As most investors are aware, David Einhorn recently presented his concerns about the poor economics of U.S. shale production at the Sohn conference. Specifically, he went after shale producers Pioneer Natural Resources (NYSE:PXD), Concho Resources (NYSE:CXO), Whiting Petroleum (NYSE:WLL), Continental Resources (NYSE:CLR), and EOG Resources (NYSE:EOG). While I think Einhorn should be commended for going against the grain and highlighting the problems in the industry, there really was nothing groundbreaking in his presentation. In fact, I first became aware of problems in the shale industry through Bloomberg articles over the last couple of years which pointed out, among other things, that shale producers were spending more on capex than they were earning back in revenues, much less profits. Other critics of the shale industry have been pointing out various problems for years. Perhaps the most notable critic is Art Berman, a petroleum geologist who works as an independent consultant, speaker, and writer. It's worth noting that he's also pretty entertaining. If you would like to get a good synopsis of his views without spending the next two months reading all of the material he so generously shares for free, here is video of a recent presentation he did for the Houston Geological Society.
Berman is not the only geologist who questions the economics, and the true potential of shale oil and gas. David Hughes, a Canadian geoscientist, is another notable critic. He has put out several detailed presentations and reports, perhaps the best of which is Drilling Deeper.
Let me stop here and say that I don't believe any human being has all of the answers about the future of oil and gas, especially in regard to shale plays. I certainly don't have all of the answers about those topics. I am just an investor who is interested in getting to the truth. So, I have spent the last year or so reading as much material on the energy industry as I could find. As I have done that, I have become highly skeptical of the economics of shale production, both for oil and gas.
In my view, one of the most important concerns raised by Hughes, Berman, and others is in regard to well spacing. Specifically, there is serious concern over how it affects ultimate recovery. I am not a geologist or any kind of expert on oil and gas. But I will attempt to explain the issue the best I can, based on my understanding.
The issue is that as E&Ps have sought to cut down per well costs, one of the ways they have chosen to do it is through something called pad drilling. Pad drilling involves drilling multiple wells on a single site. Pad drilling saves time and money for E&Ps. According to drillinginfo.com, "In 2006, when pad drilling began to take off, multi-well pads made up about 5% of wells drilled in the nine unconventional plays covered by DI Analytics. By the third quarter of 2013, the percentage had risen to 58%." Personally, I would guess the percentage has continued rising since then, though I wasn't able to locate any further data. The point is that most of the recent decrease in cost per well that many E&Ps tout can be attributed to pad drilling. So, what is the problem with that?
The problem is that independent scientists and engineers are questioning the wisdom of drilling so many wells so close together. Kevin Thuot, who holds a master's degree in mechanical engineering from MIT and works as an Engineering Research Analyst for Drillinginfo, borrows the straw, milkshake analogy from fictional character Daniel Plainview. In other words, these wells are like straws, all drinking from the same milkshake when they are drilled too close together. The process is known as interference. Thuot's data would suggest that many E&Ps are overly optimistic in regard to how closely they can space wells without affecting overall production per well. As far as I can tell, this issue is not even close to being thoroughly studied by unbiased parties, much less resolved (be sure to review the comments at the bottom of Thuot's article).
But here is the most troubling part of it. Some of the critics claim that spacing wells closer together will actually increase initial production per well in the very beginning, while reducing overall production per well. If you think about it logically, it's conceivable that fractures which occur so close together that they overlap each other would probably boost initial production rates, all else equal. But of course, they do not actually increase the total amount of oil available for extracting. Those in the industry are probably not accounting for the effect of reduced recovery per well, especially in later years. Instead, they may simply be using historical decline experience (which uses data from many wells that were not drilled so close together), and applying it to the higher initial production rates to come up with an EUR. The effect is that they can show a higher EUR for each well, when in reality, EUR per well will be lower.
Are they definitely and knowingly using high IPs based on closely spaced wells to overstate EURs? I don't know. I know that when I've read material in investor presentations and such, I recall seeing slides which boast of high 1-2 day IP rates, and/or high production rates for the first 30 days, oftentimes attributed to closer spacing of wells. It's worth noting that the Thuot study showing lower production for closely spaced secondary wells was based on total production over 6, 12, and 24 month periods. In his independent study, the effect of lowered production increased with time and density (closer spacing). So, it seems to me there may be something to this assertion that E&Ps are effectively robbing Peter to pay Paul, even while claiming it as a huge net benefit. Maybe readers can dig deeper or share the knowledge or insight they have around this issue.
