Decline curves are not well understood and, therefore, are a ripe target for fractivists intent upon distorting the economics of shale gas development.
What are decline curves? What do they really mean? Are they important and why should you care? Often the term “decline curve” is bandied about with limited understanding of its meaning or implications.
In this article I will define decline curves and highlight their relevance to operating companies, policy makers, the average citizen and leaseholders. Using some numerical examples from the Marcellus, I will demonstrate why production declines are not a valid argument against drilling for oil and gas.
Defining Decline Curves
Simply put, a decline curve is a graph of crude oil or natural gas production over time. As the resource is extracted from underground, production volumes trend downward, hence the term “decline curve.” While the concept is straight forward, its analysis is more complex. Indeed, a specialty discipline known as “reservoir engineering” uses advanced mathematics and sophisticated software to interpret data. The art is to analyze a limited amount of field data – typically a few months’ worth for a new well – and then project production years or even decades into the future. Production volumes for individual wells are continually monitored, however, and as more data is accumulated, stronger forecasts can be made.
The end result of these computations is a value known as the “estimated ultimate recovery,” or “EUR” in industry parlance. As will be shown, the importance of “EUR’s” for production companies and leaseholders cannot be understated.
Why Are Decline Curves Important?
Decline curves are important for a number of reasons. As noted, these curves provide up-front guidance regarding total recoverable volumes over a long period of time. This establishes the critical resource base not only for individual wells but also for entire geological areas. It’s in everyone’s interest to know potential oil and gas reserves. Specific concerns of individual parties depend on how they may be affected.
EUR’s are critical to energy companies for economic viability, business survival, success levels and stock prices. The industry must risk and allocate billions of dollars to exploration, drilling and production activities. To remain competitive and to provide adequate rates of return, companies drill where anticipated EUR’s are highest. To see the context in which security analysts use decline curves and EUR’s when evaluating companies and regions for investment purposes, click here and here. EUR’s are a critical part of all oil and gas companies’ financial statements. They are the foundation of a firm’s inherent value and developed with great effort and care.
Decline curves and resultant EUR’s can be important in decision making at all levels. U.S. oil and gas resources and production forecasts have enormous implications for global geopolitics, balance-of-payments and industrial competitiveness. State governments must deal with issues such as taxes and job creation. A host of issues confront local governments including zoning, road maintenance and business development. All of this affects the average citizen regardless of whether they are familiar with the concept of decline curves.
Decline Curves and the Marcellus Leaseholder
Why should decline curves and associated EUR’s concern a local leaseholder? In a nutshell: money – how much, when and for how long.
The good news is that a Marcellus shale well will produce economic volumes of gas for thirty or more years. This is due not only to favorable geology but also to the fact that natural gas is highly compressible. As product is brought to the surface, more literally fizzes out of the shale, much like the bubbles in a glass of soda. The liquid crude oil found in other areas, on the other hand, is incompressible. This generally results in steeper declines and shorter well life.
Actual data from the prolific Northern Tier region of Pennsylvania shows individual wells with typical EUR’s of 5, 10 and 15 billion cubic feet (bcf), with some higher. The variability stems from location, localized geology and operator techniques. At a cost of about $6 million per well, it is obvious why drillers strive to maximize production volumes.
More good news is that each single acre in an average EUR area of the Marcellus will likely generate a lifetime royalty of about $40,000 (more on this later.) Leaseholders must realize, however, that payments are heavily front-loaded. After a year or so, monthly royalties will begin to decrease significantly. In fact, half the total royalties will likely be paid out in the first few years of production while steady, smaller payments will continue for decades longer.
Thus, it is in a leaseholder’s interest to have a basic understanding of EUR’s to estimate the resource base and potential total royalties. Moreover, it is essential that the concept of a decline curve and diminishing payments be taken into account for financial planning. Excessive and ill-advised spending early on could lead to money problems down the road. A recently released Penn State royalty calculator provides an excellent tool to understanding declines, EUR’s and cash flows over time.
Let’s face it – if you own property in the Northern Tier where drilling is permitted and there’s a well in your backyard – you’ve won the lottery. With the State lottery, though, the touted amount is actually an annuity paid in equal installments over the course of twenty-five or more years. Most winners choose the immediate lump-sum option despite the large discount to the face value. With gas royalties, as noted, about half the total amount will be paid in the first few years and the remainder spread out.
Looking at it this way, nobody should complain about receiving more funds sooner. But given human nature, it will be disappointing to see one’s royalty earnings decline significantly over the first few years. Wouldn’t we all like to see those early big checks continue indefinitely? Alas, that’s just not the way nature and compressed natural gas work in the physical world – but with sensible planning, leaseholders can benefit enormously.
Decline Curve Scare Tactics Debunked
How many times have I heard that decline curves are steep so we shouldn’t drill? Or that we will need to run faster just to hold even? These red herrings miss the critical point – that it’s the cumulative resource available that is essential, not how fast or slow it’s extracted.
