Why Well Efficiency Is Overvalued

When investing in energy companies, or anything else for that matter, we're playing a bit of a game. There's tons of information out there coming from oil companies and the analysts that cover them, trying to paint a certain picture on oil. On the other side are the media, mostly lacking in perspective and experience, trying to make a headline or story pitch that will get lots of views, clicks and interest.

Into that morass, we have to figure out what's really happening, and make predictions on where to put our investment dollar. It's not easy.

I don't accuse anyone of misrepresentation - the oil companies are merely trying to show things in their best light, the analysts are trying to spur trading activity. Most journalists on oil come from a generalized financial background and don't have a clue. But if you look hard, you can find unbiased, deeply researched data. And there are some experienced oil players that have no 'side of the fight' they need to be on, and can interpret data and generate useful opinions on where the next investment opportunity might be. I like to think I'm one of those players.

Let's look at one idea that's been getting enormous traction, but that I disagree with, during this oil shake-up of the last two plus years: That we've entered a new era of lower oil prices that are here to stay and oil companies have prepared themselves to survive it.

We know that most shale oil companies have spent much of the last two years concentrating on lowering spending, increasing efficiencies and doing a big PR effort to assure shareholders and Wall Street that their economics can withstand low oil prices longer than the other guy, with cash neutral promises that have been laughably in the $40-55 a barrel oil range.

Now, look at just a bit of data on Bakken shale drilling from a relatively unknown source (but a terrific one) - Enno Peters of Shaleprofile.com:

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This raw data is spectacular in its simplicity, but even more in the lack of added commentary - without much analysis to accompany the interactive post, we're free to draw whatever conclusions seems obvious from these graphs of Bakken shale oil production since 2007. Here are mine:

First, production in the Bakken is now in decline - it is not clear whether this is mostly due to the decline rate of wells in core areas (an emptying of core acreage) or the sharp drop of producing wells courtesy of the oil price bust. I'm of the opinion it is mostly the latter, but even so, believe the best days of Bakken shale oil production now lay behind us. Certainly the amount of fresh capital needed at this point to move the production needle back towards increasing numbers, even if it were possible, is monumental and at least 5 years, if not 10 years away - no matter what the price of oil.

Efficiency charts are the trumpeted good news of shale oil companies, and the second chart shows that, indeed, the initial rates of return on wells have increased every year since 2007. I suggest that this is the one piece of news that oil companies and analysts remain happy to focus on. But two other less optimistic points are equally clear:

One, the rise of efficiency gains has begun to slow in recent years, indicating that efficiency can ultimately get you only so far and necessarily must flatten. That time looks like it's nearer in the future rather than later.

Two, despite the strong initial gain in production from shale wells that efficiency gains have delivered, total production from shale wells over the life of the well has definitely not improved nearly as spectacularly. Moreover, as core areas empty and less prime acreage in the Bakken gets drilled, it's clear that the average well life has decreased - making the cost effectiveness of well drilling at best remain steady. If you pay to complete a well and it only lasts 40 months instead of 60 before you need to abandon it, your gains from increased production must be measured by the cost to complete a new well as opposed to just maintaining one that's already producing. The lowered life span of shale wells is another aspect that oil companies and analysts tend not to concentrate on.

The conclusions I draw from charts like this differ greatly from the ones that most oil journalists and analysts do:

1 - Most core acreage in the U.S. has already reached its apex and will continue to show declining results - even if those declines won't be immediately obvious, perhaps for years.

2- The benefits of efficiency gains is fast approaching all it can deliver to initial well results - but for now, those 'quick barrels' that make the biggest splash on U.S. production numbers will be all that oil companies and most oil experts will see and focus on.

3 - Core acreage and longer-life wells are being spent at a fast rate, requiring an even faster rate of replacement drilling to maintain production levels from spiraling downwards - a trajectory that seems impossible to achieve considering the current decimation in capital spending and investment.

Now, tell me how that translates into smart oil investment in the next several years. We'll follow up with that easier to answer question in my next column.