conventional oil potential in the Arckaringa Basin.
Conventional oil reservoirs have a much higher chance of being commercially viable than shale oil, so these reservoirs, if discovered, will likely be both recoverable and commercially viable. Again, I have no idea why no one is talking about the conventional reservoirs in the Arckaringa Basin considering that both the shale reservoirs and the conventional reservoirs were appraised and categorized as unrisked prospective resources.
So to recap, we have about 3.5 billion BOE from shale reservoirs which are probably recoverable and discoverable but which may not be commercially viable. We also have a 90% chance of there being at least 59 billion BOE from recoverable conventional oil reservoirs, not discounted for discovery, but which are probably commercially viable if discovered.
Linc Energy owns a 100% interest in licenses and applications covering 16 million contiguous acres within the Arckaringa Basin, and the company is currently looking to sell a stake in its shale oil assets to a working partner with experience in shale oil development. Peter Bond told Australian magazine BRW that "major companies including Shell (NYSE:RDS.A) and Total (NYSE:TOT), as well as second tier oil companies such as Adani and Apache Corporation (NYSE:APA), as well as large Asian oil companies, would likely be interested in the South Australian shale oil assets." A company spokeswoman for Linc Energy told Deal Journal Australia that the company has already been approached by "several large oil companies."
Although there is significant uncertainty surrounding the valuation of these assets, I believe that the risks are somewhat mitigated by the company's goal of monetizing them at an early stage and passing off the development costs to a working partner. So despite the highly speculative nature of this investment, I have taken a small position in Linc Energy because if all goes according to plan, the potential upside to this deal may be worth several times the market cap of the company.
Disclosure: I am long LNCGY.PK. 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.
Additional disclosure: Please invest responsibly and practice sound risk management.