Bankers and Investors Finding Fracking Industry’s Underlying Models Prove Overly Optimistic

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Warren Buffet has aย famous quoteย about investing: โ€œOnly when the tide goes out do you discover who’s been swimmingย naked.โ€

When it comes to his $10 billion investmentย in Occidental Petroleum, Buffett will need to take that one to heart now that other investorsย haveย sued Occidentalย for the merger financed in part by Buffetโ€™s stake, alleging that the amount of debt required for Occidental to merge with Anadarko left the company โ€œprecariously exposedโ€ if oil prices went lower. They cited the billions that Buffett invested in the deal as compounding thisย risk.

The fracking industry doesnโ€™t care that youโ€™re a world-famous investment sage:ย It destroysย allย capital.ย 

Even in 2019, when Buffett was investing in Occidental, we knew that the fracking industry had beenย losing hundreds of billionsย of dollars the past decade. However, with the industryโ€™s staggering debt load, lack of ability to continue borrowing, and drops in oil demand due to the pandemic, the tide is now truly going out to reveal the fracking industryโ€™s failing financial performance. That receding cover has also revealed that the industry has broken one of the most basic tenets of financing for oil and gas production:ย reserveย basedย lending.ย 

Reserve based lending involves a firm estimating how much oil it has in the ground, and then assigning those reserves a value based on the most recent price of oil. A bank then lends the company money based on a percentage of this value. For lenders this has historically been a low-risk arrangement, because if a firm defaults on the loan, the bank can simply take possession of its oil field. So it has long been among theย most reliable methodsย for smaller oil and gas companies to getย financing.

But the failed financial model of the fracking industry has blown a hole in that accepted industryย wisdom.

Bloomberg recently reported that Mike Lister, aย JPย Morgan energy banker,ย estimatedย that banks wrote off approximately $1 billion in reserve based loans for shale companies in 2019, exceeding their total losses for the past 30 years, and that trend is expectedย toย continue.

Is it possible that the shale industry intentionally overstated its reserves in order to borrow more money and entice investors? It seems likely, as there is strong evidence that the industry knew its valuation methods over-predicted well volumes and reserves, but used themย anyway to secureย financing.

Speaking to The Wall Street Journal late last year, Stephen Steinmour,ย CEOย of Ohio-based regional bank Huntington Bancshares, took a more charitable view of what occurred while identifying the coreย issue:ย โ€œGeology and the assumptions were justย flawed.โ€

As we have documentedย in DeSmog, there have been many flawed assumptions about how much oil is in the shale (geology), and assumptionsย about well productionย haveย obvious flaws.

In a January 2019ย interview with Seeking Alpha, oil industry geological consultant Art Berman discussed ways that shale companies were manipulating data to overestimate potential future oil production. His conclusion is a good summary of the finances of the shaleย industry:ย โ€œโ€ฆit’s misleading at best and it’s probably borderline fraud at worst, but whatever it is, itย isn’tย honest.โ€

Borderlineย fraudย is probably the best description available for the finances of the fracking industry. How else can you lose a quarter of a trillion dollars while promising investorsย bigย profits?

The Frackerโ€™s Eternalย Optimismย 

The same month that Art Berman gave that interview, The Wall Street Journal ran an article titled,ย โ€œFrackingโ€™s Secret Problem โ€” Oil Wells Arenโ€™t Producing as Much as Forecast.โ€

Theย WSJย article that followed quoted Texasย A&Mย petroleum engineering professor John Lee, an expert on calculating oil and gas reserves.ย โ€œThere are a number of practices that are almost inevitably going to lead to overestimates,โ€ย Lee told Theย Journal.ย 

Two recent research papers highlight some of the practices that the industry has used to consistently overestimate reserves and wellย production.

โ€œAssessment of the Reliability of Reserves Estimates of Public Companies in theย U.S.ย and Canada,โ€ย a paper Lee and colleagues prepared for the Unconventional Resources Technology Conference in July 2019, reviews reserve estimates for Canadian andย U.S.ย oil and gas companies from 2007 to 2017, and then looks at historical revisions to those estimates as the companies produced the oil fromย thoseย reserves.

