Shale plays are ideal for oil and gas companies that need to limit risk in countries with a history of political and economic instability and poor respect for private property. The ability to manage political risk, coupled with a world class resource, explains why international oil firms are showing strong interest in the shale resources of Argentina’s Neuquen basin, despite the country’s record of political and economic unrest, serial default, and expropriation of foreign property.
The cash flow profile of a shale play like Neuquen makes it far less dangerous than a megaproject like Kashagan in the Caspian Sea or a deep water play off the coast of Brazil, Russia or Mozambique. In general, political and economic risks are maximised when there is a long timeline between the commitment of capital to the project, recovering the costs from production revenues, and finally securing an appropriate return for investors.
The longer the delay between capital commitment and payback, the more time there is for the external political and economic environment to change in ways which are unfavourable to the project. For a complex megaproject, like Kashagan, investors can be forced to wait years, even decades, before seeing a positive return. But for a shale project, the breakeven period on a well is shorter, and can be as little as 12-18 months.
FASTER PAYBACK PERIOD
Shale plays generally involve drilling hundreds or even thousands of wells to drain oil and gas from a continuous deposit extending over thousands of square miles, rather than sinking just a small number of wells into a discrete oil or gas accumulation. Because shale wells involve horizontal drilling and hydraulic fracturing, they are more expensive than comparable conventional wells on land, but still much cheaper than wells drilled in deep or ultra-deep water offshore – often in high pressure and high temperature formations requiring expensive specialist engineering solutions.
Shale wells tend to have front-loaded production profiles, with high initial flow rates and then a steep decline. While this is sometimes portrayed as a problem, investors prefer high initial production because it ensures costs are recovered faster.
Moreover, high initial production is often associated with a larger ultimate volume recovered over the well’s lifetime, which is also favourable to the economics of shale drilling. Investors get more money back overall and a higher proportion of the payments arise in the early years.
Unlike a conventional oil field, shale plays can be scaled up or down more quickly in response to changing perceptions about risk and return. If the political environment becomes less favourable, the drilling programme can be halted or scaled back. In that sense, the capital commitment required by a shale play is less “lumpy” and therefore less risky.
Oil and gas projects are subject to a well-defined political risk cycle, commonly called the “obsolescing bargain”. To attract foreign investment and technical expertise into a new and high-risk play, the host government will usually offer attractive terms. But once the initial investment is in place and the project enters the production phase, there is a strong incentive to revise the terms of the project to increase government revenues and reduce the share remaining for investors.
The problem of changing fiscal terms and obsolescing bargains has been well explained by Daniel Johnson (“International petroleum fiscal systems” 1994) and Peter Nolan (“The state’s choice of oil company: risk management and the frontier of the petroleum industry” 2012).
The bigger the project, and the more lumpy the upfront capital investment required, the greater the temptation to revise the terms subsequently. But shale plays require continuous investment in the drilling of new wells, so the terms need to remain favourable or drilling will stop.
Shale plays therefore align the financial interests of the drilling firms and host government more closely than a conventional field or a megaproject.
Shale investments are not entirely without risk. There are still upfront capital costs for seismic surveying and acquiring experience with drilling in the play. Drilling firms must bore dozens or even hundreds of wells before they acquire the necessary know-how to exploit the play efficiently, which represents a sunk investment.
But the upfront costs associated with developing a shale play can be measured in the hundreds of millions of dollars, not the billions associated with many frontier conventional projects, or the tens of billions spent on Kashagan.
For a large international oil company like Chevron, which is active in Neuquen and able to spread investment risks across a broad portfolio of projects, shale offers an attractive balance of risk and reward. Even for smaller independent oil and gas producers, the risks involved in developing foreign shale plays may be manageable in a way that a developing a large complex conventional project might not be.