The Coming Shale Write-Downs

By Marin Katusa

Not all shales are equal. Some shales are deeper than others; and some are dry gas, while others are gas with liquids. In North America, billions of dollars have gone into developing all types of shale formations to extract as much natural gas, natural-gas liquids, and oil as possible. The production from shale formations has truly been a game-changer for North America, but yet, oil is still more than US$100 barrel.

How can oil be more than US$100/bbl even though the shale revolution was supposed to save us from high oil prices?

First off, shale wells are very expensive to drill and complete. Including all costs, it can cost up to US$15 million to drill, frac, and complete a deep horizontal well. Because of the success of the shale revolution in North America, natural-gas prices have decreased significantly. In fact, in many parts of North America, the natural-gas shales are uneconomic without NGLs (natural-gas liquids) as a byproduct. We have written many times about the phantom shale-gas wells in North America. There are thousands of wells that have been drilled and only need less than 100 hours to be completed and producing before the wells are tied in to the system and sold for cash flow. The owners of the phantom gas wells are waiting for better prices before they complete the wells and sell the gas.

The decline rates of the shale wells are a major Achilles heel to the North American oil and gas sector. We've written in detail—not just in the Casey Energy Report, but also in the Casey Daily Dispatch—about the misleading ways energy companies can report their production numbers.

Warning to investors: Whenever you see a company reporting 24-hour initial production (IP) rates, block that company from your email list and avoid it like the plague.

IP rates are the initial production flow rates a company announces. Five years ago, the industry standard was to publish anywhere between 30- to 90-day IP rates. In the last couple of years, we have noticed a new trend of companies lowering the bar and announcing 24-hour IP rates. This is shocking and alarming, because the 24-hour IP rate is completely useless information. The decline rates of many shale formations are very harsh, resulting in 75% and higher decline rates in the first year. If a company announces a 24-hour IP rate of 1,000 barrels of oil equivalent per day (boepd), your first reaction should be to stay away from that company. It's a safe bet that same oil well will be producing around 500 boepd after 30 days, and most likely somewhere around 250 boepd after one year. That is what we mean by harsh decline rates.

So the high costs and harsh decline rates of the North American shales are two reasons for high West Texas Intermediate oil prices. Another reason that is starting to rear its ugly head is write-downs of shale formations.

The Shale Write-Down

Shell was the first major to announce a major shale write-down in North America. Shell wrote down about US$2 billion, mainly associated with liquid-poor shale projects. The wells are simply uneconomic when there is nothing but dry gas coming out of them. Remember, not all shale formations are the same, similar to how not all gold deposits are the same.

There will be more write-downs to come, and they will hurt the balance sheets of majors and juniors. Is your portfolio prepared for the coming shale write-downs? Do you understand the types of shales you're investing in?