The oil industry hype machine

What would you expect them to say?

That's the question you should ask whenever spokespersons for the oil and gas industry (or fake think tanks funded by the industry or analysts whose bread is buttered by the industry) announce a new find that is going to be a "game-changer" (or bigger than another well-known world-class field or enough to make America energy independent again).

Prepare yourself for another hype cycle in the U.S. oil and gas industry. The industry says it has found a deposit of oil that may turn out to be the largest in the world. The deep tight oil deposit goes by the name Spraberry/Wolfcamp and is located in West Texas. It's no surprise then that the industry is trotting out the America-as-the-new-Saudi-Arabia theme once again, a theme that many including me have shown to be pure bunkum.

And, the chief executive officer of Pioneer Natural Resources Company, which is currently touting its dominant position in the Spraberry/Wolfcamp deposits, added some bunkum of his own when he told The Dallas Morning News, "We’re more like a manufacturing operation than a traditional oil drilling operation.” This is the discredited notion that in tight oil and shale gas deposits, a company can drill anywhere and extract economical volumes of oil and/or natural gas. The idea has been discredited by the record of every tight oil and shale gas deposit drilled to date, deposits which settle down into a pattern of tightly focused "sweet spots" where drillers can make money and vast areas that are not profitable to drill--mainly because the oil and natural gas are too difficult to get out. 

This CEO is either intentionally misleading the reporter, or worse, he doesn't know about the historical pattern of drilling in other similar deposits--something I find hard to believe.

Though there are plenty of other reasons to doubt the claims about Spraberry/Wolfcamp, no one will know for certain what's true until the area is drilled and produced. But, in order to drill it, oil and gas companies must raise billions in capital to pay for drilling and production costs. And, in order to do that, they have to get investors interested in plowing money into the drilling of actual individual wells through what are calledprivate placements.

These placements are riskier than shares of oil and gas companies because they relate to specific drilling projects which may or may not succeed. On the other hand, such projects can be quite lucrative when they do succeed. Hence, the continuing attraction for the speculative investor.

Now, investors are not going to make such risky investments unless they believe the potential return is very high. Here's where the industry hype machine comes in. To raise the necessary capital, it is essential to get investors excited about particular oil and gas plays. The best way to do that is to create buzz in the media about the estimated size of the resources in the play. And, an easy way to do that is to invoke comparisons with Saudi Arabia and its giant oil fields as is being done in the case of Spraberry/Wolfcamp.

Many investors in such deals are not particularly sophisticated about oil and gas investments and so the hype works. The money flows in, the wells get drilled, and then the oil and/or natural gas flows or it doesn't. Or it flows, but not enough to justify producing it. Or it flows and is produced at a loss in order to get back at least some money.

Let's see what's already happening at Spraberry/Wolfcamp. First, we have the claim that Spraberry/Wolfcamp has 50 billion boe. For the uninitiated, boe is short for "barrels of oil equivalent." So, it's a mixture of oil and natural gas, but we are not made privy to how much of each is supposedly there. (About 6,000 cubic feet of natural gas contain the same amount of energy as a barrel of oil.) It's an important distinction since North American natural gas prices are so low that few operators are making any money from gas. Any emphasis on natural gas production in Spraberry/Wolfcamp should make investors skeptical about the profitability of selling more natural gas into an already glutted market.

Second, this number is labeled as "recoverable reserves" when it ought to be labelled "technically recoverable resources" which are based on very sketchy data that are continuously revised as drilling proceeds. And, just because something is technically recoverable doesn't mean it is economicallyrecoverable.

What will ultimately be economical to extract will actually be only a tiny fraction of what is technically recoverable. And, in any case, we should remember that previous large estimates of technically recoverable resources in America's shale gas fields were later rather dramatically downgraded. Furthermore, neither technically nor economically recoverable resources represent "reserves" which are, of course, only that very small fraction of resources which can be produced profitably from known--that is, drilled--fields using existing technology at today's prices.

