It took twenty years for the roof to fall in.
I sensed this problem from the beginning and remained conservative regarding the long term prospects of fracking generally. It was all a perfect trap for human nature.
It is simple. A in ground reserve is difficult to properly measure for all conventioanl oil until you are dealing with fracking. Then the one thing that you know for sure is the actual reserve. It is also so large it allows one to set caution aside and assume later production will fix it all.
Catch is and i noticed this right away is that the decline curve now matters hugely and you cannot become confident until you are about two years in. Inconvenient if your money is conservative and you want to punch in twenty wells from one pad.
The real difference in this curve turns out to be literally twice that of conventional production. Predciction error would have argued +_ one percent. It is instead 6% for conventional against 15%. for fracking. That is a nightmare as shutin happens way too soon. Yet the banks went for it all and now they discover that all that production went poof.
Bankers and Investors Finding Fracking Industry's Underlying Models Prove Overly Optimistic
By Justin Mikulka • Friday, July 17, 2020 - 10:24
Warren Buffet has a famous quote about investing: “Only when the tide goes out do you discover who's been swimming naked.”
When it comes to his $10 billion investment in Occidental Petroleum, Buffett will need to take that one to heart now that other investors have sued Occidental for the merger financed in part by Buffet’s stake, alleging that the amount of debt required for Occidental to merge with Anadarko left the company “precariously exposed” if oil prices went lower. They cited the billions that Buffett invested in the deal as compounding this risk.
The fracking industry doesn’t care that you’re a world-famous investment sage: It destroys all capital.
Even in 2019, when Buffett was investing in Occidental, we knew that the fracking industry had been losing hundreds of billions of dollars the past decade. However, with the industry’s staggering debt load, lack of ability to continue borrowing, and drops in oil demand due to the pandemic, the tide is now truly going out to reveal the fracking industry’s failing financial performance. That receding cover has also revealed that the industry has broken one of the most basic tenets of financing for oil and gas production: reserve based lending.
Reserve based lending involves a firm estimating how much oil it has in the ground, and then assigning those reserves a value based on the most recent price of oil. A bank then lends the company money based on a percentage of this value. For lenders this has historically been a low-risk arrangement, because if a firm defaults on the loan, the bank can simply take possession of its oil field. So it has long been among the most reliable methods for smaller oil and gas companies to get financing.
But the failed financial model of the fracking industry has blown a hole in that accepted industry wisdom.
Bloomberg recently reported that Mike Lister, a JP Morgan energy banker, estimated that banks wrote off approximately $1 billion in reserve based loans for shale companies in 2019, exceeding their total losses for the past 30 years, and that trend is expected to continue.
Is it possible that the shale industry intentionally overstated its reserves in order to borrow more money and entice investors? It seems likely, as there is strong evidence that the industry knew its valuation methods over-predicted well volumes and reserves, but used them anyway to secure financing.
Speaking to The Wall Street Journal late last year, Stephen Steinmour, CEO of Ohio-based regional bank Huntington Bancshares, took a more charitable view of what occurred while identifying the core issue: “Geology and the assumptions were just flawed.”
As we have documented in DeSmog, there have been many flawed assumptions about how much oil is in the shale (geology), and assumptions about well production have obvious flaws.
In a January 2019 interview with Seeking Alpha, oil industry geological consultant Art Berman discussed ways that shale companies were manipulating data to overestimate potential future oil production. His conclusion is a good summary of the finances of the shale industry: “…it's misleading at best and it's probably borderline fraud at worst, but whatever it is, it isn't honest.”
Borderline fraud is probably the best description available for the finances of the fracking industry. How else can you lose a quarter of a trillion dollars while promising investors big profits?
The Fracker’s Eternal Optimism
The same month that Art Berman gave that interview, The Wall Street Journal ran an article titled, “Fracking’s Secret Problem — Oil Wells Aren’t Producing as Much as Forecast.”
The WSJ article that followed quoted Texas A&M petroleum engineering professor John Lee, an expert on calculating oil and gas reserves. “There are a number of practices that are almost inevitably going to lead to overestimates,” Lee told The Journal.
Two recent research papers highlight some of the practices that the industry has used to consistently overestimate reserves and well production.
“Assessment of the Reliability of Reserves Estimates of Public Companies in the U.S. and Canada,” a paper Lee and colleagues prepared for the Unconventional Resources Technology Conference in July 2019, reviews reserve estimates for Canadian and U.S. oil and gas companies from 2007 to 2017, and then looks at historical revisions to those estimates as the companies produced the oil from those reserves.
Unsurprisingly, Lee and his colleagues found that U.S. shale oil companies “overestimated 1P reserves significantly.” “1P reserves” are the reserves that back reserve based lending.
