I have written repeatedly on SA to warn people that the shale oil and gas developers tend to use unreliable production models to project unrealistically high EURs (Estimated Ultimate Recovery) of their shale wells. They then use the over-estimated EURs to under-calculate the amortization costs of the capital spending, in order to report "profits", despite of the fact that they have to keep borrowing more money to keep drilling new wells, and that capital spending routinely out pace revenue stream by several times.
When the capital costs are fairly amortized, most shale oil and gas development projects are deeply non-profitable. Even the Bakken shale oil, regarded as the most profitable shale play under current pricing environment, is not profitable. Let me use real data from Whiting Petroleum (NYSE:WLL), the second largest Bakken shale oil developer, to demonstrate the real economy in Bakken shale.
Let the Real Numbers Tell The Real Story
Putting aside the shenanigans of how to properly model a shale well's production decline over time, I think the actual numbers that are indisputable will tell the true story:
- How much does a producer spend on capital spending.
- How much is the daily production volume.
- How much the production gained due to capital spending.
- What's the cost without considering the capital spending.
While any one can say anything about models, the above items are very specific real numbers that producers must report to SEC as they are, with little room for manipulation or speculation.
My idea is that the well drilling and development capital spending can be considered to serve two things:
- To compensate for the lost production due to depletion.
- To expand business and grow the daily production rate.
I think the portion of capital spending that counters the shale well declines and maintains the production at the current level, replaces the loss of value due to depletion and amortization. This portion of capital spending should be the fair amount of amortization costs.
What portion of the capital spending compensates for depletion? What portion is for growth of production? We know new wells drilled should be roughly proportional to the capital spending. Thus the production rate gained is proportional to capital spending. Part of the production rate gained merely compensate for the decline and does not show up in total production growth. The remaining part of new production rate gained shows up as growth. If we know the generate decline rate of existing production wells, we can calculate the percentage of these two portions.
Case Study on Whiting Petroleum
I choose to do a case study on WLL as they are the second largest Bakken shale developer with a long history in Bakken, and a previous case study on their Federal 14-24H well gave me a good idea how fast their wells decline.
Here are the financial numbers of recent four quarters of WLL:
|Period||2012 Q3||2012 Q2||2012 Q1||2011 Q4||2011 Q3||
Average Per Day
|Av. Per Barrel|
|Cap Ex. ($M)||1612.56||1069.38||539.55||1804.31||1311.13||13.769||$174.98|
Note that I removed items not directly related to well drilling and production, like gains or losses of asset sell, gains and losses from financial hedge contracts etc.
For each BOE that WLL produced, it brought home $71.88. Subtracting $23.62 operating costs and $21.71 amortization of capital cost, the net gain from the barrel is $26.55/Barrel. Sound like a very profitable performance, right?
But is it fair that they spend $174.98/barrel on capital spending but amortized only $21.71/barrel of that cost? Where does the bulk of capital spending go? How much production growth did WLL gain from that capital spending?
In one year from Q3 2011 to Q3 2012, the daily production grew from 70670 BPD to 82620 BPD, or 16.91%. The daily production growth was +0.0428%/day.
As I discussed before, Bakken shale wells collectively decline about -0.2% each day, or that newly added production rate may bring in roughly 1/0.2% = 500 days worth of current production rate in the future. So I use the -0.2%/day natural decline rate to calculate.
To go from -0.2% decline below 0.0% to +0.0428% growth above 0%, the difference is 0.2428%. The portion of growth equals to 0.0428%/0.2428% = 17.628%. The portion that counters the well decline is 82.372%.
Thus, 82.372% of the daily capital spending, or $11.342M, was spend merely to maintain production at average level of 78692 BPD. That should be the fair amortization amount. It averages to $11.342M/78692BOE = $144.12/Barrel amortization cost.
The remaining 17.628% of daily capital spending, or $2.427M/day, was spend to boost average production by 0.0428% in a day. That's a production gain of 78692 BPD * 0.0428% = 33.68 BPD. The cost to grow each Barrel per day production, is $2.427M/33.68 = $72061.
As I explained, each 1 BPD of initial production gain can be expected to bring in 500 days worth of production, or 500 barrels. So capital spending to gain one future barrel is $72061/500 = $144.12/barrel.
Notice that both the amortization cost of current barrels and the capital spending on future barrels both comes to the same number, $144.12/barrel. Those are very expensive barrels of oil.
This is not all the cost of the Bakken shale oil. It is only the capital cost portion. The operating cost was $23.62/barrel. So the real total cost is $23.62 + $144.12 = $167.74/barrel.
But WLL takes home only $71.88/barrel in revenue. That leaves WLL in $96 in loss per barrel. That is the true economy of the Bakken shale oil play.
Discussions and Investor Implications
I have written many articles to point out that there are mounting evidences to suggest that the US shale oil & gas industry has systematically exaggerated EURs and under-calculated the fair amortization of the capital costs as the wells deplete much faster than their projections. Thus you can not take the profit or loss number reported by these companies at face value, because they have not fairly accounted for the reasonable amortization costs.
There has been a widely spread and mistaken meme that the so called shale gas revolution brings cheap and abundant natural gas to the USA, thus it brings about the demise of the US coal industry. I keep hearing people singing the song that:
"Coal is dead. Cheap and abundant natural gas is replacing coal"
Nothing is further from the truth! I hope that by looking at the true capital and armortization costs, by looking at the rapidly growing debts in the shale industry, people should finally realize that shale gas and shale oil is not cheap at all, nor are they abundant. In the long term, coal is still the king of fossil energy. Calling coal dead is way premature. This presents an excellent opportunity for investors to jump into the coal sector to reap huge profits in a coal rebound. The profit potential is huge, because there is now a disparity of 75 times more money invested in the shale oil and gas industry versus that invested in the coal sector. When every one bets on the other side, you'd better on the other side of the market. I am holding my coal stocks firm, I advice you to do the same.
Disclosure: I am long JRCC, ANR, ACI, BTU.