Are the Light Tight Oil (LTO) Companies trying to outsmart Mother Nature with their Financial Balance Sheets?
In this post I present what I found from applying R/P (Reserves divided by [annual] Production) ratios for Light Tight Oil (LTO) for 3 big companies in Bakken/Three Forks/Sanish.
The companies are; Continental Resources, Oasis Petroleum and Whiting Petroleum, which operated 28% of total LTO extraction in the Bakken(ND) in December 2014.
- Undertaking oil and gas reserves assessments are just as much an art as a science.
From previous work with LTO from Bakken I kept track of the R/P ratio for wells/portfolios and generally found it was in the range of 3 – 4 after their first year of flow. This suggested that 25 – 35% of the wells’ Estimated Ultimate Recovery (EUR) was extracted in their first year of flow.
This made sense as extraction (production) from LTO wells are heavily front end loaded and have steep initial declines.
Examining some big Bakken companies SEC 10-K (SEC; Securities and Exchange Commission) filings for 2014 I noticed that these had R/P ratios for Proven Developed Reserves (PDP) that ranged from 7 – 9.
(Refer to the end of this post for more detailed explanations/definitions of PDP and PUD)
That did not make sense and R/P ratios give away powerful and very valuable information about likely future extraction trajectories.
About 50% of the companies’ total LTO extraction (flow) in Dec 2014 in Bakken (ND) were from wells started in 2014. In other words, the flow was dominated by “young” wells which decline rapidly. Therefore, whatever flow data (monthly, quarterly) that was annualized it should be expected a R/P ratio for total extraction around 4 for 2014.
What I present is how PDP, extraction data and R/P data derived from the 3 companies SEC 10-K statements compares to what was derived from actual data. Further, what actual data now is projecting for EUR for the average well for these companies.
LTO in Bakken will now generally work profitably with an oil price (WTI) above $80/b.
The willingness of several companies to sell more debt (obtain more credit), assets and equity to continue to manufacture LTO wells which estimates showed were not commercially viable have had many analysts puzzled.
Something was likely overlooked, and chances are that this is related to EUR driven incentives to expand assets/equity on the companies’ balance sheets (or “book to model”).
As companies drill wells and puts these in operation (production), it allows them to book reserves on the balance sheets. And reserves are the biggest portion of the LTO companies’ balance sheets.
The rush to use credit/debt to drill what likely would become unprofitable wells (applying project economics) with a lasting, low oil price appears driven by some perverse incentive to grow booked reserves to grow assets and thus equity on the companies’ balance sheets, overriding outlooks for poor profitability. High equity on the balance sheets allows for more debt.
Looking at actual, hard well data (from NDIC; North Dakota Industrial Commission) this strategy will at some point have to face up to the realities of physics and Nature. And physics and Nature do NOT negotiate.
- Using actual data for LTO wells strongly suggests that the PDP (and thus PUD) estimates in companies’ SEC 10-K filings for 2014 are grossly inflated. If so, this has inflated the assets/equity numbers on the companies’ balance sheets.
- The findings from this study suggest that the massive drilling activity funded by growing debt, was likely motivated by balance sheets expansions of assets, and thus the equity from inflated EUR numbers (“book to model”) which made room to take on more debt.
- An inflated balance sheet that allows for a debt load above the carrying capacities of the real underlying collateral, will at some point in time turn against their creators and call for revisions of future plans and expectations.
- It will be interesting to see how the LTO companies’ balance sheets and their profitability respond as it become Mother Nature’s turn with the bat.
NOTE: Actual well data used for this analysis are all from North Dakota Industrial Commission (NDIC). For wells on confidential list, data on runs were used as proxies for extraction (production).
Production data for Bakken, North Dakota: Monthly Production Report Index
Formation data from: Bakken Horizontal Wells By Producing Zone
Data on wells kindly made available by Enno Peters’ excellent and tireless work.
Continental Resources; Investor relations, SEC filings
Oasis Petroleum; Investor relations, SEC filings
Whiting Petroleum; Investor relations, SEC filings
The companies selected for this study were based on their number of producing wells (high portion of wells with 30 months or less of flow as per December 2014, their portion of total Bakken LTO extraction and these represent some spread of better and poorer than the average Bakken well.
Some companies’ 10-Ks PDP shows reserves by area/field split on oil, NGL and natural gas and are also totaled as BOE (BOE; Barrels of Oil Equivalents).
The R/P ratio
The R/P ratio for (oil, gas, coal) is a useful and powerful metric that gives away tons of information.
- The R/P ratio is a snapshot about how long the annual production level for any year versus the (estimated) remaining proven reserves at the end of that same year could be sustained.
The R/P ratio is a number which describes a theoretical rectangular production profile.
In the real world things do not work this way. The R/P number changes from one year to another and it also needs to be seen together with the production level described by it for the year in question.
The Bakken LTO companies looked at
Analyzing the time series for around 8,000 LTO wells in Bakken for 2008 – 2015 makes for a solid foundation to develop predictable trajectories towards their EUR as the time series grow. It is a Nature thing.
