How Sustainable Is North American Shale Oil Extraction?

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Includes: BP, COP, CVX, DO, ESV, NE, RDS.A, RIG, SDRL, XOM
by: Sierra Monolith Investments

Summary

Shale oil's one-year decline is 50%-80%; shale gas' one-year decline is 50%-75%. Constant drilling/fracking will become too capex-intensive to offset rapid well-decline rates.

Pure play shale oil and gas producers may be overleveraged. Borrowing toward a capex-intensive trend will lead to shutdowns in operation, and consolidation.

Fracking requires 2-25 million gallons of water per well. Wastewater disposal practices might be polluting water tables. Western states will increasingly restrict fracking due to severe water shortages.

The best NA acreage has been drilled, and the results should have been considerably better financially than the current picture of overspending and environmental damages.

Fracking causes seismic events. The environmental implications of these events remain poorly understood. Ignoring such risks may pose significant future liabilities.

Humans consume ~90 million barrel of oil per day, and this is a labor intensive effort for extraction, logistics, refining, and delivery. In the course of 3 months, oil has plummeted, and drawn a fever pitch of discussions on where price per barrel is heading on all sorts of timeline. The story goes something like this:

Oil will fall to $35 per barrel, the world now is awash with too much oil, there is a massive supply glut with no end in sight, NA Shale revolution has Russia and OPEC on its knees, the U.S. will become the Saudi Arabia of Shale oil, and will force majors to reduce capex by cutting offshore DW and UDW programs. The cost basis of NA Shale is $40/barrel, and so fracking will prevail for at least 20 years.

No doubt there is a shale oil boom going on. This chart is from an article highlighting the wisdom of Jeremy Grantham as it relates to NA shale oil extraction. Suffice it to say, Grantham has less-than-favorable opinions on the economics of shale extraction.

There is clear and extraordinary deviation from U.S. onshore mean production. And there are many assertions on how much shale extraction really costs. I agree with Grantham on his assertion; the shale fracking paradigm will stand in history as a red herring to oil pricing (something, especially a clue, that is or is intended to be misleading or distracting).

Grantham makes an interesting hypothesis in regard to fracking:

...remarkable proof that, so late in the realization of the risks of climate change and environmental damage, the US could expressly deregulate such a rapidly growing and potentially dangerous activity...

While oil pricing discussions range from OPEC, Russia, and offshore drilling, I now believe the most compelling reason for today's price drop has the most to do with the dramatic rise in North American shale oil production. Below are two graphics that display this stellar rise:

And here is a closer look at the Bakken formation:

From both of these graphics, there clearly indicates a rapid acceleration in production from North American fields over the last five years. So how long is this trend really sustainable? To start understanding the social and cultural significance of unconventional shale oil, I highly recommend the following fascinating read from The Atlantic: "Searching for the Good Life in the Bakken Oil Fields."

North American fracking represents a perfect storm of corporate interests effectively selling politicians and land owners on the goal of extracting natural resources at a white-hot pace, in a post housing bubble/wage stagnation/depressed economy. Before investing in North American shale oil, consider that there may be significant downside risks.

What are some of these risks?

1. Expected ultimate recovery (EUR) of a petroleum source is the sum of the proven reserves at a specific time and the cumulative production up to that time.

What is the EUR for unconventional North American shale oil? The three-year average well decline rates for the seven shale oil basins measured below range from an astounding 60%-91%. That means over three years, the amount of oil coming out of the wells declines 60%-91%. This translates to 43%-64% of EUR (estimated ultimate recovery) dug out during the first three years of the well's existence. Four of the seven shale gas basins are already in terminal decline in terms of their well productivity: the Haynesville Shale, Fayetteville Shale, Woodford Shale and Barnett Shale.

Here is a visual example of shale oil depletion rates for the remaining two large and supposedly economic viable shale basins; these are the Bakken, and Eagle Ford:

As you can see, even the "best of breed" appears to be closing on terminal decline.

2) Environmental risk and concern are currently being neglected due to momentum and policy strength.

