Fractional Flow

Bakken, Something About EURs, PDP Reserves and R over P Ratio

Proven reliable methods on the Estimated Ultimate Recovery (EUR) for any well (or other agreed parameter like EUR for the average well of specified vintage populations for plays, fields, companies or other) is crucial to make estimates on remaining Proven Developed Producing (PDP) and Proven UnDeveloped (PUD) reserves which are the linchpins for assets backed lending (reserves-based lending).

Attainable EURs with realistic decline curves are also the foundations for reasonable estimates on future cash flows, which forms the basis for the companies’ financial planning inclusive CAPital EXpenditures (CAPEX) for future well manufacturing.

Reserves-based lending is what the companies depend on to leverage their equities inclusive owners’ capital for loans that together sets the pace for developments of their acreage. These loans often come with clauses about the speed for the drilling of the companies’ area as the lenders want to see their capital returned with a profit within an agreed time frame. These loans come with covenants of various scopes commonly described by financial metrics which the borrowers have accepted to honor.

In this article, I will focus on PDP reserves as there is more uncertainty associated with developments of PUDs in time, price, and cost.

This article is based on a more comprehensive and granular analysis of the average EUR estimates by vintage and developments for PDP reserves and R/P for Bakken than what was presented in the article “The Bakken, a little about EUR and R/P” in August 2016.

A low R/P ratio (index) gives expectations of a steep decline in extraction from the growing population of wells, which results from Light Tight Oil (LTO) wells had steep and now steeper initial declines. The steeper declines also explain why the companies must stay on the treadmill to bring in a high number of new wells to sustain/grow the production and, more importantly, sustain/build their PDP reserves, which are the significant component for reserves-based lending.

This study estimated remaining Proven Developed Producing (PDP) reserves in the Bakken(ND) as of end Oct-19 for the reference case to 1,6 – 1,7 Gbo (Giga, billion barrels).
The PDP reserves are from all the more than 14 000 horizontal wells started from Jan-08 and per Oct-19.
The EURs for the average well of the 2008 – 2019 vintages used in this study are shown in figure SD 6 at the end of this article.
As of the end of Oct-19, the R/P (for Bakken, ND) was estimated at 3,3 (reference case).
A sensitivity analysis adding 5% to EURs for the 2015 – 2019 average vintage wells increase the R/P to 3,5.
This study Juxtaposed the PDP estimates with the PDP numbers from the SEC 10-K filings for 2018 for some public companies that are heavily exposed to the Bakken (more than 90% of their equity/entitlement production from the Bakken).
At the end of 2018, this study found that these companies’ SEC reported PDP reserves were overstated with 30% – 50%.
An independent verification confirming overstated reserves would, for those affected, likely result in a downgrade of their credit rating. A downgrade to below investment grade would have far-reaching consequences as any institutional investors would be forced to sell their bonds into a liquid starved junk bond market, and the companies would be faced with much higher interest rates for debt that is rolled over which eats into their cash flows.
Should several independent and seasoned third parties verify the magnitude of overstated reserves, several LTO companies would be cornered, and the only way to paper over this would be to sweat it out while praying for a significant lasting higher oil price (like $90/bo or higher) soon.
Cornered because any sale of a significant portion of their well portfolio to buyers that have done their due diligence based on actual well data could come up with a much different assessment from the seller’s reserves and asked price based on the seller’s booked value of the portfolio for sale. A realized sale of a significant portion of the well portfolio reflecting the buyer’s offer could highlight that the seller’s booked to model PDP reserves is much lower. A realized sale could force the seller to take considerable impairments, which subsequently would raise questions about the remaining PDP reserves on their books. And as the PDP reserves of one or several companies become questioned, more would follow.
Based on the PDP reserves from this study, it was estimated that each barrel of oil in the ground was burdened with about $30/bo (includes revenues from natural gas) to recover employed capital.
Another way to put this is that each barrel of oil has to netback $30/bo at the wellhead, or gross about $55 – $60/bo at the wellhead to recover employed capital (owners’ capital and debt) and also pay for Plugging & Abandonment. The estimated $55 – $60/bo is to recover employed capital and thus leaves no profit.
Applying simple project economics to earn a return of 7% (for the Bakken as one big project) would require an oil price of $80/bo at the wellhead for the PDP reserves as of end Oct-19.
Management in many shale companies has a performance incentive structure in which production developments has been/is dominant.
For the next 1-2 years, managements of LTO companies will generate and implement strategies that search to balance allocation of available capital to sustain and/or grow their production and reserve base (used for reserved based lending), deleverage and/or pay dividends to a growing number of impatient owners.
To exacerbate this challenge, the banks now have tightened requirements on revolving credit, decreased their loans, and voiced concern that the assets of some shale companies will not cover the loans. This is commonly referred to as balance sheet/accounting insolvency, and if the situation continues, creditors and lenders could force the company to sell assets or declare bankruptcy.
At present oil/gas prices this becomes exquisitely balancing acts as any financial deleveraging and dividend payouts eat into funds that otherwise could be made available for more well manufacturing.
Reducing CAPEX for well manufacturing below some threshold to generate some Free Cash Flow (FCF) comes with some catches, and this is not only from the prospects from a decline in production/extraction and thus operational cash flow.
Changes to the Reserves Replacement Ratio (RRR) is an important parameter to follow and how it affects PDP reserves. Many companies have relied heavily on reserves-based lending, and a significant decline in PDP reserves will, by default, increase financial leverage and may (stress) test some of the loan covenants.
Covenant light loans give less protection for investors. Credit rating agencies flagged problems with these for years, and issues with leveraged loans can happen overnight as it is challenging to see stress building on balance sheets from inflated (oil and gas) reserves estimates.
Realistic EURs and R/P estimates (produced by competent and independent third parties) could become a real game-changer for the future pace of US LTO developments.
In recent years I have come to use the global credit impulse as one of the major leading indicators to predict the band of the oil price one year forward. Back in August 2018, I used the global credit impulse (amongst several other indicators like supply and demand, storage, etc.) to predict the oil price one year forward.
As of now and for 2020, few things suggest the global credit impulse will give support for a material higher oil price. Then throw in the US presidential election in 2020, which now makes me extend my price band of $55 – $70/bo from late 2018 for Brent Spot for this year.
OPEC+ may cut more to supplies to shore up the oil price, but OPEC+ has no control over changes to the global credit impulse, the future strengths/weaknesses to the US$, and developments in affordability amongst the global consumers.
In 2019 an average oil price in the mid-’60s (Brent Spot) triggered protests amongst consumers in several economies. There is a limit to how much higher the oil price for struggling US consumers can rise before it starts to affect consumption. The affordability threshold in recent years has declined with the higher and continued growth in total global debt.

