Musings: Are The Shale Resource Estimates Realistic Or Fantasy?

Maybe you've seen the advertisements from various financial newsletters touting the investment potential of companies involved in developing the Bakken oil shale formation that spreads across North Dakota and Montana and into the neighboring Canadian provinces of Saskatchewan and Manitoba. The claims, which several years ago appeared outrageous, of the Bakken containing eight times the amount of oil as in Saudi Arabia or 21-times the reserves held by Kuwait seem less than fantasy today. 

These newsletters began trumpeting the financial impact of the Bakken for various oil exploration companies active in the formation following the 2008 U.S. Geological Service (USGS) revised estimate for the basin's reserve potential suggesting it might contain between 3.0-4.3 billion barrels, a 25-fold increase over the organization's prior estimate made in 1995, which said the field might contain 151 million barrels. The USGS stated that the Bakken formation is estimated to be larger than all other current USGS oil field assessments in the Lower 48. The agency called it the largest "continuous" oil accumulation ever assessed. This means the oil is spread rather evenly across the basin as opposed to being located in discrete deposits. The next largest continuous oil deposit is the Austin Chalk trend stretching from Louisiana to central Texas that is estimated to contain 1.0 billion barrels. Jeff Hume, president and chief operating officer of Continental Resources was quoted in an article not long ago suggesting that there could be as much as 24 billion barrels of reserves in the Bakken formation. 

Exhibit 1.  Bakken Is U.S. Largest Continuous Oil Field
Bakken Is U.S. Largest Continuous Oil Field
Source:  EIA

The success the domestic exploration and production companies have had in the Bakken has been partially responsible for U.S. oil production growing over the past two years to the highest level in over a decade. 

Exhibit 2.  Domestic Oil Production Up Last Two Years
Domestic Oil Production Up Last Two Years
Source:  EIA

North Dakota's oil production reached a peak last November at 356,697 barrels per day from 5,099 producing wells. Over the past three years, monthly oil production in North Dakota has grown by more than 2.5 times. Production is off slightly in January to 342,088 barrels per day from 5,061 wells. While we can't be certain, we suspect the traditionally harsh winter in that region of the country impacts oil production efforts, especially since the infrastructure to produce much of this additional oil has not kept pace with the rising production. There have been media stories about the dramatic increase in the number of railroad tanker cars hauling Bakken production to refineries. We are also aware of some of the oil making its way by truck across the US-Canadian border to shipping facilities there. All of that will change as new pipelines are constructed.

Exhibit 3.  North Dakota's Oil Production Soaring
North Dakota’s Oil Production Soaring
Source:  North Dakota Natural Resource Department

More important is the growth in drilling, which will be critical for boosting the state's oil and gas production in the future. The most recent Baker Hughes rig count showed 153 working rigs in North Dakota, more than double the count merely 14 months earlier. According to Mark Williams, senior vice president of exploration and development for Whiting Petroleum, "All current and planned projects could take us up to 1.1 million barrels a day."

The most important factor in the growth of Bakken oil production has been the application of drilling and well completion techniques learned from drilling the gas shales – horizontal wells with longer lateral sections and a greater number of hydraulic fracturing treatments.  Estimates are that by applying these technologies, Bakken wells that were drilled only a few years ago might produce 100,000-200,000 barrels over their lifetime but are now getting 400,000-700,000 barrels out of the deposits.  Even though the cost to drill and complete these newer wells is greater than for the older wells, the economics of greater production, especially at today's $100 per barrel oil price, are extremely attractive.

But back to the question we posed in the headline for this article. Just how realistic are reserve estimates? As we have commented on many times in our career, the biggest challenge for assessing the value of oil and gas companies is the realization that virtually all their assets lie underground. Because of that we never will know exactly how much oil and gas a company owns. Moreover, the amount of oil and gas a company can recover from the reservoir will have a huge impact on its potential value. We were intrigued by a presentation at the Ohio Oil & Gas Association Winter Meeting by Chief Larry Wickstrom of the Ohio Department of Natural Resources' Ohio Geological Survey. Mr. Wickstrom's presentation was on the Marcellus and Utica Shale plays in Ohio, the latest hot spot in the business. The Ohio Marcellus and Utica shale formation is the westernmost part of that regional play that extends from Ohio and West Virginia through Pennsylvania and New York State and on into Canada. 

