Entering text into the input field will update the search result below

2 Questions For Every Shale Company: Half-Cycle Costs And Half-Truths

Open Square Capital profile picture
Open Square Capital


  • We pose two questions for shale, focusing on incentives and full-cycle production costs.
  • We use EOG as an example to run through our analysis.
  • Understanding management compensation and full-cycle costs reveals why they're the inconvenient truth these days.

When it comes to oil, the bearish thesis has always been the growth of shale. The bear thesis contends that at today's oil prices shale can continue to grow and eventually tip the oil supply/demand balance to the point of overflowing. Said another way, the growth in U.S. shale production alone will both offset and overwhelm declining production outside of the U.S. and increasing oil demand.

While shale production will grow, there's a big difference between saying that shale production will grow versus shale production can grow unconstrained, and that's what the bears have argued. So let's just examine that for a bit since that's a key point for investors on oil prices. We'll use EOG Resources (EOG) as an example and we'll pose two questions. Two questions used by Eric Weinstein, Managing Director of Thiel Capital, whenever he encounters incumbent ideas and/or companies.

Why EOG? Well Texas producer EOG has been held up as the "Apple of the Oil Patch" with its use of apps and technology to push production efficiency. With its focus on the Permian, it's also well situated to take advantage of the growth in shale. So let's get started. Our two questions are:

  1. How is their bread buttered?
  2. What is it that they can't afford to say or think?

Buttering Up

This question goes towards incentives. For any economist, or parent of young children for that matter, this will come as no surprise. Incentives matter. So let's take a look at the performance goal for EOG executives for 2016. First there was a set of obligatory production and unit cost targets (i.e., produce +268M barrels of oil at lower than $10.26/barrel in costs, etc.). This is fairly reasonable, and many producers have such metrics. The strategic and other operational goals, however, are interesting. One such goal was "reduce finding cost and operating costs."

This article was written by

Open Square Capital profile picture
Open Square Capital, an asset management firm based in Orange County, CA, manages the Open Square Fund, a thematic value-oriented hedge fund.  For additional information please visit our website at www.opensquarecapital.com

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

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

Recommended For You

Comments (20)

Just a thought, it seems to me that "Revisions due to Pricing" would always be a negative number. If the price increased, and thus added reserves, then those reserves should be backed out since this calculation is to determine the "finding costs" for the year.

It would be simpler for all involved to just start the year with zero barrels and then add the reserves at the end of the year that were put into production and divide that by your costs, but you can add reserves by reducing lease operating expense so this sort of makes sense.

As Deadshot stated, they ae pricy on their operations.
Excellent article.

There are a couple of things I think could be more accurately depicted, such as what hedging is and utilizing the current price environment instead of going back to pre-collapse, but the point is well made.

From personal experience, EOG is probably the worst operator in the industry, and probably the best at exploration. They really are good at finding the sweet spots of plays and new plays. But they are absolutely terrible at operating the wells. And most of that is because of laziness, like depicted in this article. They want the production, they don't care if they spend $1M more on surface facilities to handle the production that they need to - it's easier to cookie cutter every facility, costs be darned. Not to mention the lavish employee costs they pass on to the non-op owners.

Very key point that all shale investors should realize: $/boepd is a flawed metric for claiming operating cost success. Your lowest $/boepd is when your production is highest. As production declines, your costs go up. So what's the best way to ensure that your "operating cost", with that as your metric, goes down? Drill a bunch of wells and pull on them as hard as you can with ESPs as soon as you complete them. Maximum rates, minimum "$/boepd", ultimate reserves and reservoir damage be darned.

Well done.
Aaron Bradley profile picture
very insightful comment deadshot thanks for that.
Thanks for that Deadshot. Absolutely agree on $/boepd
Also, this is a technicality but there is a cash benefit to the depreciation (it is a paper charge, but you get the tax savings of deducting it as a real cash savings). Since you are charging the business with replacement cost for capex for FDA (which I agree is a cash cost), you should give them this cash benefit to the income taxes. This can for instance be charged against any taxed profits on hedging (or in some cases be rolled from year to year).
I like the analysis at the end, but doesn't it look like they would have been OK with 2016 if prices had been at $50 WTI instead of $41? I know 2015 was bad even at $47, but they had service contracts that were running out, etc. from the boom. They did almost same $ per barrel loss with much lower WTI for 2016 versus 2015.

(And at $50 WTI versus 47 dropping to 41, the 2015 to 2016 year would not have had as much downward price revisions causing reserves drops, so maybe that helps them on how you calculate FD&A replacement. I.e. for same drilling, reserves would have gone up 2015 to 2016 or conversely if they kept reserves static, they could have drilled less to do it.)