My expectations for the oil price for 2020 are in line with most other analysts, and if that comes true, LTO operators should not expect much financial relief from the oil price this year.

Figure 1 Bakken split produced and PDP Oct 19 — **Figure 1:** The chart above with stacked areas shows the development in total produced (red area) and total Proven Developed Producing (PDP) reserves (blue area) from Jan-08 and per Oct-19 [rh scale]. The black line is the price of North Dakota Sweet (or Williston Sweet) [lh scale].

Figure 1 shows that since early 2015 and through the slow down till early 2017 and per Oct-19, the remaining Producing Developed Remaining Reserves (PDP) for the Bakken has remained almost flat. In other words, reserves were extracted/produced at about the same rate flowing wells were added.

LTO extraction grew from 0,92 Mbo/d in Jan-17 to 1,43 Mbo/d in Oct-19 or close to 60%.

In the same period, PDP reserves grew with an estimated 90 Mbo or about 6%.

The Price of Oil

Crude oil is the world’s biggest and most important traded commodity.

**Figure 1:** The chart shows the oil price (Brent) with some policies/decisions/events. The monetary and fiscal policies of the world’s largest economies, China [red text boxes] and the US [yellow text boxes] and supply events/policies [grey text boxes]. The red line shows the annual moving average of the oil price.

In some earlier articles, like this and this, I explored for relations between the oil price, the world’s credit creation and interest rates.

This is a continuation of my exploration of how the world’s credit creation affects the structural level of the oil price.

I found it now right to repeat one of my formulations from back in 2015:

Any forecasts of oil (and gas) demand/supplies and oil price trajectories are NOT very helpful if they do not incorporate forecasts for changes to total world credit/debt, interest rates and developments to consumers’/societies’ affordability.

As time passes more is learned and more data becomes available which in theory should help improve both the understandings and the sights.

This article presents results from applying statistical analysis (with data spanning more than 15 years) for any relations from developments in total credit/debt from the non financial sectors in 43 countries (in 2017 representing more than 90% of the worlds’s GDP) with data from the Bank for International Settlements (BIS) to changes in the oil price, refer also “Some assumptions, terms and acronyms used in the article” at the bottom.