There is much speculation about the potential reserves in the Utica shale in Ohio, which is responsible for the land rush that has been underway in the state recently. Even though there have been only a few Marcellus wells drilled in the state and virtually no Utica shale wells, its potential is believed to be significant. Mr. Wickstrom demonstrated this potential by discussing the following information. A typical conventional gas well in the Appalachian Basin will produce 100,000-500,000 cubic feet per day and 200-500 million cubic feet (MMCF) over its producing life. In contrast, a Marcellus well (and possibly a Utica well) produces 2-10 MMCF per day or four billion cubic feet over its lifetime. If one does the math of multiplying the lifetime production of each of these wells by $4 per thousand cubic feet, the current price for natural gas, there is an eight-fold increase in value for a Marcellus well compared to a conventional gas well ($16 million versus $2 million in gross revenues). Of course, this simple calculation ignores the greater cost to drill the Marcellus well (possibly $3-$5 million) and possibly other costs, too, but the magnitude of increased economic returns from the shale wells underlies the industry's excitement and aggressive behavior.

Mr. Wickstrom decided to use his presentation to not only educate his audience about the geology and challenges of drilling and developing the Utica shale, but also to help people understand how speculative much of the chatter about the formation's potential is given the lack of production data. He began this mission by explaining the formula for estimating the resource potential for a field, which was developed by two geologists in 1989. The formula is: Qt = V x D x TOC x C x %R. The volume of hydrocarbons contained in the field is a function of the volume of rock, the density of that rock, the amount of carbon content in the rock, the percent of carbon converted into hydrocarbons and the percent of reservoir space containing the hydrocarbons. While the formula sounds straightforward, it requires estimating five important variables. Drilling core samples and analyzing the formation's rock composition helps in making these estimates. By correlating the rocks from this reservoir with those from other similar basins where production history has been established further improves the accuracy of the estimates. But in the end, the estimates can be subject to wide degrees of error. Just how much? Maybe that depends on which side of the debate about the economic performance of gas shales one is on. At the present time, it is much like that old beer commercial – "less filling" versus "tastes great" both positive qualities but impossible to quantify.

Exhibit 4.  How To Forecast Basin Reserves
How To Forecast Basin Reserves
Source:  Ohio Dept. of Natural Resources

To further help the audience understand the challenge of estimating the potential size of the Utica shale formation in Ohio, Mr. Wickstrom presented data from a study of the entire Appalachian Basin's Utica/Point Pleasant formation prepared in 1989. That study concluded the formation had migrated 13.26 billion barrels of oil to conventional reservoirs in the basin. Remember, the shale formation is the source of the oil and gas that migrates into a basin's various conventional traps.

Exhibit 5.  Utica Shale Contribution To Appalachian Reserves
Utica Shale Contribution To Appalachian    Reserves
Source:  Ohio Dept. of Natural Resources

It was at this point that Mr. Wickstrom suggested the audience should have some fun and make up the numbers to manufacture an estimate of the Utica's potential. He started with the variables used in the 1989 study of the Utica formation for the entire Appalachian Basin. He suggested that based on more recent knowledge, we could increase the total organic content to 2.50% from the prior estimate of 1.34%. Then came the fun part. What should be the percent of reservoir space containing hydrocarbons that can be recovered? Mr. Wickstrom suggested we should start with the percentage used in the various studies for the Bakken formation – 1.2%.  Plugging that number into the equation, we arrive at an estimate of 1.96 billion barrels of oil or its equivalent for the Utica formation.

Exhibit 6.  Widely Different Forecasts From Minor Changes
Widely Different Forecasts From Minor    Changes
Source:  Ohio Dept. of Natural Resources

What happens, however, if you change the recovery factor? Mr. Wickstrom boosted that number to 5%, and suddenly the Utica may contain 8.2 billion barrels of oil or its equivalent. That's more than a fourfold increase. What could this mean to our crude oil and natural gas reserves?

Exhibit 7.  The Fantasy World Of Projections
The Fantasy World Of Projections
Source:  Ohio Dept. of Natural Resources

By assuming that the hydrocarbon volume is split 1/3rd natural gas and 2/3rds crude oil, we have the basin containing either 3.75 TCF of gas and 1.31 billion barrels of oil on the low side, or 15.7 TCF of gas and 5.5 billion barrels of oil on the high. Given these oil estimates, the Utica formation in Ohio contains less than half the oil in the Bakken formation or it contains one and a half times more! For natural gas, the Utica shale represents either two-tenths of one percent of the nation's potential conventional gas reserves as estimated by the Potential Gas Committee in its 2008 study, or it accounts for 9.4% - quite a difference in magnitude. 

Once you go through this analysis, it becomes easy to understand the hype surrounding the Ohio Utica play. The optimistic estimates, based on reasonable assumptions about the geology and recoverability of the hydrocarbons, will certainly get the attention of industry players and especially Wall Street that loves to create overly optimistic scenarios. But as Mr. Wickstrom cautioned, without drilling wells and developing a production record, these estimates are all fantasy.