Unsurprisingly, Lee and his colleagues found that U.S. shale oil companiesย โ€œoverestimated 1P reserves significantly.โ€ย  โ€œ1P reservesโ€ are the reserves that back reserve basedย lending.

The authorsโ€™ conclusions do not characterize an industry making predictions based on hard data. โ€œWe can conclude thatย U.S.ย filers are overconfident,โ€ they state. โ€œWith biases somewhere between extreme overconfidence combined with negligible directional bias [and] moderate overconfidence combined withย extremeย optimism.โ€

So according to the data used in this research, U.S.ย shale companies consistently overestimated reserves. How could that be possible for an industry with all the best engineers and well over a hundred years of experience estimating reserves if it wasnโ€™t intentional?ย Flawedย models.

Drill rig at sunset in Texas
A drill rig in the setting sun. Ector County, Texas. May 28, 2020.ย Credit:ย ยฉ Justin Hamelย 2020

The industry uses models to estimate the volumes of oil that future wells might produce, then combines those figures to estimate total potential oil reserves. But according to a paper on estimating petroleum reserves, published by the Society of Petroleum Engineers in 2018, these models areย flawed.

โ€œUsing Data Analytics to Assess the Impact of Technology Change on Production Forecastingโ€œย addresses the issues around the models being used to predict futureย oilย volumes.

One of the authorsโ€™ main conclusions is that the models used to forecast oil well volumes do not take into account many of the recent advancements in extraction technologies that the industry likes to tout, but that have led to faster well decline rates and lower total production. One of the important factors they do not account for is tighter well spacing, which leads toย well interference (aka frac hits or childย wells).ย The industry had hoped that putting wells closer together would result in more oil production but the reality is that the wells interfere with each other if they are too close to each other, and thus the wells produce less oil than wasย predicted.

โ€œFor example, in the Bakken [a shale play spanning parts of Montana, North Dakota, and Canada], the terminal decline rate increases by upwards of 10 percentage points for wells with modern completions in multi-well pads,โ€ the authors state.ย โ€œSince production life is dependent upon terminal decline rates, spacing and completions effects must be accounted for in type curves for wells in multi-wellย pads.โ€

Flawed models give flawed results, but results that make the fracking industry look better to bankers andย investors.ย So the industry continues to use them to conveniently predict there is more oil in the ground than is actuallyย there.

One of the paperโ€™s major findings is that shale operators are using decline rates of 5-8 percentย a year. These were accurate for conventionally drilled vertical oil wells, but are far too low for horizontal fracked wells. The researchers found in those cases that decline rates could be above 15 percent, which significantly affects how much oil the well will produce over its lifetime โ€” and thus the reserves estimates based on the lower decline rates are significantly higher than what the well will actuallyย produce.

Oil offload at Midland Tank Farm
Oil offload at the Midland Tank Farm. Midland, Texas. May 28, 2020.
ย Credit:ย ยฉ Justin Hamelย 2020

โ€œTerminal decline rates have a direct effect on reserves reporting and ultimate profitability of unconventional wells,โ€ the paper concludes, โ€œbut have not been deeply studied in theย literature.โ€

So if wells are declining at rates two to three times higher than the industry is estimating, it isnโ€™t hard to see why the industry consistently overestimates its well production forecasts: Their models are not based on what is actually happening in the shale plays producingย oil.

David DiCarlo, an associate professor on the petroleum engineering faculty of the University of Texas at Austin, summed up the problemย forย DeSmog.

โ€œThe models being used for unconventional wells are based on results from conventional reservoirs,โ€ he said. โ€œThey do not take into account the impacts of variables like increased well interference due to tighter well spacingโ€ leading to overestimating oil reserves by an average of 30 percentย when compared to models thatย do.

The problems with these models are no secret within the industry. But they continue to provide the baselines for fracking industryย financing.