Developments in total credit/debt is very much related to developments in interest rates, primarily the US Federal Reserve Bank’s (FRB) funds rate (as the US dollar is the world’s dominant reserve currency) which now is expected to be set higher, the London Inter Bank Offered Rate (LIBOR) and the US Treasuries 10 Years rate. A keen eye should also be kept on developments on the now flattening yield curve and exchange rate fluctuations.

It is also important to make good assessments about the abilities to the various balance sheets to take on and service more debt. This helps monitor developments in consumers’ affordability which forms the demand side of the equation.

The structural oil price is formulated from the interactions of fiscal and monetary policies and supply events/policies.
The oil price has shown and will continue to show wide fluctuations. It is the monetary and fiscal policies that give the dominant structural support for demand and thus the oil price (defines the price movements).
Suppliers have little control on demand, but could resort to supply policies to support a price floor.
The price collapse in 2014 was a result of strong growth in supplies, primarily led by debt fueled US Light Tight Oil (LTO) extraction.
The strengthening of the US$ (oil is priced in US$) has now resulted in very high oil prices in local currencies, refer also table 1.
Broadly speaking, it now appears that the world’s non financial sector needs to add $8 – $10 Trillion annually in credit/debt to support growth in the oil price, refer also figure 8.
Estimates based on data from the Institute of International Finance (IIF) and BIS show that in Q1 2018 the world’s total non financial debt was $188 Trillion with another $61 Trillion in the financial corporations, totaling $249 Trillion.
Since 2000 there has been 3 distinct credit/debt cycles for the 43 (refer also figure 7 and 8).
The first ended in mid 2008 with the Global Financial Crisis (GFC) (duration about 7 years).
The second ended with the collapse in the oil price in mid 2014 (duration about 5 years).
The third started about mid 2015 and, as of writing, could be entering its fourth year.
The analysis found strongest correlation (above 0,72) between changes to the 43s total private and public credit/debt creation and changes in the oil price at a time lag of 3 months, refer also figure 10.
- Why this matters? If the world’s credit/debt growth supports the oil price, a slowdown or reversal of the world’s credit/debt creation (deleveraging) should be expected to affect the oil (and energy) prices negatively.
  The results of the statistical analysis show there is an expected time lag of about 3 months from major changes in the world’s credit creation (leading indicator) to changes in the oil price. The correlations were strong with a time lag of 0 – 6 months from changes in the credit creation to changes in the oil price.
  The supply surplus starting in 2014, which collapsed the oil price, appears to be the driver for a period with lower credit creation, which suggest that the lowered oil price temporarily lowered the world’s demand for credit.
Changes in credit creation are the strong leading driver of changes in the oil price.
A simple illustration of the perspectives of the relations of the oil price, interest rate and total debt is now to look at how much the oil price has to grow to have similar effects on the world economy as an increase in the interest rate of 0,25% on the worlds’ total debt of about $250 Trillion, which continues to grow.
An increase of the interest rate of 0,25 % adds $625 Billion to the world’s annual debt service costs. The world now consumes about 30 Gbo/a (crude oil and condensate) which means that an increase in the oil price of $20/bo has about similar effects on the world economy as an interest rate hike of 0,25%. Some major central banks, led by FRB, now plan for more interest hikes and Quantitative Tightening (QT) in the near future.
The above serves as a powerful illustration of the growing competition for how the consumers’ available funds will be prioritized between servicing growing debts or supporting a higher oil price.
Historically, precedence was given to debt service and consumers reduced other (including oil) consumption.

More on LTO Economics in the Bakken

The goal for any commercial company is to make as high as possible profit and returns on invested (employed) capital, primarily the owners’ capital, equity.

Light Tight Oil (LTO) extraction from the Bakken and Three Forks formations in North Dakota had a new high of 1,17 Mbo/d in Apr-18 according to data published in Jun-18 by the North Dakota Industrial Commission (NDIC).

This article is an update of this (which has more details on specific costs to which there are small changes) and is a small expansion focused on profitability/financial metrics.

