This article first appeared in Economia Exterior, Spain’s leading Economic journal, Spring, 2014
By Deborah Lawrence (Rogers)
The Energy Information Administration (EIA), the forecasting arm of the US Department of Energy, predicts that the US will produce approximately 9.6 million barrels of crude per day by 2016 approximately half of which will come from tight oil. This has sparked euphoric rhetoric about energy independence in the US. While talk of energy independence plays very well in the current US political environment, the viability of such independence does not seem to be adequately scrutinized. Wells are short lived, expensive and have poor recovery efficiency. Reserves have been significantly over-estimated by operators and company financials deteriorating steadily for the past four years. Technological innovations such as longer well laterals have proved questionable as to long term performance and companies the size of Exxon Mobil and Royal Dutch Shell are booking massive impairment charges on their shale assets with Shell announcing that they intend to sell 50% of their North American shale properties. Further, both EIA and the International Energy Administration (IEA) project that shales will peak shortly and then decline rapidly. IEA projects that the “shale revolution” will be a thing of the past in a mere decade.
Energy is the bedrock of the global economy and as such its unobstructed availability is paramount for the stability of all modern economies. Moreover, economic stability means political stability. More than a decade of US involvement in foreign wars, particularly Iraq, with the concomitant loss of life, exorbitant expense and political failure, has left the American public weary of Middle Eastern politics and further engagement in the region. The Iraq war, estimated to cost the US in excess of $2 trillion, was touted by the Bush administration as a war about freedom and democracy. In actual fact, it was a war about oil and keeping oil supplies stable.
Although most Americans believe that a majority of the crude used in the US comes from the Middle East, in fact, it does not. Only about 18% of total imports come from the region. America imports crude from 80 different countries including its closest neighbors, Canada and Mexico. But this is lost in the current political posturing regarding energy independence. Sweeping statements are made by industry and some elected officials that energy independence would free the US from Islamic terrorism thereby avoiding future conflicts or wars involving crude supplies. This is a message the average American desperately wishes to hear. The irony is that even if the US became energy self sufficient, it would not alleviate the need for US involvement in protecting oil supplies. Simply stated, the US could neither afford to disengage politically from its strategic alliances nor refuse to render help to allies should disruption of supply become imminent. The global economic implications would simply be too severe. But the promise of energy independence is like a siren’s song.
Two additional factors are driving industry to heavily promote unconventional oil and gas. Firstly, conventional oil and gas finds are becoming harder and harder to locate. This is forcing industry to produce hydrocarbons from sources that were once thought to be inferior. In fact, shales used to be referred to as “junk rock”. When production from shales became a necessity, however, industry quickly changed its pejorative tone and engaged in a considerable public relations campaign to convince elected officials and the public at large that shales were the new energy panacea. Secondly, industry recognizes that it faces not only significant exploratory hurdles but also considerable regulatory hurdles globally due to climate change. Generating rhetoric about energy independence and cheap and abundant supplies is, therefore, quite seductive in such an environment and gives the illusion of confidence. Business as usual can prevail. Unfortunately, the underlying economic and performance fundamentals belie such seduction.
Examining the financials of shale operators, specifically cash flow statements, for a universe of twenty oil and gas companies drilling in the US, one is immediately struck by the deterioration of free cash flow (FCF) amongst every participant without exception.
FCF is very useful in that, unlike earnings and other financial metrics, it is difficult to manipulate. A company, just like a family, can only expand its spending based upon the cash left after its bills are paid. Free cash flow can be defined as operating cash flow less capital expenditure less any dividends. Without FCF a company cannot continue to grow and enjoy financial health. While it is not unusual for companies to experience short periods of negative FCF when expanding operations quickly, a long term pattern of negative FCF denotes a serious problem. Long term negative FCF forces a company to either sell assets, dilute shareholder equity to raise cash or issue more debt. All of these choices destroy shareholder value.
Examining these operators, one finds that FCF has not only been negative but has also deteriorated significantly over the past four years. This is a long term pattern. It also accounts for the massive impairment charges being booked and the sale of assets. Asset sales have been particularly interesting in that some properties could be classified as fire sales having been sold for as little as 1/4 of the value the company had claimed in investor presentations only months before. Of these twenty corporations, approximately $167 billion was spent on CAPEX between 2010-2012 with not a single operator generating positive FCF. Clearly this is not a sustainable business model and is particularly troubling if such companies are being relied upon to provide energy independence. Some are literally teetering on the brink of bankruptcy.