Investor Economics and ‘Corporate Math’ย forย Reservesย Estimates

Bethany McLean, a journalist and contributing editor for Vanity Fair magazine,ย is the author ofย Saudi America,ย a book that explores the ponzi scheme-like nature of the economics ofย U.S.ย shale oil production. In a Februaryย interview with theย Texas Monthly podcast,ย McLean discussed the idea of โ€œcorporate math or investor economicsโ€ to describe, for example, how fracking companiesย tell investorsย they can break even at $25 per barrel, when the reality is that at that price or similar, they are losing large sums ofย money.

Inย Saudi Americaย McLean documented how this practice of โ€œcorporate mathโ€ has been used with reserves estimates, by comparing the estimates fracking companies made for theย Securities and Exchange Commission (SEC) with what they told investors. The results are remarkable, especially when we know that the data show that in many cases even the estimates given to theย SECย were overlyย optimistic.

โ€œOne investor analyzed 73 shale drillers in 2014, and found that almost all of them reported higher oil and gas prospects to investors than they did to theย SEC,โ€ McLean wrote. โ€œFor instance, Chesapeake [Energy Corporation] reported 2.7 billion in โ€˜barrel of oil equivalentโ€™ โ€”a measure that equates natural gas with oil โ€” to theย SEC, but 13.4 billion to investors. Pioneer reported 845 million to theย SECย and 11 billion to investors. In total, the industry reported 33 billion of barrels of oil equivalent to theย SECย and 163.5ย toย investors.โ€

How likely is it that the forecasts given to investors were accurate? Those are notย roundingย errors.

Chesapeake has since declared bankruptcy. But that didnโ€™t stop the company from recently giving its senior managers another round of bonuses, saying the payouts would help themย remainย โ€œmotivated.โ€ย 

Misleading investors has paid very well for fracking companyย executives.

Plausible Deniability andย Independentย Audits

A main cause of the 2007-2010 financial crisis was that supposedlyย independent ratings agenciesย rubber-stamped near-worthless mortgage-backed securities with investment gradeย ratings.

When it comes to the reserve estimates that fracking companies provide to the SEC, there is also a supposedly independent review process:ย Qualified petroleum engineering firms audit the reserve estimates used for reserve based lending. However, based on the huge spike in write-offs on reserve based loans in 2019, this could become the industryโ€™s own version of the sub-prime mortgage rating debacle.

DeSmog has covered the brief history of theย fracking company Alta Mesa.ย The company promised โ€œworld class assetsโ€ to investors but the reality was that the oil simply wasnโ€™t there. The company quickly went bankrupt. Multiple investors have sued, alleging that Alta Mesaโ€™s management and financial backers made โ€œmisleadingโ€ financialย statements, and the firm now faces an SECย investigation.

It may be hard for Alta Mesa to claim ignorance in these proceedings, as it was run by a frackingย industry veteran and backed by financial industry heavyweight Riverstone. If anyone knows the reality of the shale industry, it should be a teamย likeย this.

Inย the proxy statement for the formation of the company, an audit by Houston-based petroleum consultancy Ryder Scott found no problems with Alta Mesaโ€™s reserves estimates of its supposedly world classย assets.ย The firmโ€™s โ€œoverall procedures and methodologies [used] in preparing their estimates of the proved reservesโ€ complied with SEC regulations, Ryder Scott concluded, and were, โ€œin the aggregate, reasonable within the established audit tolerance guidelines of 10 percent as set forth in theย SPEย auditingย standards.โ€

But a closer look reveals just how little oversight such audits actually provide. Ryder Scott used Alta Mesa data, and โ€œreviewed such factual data for its reasonableness,โ€ but admitted that it did not conduct โ€œan independent verification of the data furnished byย Altaย Mesa.โ€

This is how firms arrange plausible deniability: An independent auditor simply agrees with everything the companyย says.

Alta Mesa ended up in what is known as a โ€œfree fallโ€ bankruptcy, which is as bad as it sounds. What was one of the main issues?ย Reserveย basedย lending.ย 

The bank determined that the reserves were worth far less than what Alta Mesaย had claimed and ultimately cut their value by almost 50 percent.ย That this occurred in August of 2019, when the price of West Texas crude was averaging just under $58 a barrel, shows that low oil prices were not theย problem.

