Attack of the Bakken Strippers

Dirty, low-output strippers. Oil companies racing to pump dinosaur sauce out of shale reserves are spending millions (that’s a lot of singles!) to defeat them. The inevitable fate of oil wells is easy to overlook in the early stages of a domestic oil production renaissance, but all investors should familiarize themselves with strippers. According to Art Berman, a geologist and industry consultant, shale oil well production declines at an average of 40% per year. At that rate it takes a mere six years for most wells to produce just 10 to 15 barrels per day – becoming stripper wells.

Sorry to disappoint.

What’s the significance?

Strippers are detrimental to the efficiency of the oil and gas industry and our economy – and I have numbers to prove it. Here’s a quick look at a 2009 report (opens PDF) from the Interstate Oil and Gas Compact Commission (IOGCC) on marginal and stripper wells:

• Nearly 85% of all oil wells in the United States are stripper wells, which account for 20% of total production.
• In 2009 stripper oil wells cost the United States economy $34.51 billion in lost output, while losses from stripper gas wells totaled $25.83 billion. The total loss from stripper wells ($60.34 billion) could have paid for the entire auto bailout ($25.1 billion) and nearly all government stock purchases ($40 billion) of AIG and Citigroup.
• From 2008 to 2009 stripper oil and gas wells cost the United States economy an estimated 305,000 jobs.

Production will boom in the next decade, but any bump in economical wells (opposite of stripper wells) is doomed to be a short-lived trend. How can we be so sure? This isn’t our first rodeo. Stripper wells are the physical entity behind Hubbert’s Curve, which was used to predict peak oil in the United States in the late 1960’s. Hubbert proposed that a decline in new oil discoveries would be followed by a drop in oil production several years later. One can easily insert “stripper wells” between the logical leap from “declining discoveries” > (insert here) > “declining production”.

Look at this data I compiled from the Energy Information Administration (EIA):

 

 

It is important to note that not all developmental wells drilled turn into full-blown production wells, which is illustrated by our desperation following the 1979 Energy Crisis. Despite a massive peak in developmental wells being drilled oil production flat lined. The key is that it generally takes several years for production to respond to major increases and decreases in developmental well drilling.

Gerbil on a treadmill

Don’t get me wrong, there is tremendous growth in shale oil plays. Hess (NYSE: HES) and Marathon Oil (NYSE: MRO) are just two companies with deep pockets carving up the domestic oil landscape. Increased Bakken production helped Hess tremendously in 3Q12, which I pointed out as a great opportunity back in May. Marathon could return the growth favor this week by beating estimates calling for a modest 10% YOY growth.

Just be cautious when projecting long term growth for shares. Given the amount of wells coming online through 2015 it will be easy to cover-up the 40% decline rates in the near term. The long term is another story. Once startups of new wells begin to decline those gaudy decline rates have enormous headache-potential for investors.

An IMF report (opens PDF) presented earlier this year detailed the rocky relationship between geology and drilling technology. Michael Kumhof, one of the authors of the report, told David Strahan of NewScientist that “we have to do these really expensive and really environmentally messy things just in order to stand still or grow a little”.

To see how this gerbil-on-a-treadmill scenario could pan out simply observe that the 1980 doubling of developmental wells only resulted in a lousy 4.6% increase in oil production years later.

Foolish bottom line

The IMF report takes into account many industry statistics and geological constraints that are usually omitted from reports issued by financial analysts, peak oil advocates, and even the Department of Energy. Thus, it has been hailed as the Goldilocks report – not too pessimistic, not too optimistic – and is a must read for investors.

It is likely that once startups of new wells begin to stabilize or decline a decline in production will follow. That would mean companies currently growing assets in shale oil plays will need to work just as furiously competing for fewer wells just to offset declining production. For instance, Statoil (NYSE: STO) has endured 50% declines in its wells since 2000. As a result, despite recent investments in the Bakken Shale investors have been stuck with 0% gains (excluding dividends) since September 2005.

Will smaller players such as Triangle Petroleum and Kodiak Oil be able to survive a battle over resources with deeper-pocketed rivals? It is still too early to tell for sure, but that doesn’t mean you can’t be proactive. Keep an eye on trends in developmental well drilling as well as cues in the annual reports of companies. Dig yourself into a defensive position now because the Bakken strippers are coming.

Motley Fool