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Chris Martenson:    Welcome to this Peak Prosperity podcast. I am your host, Chris Martenson. You know, we talk about the Three E’s all the time here, that’s our focus. The economy, energy and the environment. And as you well know, my view is that knowing about where we are in the energy story is more important than tracking the economy closely. The economy is a subset of energy, not the other way around. No energy, no economy. It’s really that simple. Now digging a little deeper we know that it’s the energy returned on the energy you invest that provides the surplus energy upon which every single facet of our sophisticated, technological, mobile and abundant lifestyles depend.

Recently, there have been a number of energy narratives dominating the US and global airwaves that really should not go unchallenged. I am very excited to have today’s guest on because I know of nobody that has been doing a better job of unpacking the complexities and tracking the realities of the oil portion of our energy story. Coming to us from Sugarland, Texas—what better location, right?—is Arthur Berman, a geological consultant with 34 years of experience in petroleum exploration and production. He has published over 100 articles on petroleum geology and technology, made 25 presentations just in the last year to professional societies, investment conferences and companies, and is currently consulting for several E&P companies and capital groups in the energy sector. You might have seen him on CNBC, CNN, or in Platt’s Energy Week, BNN, Bloomberg, in the Financial Times, New York Times, he has been there. Arthur, thank you so much for joining us.

Arthur Berman:       It’s a pleasure to be with you, Chris.

Chris Martenson:    So let’s start with the shale oil narrative. It goes something like this: US ingenuity and technological breakthroughs have unlocked vast amounts of oil. So much that the world supplies are now swamped and in reaction the price has plunged by more than 50%. Saudi Arabia is fighting to preserve market share by refusing to cut production so that they may gain a longer term advantage over US producers. Anything wrong with that narrative?

Arthur Berman:       Well, there is everything wrong with that narrative. Of course everything in that narrative has some basis in truth or it wouldn’t be the storyline that it is. But let’s start with the vast resources of new oil that have been unlocked by shale or tight oil production. You know, if you look at any kind of reasonable assessment of the plays—and there is really only two of them, it’s the Bakken Shale in North Dakota and the Eagleford Shale in South Texas. The Permian certainly is producing a lot of oil, but it is kind of another story we can talk about later. And the reason it is another story is because the reserves just aren’t really there.

But if we look at the Bakken and the Eagleford and we look at the proven reserves that anyone can find on the EIA Energy Information Administration’s website and we look at both the proven and the proven undeveloped, which basically are still not drilled yet, what we find is a big surprise and that is that we have only got something like two years worth of production left given current US consumption. To listen to the kinds of things that we hear on television and the radio and read in the newspapers  you would think we've got decades and decades of production. But the numbers just aren’t that big, Chris. We are talking about 10 billion barrels of oil from all of the tight oil plays. That’s not my interpretation. Those are the published proven, plus proven undeveloped reserves based on the latest information we have.

Well, the United States uses about 5.5 billion barrels of oil every year. So 10 billion barrels from tight oil is less than two years. Those are the facts. We can talk about any other narratives or storylines you want but as far as I’m concerned that is the bottom line. And like I say, I am including the proven undeveloped reserves which have not been drilled and ordinarily my advice to companies is don’t put too much faith in proven undeveloped reserves because a lot of them won’t be there.

Chris Martenson:    And why won’t they be there?

Arthur Berman:       Because they’re not commercial. The way that the Securities and Exchange Commission generously rewrote the rules for booking reserves with the shale players—this was back in 2010—was that you can book anything as a proven undeveloped reserve simply by proximity. So in other words if you've got a track that is within a mile or two of a producing well, you can call that proven undeveloped. Now as we know from all oil and gas drilling, but particularly from shale oil and gas drilling, one location away—which is to say maybe 40 to 90 acres away—is always a big surprise. But a mile away, 640 acres away, you don’t have any idea what is out there because the rock is far from homogeneous. Even when we look at the core, the best areas, the sweet spots if you will of the shale plays, there is tremendous variability between closely spaced wells. That is why I say it is just – it is kind of a crap shoot for those proven undeveloped reserves. We will know when they are drilled and right now it is just a placeholder—a very generous placeholder, I might add.