โ€œHistorically, lending to the oil and gas industry on a secured basis has been one of the most safe places for commercial banks to make loans,โ€ Buddy Clark, a partner at industry law firm Haynes and Boone, explained to theย Houston Business Journal in January.

The New York Times recently reported that energy consultant Rystad Energy expects as many as 250 oil and gas firms to declare bankruptcy by the end of 2021. With this historic industry crash, the days of banks considering reserve based lendingย as nearly risk-free are likely a thing of theย past.

Industry Leader Lobbies for Looser Reservesย Estimatesย Regulations

One consistent trait of the fracking industry is that theย CEOs will always double down on misleading investors, because as long as the company exists,ย CEOs keep getting bonusesย no matter how much money they lose forย investors.

A first bankruptcy is just an opportunity to get more investors toย fund a second bankruptcy with more executive bonuses.ย Anย industry bailoutย is just another opportunity to pay executive bonuses.ย Every year isย another yearย to predict thatย this will finally be the yearย fracking makes money. Every year theyย areย wrong.

Andย lobbying for bailouts,ย deregulation,ย and looser accounting standards are all par forย theย course.

Harold Hamm, the chairman of fracking giant Continental Resources, was a fixture in Washington,ย D.C.ย even before hisย close friend Donald Trumpย became president. In 2015 Hamm testified to Congress in support of efforts to lift theย oil export ban. Among Hammโ€™s arguments in favor of lifting the 40-year-old measure, Hamm categorically ruled out the possibility of U.S. crude oil being exported to rival nation China,ย a claim that made little sense at the time, and proved false within a year of the banโ€™s 2016 demise.

Despite his relentless optimism about the fracking industry, Hammโ€™s company has faredย very poorly, and he has used hisย connection to Trumpย to lobby forย various bailoutsย andย favors.

Last year Hammย wrote a letterย to theย SECย advocating that oil companies be allowed to double how long they can count potential future production as proved reserves, from 5 to 10 years. At a time when it is clear that the reserves estimates from the industry are overly optimistic, Hamm is asking for even looser regulations that could allow companies like his to borrow more money using these inflated reserveย estimates.

This is how the fracking industry has maintained its access to financing: It keeps changing the rules, misleading investors, and making new promises, and the executives continue to collect exorbitantย pay.

And itโ€™s workedย in part thanks to those flawed models that, as the industry knew, overpredicted oil well production and reservesย โ€” until the tide went out and we all could see that there just wasnโ€™t as much oil in the shale as theย industryย predicted.

Itโ€™s now clear that the โ€œcorporate mathโ€ used to justify the financing of the fracking industry just simply does not add up. In the case of just one failing firm named Templar Energy, theย Wall Street Journal recently reportedย that once the assets that it used to secure financing are liquidated, the banks are expected to receive $0.21 back for each of the dollarsย theyย loaned.

Itโ€™s a far cry from 2015, when the banks loaning money to Templar, along withย Templarย CEO David D. Le Norman,ย were all very confident about the value of thoseย assets.

โ€œOur lender group has recognized our high quality asset base, significant reserve growth, and disciplined approach to the development of the assets.ย We appreciate the continued support,โ€ย Le Normanย stated in aย pressย release.

But that โ€œhigh quality asset baseโ€ was valued using models that predicted future well production and oil reserves that the industry already knew were flawed and overly optimistic, but continue to use to this day. The oil and gas industry has sold theย fracking boom as a โ€œmiracle.โ€ย  But the real miracle is how long the industry was able to fool investors into believing it would ever beย profitable.

Main image:ย May 27, 2020, dozens of drilling rigs are stacked at the Patterson-UTI yard in Midland, Texas, after the oil price went negative on April 20, 2020.ย Credit:ย ยฉ Justin Hamelย 2020

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Justin Mikulka is a research fellow at New Consensus. Prior to joining New Consensus in October 2021, Justin reported for DeSmog, where he began in 2014. Justin has a degree in Civil and Environmental Engineering from Cornell University.

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