Also, I don't completely understand the 3 year average FDA. If that makes sense. Not disagreeing, just don't have head wrapped around it.
Cant read the exhibits. Some good comments about stock payments but still hard to follow to the end if you don't show exhibit clearly or do some calculation to say what the value of the transferred stock was.

Shale overall was clearly rising with price in the low 50s so I think a simple explanation is that drilling does make sense at these prices for the industry. It is easier to assume rationality than irrationality in a market.

40s is a whole nother kettle of fish. And will make some of these guys reduce capex no doubt (depending on rock quality).
Open Square Capital profile picture
21793061 - new charts uploaded. Hope that adds some "clarity"!
Thanks, helps.

For the equity, I really don't see any excuse not to include that. Would bump it up to ~$15 per barrel.

For the price changes, I'm just not sure. Can't wrap my head around what makes sense. Do you give them a windfall when prices move in their direction? And do the numbers on price revisions correspond to the "new areas" or just to the old ones. Really hard to think about as some development of old areas occurs and is relevant. You could be a hardass and say they have to be exposed to the price of oil like the investor is but then is this really an actionable incentive.

Again, not arguing one way or another but just don't know on management incentives. Even leaving incentives aside and just looking at it as a metric, if you let price swamp everything else, do you lose some information you would have wanted to see? Donno.
Baidewei profile picture
I have noticed something odd going on here. The bull community appears to be supportive of the price of oil (makes sense) and depletion rates for shale (makes sense) but is also somehow invested into the actual onshore companies. This is very contradictory.

So - here's my standpoint: I'm bearish on oil price (because, everybody lies, everybody cheats and everybody is greedy in oil), I believe the demise of US onshore is being greatly over-hyped (especially when the SuperMajors decide they're getting in), and I also believe that the current, existing, non-major players are crap and should, for the most part, go bankrupt.

Now - betting against the onshore guys because you think the price of oil is going to tank makes sense, because, obviously, they're hemorrhaging money like RMS Lusitania, so that's logical.

But - supporting the equities of these losers, while believing the oil price is going to skyrocket, while complaining that shale is over-hyped and depleting to zero - now that, is a problematic thesis.

So let's assume that everybody is smart here - none of us are complete knuckle-dragging mouth breathers, and that, ok. nobody in their right mind would support the onshore equity if their theory is that oil price is going up because of depletion rates and onshore plays are all a disaster.

Then... who exactly is actually supporting the onshore equity? Hmmm... writing on the wall anyone? It might just be time for all of us to reach across the aisle, hold hands, and buy a massive number of puts on everybody onshore.
Aaron Bradley profile picture
reasonable thesis Baidewei.
the answer to your question is invest in companies that spend within cash flow and don't grow for growth sake. most of these companies will be found in canada since lending is more conservative there for E&P's.
HFIR's top pick Gear energy comes to mind.
johnny..cage profile picture
Nice piece keep up the good work.

I am simply amazed at the stupidity in the market. Goldman calls these EOG guys the new oil order. Why would one buy an EOG over an Exxon?

The last shale lie on accelerated productivity will come to light over the remainder of this year in the reports. We'll see shortly these guys are drilling sub tier one properties with breakevens North of 60. Why free equity money that's why.
Aaron Bradley profile picture
have they used shares to buy reserves in other years then 2016?
Aaron Bradley profile picture
important piece for people who think shale break evens are in the 30-40 range who dont understand half-cycle vs full-cycle costs. this is a side to shale you will never see on bloomberg, cnbc, etc. its a shame.
i chuckled at the " these are not the numbers you are looking for" line, ty.

1 quibble: please use images that you can enlarge when you click on them in the future. current images are too small.
Very good article and step by step breakdown of costs. Thanks!!
Once again, a bad outcome from government interference. This time, it's artificially low interest rates causing too much easy money. When interest rates skyrocket, then companies will go bankrupt and oil prices will go through the roof.
edaskew profile picture
Right. Exactly right. Great article. Great reply. All that's needed here is patience and confidence in this simple truth.
canyonwlf7 profile picture
Year over year Daily Cumulative Average per EIA is 9.1 vs 8.9m not very impressive, not to mention production seems stuck at 9.3m for over a month, has Shale the Unicorn plateaued?
The truth is because of the depletion rates they are forced to drill or see production fall substantially. They accumulate more debt and walls street keeps financing their activities. A famish saying you owe some back he will want it back ASOP if you owe someone a million he will loan you more money in hopes of getting it back.
HFIR profile picture
Excellent article.
Disagree with this article? Submit your own. To report a factual error in this article, . Your feedback matters to us!
To ensure this doesn’t happen in the future, please enable Javascript and cookies in your browser.
Is this happening to you frequently? Please report it on our feedback forum.
If you have an ad-blocker enabled you may be blocked from proceeding. Please disable your ad-blocker and refresh.