Well fundamentals are not much better.
In 2012, Exxon Mobil announced that 40% of its reserve replacements were coming from two shale plays in the US, the Bakken and the Woodford. By the time the announcement was made in early 2013, the Woodford was running a mere two rigs and the Bakken, though proclaimed by industry as the poster child of tight oil formations, had not increased per well production since June 2010. This lack of growth in production is even more damning when one considers that the number of new wells drilled more than doubled during that time. The problem lies with the steep declines in older (legacy) wells. Bakken legacy wells were declining so quickly that newer wells coming online were simply not able to raise the per well production. In fact, according to EIA, in 2011 the average daily decline in the Bakken was approximately 20,000 bpd. By 2013, a mere two years later, this rate has increased to 63,000 bpd or more than threefold.
Further, based on actual production data, comparison now demonstrates that operators have overestimated shale reserves by a minimum of 100% and as much as 400-500% in some plays. Unfortunately due to a loophole in the Securities and Exchange Commission’s rule change for oil and gas which went into effect in 2009, companies were able to borrow monies based on such inflated reserve estimates without necessarily having them independently audited. Moreover, in plays such as the Bakken which contain tight oil, production data show that the average Bakken well is at stripper status by year six. In other words, at a level where wells are often abandoned. Shale wells, despite all the hype, are not long lived and cannot prove abundant without prolific and continuous drilling programmes. To put this in perspective, the average annual declines of both the Bakken and Eagle Ford plays are 38% and 42% respectively. Such declines are breathtakingly steep and approximately 10x the global average. This means that operators must replace 38% of Bakken production and 42% of Eagle Ford production each year just to maintain a flat production profile without further growth. Further, these percentages rise each year as legacy well declines accelerate together with newer wells being drilled outside the sweet spots. Such is the precarious nature of shales.
Moreover, EIA states the growth in US tight oil production to be approximately 2.3 million bbl/d. Global consumption figures, however, are 91 million bbl/d. US tight oil, therefore, is providing less than 2.5% of current global consumption on wells that are declining at an average of 38-42% per annum with no significant replacement on the horizon. Add to this that global consumption is forecasted to grow in excess of a 1million bbl/d for the next few years and most of the US tight oil contribution evaporates.
Returning to Exxon Mobil’s 2013 press release on reserve replacement, it becomes clear that one of the world’s largest energy companies is now heavily reliant upon shale gas and tight oil to grow its reserves. For a large, global diversified oil and gas company to admit that nearly half of its reserve replacements are coming from a mere two shale plays is troubling. It confirms that conventional plays are being superseded by unconventional plays which have dismal recovery efficiency, steep depletion and cost significantly more. Though industry has spent the past decade denying the peak oil argument, it becomes harder for them to deny that new finds are more difficult to come by and costs are rising significantly. EIA confirms this prognostication in its projections of enormous growth in unconventional production. Oddly, this is extolled by oil and gas apologists as a positive. In actuality, EIA is merely confirming that conventional plays are no longer readily available and will be replaced as they decline by costlier, shorter lived shale gas or tight oil at considerably more expense.
In a recent presentation, Adam Sieminski, head of EIA stated:
“Six tight oil and shale gas plays taken together account for nearly 90% of domestic oil production growth and virtually all domestic natural gas production growth over the last 2 years.”
Mr. Sieminski went on to state:
“Of the six plays, the Bakken and Eagle Ford plays account for about 67% of oil production growth; the Marcellus play accounts for about 75% of natural gas production growth…U.S. crude oil and natural gas production is up dramatically since 2010 and will continue to grow rapidly..”
EIA’s projections of rapid growth bear scrutiny.
There are approximately 30 shale plays in the US at present. The vast majority of production (90%), however, is coming from a mere six plays out of the thirty. Most shale plays are not prolific and book marginal performance. Further, in spite of assurances of growth, monthly reports issued in February, 2014 by EIA confirm that 74% of total new production brought online in the Eagle Ford was off set by legacy well production declines. The same holds true for the Bakken where 73% of new production was directly off set by older well declines. Without a significant ramp up in drilling, both of these plays will continue to deplete to the point where new production is 100% outstripped by older well declines. This has already occurred in shale gas plays. Without continuous and prolific drilling, shale plays quickly go into decline. Moreover, and perhaps most troubling, EIA predicts that tight oil production in the US will peak as early as 2017, a mere three years hence.