If E&Ps are doing this, how can they get away with it? Well, EUR is only an estimate. When human beings are allowed to use estimates in order to determine the profits they report, investors should consider the incentives involved. I worked for publicly traded companies in the past. I know what kind of pressure can be put on people to deliver the goods, so to speak. It's human nature that this pressure will manifest itself, at least to some degree, in regard to accounting decisions. In my personal experience, accounting auditors are incredibly conservative and truly want to make sure that companies are reporting the most accurate information they possibly can. In fact, in my experience, they can be too conservative at times. However, auditors are not scientists. If a scientist can demonstrate to them a reasonable method using what appear to be reasonable assumptions, I imagine they would be satisfied. Auditors, more than anything else, want to see logical and numerical justification for the estimates and assumptions being used. Since EURs typically are derived using empirical data, there would be very little reason for an auditor to question a method that does not properly account for well interference over time, unless maybe they had been reading the work of Thuot, Hughes, and Berman.
If there is any truth to the critique, this represents a huge problem for E&P investors. What overly optimistic EURs would mean for investors is that DD&A expense is artificially backloaded, under the unit-of-production method. Again, I am not an expert, so readers should please correct me if they believe I am wrong. I have only looked at what goes into oil and gas accounting at a very high level. But in so doing, I was suprised to find that they are able to capitalize most of the expenditures associated with exploration and development, even including some salaries. You read that right. Oil and gas companies are able to book even salaries as capital expenditures. So, backloading DD&A would definitely do wonders for their near term profitability, at least from an accounting standpoint.
Notice that I'm not even claiming that these companies are playing outside the rules. I'm saying that when presented with two options for reporting something, one optimistic and one not so optimistic, human beings who have financial incentive to be optimistic will tend to do exactly that. I think that's probably true to some degree, even if well spacing doesn't turn out to be nearly as much of a drag on ultimate recovery (per well) as the critics seem to believe. One way or another, if Einhorn is correct, many shale companies are somehow losing money even while reporting GAAP profits. However, it's worth noting that many of them never reported much profit, even during times of high oil prices.
The truth is no one actually knows with any certainty what these wells are going to be producing even a few years down the road. We simply do not have the historical experience to guide us the way we do for production in conventional plays using long established techniques and technologies. If the wells don't produce as expected down the road, there will be massive write downs and much lower than expected cash flow in the future. There could also be a spike in plugging and abandonment expenses. These concerns alone should warrant a fairly steep risk premium for the industry. Further, even outside of the issue of well spacing, investors who are intellectually honest with themselves will have to admit that much of the capital expenditures of shale companies really are better characterized as operating expenditures, in light of the extraordinarily high decline rates experienced by shale plays thus far. After all, they call it the drilling treadmill for a reason.
Speaking of being intellectually honest with ourselves, I have to say that I believe many shale investors may be suffering from confirmation bias. Confirmation bias is something we all experience to some degree. However, U.S. shale is a story we really want to believe in for reasons that go beyond personal investment success. We want to believe that U.S. ingenuity in the shale space is bringing about energy independence, peace, and prosperity. We want to believe it's going to bring high profits for investors and low prices for consumers. It has been a source of American pride and optimism, during a time in which those things were difficult to come by elsewhere. The effect of confirmation bias is likely to be even stronger in regard to such a compelling story.
So, investors in shale companies should really attempt to combat this by reading dissenting views and seeking out information that runs contrary to their pre-conceived notions. If the story is worth investing in, it will stand up to scrutiny. There is plenty of such information to go around, and much of it comes from within the industry itself. For example, Schlumberger's CEO Paal Kibsgaard, in a recent presentation had this to say of shale production:
"After having doubled the horizontal length and number of stages per well in the past five years, while also significantly increasing volumes of water and proppant per stage, the average well production has still not improved noticeably."
That really flies in the face of the constant refrain we are always hearing about the revolutionary technology and productivity improvements in the shale space. It certainly doesn't jibe with the claims we often see in investor presentations put out by E&P companies. However, to be fair, Kibsgaard does go on to outline ways that he believes the industry might be able to improve going forward. Still, it would appear that he is stating unequivocally that 5 years of experimentation, using many billions of investor capital, has not produced any noticeable improvement. There are plenty of good reasons to be skeptical of the claims of shale producers.
In part 2 of this article, I will attempt to outline logical ways for investors to profit from this information. Maybe there is a huge bubble in shale E&P that will soon burst. In that case, there will be clear winners. However, maybe the shale industry really will thrive in the future. I believe there are some stocks that will profit investors handsomely under either scenario.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: In this article, I am only giving my opinion, which is based on my own limited understanding of the topics covered. I do not claim expertise in any of the topics covered.