The Debate Over Shale Oil Reserve Estimates Suggests EOG Resources Might Be A Good Short

Summary

• EOG is the biggest player in the Eagle Ford shale oil play.
• A debate has erupted over the methodology for estimating shale oil reserves.
• If the doubters are correct, shale oil reserves are potentially overstated.
• EOG could be a casualty of the outcome.

Is the oil industry overstating its reserves in shale oil? This issue surfaced recently in an article in Business Week.

Most oil and gas investors have never heard of Jan Arps or seen his commonly-used formula for calculating the Estimated Ultimate Recovery ("EUR") from an oil well. Arps modeled the behavior of oil wells and created his formula in 1945, and it has enjoyed widespread adoption ever since.

Source: Stockology

SA Author Michael Filloon follows the Bakken and the stocks of companies operating in the Bakken extensively. He published an article on EOG on January 7, 2013, which was the subject of some online debate. Blogger JJ2000426 writing on the blog "Stock Psychology" did an admirable job of analysis of the discrepancy between EUR calculated by the Arps formula and a modified formula he argued more accurately estimated EUR for shale oil.

The Business Week article raises this issue to a higher level and provides some support for the assertion that shale oil reserves may be overstated. If they are, the ramifications are significant for investors.

Bloomberg ran an article on November 12, 2013, with the headline: "U.S. to Be Top Oil Producer by 2015 on Shale, IEA Says." That sort of sentiment is probably playing a role in the Obama administration's foot dragging on a decision for Keystone XL. Regardless, the ebullience for the U.S. outlook on oil production is potentially rooted in sand rather than bedrock, and the sand could shift very quickly.

Shale oil production has high decline rates. Wells put into production achieve very high rates of output early in their lives and then fall off very sharply.

The rapid decline is a "double whammy" if the EUR is a lot less than previously thought. Not only will production fall swiftly after an initial boom, but also it will end years earlier than the developers have modeled. The result could be some very large downward revisions in oil reserves and substantial declines in future production for some very large and highly-valued oil producers.

So who gets hurt?

EOG Resources (NYSE:EOG) is the biggest player in Eagle Ford and was the subject of a bullish article by SA Contributor Heather Ingrassia on April 2, 2014. Trading at over 18 times earnings and about 7 times cash flow, EOG is fairly valued at about $100 a share if the reserves turn out to be correctly estimated. If they are overstated, the stock will suffer.

Chesapeake (CHK) also has exposure to shale oil in Eagle Ford and shale gas in the Marcellus area. Chesapeake is enjoying very high profitability at natural gas prices of $4.30 per Mcf, offering high leverage to the current hydrocarbon prices with target returns on investment for new wells coming in at 110%. However, at 36 times earnings, the stock has discounted just about everything positive likely to happen and seems quite vulnerable to any pullback in commodity prices or downward revisions to reserves. In the current environment, I think CHK could very easily trade higher, and for the time being, I will simply avoid the stock.

There are many other names with shale oil and gas reserves, and the debate over what the ultimate recovery from those reserves might be is by no means decided. The outcome will be determined by Mother Nature and not by mathematics, so there is little need to try to run the Arps model yourself, modified or otherwise. It suffices to be informed; there is a debate, and the outcome could be material to your financial health.

Doubts about reserves estimates in oil & gas and mining companies have been around for decades, and the integrity of the large oil & gas companies' disclosure is really not in question. Their approach has been used for decades. The issue is whether the approach is wrong. At this point in time, the shale plays are relatively young, and the data are sparse.

My personal view is that the Arps formula produces unreliable results for fracking, and investors should approach the area with caution. My approach is buy oil & gas companies with diversified resource bases at prices of 5 to 7 times cash flows and reasonable balance sheets. History has taught me that higher prices rarely pay off, given the need for reinvestment of most of the operating cash flows to simply maintain production, and that the key metric for valuation is the recycle ratio (the ratio of net back per barrel or barrel equivalent sold to the cost of replacing it, including all finding and development costs) and where that is 1.5 or greater, one tends to get decent returns if the stock is purchased for less than 7 times cash flows. If the reserves are overstated, the recycle ratio will be overstated as well. The risk of overstatement is higher in the shale plays than the conventional ones, so a diversified asset base becomes more valuable.

I am bullish towards oil & gas generally. On the long side, I have sizeable holdings of Penn West (PWE), Pengrowth (PGH) and Canadian Oil Sands (OTCQX:COSWF) and on the short side, I may buy a few long-dated puts on EOG, although I currently have no position.

For investment advice on oil & gas investments, speak to an investment professional and do your homework. Good luck with your investments.

Disclosure: I am long PWE, PGH, COSWF. 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.