Monday, April 26, 2010

So What Do You Think About Arthur Berman?

I've gotten that question a few times by email but have been reluctant to answer it.  I was cornered yesterday in person, so I'll tell you what I said, especially in regards to the Haynesville Shale.  First a disclaimer: I am unqualified to answer the question on its technical merits, but I will answer as an observer.

First, it is important to understand what Mr. Berman is saying.  I've read posts that damn him as being anti-shale gas.  I don't think that's true.  As I understand, he is saying 1) producers are understating costs (especially lease acquisition costs) as part of their rosy productions, 2) shale formations are not uniform in geology and are not suitable to be "manufacturing plays," and 3) producers might be overly optimistic about estimating recoveries from shale wells to boost their reserves to be more attractive to investors.  These combine to have larger implications.

Mr. Berman has said that he thinks shale formations are part of the future of the industry, but he believes it will take much higher natural gas prices for them to be economically feasible.  Many have suggested that his conclusions are based on partial data.  But because much of the data is proprietary it is kind of hard to know if he is right from the outside.

To me, the short answer is that the truth lies somewhere in-between. 

It is very hard to make generalizations about the Haynesville Shale.  To begin with, every acre of land was leased for a wide range of lease bonuses, from $0 (HBP) or $150 (pre-Haynesville land rush) to $25,000.  That baseline cost will create very different levels of profitability (or loss) that will vary by the acre.  You can assume an average lease cost of $5,000, as many companies report, but that average cost is misleading because a marginal well on low cost acreage might be more profitable than a boomer on expensive acreage.  One thing is for certain:  the "gold rush" mentality of leasing land at any cost really screwed up the play's economics for producers.

I think Mr. Berman is makes good points about the variability of geology. Just looking at the early production, you can tell where the more fertile areas are.  There are some pretty big changes over short distances, suggesting faults or other geologic factors.  Wells in North Caddo Parish might not be that great, but should they be lumped in with the sweet spots in DeSoto and Red River Parishes?  There are lots of geologic factors that go into determining where the best wells will be, and I think the producers in the Haynesville learned that much faster than the Barnett producers did.  Mr. Berman suggests that there are lots of inconsistent physical features in the shale that prevent a "manufacturing" approach to bring economies of scale to drilling wells.  That may be true on a large scale basis, but I think producers will be successful in mass producing on a smaller scale.  Given the crazy patchwork quilt of leased acreage, I don't think any producer can even attempt a large scale manufacturing project anywhere but in a few parts of the play.

His third point about over-estimating reserves also probably has some merit.  Where I fault Mr. Berman for over-generalizing, the same might be said about some producers.  Making generous assumptions about potential reserves allows companies to book fat reserves, which investors covet.  But it also has the impact of making finding and development costs look low because the bigger the reserves the bigger the denominator in the F&D cost calculation and the lower the F&D number, which gets back to his first point about underestimating costs.  My take is that estimating reserves from shale is a lot different from estimating traditional reservoirs, so the methodologies are still a bit raw and the reserve estimates might not hold as much water as they used to.  Because there are huge implications from reserve estimates, it is not a endeavor entered into lightly by producers (or their auditors).  But it is probably too early to say who is right and who is wrong. 

It will be interesting to see if new production methods, such as restricted choke sizes, aimed at flattening decline curves and improving recoveries will impact Mr. Berman's argument.  Obviously it's too early to tell, but over just the past two years, advances in technology and technique have led to much improved wells, and I don't know if that has been factored into his analysis. 

What is clear is that gas producers have their backs against the wall in the current price environment.  A recent article from Business Week (that quotes Mr. Berman) notes that many producers will not be able to maintain the current pace of drilling at low commodity prices because low commodity prices are suppressing cash flow.  That is an indication that Mr. Berman is right about $4 gas, but that's hardly a stretch.  What about $5 or $6?  I think it will be hard to generalize, but the producers will know which wells are profitable and the answer is different for each one. 

Expect "prudent allocation of capital" to be the buzz phrase this year.  Sure, producers need to drill to hold their leases, but as prices stay low many are going to have to make some hard decisions to cut back capital spending and risk losing expensive leases.

Bottom line: I think Mr. Berman makes some valid points, but I believe his conclusions are very pessimistic based on overly generalized data.  I think he relishes the role of Devil's advocate.  He gets lots of attention and has staked out an area where there is not much competition.  He seems to have become defensive about his position, especially since the situation got personal when he lost his position at World Oil.  There are many people saying unkind things about Mr. Berman, but it would be a mistake to dismiss his position entirely.  Opposing viewpoints are valuable because they test assumptions and temper conclusions.  Plus, you always want to have someone around to call the authorities if everyone is drinking the wrong flavor of Kool-Aid.


Anonymous said...

I have difficulty with seeing his position as reality because he draws data from here, there and everywhere. I would love to know who backs him.

Eric said...

Anonymous...Could you specify the different areas that Art gathers his data from.