Let’s back up a step and review some terminology. An oil resource describes the total amount of oil in place, most of which typically can’t be technically or economically recovered. For example, the Bakken Shale centered under North Dakota may contain several hundred billion barrels of oil (the resource), but what is economically recoverable may be less than 10 billion barrels. The portion that is technically AND economically recoverable is the proved reserve. Because of the requirement that the oil be economically recoverable, proved reserves are a function of oil prices and available technology.

While the most recent estimate from the EIA is that there are 3.2 billion barrels of proved reserves in the Bakken, that reserve would have to be written down to essentially zero if oil prices fell and remained depressed. This is an important point often missed when an oil or gas company, for example, has to write down reserves. There is often a misinterpretation that the company failed to find oil or gas where its geologists thought it existed, but more often it’s that the oil or gas that is there requires a higher price before it can be classified as a proved reserve. Another way to think about it is that proved reserves are much larger with oil at $100/bbl than they are when oil is $50/bbl. So if oil and gas prices fall, companies may have to write down proved reserves (and vice versa).

To illustrate, according to the 2013 BP Statistical Review of World Energy, US proved crude reserves were 30.7 billion barrels at the end of 2002, when oil prices averaged around $25/bbl. Over the next 10 years, the US produced 27 billion barrels of oil — 88 percent of the 2002 proved reserve — and yet at the end of 2012 the proved reserves had grown to 35 billion barrels (with oil prices over $100/bbl). What happened? The shale oil boom happened, enabled by much higher prices and improved technology, and oil resources in North Dakota and Texas turned into proved reserves at the higher prices.

But the oil in the Monterey Shale was never in the proved reserves category. It is a case where there is a potentially big resource, but the geology is much more complex than in the Bakken or Eagle Ford. As a result California has not enjoyed the shale oil booms underway in North Dakota and Texas.

Between 2002 and 2012, California’s proved reserves actually declined from 3.63 billion barrels to 2.97 billion barrels. Over that same time frame, North Dakota’s proved reserves ballooned from 342 million barrels to 3.76 billion barrels (again, “resources” became proved reserves as fracking made production economical), while Texas’ proved reserves went from 5.02 billion barrels to 9.61 billion barrels.

Why is the Monterey Shale different, and why were estimates slashed? The original estimates for the Monterey Shale assumed that the oil would be as easy to produce as it is in the Bakken or the Eagle Ford. In those locations, the resource is relatively horizontal and layered, so a drill can be turned to drill a horizontal well 5,000 to 10,000 feet in length. The Monterey Shale layers have been bent and fractured by California’s seismic activity, such that the 2 mile horizontal wells in the Bakken don’t translate to the Monterey. As oil companies gathered experience in the Monterey, it was recognized that it would be no Bakken — at least not with oil at current prices.

Many of the narratives in the wake of this revision pointed fingers at “the oil industry” for the inflated estimates of the oil held in the Monterey Shale. But guess who has been warning for years that the Monterey estimates were inflated? Actually, the oil industry.

One has to keep in mind is that the “oil industry” is not a unified, monolithic entity. Chevron (NYSE: CVX) has a major presence in California (it’s also headquartered there), and is among those who have long expressed skepticism at the Monterey’s potential. In a statement for CNBC story on the Monterey Shale more than a year ago, Chevron wrote “Chevron does not see the same level of promise in the Monterey Shale as other companies…we have not been encouraged by the results of the wells we have drilled into the formation.”

There is an important lesson there. No all oil companies are the same, and one has to be careful of painting with a broad brush. Some oil companies are overleveraged. That doesn’t extrapolate to the conclusion some have made that the shale boom is built on a house of (credit) cards. Some companies are investing far more than they will recoup any time soon, and some will have negative free cash flow for several years. These companies need prices to remain high, and for production to continue expanding. But that isn’t universally true. There will be winners and losers (and that includes countries, some of which have huge shale resources but either challenging geologies or insufficient water for fracking).  

So I wouldn’t be so quick to dismiss the shale boom on the basis of the Monterey revision. In contrast to the downsized estimate for Monterey, last year the US Geological Survey (USGS) more than doubled its estimate of recoverable oil in the Williston Basin (home to the Bakken) on the basis of field results — the same process that led to the downward Monterey revision. Was this widely reported by those who are now gleefully calling the shale boom a myth? If not, I would argue that they aren’t being entirely objective, and are falling victim to confirmation bias.