Third, one has to ask why Pioneer Natural Resources, one of the largest holders of drilling rights in the Spraberry/Wolfcamp deposit and the chief cheerleader for its exploitation, would almost immediately sell 40 percent of the company's stake to a foreign investor.

There are many reasons to sell a stake such as raising money for new ventures. But, Pioneer is telling the public that this deposit may be the largest in the world. Does the company really expect to do better than that with the money it received from the sale of a large portion of its interest? Or does the sale tell us that the company doesn't have as much faith in Spraberry/Wolfcamp as its pronouncements seem to indicate? Furthermore, this outside investor will also shoulder 75 percent of the "drilling and facilities costs" as part of the deal. Alas, the problem of finding money to drill the actual wells has in this case simultaneously been solved with other people's money.

The last time foreign investors came rushing into U.S. oil and gas deals was at the tail end of the shale gas boom, and they subsequently got clobbered. It has often been an indication that a boom is ending when foreigners flock to a particular American investment theme since foreigners are usually the last ones in.

This may have to do with the fact that even in the age of instantaneous electronic communication, it is still difficult to get a read on what is happening an ocean away until something has become a fairly big story in the media. (And, so it's no surprise that companies like to talk to reporters in highly optimistic tones as they seek outside investors.)

What ought to worry these late-to-the-party investors is the fate of those who invested not only in shale gas, but also in certain tight oil plays. (Tight oil is often mistakenly called shale oil which actually refers to oil made from oil shale, but that's a different story). Investors believe oil should be a better investment than natural gas since world rather than regional markets dictate the price, and that price continues hover near all-time highs based on the average daily price over the last three years. There is something to this logic unless the amount one is able to extract is small. And, that's what is happening to investors in the Colorado and Ohio tight oil deposits who thought they were in for a bonanza. Both regions were heavily touted, and both turned out to be huge disappointments.

A few reporters are starting to catch on to the pattern and including dissenting voices in their coverage.And, a just recently retired industry CEO has now said publicly that the shale gas and tight oil story is overblown. Mark Papa, former CEO of EOG Resources, which has extensive positions in both shale gas and tight oil, told Forbes recently: “The chances of the U.S. being independent in oil are very slim.” He added, "We’ve studied this from the rocks’ point of view. There’s a whole lot of plays that will have zero significance."

It's possible that Spraberry/Wolfcamp will turn out to be a very profitable venture for oil and gas companies with holdings there. Pioneer Natural Resources has already made a considerable sum by selling a 40 percent share to someone else. And, it's possible that even individual investors in wells may end up glad they invested. No one can know for certain. But all indications are that these investors should not base their decisions solely on the information coming from the industry.

Unfortunately, the public--which mistrusts the oil and gas industry almost universally--for some reason takes the industry's self-interested pronouncements about supply at face value. Perhaps this is because the public does not understand the true purpose behind these pronouncements.

Beyond the industry's desire to raise capital and sell off assets at a profit, the hype cycle aids industry trade groups such as the American Petroleum Institute (API) in propagating doubtful stories implying America is about to become energy independent. (The API has stopped making explicit statements on this subject which it knows are unsupported by the data. Instead, it keeps repeating the word "abundance" to give the impression that the country is or will soon be energy independent.)

The purpose of such stories is not particularly patriotic. Rather, these stories are designed to slow the transition to alternative energy sources by making such a transition seem far less urgent. In the process, the API is able to protect the value of its members' underground inventories of oil and natural gas, some of which might become stranded or at least less valuable in the event of a rapid transition to alternative energy.

As the reality of tight oil and shale gas sets in, even energy analysts--who so often parrot what the industry tells them--are starting to look skeptically at industry claims:

"Oil companies take production data from existing wells and extrapolate it over an entire field that might be millions of acres. And the oil business is rife with cases of fields that were the next big thing but ultimately produced nowhere near early estimates," said Benjamin Shattuck, an analyst with the energy research firm Wood Mackenzie.

If the analysts are finally looking skeptically at industry pronouncements, you should, too. Don't fall victim to the emerging hype cycle over Spraberry/Wolfcamp or the next cycle over something else, or the next one after that.