And yet, EIA states in their 2014 Annual Energy Outlook (AEO):
“The pace of oil-directed drilling in the near term is much stronger than in AEO2013, as producers locate and target the sweet spots of plays currently under development and find additional tight formations that can be developed with the latest technologies.”
This is an interesting statement given that there are no additional tight oil formations on the horizon which could replace the Bakken and Eagle Ford. Although the Cline in Texas and the Monterey in California were recently hyped to be much larger than the two existing plays, exploratory wells in both have proved hugely disappointing. Executives at Chevron admitted, after drilling dry holes in the Monterey, that they believe the oil migrated out of the formation through fault lines. EIA downgraded the reserve estimates of the Monterey for 2013. Interestingly, independent geological assessments of production data for the Monterey indicate that EIA’s estimate is still wildly optimistic. The Cline, too, is now facing overt scrutiny as exploratory wells have produced meager results. Given that the two best hopes for replacement of Bakken and Eagle Ford production now appear dubious at best, it may prove quite difficult to “find additional tight formations that can be developed with the latest technologies.”
The euphoria surrounding the “shale revolution” is clearly over-hyped. Speaking of new well production and downplaying the concomitant decline and increased costs is disingenuous and misleading. Unfortunately such tactics have been successful and have left the average American as well as the average global citizen believing in the illusion of confidence regarding shale hydrocarbons in general. This illusion of confidence speaks more of politics than performance.
Another aspect of energy independence, and perhaps the most important, is often glossed over. It is a fact that true energy independence means freedom from depletion. This is impossible with hydrocarbons. From the first moment of any well’s life, depletion begins. In shale gas and tight oil such depletion rates are staggering.
There is a perpetual circularity which must occur to keep hydrocarbon energy supplies available. It requires relentless searching for new energy caches, a relentless drilling schedule which inevitably results in relentless depletion and the cycle begins anew. This is the nature of hydrocarbon production because oil and gas are finite. The added detriment of supply disruptions add to price volatility and global economic impediment.
Renewables, however, can use the same locales in perpetuity for energy generation. There is no need for abandonment and as such legacy environmental degradation is minimal. There is no need for a continuous search to locate new energy caches. But perhaps most importantly of all, there is no depletion. This is true energy independence. Further, supply is relatively local, within national borders, so potential supply disruption can be abated or avoided altogether.
Energy independence from hydrocarbons is not really possible. Our definition is flawed. Although the US Department of Energy predicts that the US might be able to produce enough crude to alleviate its imports, that would not exonerate the US from its responsibilities as a global citizen to protect crude supplies and maintain stability in chaotic regions with large hydrocarbon production. Nor will the US production of tight oil alter the global price of crude in any meaningful way. Indeed, even at EIA’s best case scenario, it will hardly be noticed. Such added production would only superficially alter the balance of trade. The real balance of trade issues can only be remedied through domestic savings. And lastly, but perhaps most importantly, hydrocarbons follow a depletion schedule that is relentless. There is no way round this. It is the depletion which makes them unsustainable. It is the depletion which makes true independence impossible. All of the positive qualities promised by energy independence really don’t exist.
The global economic markets are enslaved by a tedious need to be ever searching for new energy while depletion is ever marching downward. At some point, inevitably, supplies begin to dwindle and are harder to come by. Hence the predicament the world faces at present. True energy independence means being able to supply an infinite amount of energy for an infinite period of time. Hydrocarbons cannot provide this for the simple reason that they are not self generating.
We have found ourselves at a crossroads: global choices include the road of hydrocarbon production at greater and greater expense and less and less abundance of choice. We are now forced to accept a growing reliance on shale gas, tight oil and tar sands simply because we have exhausted supplies of conventional hydrocarbons. But there is another road: we can choose the road of renewable energy generation which affords us stability of production with no depletion, no perpetual search for new supplies and no foreign control. That is true global energy independence.