The authors’ conclusions do not characterize an industry making predictions based on hard data. “We can conclude that U.S. filers are overconfident,” they state. “With biases somewhere between extreme overconfidence combined with negligible directional bias [and] moderate overconfidence combined with extreme optimism.”
So according to the data used in this research, U.S. shale companies consistently overestimated reserves. How could that be possible for an industry with all the best engineers and well over a hundred years of experience estimating reserves if it wasn’t intentional? Flawed models.
A drill rig in the setting sun. Ector County, Texas. May 28, 2020. Credit: © Justin Hamel 2020
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The industry uses models to estimate the volumes of oil that future wells might produce, then combines those figures to estimate total potential oil reserves. But according to a paper on estimating petroleum reserves, published by the Society of Petroleum Engineers in 2018, these models are flawed.
“Using Data Analytics to Assess the Impact of Technology Change on Production Forecasting“ addresses the issues around the models being used to predict future oil volumes.
One of the authors’ main conclusions is that the models used to forecast oil well volumes do not take into account many of the recent advancements in extraction technologies that the industry likes to tout, but that have led to faster well decline rates and lower total production. One of the important factors they do not account for is tighter well spacing, which leads to well interference (aka frac hits or child wells). The industry had hoped that putting wells closer together would result in more oil production but the reality is that the wells interfere with each other if they are too close to each other, and thus the wells produce less oil than was predicted.
“For example, in the Bakken [a shale play spanning parts of Montana, North Dakota, and Canada], the terminal decline rate increases by upwards of 10 percentage points for wells with modern completions in multi-well pads,” the authors state. “Since production life is dependent upon terminal decline rates, spacing and completions effects must be accounted for in type curves for wells in multi-well pads.”
Flawed models give flawed results, but results that make the fracking industry look better to bankers and investors. So the industry continues to use them to conveniently predict there is more oil in the ground than is actually there.
One of the paper’s major findings is that shale operators are using decline rates of 5-8 percent a year. These were accurate for conventionally drilled vertical oil wells, but are far too low for horizontal fracked wells. The researchers found in those cases that decline rates could be above 15 percent, which significantly affects how much oil the well will produce over its lifetime — and thus the reserves estimates based on the lower decline rates are significantly higher than what the well will actually produce.
Oil offload at the Midland Tank Farm. Midland, Texas. May 28, 2020. Credit: © Justin Hamel 2020
“Terminal decline rates have a direct effect on reserves reporting and ultimate profitability of unconventional wells,” the paper concludes, “but have not been deeply studied in the literature.”
So if wells are declining at rates two to three times higher than the industry is estimating, it isn’t hard to see why the industry consistently overestimates its well production forecasts: Their models are not based on what is actually happening in the shale plays producing oil.
David DiCarlo, an associate professor on the petroleum engineering faculty of the University of Texas at Austin, summed up the problem for DeSmog.
“The models being used for unconventional wells are based on results from conventional reservoirs,” he said. “They do not take into account the impacts of variables like increased well interference due to tighter well spacing” leading to overestimating oil reserves by an average of 30 percent when compared to models that do.
The problems with these models are no secret within the industry. But they continue to provide the baselines for fracking industry financing.
Investor Economics and 'Corporate Math' for Reserves Estimates
Bethany McLean, a journalist and contributing editor for Vanity Fair magazine, is the author of Saudi America, a book that explores the ponzi scheme-like nature of the economics of U.S. shale oil production. In a February interview with the Texas Monthly podcast, McLean discussed the idea of “corporate math or investor economics” to describe, for example, how fracking companies tell investors they can break even at $25 per barrel, when the reality is that at that price or similar, they are losing large sums of money.
In Saudi America McLean documented how this practice of “corporate math” has been used with reserves estimates, by comparing the estimates fracking companies made for the Securities and Exchange Commission (SEC) with what they told investors. The results are remarkable, especially when we know that the data show that in many cases even the estimates given to the SEC were overly optimistic.
“One investor analyzed 73 shale drillers in 2014, and found that almost all of them reported higher oil and gas prospects to investors than they did to the SEC,” McLean wrote. “For instance, Chesapeake [Energy Corporation] reported 2.7 billion in ‘barrel of oil equivalent’ —a measure that equates natural gas with oil — to the SEC, but 13.4 billion to investors. Pioneer reported 845 million to the SEC and 11 billion to investors. In total, the industry reported 33 billion of barrels of oil equivalent to the SEC and 163.5 to investors.”
How likely is it that the forecasts given to investors were accurate? Those are not rounding errors.
Chesapeake has since declared bankruptcy. But that didn’t stop the company from recently giving its senior managers another round of bonuses, saying the payouts would help them remain “motivated.”
Misleading investors has paid very well for fracking company executives.
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