A Contrarian View on the Shale Oil and Gas Revolution

If you've ever even briefly perused a financial publication, surely you must have run across at least a few mentions of shale oil and gas and how its growing production is revolutionizing the U.S. economy. Over the past few years, the phrase "shale gas revolution" has become commonplace, with the phenomenon attracting interest from all types of investors from all over the world.

The list of shale oil and gas proponents is long and varied. PIMCO's Mark Kiesel, recently named Morningstar's "Fixed-Income Fund Manager of the Year" for 2012, called advancements in oil and gas drilling technologies a potential "game changer" for the U.S. economy. Prominent energy expert Daniel Yergin has touted the positive impacts of the shale gas revolution on America's manufacturing sector, its balance of payments, and employment. Even Dylan Grice, former global strategist at Societe Generale and usually a go-to source of contrarian wisdom, is sold on the merits of shale gas, writing last year that "shale gas will be as disruptive to the global economy as the Internet was."

But despite an impressive array of advocates, there are also a fair amount of skeptics who argue that the quantity of recoverable shale oil and gas in the U.S. has been grossly overstated. They argue that shale wells suffer from steep decline rates in the first couple of years of production, followed by a sharp drop-off in output over their remaining lives. Do these skeptics have a point or have they been conducting their research a bit too close to the gas fumes?


The contrarian view on shale oil and gas
I don't think it would be a stretch to say that most commentators are sold on the future of shale gas. They expect it to yield tremendous benefits for the American economy, not the least of which is the ultimate goal of energy independence. But as with any topic, there are two sides to the coin.

Now meet the skeptics. In my research so far, I've come across Arthur Berman, who is a principal and consulting geologist at Houston-based Labyrinth Consulting Services, David Hughes, a Canadian geoscientist and a fellow at the Post Carbon Institute, and Bob Brackett, a senior research analyst at Bernstein Research.

Berman is probably one of the most prominent skeptics so, in the interest of time, let's assess his argument. His view, which has been shaped by meticulous analysis of thousands of individual oil wells in the U.S., is that Citigroup's and others' optimistic projections are far too rosy.

He argues that they fail to take into account the rapid decline rates of shale wells, a point he drove home in a presentation, "Oil-Prone Shale Plays - The Illusion of Energy Independence," given at an energy conference at the University of Texas last month.

Shale well decline rates and companies that would benefit
In illustrating how quickly shale wells can be exhausted, Berman used the Bakken as an example. Currently, the prolific formation boasts roughly 5,000 wells in North Dakota that are posting average production of around 143 barrels per day, which comes out to a little over 700,000 total barrels per day. While this level of production is an extraordinary achievement, he argues that it cannot be sustained for very long.

His case-by-case analysis of around 2,500 Bakken wells led him to conclude that, unless a lot more wells are drilled, output would fall by nearly 40% within a year. Assuming this rate of depletion, roughly 1,600 new wells will have to be drilled just for production to stay flat. If we extrapolate similar production profiles for other shale wells in the country, the end result for production by 2020 is strikingly lower - just 1 million-2 million barrels per day according to Berman's calculations.

If he is right, faster than expected declines in U.S. gas supply will likely have major implications for natural gas companies. The combination of falling supply and rising demand could put substantial upward pressure on gas prices, leading to higher profits for energy companies that derive the bulk of their revenues from gas sales. However, operating costs would also rise and could offset the benefits of higher gas prices to varying degrees.

Companies like Chesapeake Energy , as the nation's second-largest gas producer, and Encana and EOG Resources , which derive the bulk of their revenues from natural gas, would likely be affected. And companies like Ultra Petroleum and Southwestern Energy , because they are low-cost producers of natural gas, may actually benefit from a faster than expected surge in gas prices.

Final thoughts
After assessing the arguments of both the shale bulls and bears, I have adopted a slightly more skeptical stance on the future of U.S. oil and gas production. While production has risen rapidly over the past five years, estimates of future production growth are clearly prone to huge biases.

In my opinion, there are so many variables involved, such as the effect of government policies and the rate of advancement in drilling technologies, that it becomes almost useless to project oil and gas production more than a few years into the future.

After all, I'm no geological expert and am forced to rely on experts' calculations. When they say that output from the Bakken shale will reach a certain number of barrels per day by 2020, all I can do is check their assumptions to the best of my ability. If they seem reasonable, I'm usually inclined to accept their calculations in good faith.

But isn't that the wrong thing to do? Isn't this type of blind faith exactly what prevented us from seeing one of the biggest housing bubbles in history? Shouldn't we question where the experts are getting their numbers from and meticulously analyze the fine print?

Just as most observers kept mum when banks created complex financial products that were supposed to diversify risk, hardly anybody questions the logistics of shale oil and gas production. Isn't it worrisome that some of the largest gas producers spend multiples of their operating cash flow to finance exploration and drilling ventures? Isn't it troubling that estimates of shale wells' economic lives and decline rates vary so drastically? Maybe, maybe not. I'm not sure. But I feel it would be disingenuous not to raise these questions.

Luckily, we live in a world with plenty of independent thinkers and contrarians. While we may lack the expertise and data to calculate our own decline rates, we have access to a wealth of information that can help us separate hype from reality.

While I have been very bullish on the prospects for U.S. oil and gas production - as evidenced by my previous articles - I will be sure to pay closer attention to new research that presents a different view. After all, getting both sides of the story is crucial to becoming a better investor.

Energy investors would be hard-pressed to find another company trading at a deeper discount than Chesapeake Energy. Its share price depreciated after negative news surfaced concerning the company's management and spiraling debt picture. While these issues still persist, giant steps have been taken to help mitigate the problems. To learn more about Chesapeake and its enormous potential, you're invited to check out The Motley Fool's brand-new premium report on the company. Simply click here now to access your copy, and as an added bonus, you'll receive a full year of key updates and expert guidance as news continues to develop.

The article A Contrarian View on the Shale Oil and Gas Revolution originally appeared on Fool.com.

Arjun Sreekumar has no position in any stocks mentioned. The Motley Fool recommends Ultra Petroleum. The Motley Fool owns shares of Ultra Petroleum and has the following options: Long Jan 2014 $20 Calls on Chesapeake Energy, Long Jan 2014 $30 Calls on Chesapeake Energy, Short Jan 2014 $15 Puts on Chesapeake Energy, Long Jan 2014 $30 Calls on Ultra Petroleum, Long Jan 2014 $40 Calls on Ultra Petroleum, Long Jan 2014 $50 Calls on Ultra Petroleum, and Short Jan 2014 $20 Puts on Ultra Petroleum. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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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