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Oil Prices Gain 2% on Tightening Supply

Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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The Biggest Value Trap In U.S. Shale Right Now

Shale

The growth of oil producers is often tracked by a measurement known as the reserve replacement ratio. This compares the proven reserves of oil and gas to actual levels produced. If producers are unable to keep this percentage above 100 percent then they typically realize a loss in share price. To be considered “proven” producers need to be 90 percent positive these resources exist and are extractable. The catch with proven reserves is that they cannot be accounted for if it doesn’t make financial sense to recover the oil or gas. In the past year, this caveat has begun creating issues for producers.

According to EY records, 11 exploration and production companies in the United States realized a collective loss of over 2.12 billion barrels of oil in proved reserves for 2015. The majority of this figure was contributed by natural gas, a market seriously oversupplied. Because of the shale boom, natural gas prices have fallen to $2.5 per mmbtu, much less than the $4.2 per mmbtu figure recorded in 2014. Producers are struggling to pump gas out of the ground at a price that makes economic sense.

Proven reserves are predicted to be assets and are recorded as such. As of 2010, the SEC expects producers to pump the oil within five years as proof. Many shale companies were on board for this decision because it meant they could show shareholders extra inventory. Oil drillers are now failing to deliver evidence of these proven reserves and are losing them as assets. Chesapeake Energy Corp. had to remove 1.1 billion barrels from their proven reserves last year, over 45 percent of their inventory.

It’s not that these resources were incorrectly measured, they are very much still there. If oil producers are able to find the means to pump the oil and gas out of the ground at a reasonable cost once more, then proven reserves could reappear on company balance sheets. An alternative to waiting for prices to rebound is producers could find a way to extract resources at a cheaper price. Shale extraction is becoming more efficient, increasing this possibility. Related: Is The Oil Price War Finally Over?

A report by Haynes and Boone notes that as of September 7th 58 oil producers in North America have filed for bankruptcy. This accounts for more than $67 billion in debt. Ultra Petroleum was one of these companies with $3.9 billion in debt and Penn Virginia leaving another $1.2 billion on the table. In 2012, Penn Virginia claimed it was no longer interested in pumping certain natural gas reserves but it allowed these undeveloped fields to appear on their report to the SEC months later, accounting for more than 40 percent of their reserves.

With OPEC’s announcement that they will be cutting production, the oil market has recovered slightly. If oil prices hold steady or continue to rise, producers in the United States could gain the motivation to claim their costly resources.

There are growing concerns for whether producers are ever going to recover these resources. The SEC will continue to remove proven reserves from producer’s assets resulting in the notional supply of oil and natural gas decreasing. Investors will likely see a slight increase in the respective futures markets with the next release of company’s annual 10 k reports. Shale producers, however, will be disappointing investors if they show a decrease in reserve replacements.

By Michael McDonald of Oilprice.com

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  • JHM on October 05 2016 said:
    Price competition from renewables may keep that natural gas prices below $4/mmbtu. Thus gas resources which require prices above $4 may be permanently locked out of proven reserves.

    So the challenge of replacing gas reserves is to find resources that are economic below say $2/mmbtu.

    A similar phenomena exists for oil, but as of yet price pressures from renewables are not bearing down so heavily. As the auto fleet becomes more electrified, severe price pressure will commence. So within about 10 years the price of oil will be capped by EVs powered surplus renewables. I belive this cap will be about $25/b. So if you want to replace oil reserves, you need resources that are economic at below about $15/b.

    There's very good economic reason why investments in exploration are down sharply. It's not just that the current price of oil and gas are low, but that there is severe risk that advances in renewables and batteries will suppress prices long-term. Replacing reserved is inherently a long-term bet, and that bet has tremendous downside potential.

    Does the world really need a 51 year crude reserve to production ratio? In the time it takes for this to fall to just 35 years, EVs could own 99% of the new car market. Who really wants to take that bet?
  • randy verret on October 05 2016 said:
    I've noticed a couple of your other comments on this site regarding the untimely demise of the oil & gas industry. The technologies to advance electric vehicles are sizeable, especially with batteries & range. Any engineer in that sector will confirm that. Investments are down in O & G exploration because of the price of the commodity, not FEAR of renewables. If you look at creditable worldwide data, 20% of energy consumption is currently electricity, the remaining 80% is predominately fuel for vehicles. Just saw, for example, where the EU approved the Paris Climate accord and all the AIRLINES, responsible for 2% of GHG emissions are committing to a lower carbon future through alternatives. OK. Those alternatives (biofuels) produce about 100 million gallons a year. Sounds significant. Problem is, the airline industry consumes about 83 BILLION gallons of jet fuel a year. SCALE is a huge challenge, especially when you start talking about the transportation sector. Unfortunately, there is no EASY BUTTON in this arena. I have a feeling the transition away from fossil fuels is going to take a while. Don't buy flowers for the fossil fuel grave just yet...

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