Chris Martenson:    I think it was 2011 or maybe '12, I am losing track of time, I guess, but I remember reading a presentation by Continental Resources and they were talking about how in the Bakken they were going to do this down hole spacing. They were going to go down deeper into the Three Forks formations and they were going to claim they were going to have up to—I don’t know—20 wells per pad, per section. Do you know what came of that?

Arthur Berman:       Well, I haven’t seen any results that suggest that that is a reality. Here is the problem, Chris, I have seen similar kinds of fairy tales that have been presented for the Permian Basin by Pioneer National Resources and you know, so first, could you do that? Yea, absolutely, you could. I mean the technology exists to do it. Big question: What does it cost? The way these guys draw on their whiteboards and put all of these laterals stacked at different depths makes it look like a piece of cake—literally a piece of layer cake is what they call it. But each one of those wells still costs, you know, in the case of the Bakken $10 million. So you can do it, yea, you can do it. The question is does it make any money? Does it even break even? And that’s the part that is almost never addressed in the narrative that we are talking about. Is anybody even breaking even in these plays, much less making money, and what if they do what they are telling everybody they are going to do which is to drill these tiered multi lateral wells or they talk about infilling on 40 acre spacing or something like that. Again, the question is yea, you can do that but what does that do to your returns? What does that do to your profits? And they never want to talk about that.

Chris Martenson:    I want to talk about this profit side a bit because I have been very confused by what is going on there. So before we get to the actual company profitability maybe you can shed some light on this. With the run down in oil prices, the media was just swamped with various analyses coming from a variety of usually sell-side analysts saying "here is the all-in break even cost for play X, play Y, play Z" so you know they stack all the plays out. I never really understood what was involved in those break even analysis. Can you shed some light on that? When we are looking at those are we looking at truly the all-in, full cycle, self sustaining break even cost? Is this just the per well drilling cost? What are we looking at when we are looking at a chart that purports to tell us what the break even cost of a play is?

Arthur Berman:       Well, that’s the key question, Chris. It is like asking what does it cost. It is easy to say this is what it is. But what is involved? You know, what are your assumptions. Your point is dead on and that is: What costs have been included and what costs have been excluded? I have read all of those silly articles and basically, this is a pattern that we see. We saw it with shale gas when the price of gas dropped from $14 or $15 per thousand cubic feet first to eight and then to six and then to four. And every time the price goes down the companies have another fairy tale for why they are still going to make money or break even on the lower price. Well, we have seen the same thing as oil prices have dropped. When oil prices dropped to 80 we saw you know, a whole stream of articles saying oh well all of these companies can still make money at 80. And then it went to 70 and now they can make money at 70. Recently, I have seen some preposterous articles that say that some of these operators can make money at $20 or $30 a barrel. It’s bogus. The whole thing is bogus.

So what they are doing for the most part is they are just telling you about point forward cost. They are just telling you—if their only costs were drilling and completion, then what price could they break even at? That’s fine. That is a measurement that is useful in some ways because companies have different amounts of debt and different amounts of overhead and differing levels of operating costs and all of that. But if you are really talking about a break even price, at the very least you have to include what are your lease operating expenses? What does it cost to do business out there, you know? You have people running around checking and metering wells and you’ve got royalties and taxes and transportation and gathering. Plus you got a whole company with employees and buildings. I mean yea, that stuff is not free and these oil and gas companies don’t have another profit center to charge it to so eventually it all comes back to the well. And then there is debt. Almost none of these companies have low debt. Most of the independents, their debt is something like 50% or more of their value and they have got to pay interest on that debt every month just like you and I do on whatever loans we have.

