Has the Potential of Shale Oil and Gas Been Overstated?

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Over the past year, political disagreement has been one of the biggest impediments to restoring the American economy and bringing it closer to operating at its full potential. Though the so-called "fiscal cliff" was avoided, a meaningful resolution on America's fiscal situation is yet to be reached. Most Americans believe, rightly so, that Congress just can't seem to agree on anything.

But in a world repeatedly brought to a standstill by partisan rhetoric, one of the few things that people do seem to agree on is the rapid growth of American energy production. Most experts -- whether analysts, geologists, or economists -- would probably agree that rising oil and gas output will likely create a substantial numbers of jobs and provide a major boost to U.S. GDP in coming years.

But there are others -- admittedly a small minority -- who argue that the potential of oil and gas to reignite the U.S. economy has been vastly overstated. They suggest that America's reserves of shale oil and gas have been grossly misrepresented by official statistics and that we have nowhere close to a 100-year supply of shale gas. Do these skeptics raise a genuine concern, or are they motivated by other factors to misconstrue the facts?

The skeptics' view
The crux of the skeptics' argument is that the true amount of shale oil and gas has been grossly overstated because of out-of-date models that fail to properly account for shale wells' decline rates, which, they argue, are extremely high. Hence, they characterize shale production as extremely uneconomical at current prices.

David Hughes of the Post Carbon Institute is one of the skeptics and has a very pessimistic view about the production potential of shale wells. For a study that should be released by the Post Carbon Institute next month, Hughes has meticulously analyzed detailed information about individual shale wells, especially those in the Bakken formation of North Dakota and Montana.

His analysis has led him to a sobering conclusion: Bakken wells decline extremely quickly. He finds that, once production from the average Bakken well begins to decline, its production flow falls to a fifth of its peak level within just two years. Separate calculations by the North Dakota Department of Mineral Resources reached a similar conclusion.

This finding has one major implication. For annual production from the Bakken to keep rising, energy producers will need to bring on more and more new wells each year. According to Hughes' calculations, more than 800 new wells per year will be needed to offset field decline.

Moreover, he found a great degree of variation across Bakken wells. While some wells have been remarkably productive, such as, for instance, Kodiak Oil & Gas' wells in McKenzie County, N.D., the average well has not. Hence, a handful of super-rich wells may be skewing the average production data upward.

Implications of the skeptical view
David Hughes is not alone. Joining him are Arthur Berman, a Houston-based geologist and consultant; Bob Brackett, a senior research analyst at Bernstein Research; Chris Nelder, an energy analyst and consultant; and many more who believe that the shale gas revolution has been overhyped.

The widely divergent estimates of future shale production among experts highlight some important facts. Specifically, they show how the lack of a comprehensive data set presents a major setback in reaching agreement on the productive potential of shale wells.

Because shale production is a relatively recent development, there are no shale wells that have concluded a full life cycle as of yet. Hence, their estimated ultimate recoveries, or EURs, are all based on models, which, of course, are based on assumptions.

EUR is a very important concept in oil and gas geology. It represents the total amount of hydrocarbon that can reasonably be expected to be economically recovered from an oil and gas well, field, basin, or reservoir by the end of its producing life.

Energy companies use the measure for various purposes by energy companies, the most important of which is to determine whether a well, field, basin, or reservoir is economically viable and profitable to drill. Hence, EURs shape many major decisions by energy companies. Yet they are just estimates. In many cases, they can vary drastically depending on the assumptions used in the model.

Some of the shale gas industry's largest operators are projecting EURs in the range of 5 billion to 10 bilion cubic feet or higher per well. In sharp contrast, Berman reckons average EURs are closer to 1 billion to 2 billion cubic feet per well. Here, the numbers make all the difference.

Since profitability is determined by the actual ultimate recovery and the price of natural gas at the time, an EUR of 2 bcf would fetch roughly $4 million at a price of $2 per mmBtu, while an EUR of 10 bcf would obviously fetch five times that amount. Hence, the difference the actual ultimate recovery makes to a natural gas producer's bottom line is hugely important.

How to invest in natural gas companies
If you're still uncertain about the future outlook for natural gas prices, as I am, you may want to consider some safer strategies to gain exposure to the commodity. In my view, investing in high-quality oil and gas companies that have a balanced production mix between crude oil and natural gas is probably one of the safest bets.

One company that I recommended investors take a closer look at in a previous article is Devon Energy . In recent years, the Oklahoma City-based company has achieved a much more balanced production mix and plans to continue growing liquids production at a rapid clip for the foreseeable future. Devon is also very well managed and boasts a strong balance sheet.

Another safer way to gain exposure to natural gas is by investing in well-hedged companies. Among North American energy companies, hedging through commodity derivatives is one of the most effective and commonly used risk-management tools to mitigate commodity price risk.

One of the most conservatively hedged upstream companies out there is Linn Energy . The company has hedged 100% of its expected oil production into 2016 and 100% of natural gas production into 2017. Linn employs a unique strategy, which entails acquiring oil and gas properties with low-risk production profiles and relatively low operating costs. This strategy, in combination with its highly conservative hedging strategy, has served it well so far and should continue to do so.

And finally, if you're convinced by the skeptics' argument that gas prices will rise faster than expected and want to take a riskier route, you may want to check out some high-quality pure-play natural gas companies. Two that are worthy of further consideration are Ultra Petroleum and Southwestern Energy .

While there's probably some near-term downside for these companies, they may be compelling longer-term opportunities. Both are two of the lowest-cost producers of natural gas in North America. When prices finally rebound -- whenever that is -- Ultra and Southwestern should see their profits soar.

The article Has the Potential of Shale Oil and Gas Been Overstated? originally appeared on Fool.com.

Fool contributor Arjun Sreekumar has no position in any stocks mentioned. The Motley Fool recommends Ultra Petroleum, owns shares of Devon Energy and Ultra Petroleum, and has options on Ultra Petroleum. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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