To debunk these specious claims, we’ll examine our Northern Tier Marcellus. I’ll be using some general, rounded numbers to make the calculations less cumbersome. The arguments, though, are no less valid. Please follow me as I perform some simple calculations. I’ll prove that the total resource base in the Marcellus is more important than the speed at which the natural gas is extracted.
Here’s the myth that anti-development folks dredge up from time-to-time: drilling is self-defeating because of steep decline curves. In this argument, they conveniently omit the magnitude, or EUR, of the resource being tapped.
Let’s use some real numbers then, and see what happens to this myth.
Several years of actual hard, incontrovertible data from the Northern Tier show EUR’s per well of 5, 10 and 15 bcf. A number of wells are indicating even higher EUR’s as advancing technology improves results. That being said, in this example we’re going to use a round EUR of 10 bcf. Currently, four wells per square mile are drilled on average, or one for each 160 acres. If we use a reasonable price of $4.00 per thousand cubic feet (mcf), each well will generate $40 million in revenues over its lifetime. If farmer Bob has a 160 acre spread and a typical15% royalty rate, he’ll receive $6 million in front-loaded royalties. Happily, farmer Bob will get to keep his property, buy new equipment, donate to worthy causes, take a well-deserved vacation and pass the family farm to his heirs.
Now let’s look at the larger picture to debunk the decline-curve-anxiety myth.
We’re creating Gasford County, which happens to be a handy 1,000 square miles in size. With our typical drilling density of four per mile, 4,000 drilling sites exist. Now the numbers start to get big – each square mile of surface area will produce $160 million in total revenues. Total potential in all of Gasford County is a staggering $160 billion, with a “b.” At 15%, $24 billion in royalties will be paid to landowners.
“Fantasy” say the anti-drillers who refuse to acknowledge EUR’s backed by years of hard, incontrovertible data. “Those declines will set in,” they assert.
Yes they will – but let’s see if a problem really exists. To do this, we’re going to perform a thought experiment in which we bracket the hypothetical extremes and calculate what happens. At one end of the spectrum, we’re going to generate an admittedly unrealistic 100% decline where our typical 10 bcf EUR well is depleted all at once. At the other extreme, we’re going to have an equally unrealistic zero percent decline, with a rock-steady production of 1 million cf/d per well. After 10,000 days, or 27+ years, our EUR of 10 bcf will be exhausted, and production will terminate. (Remember, this is a thought experiment.)
A target production of 4 bcf/d would be reasonable in Gasford County given its size and resource base. With our 100% decline rate, each well would immediately yield its 10 bcf of gas. Therefore, one well would need to be completed each 2 ½ days to achieve our desired production level. (That is, 10 bcf per well divided by our production target of 4 bcf/d.) That sounds like a lot of wells, nearly 150 per year – is this rate achievable? Why yes, with only ten modern rigs since each can readily complete a well in three weeks. Gasford would then happily produce a constant 4 bcf/d for 27 years (4,000 sites divided by 150 wells per year), at which time all the gas runs out, the rigs depart and production ceases. Total production would amount to 40 trillion cf.
Let’s now use the same ten rigs in our world of zero percent declines and our level production rate of 1 million cf/d per well. With identical well completions of 150 per year, at the end of the first year, we would see a production rate of 150 million cf/d. Each year would add the same amount, and after 27 years of slow but steady increases, our production target of 4 bcf/d would be attained. At this time, all 4,000 wells sites would be drilled and the rigs would depart. This 4 bcf/d level would prove only transitory, however, as the first wells drilled decades earlier would finally be running dry. In fact, it would take another 27 years for residual production in Gasford to finally dwindle to zero. Our zero decline case results in a fifty-four year process in which the same 40 trillion cf is produced.
By constructing these hypothetical extremes, I show that a 100% decline curve taps the available resource more quickly and efficiently than a zero decline. Results in the real world, of course, lie in between. What actually occurs is a reasonable financial composite of front-loaded revenues followed by a longer-term income stream. Thus, decline curves are not the catastrophic construct made out by the anti-drilling crowd. Clearly, citing these curves is not a valid argument against tapping the abundant natural gas and crude oil resources with which the nation is blessed and made prosperous.
Summary and Conclusions
Decline curves and associated EUR’s are fundamental to understanding and quantifying the hydrocarbon resources in any given geological area or for any individual well. Moreover, analyses of these parameters are critical in the allocation of billions of dollars in capital expenditures associated with exploration and production activities.
Policy makers at all levels must understand the nature and magnitude of hydrocarbon resources to make informed, intelligent decisions. Citizens, too, should be generally aware of the revolution taking place in the oil and gas industries.
Importantly, it is essential that all leaseholders – especially ones receiving royalties – understand the basics of decline curves and EUR’s. Otherwise, they may have won the lease-lottery, but wind up mismanaging their windfall.
Finally, to those who are against tapping hydrocarbons due to steep decline curves, please come to the realization that this argument has no merit. It is the fundamental resource base that is most important – and this economic reality is what determines drilling activity.
Note: Photos supplied by Chris Acker. They depict the drilling that took place on his property recently.