Now you factor all that in and what you find is the best companies—and there are some good ones—in the very best parts of the plays are maybe breaking even at $95 or $90 a barrel. Now we did a study recently for a client where we looked at the core of the Bakken. The four counties that are the sweetest of the sweet spots and we looked at the top operators and we did the full analysis. And what we came up with was in that very best part of the Bakken you needed about $83 per barrel of oil equivalent to break even.

Now the other thing that is bogus about these analyses is: Where do you get your reserve numbers from? I mean everybody who is listening to this knows something about economics and you got to have a number. What is your average well—you are saying your average well breaks even at Price X, well tell me what reserve number that is based on. Because if you are basing that break even price on a reserve that says you are going to make a million barrels of oil versus three quarters of a million, well the economics are going to be completely different and therefore the break even price is going to be different. And it is not just the reserves, it is the rates at which you produce that well. Are you going to produce that let’s say million barrels over 50 years? Are you going to produce it over five years? Because we are talking about the time value of money and the faster you get your money back the quicker you get out of your net present value hole in the ground. None of these things are ever discussed. And frankly, most of the so-called research analysis that is done—I think they just get their reserves from the companies. The companies just make up a story and tell them "okay our average well makes this much" and that is what they use. Now I go in and actually figure out what I think the most likely reserves are by doing the hard work, by doing the decline curve analyses and doing that. And once you have got the reserves and once you have got all the costs—and costs are publicly available. These companies give it to Securities and Exchange Commission. Then you can actually do the real work of figuring out where they break even and it is way above what you are hearing in mainstream media.

Chris Martenson:    Well, maybe this helps explain a conundrum confusion that I have had for a while. For years I have been tracking the financial returns of the largest shale operators. There are about 80 in my list that I look at. And specifically the cash flow statements because to me—they are supposed to be cash cows and this always comes back to the cash flow. If you want to know if a business is going to do well or not, are they  producing positive free cash flows? And what I have seen there—and other people have commented on this as well; it is pretty well-known I think. I have even seen it printed in Bloomberg, but these companies have consistent negative free cash flows every year I have been tracking them including 2011, 12, 13 when oil prices were twice what they are. I’d love to get your take on this phenomenon. I mean is it – does it make sense that I should be concerned that a company that theoretically is doing a plumbing operation in the Bakken and is making money and breaking even theoretically at $50 a barrel that they were all sporting steeply negative free cash flows through what were arguably the best years?

Arthur Berman:       You got to look at that, Chris. I mean that’s absolutely critical. I look at it too. If you look at third quarter earnings we will get full year earnings here well, they are starting to come in now. February is usually the month. But yea, I see the same thing you do and that is that the very best of the companies in these tight oil plays—companies like EOG for instance—they are barely cash flow positive. And of course when you are looking at the free cash flow number you are not really sure of all the costs that have been included. You got to look at each statement. Yes, you are absolutely right. If we look at the oil weighted, on shore companies—and I follow about 50 of them—what you find is that their third quarter results say that they got negative free cash flow of about $5 billion. You know, the price of oil in third quarter was $93 a barrel, so you can just imagine what fourth quarter is going to look like. It is going to be a total train wreck if they were losing money back then.

So yea, I look at the same thing you do. I look at free cash flow, the difference between capital expenditure and cash from operations. I look at debt pretty hard too. And debt to equity is an okay measure except that you got to take the company’s word for their equity. I like to look at debt as a function of free cash flow. In other words how long would it take this company based on the free cash flow that it is showing to pay off its debt. Well, if they got negative free cash flow they are never going to pay off that debt. They keep getting farther and farther into debt every year.

My view on this thing is that a lot of people don’t fully understand the technical work that I do, and I don’t expect them to. Maybe they say "well, we have read other people’s analysis that are more optimistic than yours" and I say "fine. Let’s put that on the table on the side for a sec and let’s look at"—what you look at, Chris. Let’s look at the cash flows and the balance sheets of these companies because if they are really making – if they are really as profitable as they say then we ought to see it reflected in the cash flows and the balance sheets and we don’t. We just don’t. I wish we could say something different, but these are facts. We have to look at facts.

