Shale Oil Stocks: Investors Question Industry’s Performance

America’s shale revolution grew out of a well-orchestrated dance. For almost a decade, producers wooed investors by touting rosy estimates of how much crude oil they could profitably drill, and investors forked over money. That ended last year, even before the global pandemic sent oil prices tumbling. Investors, after years of meager returns, began demanding that shale companies stop marketing mythical future barrels that would never earn a dollar. There’s still no truly standardized way to gauge how accurately companies count their reserves.

Interviews with five current and former engineers, who spoke on condition of anonymity, describe an ongoing culture that rewards happy talk. Two of the engineers say executives explicitly told them to inflate reserves. Others say the requests were implied, with only engineers who produced aggressive estimates landing promotions. Some say they were fired or saw their coworkers let go because they were reluctant to fudge key metrics.

When investors put money into a shale company, one of the most important things they need to know is the value of the oil the company can get at while still earning them returns. The estimates are more art than science. Shale drilling is still a relatively new technology, and the engineering is complicated. Output from horizontal wells declines faster than production of traditional wells. So-called child wells drilled too close to “parent” wells reduce output. The results can be a minefield for investors, who’ve discovered the hard way that not every company gets it right.

“It’s a classic example of crossed incentives,” says Clark Williams-Derry, an analyst at the Institute for Energy Economics & Financial Analysis. “All the incentives are pointing in the direction of irrational exuberance.”

The U.S. Securities and Exchange Commission requires oil companies to report with reasonable certainty the volume of reserves in wells that are profitable at a price set by the agency the year before. The wells must be drilled within five years of being added to a company’s books. The calculations take into account the rate at which a well’s production is likely to decline, how closely the wells are drilled, land and capital costs, and, of course, price per barrel.

Before the SEC adopted its current reporting rules in 2009, there were a series of reserve scandals that involved Royal Dutch Shell Plc, which the agency fined $120 million in 2004, leading to the exit of top executives, and a few years later El Paso Corp., which settled charges for inflating reserves. Both companies settled without admitting or denying wrongdoing. Since then, high-profile fines and penalties have been noticeably absent, even when insiders have raised concerns. Some analysts are still skeptical of many numbers they see.

“We’ve seen some companies where their public well data is showing that the wells are a lot less productive than what the company originally asserted,” says Noah Barrett, an energy analyst at Janus Henderson Group Plc. “There’s a lot of subjectivity around what actual decline rates will look like over the full cycle of a well.”

Problems with estimated future output have dogged the U.S. shale patch. One company, SandRidge Energy Inc., lowered its reserve estimates in eight of the last 10 years, according to data compiled by IHS Markit, even as the average oil price rose in four of those years.

Executives routinely pressured engineers to increase their estimates to bolster SandRidge’s market value, a former employee wrote in a 2015 memo to company management, which was seen by Bloomberg News. Weeks later the employee was dismissed. Eventually the SEC began an investigation, which SandRidge disclosed when it filed for bankruptcy in 2016. The employee’s dismissal coincided with layoffs, but the investigation found that managers had discussed replacing the whistleblower with “someone ‘who could do the work without creating all of the internal strife.’”

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