This study/analysis presents some data on and derived from R/P for 3 companies that are big in LTO extraction in Bakken(ND) and what to expect from actual data versus those reported on their SEC 10-K 2014 filings.
EUR trajectories for the average wells by vintage
Exclusive of the 2008 – 2010 vintage wells, the average for the younger ones are within a small trajectory band.
Wells of 2014 vintage pulls the average down. Wells started in 2015 have so far performed better, but are not included in this study. Exclusive of the vintages 2010 and 2011, the average for the younger ones are within a small trajectory band.
Whiting’s operated wells of 2014 vintage started out better than average and have in recent months moved to a trajectory converging with the average. Wells so far in 2015 are closely tracking the average for all.
Exclusive of the 2008 – 2010 vintages, the average for the younger wells are within a small trajectory band.
LTO Wells and Extraction
Table 1 shows that the wells in this study that had flowed 30 months or less as per December 2014 constituted a major portion of the total LTO flow (production) and total number of wells.
Long time series with actual data provides more reliable descriptions about what to expect than relying on extrapolations of Initial Production (IP) numbers and/or shorter time series of production followed by tweaking some exponential/hyperbolic factors in the equations for well models.
The R/P Analysis
How the R/P numbers based on actual data were derived?
By totaling the projected EUR of LTO for the average well that started to flow from Jan 08 to Dec 14, adjusting this with what had been extracted (this is measured and reported by NDIC!) for the same period, results in an estimate of PDP (the R for the R/P equation) at end 2014.
The P is total LTO extracted/produced in 2014.
NOTE: The estimated overstatement of PDP at end 2014 does not equate to a similar estimated divergence for the EUR of the average well, refer also table 1.
The estimated magnitude of PDP overstatements was tested and confirmed by alternative approaches, like using BOE as a basis, Q4 2014 numbers for production in the R/P ratio and more.
The Balance Sheets
Now let us move over to these companies’ balance sheets as these were filed with the SEC in their 10-Ks for 2014.
A balance sheet contains a lot of useful financial information about a company.
Here it will be kept simple focusing on the relation as described by the equation below:
- Equity = Assets – Liabilities
If, it is, as I have shown in this post/analysis that the presented companies’ PDP reserves for LTO (in Bakken) are grossly overstated (hard numbers and Nature do not lie!), then what follows from logic is that it should be expected that the numbers on Proven UnDeveloped (PUD) LTO reserves are subject to about the same inflation as the PDP numbers.
This leads to some interesting prospects.
LTO companies’ assets on their balance sheets are primarily described by their PDP and PUD numbers (the reserves).
If, this analysis by direction and magnitude reflects reality, then this with time will show up in financial performance (not only from oil price changes) through metrics for profitability. There are several good profitability metrics that with time will reveal imbalances from an inflated balance sheet with poor/none profitability. Profitability metrics will be the proverbial canary that will give away the true strength of the balance sheet.
If, PDP and PUD reserves are overstated by a very high percentage, ceteris paribus (all things equal, i.e. prices as per 2014), then the balance sheet assets at some point in time will have their day of reckoning and deflate to reflect reality.
Now add the effects from a much lower oil price at end 2015 relative to 2014.
(and…..equity is gone!)
As reserves are depleted (extracted), this becomes recognized on the balance sheets as depletion. From what has been shown in this post the unit depletion numbers are probably based on inflated EUR numbers which understates depletion adjustments which thus overstates assets and equity.
The reality of this arrives as the “non-existent” volumes do not show up.
The focus from Wall Street analysts on Initial Production (IP; production for a well during a defined period of time as the well starts to flow, normally during a 24 hour period early in the well’s life) is misguided from the belief that there are good correlations between IP and EUR in the shales. Statistical analysis for correlations between IP and expected EUR in shales from actual data has shown these to be poor.
In LTO extraction there has been little empirical data available for benchmarking of the models. This will with time change as longer time series of actual data become available to calibrate the models with.
Overly balance sheets focused (as in myopic) investors/creditors will continue to be confident from the numbers of IP and balance sheets and will in the near future spend sleepless nights wondering why such good IPs and strong balance sheets produces poor or no profits and/or why they do not fully receive the money lent.
Their worries will gradually morph from being focused on return on investment to return of investment.
The mysteries created by Nature’s lack of cooperation with the balance sheets will surpass any other existential questions; also the one about what there was before the “Big Bang”.
As observations of/feedbacks from Nature, hard data and logic demonstrate poor compliance with some human created EUR and/or financial models, the models become ripe for revisions to reflect these feedbacks.
Definitions for some acronyms for reserves used in this post.
“proved developed reserves” Reserves expected to be recovered through existing wells with existing equipment and operating methods.
“proved undeveloped reserves” or “PUD” Proved reserves expected to be recovered from new wells on undrilled acreage or from existing wells where a relatively major expenditure is required for recompletion.