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The American Energy Revolution



April 15, 2014 – Comments (0)

Board: Berkshire Hathaway

Author: rclosch

“Frackers” by Gregory Zuckerman is interesting and important Book, and is a must read for anyone interested in the price of oil. It is a story is about a handful of American wildcatters that struggled for twenty years to find a way to recover the oil and gas trapped in shale rock. There are no Harvard MBA’s, No large international companies in this group just a few middle class Americans and a couple of second generation Greek immigrants. Their quest turned out to be much more difficult than they expected it to be. A few of the contestants lost their companies to bankruptcy in the process, but those that survived long enough to understand multistage fracking and horizontal drilling not only have become multi billionaires, but have changed the world in a way that very few people ever will. But, above all it is a story that could only have happened in America.

It is easy to underestimate difficulty of this quest or the enormity of the accomplishment of this small group. Fracking was been ignored as a waste of time and money by the major international oil companies. It was not until 2009 that the last pieces of the puzzle finally came together and this group of small independent producers began to produce oil and gas in meaningful quantities. Now the trickle has become a flood and all of the existing assumptions that have governed the energy business are beginning to change (for example “Peak Oil” now has been put off for a few generations).

We are just beginning to see the potential of tight oil and gas. Natural gas prices in the US are a third of what they are in Europe or Asia. This has profound implication for the American chemical companies which in the eighties watched most of their business move to Asia. There has not been a new Refinery to produce petrochemicals (the raw material of all plastics) built in this county for twenty five years. Now, in early April 2014 a joint venture Chevron Phillips, broke ground on a $6 billion dollar ethane cracker in Bay town Texas. An ethane cracker is massive piece of equipment needed to convert ethane (a component of natural gas) into ethylene which is used to make plastics. The Company will also build nearby two polyethylene units which convert ethylene into polyethylene pellets. The pellets are used to make a variety of industrial and household plastics. So far the chemical industry has announced $105 billion of similar projects in the United States based on cheap gas and energy.

The rapid conversion of electrical generating capacity to cheap gas means that electrical rates in in the United States are now among the cheapest in the world. For the next few years the advantage will be with the United States because of the head start these wildcatters have given this country, but in the long run this is a global event, as many countries have large areas of shale rock. Mexico and Argentena have large areas of shale that can produce Oil. Europe has shale and China has the world’s largest reserves of shale gas. In the long run shale can have a profound impact on countries that produce petroleum and the price of crude oil. Barron’s lead story in its March 29, 2014 predicted that oil will drop in price to $75 dollars a barrel and that could have negative implications for countries such as Russia since much of their oil comes from Siberia any cost more to produce than oil from shale.

As energy gets cheaper it will lower the cost of producing almost anything. Energy independence for the US will change the face of international politics, because we will no longer have to buy Crude from countries with politics we do not like.

Continental Resources

In 2007 Continental Resources (a large producer in Bakken region on North Dakota) had total proved Oil Reserves of 104 Million barrels. In the six years since then the company has produced 107 million barrels of crude oil. Yet as of 12-31-2013 their crude oil reserve has grown to 738 million barrels. Obviously they are finding oil a lot faster than they are producing it, and since this increase in reserves is coming from approximately the same area under lease, it means they are finding and recovering a lot more oil from the shale rock than they had estimated they would be able to recover a few years ago.

In February 2013 Harold Hamm the founder of Continental announced the results of finding of early production in the SCOOP area in Oklahoma and Texas estimated that
Continental might be able to recover as much as 1.7 Billion Barrels from the SCOOP area, which currently shows proved reserved oil as 54 million barrels.

92% of Continentals growth in proven reserves has come from drilling and more effective fracking in the same areas that have been producing in since 2007 by finding better ways to get more of the oil and gas out of the shale. From January 1, 2009 through December 31, 2013 the estimate of barrels of equivalent energy that can be recovered from the Bakken shale rock has increased by 940%.

Continentals profit has grown from $71 million in 2009 to $764 million in 2013. This is in sharp contrast to Chesapeake Energy (which earned $14 million in 2012) and the other gas producers who have gotten so good at what they do; they have destroyed the price of their commodity. Continental has benefited is the result of Harold Hamm’s decision in 2005 to concentrate on the production crude oil even though at the time it was believed that it was not and never would be economical to produce crude from shale. Petroleum prices have held up because of strong Global demand, and Hamm was right. His reward for his stubborn and relentless pursuit petroleum from shale rock is his personal stock holding in his company which is now worth $14 billion. Not a bad reward, and perhaps it tells you something about our market system. The existence of huge rewards gets people to take huge risks, and helps to explain why the US was able to find a way to produce energy from share rock.

“North American producers have developed technologically advanced drilling and completion processes to produce oil from tight formations.”

See Charts

As Yogi said “Prediction is hard, especially when it is about the future.” and nowhere could there be a better example than the future of energy prices. This is a lesson learned the hard way by Chesapeake’s Aubrey McClendon who bet the company or at least his share of the company on a prediction that the price of natural gas would increase substantially. It apparently did not occur to him that the billions of dollars that Chesapeake and their competitors where pouring into increasing their production would have any impact on the price to gas they were producing.

So is will the oil producers do the same thing to the price of oil that gas producers did to the price of gas? Long term government estimates say they won’t, but, history says that commodities eventually cycle around the cost of production. For the last three years Continental has managed operating margins that averaged 45% compared to 11% at Exxon Mobil and 15% at Chevron. Since they all operate in the same price environment this would seem to indicate that tight oil has become cheaper recover than is generally realized. The price to recover this energy may even continue to decline as the majors with their huge piles of cash decide to enter the area.

Mitchell Energy

The business is not without problems. George Mitchell of Mitchell Energy has spent his life pioneering the shale gas revolution and is considered the father of fracking. In February 2012 he listed two problems that he felt the industry had to deal with. One critical problem is regulation. The industry must be regulated to make sure that the independent producers frack their wells properly. Improperly drilled wells can cause accidents and any accident will cause the public to fight the use of fracking. So he does not want to see shale energy interfere with the development renewable energy and suggests that the government adopt policies that will support the continued development of renewable energy such as enacting a sales tax on gasoline. 

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