There are now clear and emerging scientific studies that link fracking and wastewater disposal as a causative variable to earthquakes. What the industry may be consciously ignoring at this time is a need to better understand the risks the practices pose to surrounding communities, water tables, and low level exposure to "proprietary" extraction chemicals.

Fracking wells in the U.S. generated 280 billion gallons of wastewater in 2012. There are presently no clear cost benefits studies or health assessment on impacts of large-scale fracking in areas with large populations dependent on aquifers for their drinking water. This is a disaster waiting to happen. Consider the following indicators:

  1. Pennsylvania has made public 243 cases of contamination of private drinking wells from oil and gas drilling operations.
  2. According to a 2013 report, chemicals from oil and gas wastewater pits have contaminated water sources in New Mexico at least 421 times.
  3. In California, oil and gas companies pumped nearly three billion gallons of waste water into underground aquifers that would have qualified safe for drinking water or irrigation. These aquifers should be protected by the EPA. State officials tested eight water supply wells within a one-mile radius where four water samples came back with higher than allowable levels of nitrate, arsenic, and thallium.

If there are supposed to be any brakes on safety concerns of the fracking boom, the momentum of this effort appears to be currently overwhelming policy. Any forum for constructing a regulatory regime sufficient to protect the environment and public health, and enforcing such safeguards at more than 80,000 wells, plus processing and waste disposal sites across the country, appears to be absent at this time. This will change, and hopefully before there is a serious disaster.

3) Is the cost basis a game of liar's poker?

The cost basis for shale oil production is likely to remain a game of liar's poker well into 2015. Below is one of the better examples of a graphic that suggests a realistic breakeven is $75 per barrel.

The objective of the game is to bluff markets into believing that your capex does not exceed revenue. The shale boom is about to show its hand in 2015.

4) The affect of politics.

Fracking involves the injection a mix of pressurized water, sand and chemicals to unlock hydrocarbons from rock. This process can trigger earthquakes. Many environmental groups say the technique is wasteful, polluting and noisy, but the industry says it is safe. So, up to now, knowing what is known, who appears to be winning the argument?

5) WTI oil price per barrel is a leading trend indicator for rig count. As rig counts decrease, so then does production.

In the graphics below, at the peak of the housing bubble bust (2009), notice the trough in WTI oil PPB precedes the trough in North American rig count by 4.5 months.

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Expect shale oil production to begin a protracted and terminal decline starting in five months.

Conclusions

1) North American shale extraction is a rogue event creating a temporary (six- to 12-month) price decline in crude oil pricing. North American shale production decline and declining drill rig count may be observable in as near as May 2015.

2) Avoid pure North American shale plays. North American shale oil production will decline in 2015-16 as high depletion rates predicate higher capex on what is already over-leveraged firms.

3) Political and environmental concerns will increasingly create significant headwinds for drilling and fracking operation expansion.

4) Now is a golden opportunity to dollar cost average into large integrated E&P firms who possess a diversified portfolio of onshore and offshore conventional and unconventional assets. These firms will benefit from a reversion back to mean oil pricing for sustainable E&P. BP Plc (NYSE:BP), Chevron Corporation (NYSE:CVX), ExxonMobil Corporation (NYSE:XOM), Royal Dutch Shell Plc (NYSE:RDS.A), and ConocoPhillips Company (NYSE:COP) are attractive.

5) Offshore drilling may be attractive over the next six months, and are worth considerations. Transocean (NYSE:RIG), Noble (NYSE:NE), Diamond Offshore (NYSE:DO), Ensco (NYSE:ESV), and Seadrill (NYSE:SDRL). Dollar cost averaging into the current weakness may reward a patient investor on a 24-month timeline. For example, SDRL recently suspended its dividend to par debt, has an existing backlog that exceeds its market cap, FCF is enormous, and the most modern fleet on the planet.

Summary

As politics and the sobering reality of capex and EUR for North American shale oil become more transparent, integrated majors must secure offshore assets as a portion of their broader portfolios. With the crescendo of bearish oil sentiments nearing a fever pitch, I believe diversified oil firms and offshore drilling have upside potential over the next 24 months with a dollar cost averaging approach.

Disclosure: The author is long BP, COP, SDRL.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.