There's something odd about the U.S. oil production boom.
Yes, the U.S. is now a player on the world energy stage, producing enough to strike fear into the hearts of OPEC's member states. Crude production in the U.S. has practically doubled in just 10 years and is now approaching the production levels of OPEC's leader: Saudi Arabia.
US Crude Oil Production data by YCharts.
That the shale revolution changed the very fabric of the American oil industry is an understatement. Until the ability to frack rock and drill horizontally came along, U.S. oil production had been on a slow, downward slog from its peak in the early 1970s. Now, the sky is the limit -- with the president of the United States calling for U.S. energy independence.
Could the sun be setting on the shale revolution? Image source: Getty Images.
But according to researchers at the Massachusetts Institute of Technology (MIT), there is something very wrong with these calls for ever-expanding U.S. production. In fact, the party may be over far sooner than anyone can imagine.
What happens when you assume
Oil producers and investors have lots of data sources. Geologic data, core samples, and estimates put together by experts are all on the table in the search for crude. One of the primary data sources for all stakeholders is a government agency: the U.S. Energy Information Administration (EIA).
The EIA is the entity that puts out weekly oil supply and demand data, as well as the all-important oil and petroleum oil inventory statistics. The agency also puts out longer-term projections for oil production in the U.S. At present, the EIA's forecasts for long-term U.S. oil production growth are pretty bullish:
Naturally, something as big as the shale revolution calls for some research.
The two MIT researchers, Justin Montgomery and Francis O'Sullivan, dove into the data behind the EIA's long-term estimates. What these inquiring minds found when they analyzed the EIA's data left them scratching their heads.
They noticed that the administration was being aggressive in its assumptions of well productivity. The shale revolution is, at its base, built on bringing advanced technologies to an old business. In its reports, the EIA assumes the average productivity of individual wells will continue unabated.
As the well-known investing caveat goes, past performance is not indicative of future results. And yet that is precisely what the EIA is banking on.
To critique the EIA's estimates, Montgomery and O'Sullivan dug into the data on ground zero of the shale revolution: North Dakota's Bakken deposit. North Dakota has been one of the significant beneficiaries of the shale revolution. Oil that was once thought to be impossible to produce burst forth.
But by tweaking the EIA's assumptions using well data from the Bakken, the two researchers found that production from new wells could undershoot the EIA's estimates by a wide margin -- as much as 10%. How soon? By 2020, just three years from now.
All the more interesting, the EIA couldn't dispute the researchers' questions. When queried via email, an EIA scientist in charge of oil, gas, and biofuels exploration and production analysis, Margaret Coleman, granted that MIT's study raised valid points.
So are we back to importing most of our oil?
In the EIA's defense, when dealing with something so complicated, some underlying assumptions are inevitable. In her response, Coleman pointed out that few oil fields have the detailed well data that MIT used to question the EIA's estimates. This raises a fair question: What should the EIA do in the absence of academically acceptable data?
The other criticism of the MIT researchers report has, no doubt, already occurred to the reader: Don't bet against technology. Technological advances often come out of nowhere to change the world. Who's to say profit-seeking oil companies won't wrench ever-increasing amounts of oil out of the ground?
Yet Montogomery and O'Sullivan point out that many shale drillers have increased productivity over the past three years by focusing on "sweet spots" -- not true efficiency gains. This is an intriguing idea and suggests it might be worth focusing on the shale drillers that truly have an edge up on the competition.
What it means for oil stocks
To recap, MIT researchers have found the EIA's future estimates of U.S. crude oil production problematic. Essentially, the EIA assumes technological advances will continue to make individual wells more and more productive. The problem with this is twofold:
- What if these advances never come?
- Well productivity compounds over time. A slight error in the actual change in well productivity today means a massive swing down the line.
The implications for oil and natural gas stocks couldn't be more significant. This is their bread and butter. Should the EIA prove wrong, and the MIT researchers correct, it would be extremely bullish for oil prices. But an unfortunate fact arises: High prices won't do shale producers any good if there's less and less oil for them to produce.
Oil stock investors, like shale oil, are between a rock and a hard place.
The best way to play such an environment is to focus on oil companies with abundant reserves and low production costs. Names like Diamondback Energy, EOG Resources, and Apache Corp. all come to mind. International names like Royal Dutch Shell and Noble Energy, with reserves outside the shale patch, also stand to benefit mightily from rising oil prices should U.S. oil production estimates come up short.
