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America’s shale revolution grew out of a well-orchestrated dance. For almost a decade, producers wooed investors by touting rosy estimates of how much crude oil they could profitably drill, and investors forked over money.
That ended last year, even before theglobal pandemic sentoil prices tumbling. Investors, after years of meager returns, began demanding that shale companies stop marketing mythical future barrels that would never earn a dollar. There’s still no truly standardized way to gauge how accurately companies count their reserves.
Interviews with five current and former engineers, who spoke on condition of anonymity, describe an ongoing culture that rewards happy talk. Two of the engineers say executives explicitly told them to inflate reserves. Others say the requests were implied, with only engineers who produced aggressive estimates landing promotions. Some say they were fired or saw their coworkers let go because they were reluctant to fudge key metrics.
When investors put money into a shale company, one of the most important things they need to know is the value of the oil the company can get at while still earning them returns. The estimates are more art than science. Shale drilling is still a relatively new technology, and the engineering iscomplicated. Output from horizontal wells declines faster than production of traditional wells. So-called child wells drilled too close to “parent” wells reduce output. The results can be a minefield for investors, who’ve discovered the hard way that not every company gets it right.
“It’s a classic example of crossed incentives,” says Clark Williams-Derry, an analyst at the Institute for Energy Economics & Financial Analysis. “All the incentives are pointing in the direction of irrational exuberance.”
The U.S. Securities and Exchange Commission requires oil companies to report with reasonable certainty the volume of reserves in wells that are profitable at a price set by the agency the year before. The wells must be drilled within five years of being added to a company’s books. The calculations take into account the rate at which a well’s production is likely to decline, how closely the wells are drilled, land and capital costs, and, of course, price per barrel.
Before the SEC adopted its current reporting rules in 2009, there were a series of reserve scandals that involvedRoyal Dutch Shell Plc, which the agencyfined $120 million in 2004, leading to the exit of top executives, and a few years later El Paso Corp., which settled charges for inflating reserves. Both companies settled without admitting or denying wrongdoing. Since then, high-profile fines and penalties have been noticeably absent, even when insiders have raised concerns. Some analysts are still skeptical of many numbers they see.
“We’ve seen some companies where their public well data is showing that the wells are a lot less productive than what the company originally asserted,” says Noah Barrett, an energy analyst atJanus Henderson Group Plc. “There’s a lot of subjectivity around what actual decline rates will look like over the full cycle of a well.”
Problems with estimated future output have dogged the U.S. shale patch. One company,SandRidge Energy Inc., lowered its reserve estimates in eight of the last 10 years, according to data compiled byIHS Markit, even as the average oil price rose in four of those years.
Executives routinely pressured engineers to increase their estimates to bolster SandRidge’s market value, a former employee wrote in a 2015 memo to company management, which was seen by Bloomberg News. Weeks later the employee was dismissed. Eventually the SEC began an investigation, which SandRidge disclosed when it filed for bankruptcy in 2016. The employee’s dismissal coincided with layoffs, but the investigation found that managers had discussed replacing the whistleblower with “someone ‘who could do the work without creating all of the internal strife.’”
Around the same time, Chris Bird, a petroleum engineer who’d bet against SandRidge stock, shared with the SEC his analysis that SandRidge’s reserve estimate was about 4.6 times higher than his. In an interview, Bird says he didn’t know whether the SEC considered his complaint.
Although the regulator fined SandRidge for violating whistleblower protections, it never cited the driller for inaccurate reserve reporting. In its disclosure of the SEC investigation, SandRidge said that more than 85% of its reserves were calculated by an independent outside firm. (It agreed to the fine over whistleblower protections without admitting of denying the SEC’s findings.) The company said last month it may not be able to continue as a going concern, foreshadowing what could be its second bankruptcy in five years. Judith Burns, an SEC spokeswoman, says the agency doesn’t comment on specific companies. SandRidge declined to comment.
“Buyer beware is my advice,” says Art Berman, a geologist and consultant who was one of the shale industry’sfirst outspoken critics. “The notion that the SEC should step in, I don’t agree with that. The investors ought to recognize that they’re making a high-risk investment.”
Correspondence between the SEC and shale companies over reserve reporting has dropped off. In 2014, the agency sent six letters to producers asking them to provide more information about how they got their numbers. Only two such letters have been sent in the last three years, based on a review of public filings by 26 U.S. oil and gas companies. “The SEC has let the shale patch game the system,” says Ed Hirs, a longtime energy fellow at the University of Houston. “The market has figured this out. Look at the cash flow generated from the companies. The fact is they ain’t making any.”
Shale producers’ reserves are audited by third-party firms that use producers’ well-level data. They help provide a check against wishful thinking but don’t always catch the impact of technical challenges such as wells drilled close together interfering with one another, says John Lee, a professor at Texas A&M University who’s known as the “godfather of reservoir engineering.” Some companies are moving toward using automated analysis to remove human bias.
Other industry players consider audit firms a rubber stamp, signing off on optimistic expectations to get repeat business. Thad Toups, president ofHaas Petroleum Engineering, says his firm has been fired for reserves estimates a client considered too conservative. “The finance people outvoted the engineers,” Toups says. “There’s just so much competition for capital.”
Independent data providers have swooped in to take advantage of the inconsistencies. Often, they make their own assumptions on future production.Ring Energy Inc., a driller in the Permian Basin region of West Texas and New Mexico, spent much of its first-quarter earnings call with analysts in May refuting the findings of Wildcax, a data shop critical of Ring’s reserve estimates. Wildcax, in its online newsletter, said Ring had reported three times more reserves than it should have. Ring argued Wildcax couldn’t have known enough to make such a call. “It’s extremely difficult to adequately perform a reserve evaluation based on publicly available information only,” Daniel Wilson, Ring’s executive vice president of operations, said on the call.
“Every year we have a small army of professionals, whether it’s third-party engineers, engineers at our banking syndicate, the bankers themselves, our independent and third-party auditors, and our internal auditors that review our information every year, twice a year,” Wilson said. Ring didn’t respond to requests for comment. The company last week said it had its borrowing capacity reduced by $50 million, a much less dramatic cut than many of its peers have recently experienced.
Today, the shale patch is watchingcrude prices inch higher. Some companies will file for bankruptcy. Others will be gobbled up on the cheap. It’s unclear whether investors will return to help drillers make another run at American energy self-sufficiency. “This time the fear is more systemic,” says Jeff Krimmel, who spent his career in strategy and market intelligence at oilfield-service companies until he was dismissed in April. “The shale story is a very powerful story. It would be really, really nice if it worked out.”
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