By John Kemp
LONDON Aug 6 Shale sceptics have seized on big writedowns in the value of shale gas and oil properties in North America to question whether the fracking revolution could be running into trouble.
On Aug. 1, Shell became the latest in a long line of oil and gas companies to reveal a multi-billion-dollar writedown in acreage value.
It announced just over $2 billion in impairments "predominantly related to liquids-rich shale properties in North America, reflecting the latest insights from exploration and appraisal drilling results and production information".
Others to acknowledge impairments of their U.S. shale assets have included BG Group and BHP Billiton.
"Over the past few years, the oil majors have been punch drunk on U.S. shale. Now comes the hangover," Guy Chazan wrote in the Financial Times on Aug. 1. "Shale writedown is bad news for U.S. shale," he warned.
Analysts at Bernstein Research, which has long sought to inject a note of scepticism and realism into the debate about shale's potential, expressed caution over "exploration and drilling results that are clearly weaker than Shell had expected (shale oil bulls take note!)"
However, writedowns by Shell and some other majors are a sign they came to the shale boom late in the day, overpaying for lower-quality and less well-explored assets - not that the shale revolution is stuttering.
Until recently, the majority of writedowns have been related to gas-rich properties, struggling amid the prolonged downturn in gas prices.
Chesapeake Energy lost its colourful chief executive, Aubrey McClendon, earlier this year, mostly because of a shareholder revolt after the company overpaid and over-expanded in gas acreage and struggled to generate adequate returns when gas prices fell.
Sandridge saw a similar defenestration after its highly speculative wildcat acreage failed to yield the hoped-for bounty, and gas prices remained stuck near rock-bottom.
With no sign of a recovery in gas prices, most exploration and development firms have shifted their attention to formations or parts of formations rich in crude oil and condensates.
However, the impairment of Shell's liquids-rich assets has highlighted the limitations of that strategy, and inspired another bout of worrying over whether the recent rise in U.S. oil production can be sustained.
In reviewing the shale boom and its aftermath, it is important to keep a sense of proportion. Just as shale enthusiasts ignored the problems of translating the technology to other countries, doomsters risk being too quick to interpret the financial difficulties of shale investors as a sign the technology is running into trouble.
It is critical to separate the production potential of the technology from the accounting value of the shale leases that companies have bought.
The shale business, particularly between 2007 and 2011, exhibited all the signs of a bubble. A disruptive new technology unlocked enormous riches for early adopters, prompting a belated rush by other investors and companies to join in and catch up.
The results were predictable. Late investors substantially overpaid for leases. Costs rose. Markets became oversupplied. Selling prices slumped. Fabulous returns turned to a trickle, leading to writeoffs in the value of the assets.
The writedowns have been concentrated among companies that bought into the shale boom very late, either by leasing acres themselves, or buying companies with already-established acreage.
The story has been repeated over and over with disruptive technologies. Minnesota University's Andrew Odlyzko chronicles how the pattern of overpaying and over-investing in new technologies has been manifest from the railway mania in Britain in the 1840s to the Internet and broadband boom of the late 1990s in a superb monograph on "Collective hallucinations and inefficient markets: The British Railway Mania of the 1840s."
But while railway investors lost the equivalent of several trillion dollars in today's money, the mania bequeathed a network of main lines that became the enormously useful and valuable mainstay of Britain's railway system.
Something similar now seems to be happening with the shale industry.
Gas and condensate producers have been victims of their own success. Prodigious output from fracked gas wells has crashed the price of natural gas and more recently of condensates such as ethane, propane, butane and natural gasoline.
But oil-focused producers have fallen victim to another problem: overpaying for acres.
Shales are heterogeneous, varying enormously between different formations in different parts of the country, and even over quite small distances of a few kilometres with the same formation.
Oil and gas production from extensively drilled shales such as Bakken, Barnett, Eagle Ford, Haynesville and Marcellus has proved a poor guide to output from less well-known plays like the Utica, Woodford and Conasagua.
Even within a single well-explored play like Bakken, output can vary enormously between "sweet spots" near the centre of the formation and outlying areas, as well as from one well to another across sections of a couple of kilometres.
LATE BUYERS' REMORSE
Fracturing techniques must be customised for each play to achieve the best results. It takes time and drilling a lot of wells to get the approach right and identify the most productive parts of the formation.
Established players such as Continental Resources in the oldest plays have had years to hone their drilling programmes and focus on the most promising acreage.
They bought leases early, paid modest signing bonuses and agreed reasonable rental, royalty and overriding-royalty payments. Since then, they have traded leases to achieve consolidated tracts covering the best areas that can be drilled efficiently.
By contrast, latecomers bought leases at vastly inflated prices during the height of the mania, many for poorly explored formations, in non-contiguous blocks. For a few years, shale leasing was akin to a modern gold rush. It comes as no surprise many of these leased acres are not worth what the companies paid.
That doesn't mean all these shales are bound to disappoint. It does mean more (expensive) exploration and appraisal work will be needed. Drillers and pressure pumpers will have to experiment with different techniques to get it right.
Some shales may never prove very productive. Others require more investment, in some cases much more.
Meanwhile, those companies that bought acres near the top of the boom will have to recognise they overpaid and will never recoup all their investment in the hoped-for timeframe.