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The “Granddaddy” of Shale Formations Just Got Profitable Again

by | published June 11th, 2010

You probably won’t see California on a list of places to find new oil.

After all, the Western state has been producing and exporting crude for more than a century. Only six years after Colonel Drake’s famous first U.S. oil well, in northwest Pennsylvania, a company called Union Matolle began to extract crude from California’s Central Valley. By the 1920s, when the huge Signal Hill field south of Los Angeles came on-line, California was leading the world in oil production.

Ninety years later, overall production from traditional fields is declining, dropping by almost double-digit percentages each year. Volume is less than half what it was just a few decades ago.

California remains the third most productive state in the country, but it is a mature oil region – for that matter, so is the whole country. More exploration and development has taken place in the U.S. than anywhere else on Earth. But when over 60% of national daily production comes from stripper wells – which produce less than 10 barrels a day and require considerable artificial lifting just to stay in service – it’s no wonder we’ve become ever more dependent on foreign sources.

But don’t give up on domestic oil just yet. Because a revitalization of drilling is taking place in the Golden State, and it is aimed at the granddaddy of all formations…

The Monterey Shale: 500 Billion Barrels We Won’t Need from the Middle East

Rather than seeking out huge new fields – an unlikely prospect in an area already so thoroughly studied – production companies are tapping into the foundation of the state’s entire oil largesse.

The Monterey Shale is the source rock for much of the state’s production. Shaped like a rib, it extends from northern California down through the Los Angeles area, offshore, and onto outlying islands. The Shale is a motley mix of everything from folded mud deposits to highly dense “chert” (flint-like stone almost impossible to drill through in some places). Of the hundreds of deposits discovered to date, no two are exactly alike. That makes extensive drilling plans difficult.

But there is some major upside making it well worth the trouble.

Geologists estimate between 350 and 500 billionbarrels of oil equivalent (crude oil and natural gas) can be extracted from the Monterey Shale with current technology. With everybody looking onshore today for volume and reappraising the energy mix after the BP Gulf of Mexico disaster, this is quite significant.

Oh yes, and it is also domestic, meaning every barrel that comes out of the Monterrey is one less barrel of foreign oil reliance.

Unlike other shale plays I have talked about here, such as the Marcellus, the Monterey is primarily oil, not gas. Companies can extract a good amount of that oil using simple vertical wells, rather than the more expensive horizontal drilling needed for shale gas plays. (Some horizontal, or directional, drilling will be used, but it is not required in all fields, greatly reducing operating expenses.)

Also unlike shale gas, Monterey shale does not require hyrofracturing – the high-pressure injecting of several million gallons of chemically-laced water downhole to blast open the rock – a great reprieve from the environmental concerns over toxic flowback.

Wells are averaging 2.5 million barrels in the South Ellwood offshore zone and between 400,000 and 1 million barrels onshore. Pay zones (where the oil exists within the rock) are also wider, measuring on average 200 to 300 feet in depth, and the shale formations are thicker than those found elsewhere in the country. That translates to more oil per acre.

The Monterey Shale was certainly known for some time; it has been developed in small volume since the end of the 19th century. The downside has always been the rather anemic recovery rate – only about 10% of the crude available per well.

However, a breakthrough came in 2005. The Department of Energy sponsored a demonstration well using a new process called Managed Pressure Drilling (MPD). The air-injection system comprising the basis of the MPD approach allows use of the “California cocktail,” the conventional acidized drilling mud widely used throughout the state to release oil in large amounts.

Estimates now put lifting costs for wide new areas of the Monterey at less than $10 a barrel. With crude oil again moving toward $80 a barrel and beyond, profit projections back in California are becoming more and more impressive.

The introduction of technology like MPD is important in another respect, too. With deeper pay zones, the improved drilling methods are allowing the lifting of a greater amount of the available crude without increasing operational costs. In fact, the deeper the pay zone, the lower the overall lifting cost per barrel.

No surprise, then, that the Monterey Shale is attracting some heavy interest and some very appealing companies.

Two Ways to Profit

Leading the pack is Denver’s Venoco Inc. (NYSE:VQ), a small producer already extracting from the offshore South Ellwood fields in the Monterey, with big plans to expand into onshore production. It is currently working at 22 deposits and has begun a large-scale development project. The company has 300,000 acres under lease and in excess of 10 billion barrels available for extraction at its current sites.

And here’s what makes it really attractive: In the teeth of a strong bear market over the past month, VQ share value has increased 26%. That value has also risen 46% over the last six months and 92% over the past year.

The main company in the rush to the Monterey will be a larger dominant regional producer – Los Angeles-based Occidental Petroleum Corp. (NYSE:OXY). Having established a major presence in Kern County – part of the Monterey Shale play or just adjacent to it, depending on whom you talk to – OXY is about to phase in a broad development strategy.

The company has been unusually tight-lipped about its plans. However, two things are known. First, embarking on an energetic leasing campaign, it now has over 1.2 million acres in the Monterey. And second, according to internal company estimates, OXY will spend $6.3 billion to develop the acreage over the next four years, anticipating that 25% of its California production (about 56,000 barrels per day) will come from the shale by 2015.

One final point of interest to investors who are looking for domestic oil production opportunities (and aren’t we all?). Present estimates of how much oil is extractable from the Monterey remain based on log calculations – data retrieved from well characteristics and used as the basis for initial lifting estimates. On the other hand, actual production tests by VQ and others are getting volumes greater than the logs predicted. That indicates a higher upside potential for overall extractions and a greater bottom line impact.

Seems the more we look elsewhere for oil, the more we end up right back home.

Kent

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