Scenarios were run there no wells were added as of Jan-19 (in the Bakken, Three Forks formations) with an initial flow above 1,2 Mbo/d to get estimates on NPV (DCF) and returns for the project and on equity (owners’ capital), ROE and ROI with a sustained oil price of $60/bo and what oil price would provide the project with a 7% return (ref table 1).
All at the wellhead (WH).
These runs had cut off end 2040.
The objectives with such scenario analysis is to establish baselines from which it becomes possible to follow developments in several financial metrics, also adjusted for oil price movements.
Applied to companies, it provides for benchmarking of companies’ management performances.
At $60/bo (and $2,50/Mcf for natural gas) the Bakken project would return about 4%.
A 7% return was obtained with a sustained oil price of $73/bo (and $3,00/Mcf).
- The above estimates do not include costs for acreage, 800 Drilled UnCompleted (DUC) wells with an estimated total cost (employed capital) of $2,0B – $2,4B, any refracking (ref Marathon), flared gas and future costs for Plugging & Abandonment (P&A) for about 12 000 wells started as of Jan-09 to end 2018, estimated at a total cost of $1,8B – $2,4B and recognized write downs.
Including the items described above, the estimates show a full cycle return of 7% for the Bakken as one big LTO project would be achieved at a sustained future oil price at about $80/bo [$90/bo WTI].
One of the best and most reliable metrics for investors are NPV projections for Equity (Owners’ Capital).
A NPV projection for equity that comes in at about 0 with a discount rate of 10% (the higher the better) is considered acceptable (reference also tables 1-5).
This metric allows comparisions across sectors.
A run was done to estimate the effects from pushing back the time from where no wells were added with 5 years (from 2019 to 2024) while remaining close to cash flow neutral (all other things kept equal). This reduces the return for both the project and equity (owners’ capital).
The discounted return on equity (owners’ capital) was lowered from 14% to 10% with $73/bo at WH.
Alternatively a higher oil price is required to achieve some targeted return.
By applying financial leverage in the extractive industries, like oil extraction, it allows to extract the reserves faster (accelerate the depletion). In the Bakken the use of high financial leverage explains the rapid buildup in extraction levels.
In this article financial leverage expresses the ratio of debt [inorganic funding] to equity [owners’ capital] used in a company’s investment.
When financial leverage works, it boosts return (acts as a multiplier) on owners’ capital.
If it does not work (what many companies painfully discovered after the oil price collapsed in 2014), leverage works fast in the opposite direction and destroys owners’ capital.
- From companies’ SEC reports it was found that there is a huge span in their financial performances in the Bakken, one major big oil company has lost all their equity of $4+Billion [in the Bakken], one was found to have big negative retained earnings (accumulated deficit) of $2+Billion and then there are several companies on trajectories towards varying degrees of profitability.
The 3 years, 2015-2017 with the oil price under $50/bo left primarily the wells of the 2014 – 2016 vintages (ref also figure 2), suffering from the low oil price, and it is now projected these vintages could incur total losses (write downs) of $6B – $8B with a sustained oil price of $60/bo.
These losses are and/or will be recognized on the companies balance sheets (equity, reduced owners’ capital) as the wells end their economic life and are Plugged & Abandoned (P&A).
- Older vintages and future wells could fully or partially make up (cover) for these losses from their profits at a sustained oil price of $60/bo. A lasting oil price above $60/bo speeds the healing.
  Irrespective of a future higher oil price and how this probable loss is handled by the oil companies, the 2014 – 2016 vintages will for many years provide strong headwinds to the profitability for many companies in the Bakken.
  This is one of the many things that is hard (close to impossible) to identify from the companies’ SEC filings.

This post includes some estimates with some profitability metrics for the average 2017 vintage well for 2 price scenarios and how a company with solid finances and strong discipline can boost discounted return on equity.
This also illustrates why project NPVs, undiscounted cash flows, time to pay outs, ROE and ROI may be poor metrics when analyzing and ranking several projects and/or companies.
Short story, several metrics should be estimated and compared to get the best possible information about the prospects for financial profitability for any project/company.

Figure 1 Bakken annual NCF and Cumulative 2009 to Apr 2018 — **Figure 1:** The chart above shows the estimated net cash flows by year [black columns]. The red area shows the estimated cumulative net cash flow since Jan-09 and per Apr-18. LOE, G&A and interest rates (effective, i.e. adjusted for tax effects) based on a weighted average from several companies’ SEC 10-K/Q filings. Taxes according to what was in force. Price of oil, monthly North Dakota Sweet (NDS) and realized gas price; the average from several companies’ quarterly reports.

NOTE; the chart in figure 1 shows an estimate (red area) on the development of total capital employed (equity and borrowed) (as from Jan-09 to Apr-18) that first needs to be recovered before profits can be made.

The payouts were reached late 2022 at $60/bo and late 2021 at $73/bo.

The chart does not give any indication about future profits or losses.