Yes, this shale boom will inevitably end. And yes, we still have to keep in perspective that oil is a depleting resource, and we need to continue to plan for the ultimate depletion of that resource. But we also have to acknowledge reality. It’s not a myth that since 2008 US oil production has been rising at its fastest rate in history. It’s not a myth that North Dakota has had a 10-fold increase in oil production in 10 years, or that Texas oil production has gone up by nearly 2 million barrels per day in four years. If you have shunned shale oil and gas companies because you have been convinced that this boom is a myth, you have missed out on a lot of very real opportunities.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Updates

Peddling Ignorance on Rice  

There’s nothing like stringing two sensational and unrelated stories together to make a bogus point. If you extrapolate from the largely irrelevant Monterey Shale estimate to the working shale basins around the US, why not also tie in long-standing concerns about the borrowing by drillers in these basins to make the entire oil & gas industry seem like a scam.

That’s just what Chris Martenson, who describes himself as “an economic researcher and futurist specializing in energy and resource depletion,” has done on his Peak Prosperity blog. He took the hyperbolic coverage of Monterey news and married it to a nearly-as-hyperbolic recent Bloomberg News story about borrowing by shale drillers to warn investors of a rapidly dimming outlook:

The best plays were tapped first, not by some accident of technology or lucky holes plunged into the ground, but because they were cheapest to prosecute. The remaining shale deposits are less rich, more costly to explore, and the profitable pockets much harder to find.

Your main take-away is this: the US has a lot less shale reserves on the books today than it did yesterday. Look for future downward revisions as the other remnant shale plays are poked and prodded and found to be wanting.

Investors need to be wary here too. The hype about shale prospects are wedded to a Wall Street cheap capital machine that is showing clear signs of over-heating.

Martenson then threw in a quote from Bloomberg about Rice Energy (NYSE: RICE), one of our better performing Aggressive Portfolio holdings, planning “to spend $4.09 for every $1 it earns in 2014.”

“When you are spending $4 to earn $1, somebody ought to be asking some hard questions. Especially the investors,” Martenson concluded.

Investors should indeed ask the hard questions, and dismiss Martenson as a result. He seems to know little about Rice, its history or the economics of the Marcellus and Utica basins where it operate.

Here are some relevant facts:

• In contrast to the rather academic argument over Monterey’s ultimate resource, government geologists have consistently underestimated Marcellus production, revising near-term estimates higher in response to strong production data

• Rice was among the earlier lessors in the Marcellus and the Utica, so that the acreage it holds is not some leftover but widely considered some of the choicest in the core of these plays

• One reason it’s viewed that way is that, in stark contrast to the Monterey, the shale Rice is fracturing is especially uniform, allowing the company to efficiently drill many long horizontal wells without much variation in their output

• Because Rice is in the early stages of its development program, it’s naturally spending way more than what it’s earning from its few producing wells, which tells us nothing about these wells’ economics

• Rice is targeting triple-digit rates of returns (meaning its wells could pay for themselves in as little as a year.) During the most recent quarter it sold its natural gas for five times what the cash production cost per unit. Given these fundamentals, how much would you borrow at 6.25% per annum to drill on similarly promising turf? Answer: as much as you could

Oil & gas prospecting is a risky business, the depletion rates of the new shale basins remain subject to informed guesswork and, as Robert points out, leveraged explorers like Rice need energy prices to stay high to deliver on their promise. Nevertheless, early returns have been promising enough to boost Rice shares 26 percent since our Feb. 13 recommendation. The Monterey is entirely irrelevant here. Buy RICE below $33.

To Russia With Rigs

It seems like only yesterday (it was actually last month) that we were trying to talk subscribers out of selling Seadrill (NYSE: SDRL) below $33 a share. Now it’s back above $37 as investors reassess recent concerns about a soft spot market for offshore rigs in light of resilient crude prices and the oil industry’s long-term imperatives.

Today’s early 2 percent gain comes in the wake of an announcement that the company’s North Atlantic Drilling (NYSE: NADL) subsidiary will become the preferred supplier of rigs to the Russian state-owned giant Rosneft for exploration in the Russian Arctic, and the recipient of a significant but as yet unspecified equity investment by Rosneft.

Rosneft CEO Igor Sechin went so far as telling a Russian TV channel that his company could eventually acquire a 50 percent stake in Seadrill itself, according to Reuters.

This is a coup for Seadrill founder John Fredricksen, the Norwegian billionaire’s reward for attending the St. Petersburg Economic Forum even as Russia foments disorder in democratic Ukraine. But it also underscores the long-term imperative to drill for oil offshore as the old fields on land, including those in Russian Siberia, gradually run out of crude.

Despite the recent rebound, Seadrill shares continue to yield more than 10 percent at the current dividend rate, which the company has promised to maintain at least through the end of next year. So investors are getting paid well to wait for the probable revival in global offshore drilling demand. Buy SDRL below $50.

— Igor Greenwald