Chris Martenson:    Another fact that has eluded me for a while is looking at for instance, the severance taxes that Texas pulls out or the rate of taxation that North Dakota is pulling out or Pennsylvania. So oil gets pulled out of the ground, a portion of that goes to the royalty owner, a portion of that goes to the state. And I look at those state pulls and in Texas they actually did a study where they said "wow, we pulled in about a billion dollars in severance taxes. Hey, over the same period we incurred about $4 billion in road damage, infrastructure damage roads, bridges and things like that." It seems to me that the all-in cost of a barrel of oil if we want to include that socialized part, which is—let’s be clear I think the taxpayers of Texas are subsidizing the business if you are only pulling a billion and you are incurring $4 billion in costs. Is that a fair way to look at it and is it true then that the all-in cost of this barrel is still being subsidized in some way that we haven’t really accounted for yet?

Arthur Berman:       Sure and I know that you think about the same things I do. I think about net energy or energy return on investment and you are talking about highways and other sorts of infrastructure and typically that is not included. But you know, let’s just look at the physical energy that is – that you have to put in to get a barrel of oil out. Most of this tight oil has a return of something like 5:1. You get back five units of energy for every one that you put in and we compare that to just about any other source of energy if we look at like middle eastern oil it is probably something like 100:1 and most conventional world averages outside the middle east are maybe 30:1. When we hear that the United States is going to be energy self sufficient or we are moving in that direction, we have to be very clear that this is super expensive oil that is being produced. Who bares the cost of that? There are the social costs and the infrastructure costs, but basically what we are seeing unfolding right now as oil prices are down below $50 is the ground truth. The ground truth is that these plays cannot survive on anything other than sustained $100, $90, $95 oil prices and that is the bottom line. So while everybody is celebrating and beating our chests about how we are the best and we are number one, let’s keep in mind as long as the world can afford to pay for $100 oil, maybe we are number one. but watch what happens when the price goes down a little bit as it has right now and you’ll see that no, we’re not number one.

And along those lines, if you just look at proven reserves of the world—again, anybody can access this information—the United States is a very long eleventh among the producers of the world, which isn’t bad. It isn’t bad to be eleventh. It is good to finish a marathon as opposed to not being able to finish it at all, but you are not in the top tier. So when we actually look at reserves versus just rates of production – the rate of production is the sprint, the reserve is the marathon. The United States is not a big oil producer and as I said we are going to be out of this stuff in a couple of years.

Just today I was looking at the Eagleford shale which is one of the two biggest plays and according to many analysts—in the United States that is—many analysts it is the play that has the most durable break even oil price at low cost. Well, even the EIA shows Eagleford oil production peaking in 2016. That is next year! Where do we get this decades of production? Okay fair enough. The production from the Eagleford isn’t going to stop in 2016; it will go on for many, many years, but at greatly reduced rates of production every year. In this particular case I think the EIA and IEA have it pretty close to right. Not exactly right, but pretty close. They look at the US tight oil plays and they see a couple of years, maybe five years before things start to fall off. I think it is less, but I am not going to split hairs.

The point is that what we found is expensive and we have got a few years, not decades, of it. So when we start hearing people pounding the table about how the United States should lift the ban on crude oil exports, well that is another topic if we are just talking about free trade and regulation, but what in the world is a country like ours doing still importing five plus million barrels of crude oil a day and we have got maybe two years of supply from tight oil—what are we thinking about that we are going to export oil? What is that about? That is just a dumb idea. It is like borrowing money from a bankrupt person, you know? It is just – it is like wow, what are you guys thinking about here? And I will tell you what they are thinking about. The companies are thinking it is easier for them just to sell the oil overseas than it is to go through all the hassle of having to blend it with heavier oil and refine it and then go sell that overseas.

Any way you look at this thing, Chris, I think you just have to be realistic. And the realistic view is: Let’s give ourselves credit for ingenuity. We have done something that a few years ago probably almost no one thought was possible. But let’s also be realistic. This is the most mature petroleum province on earth. We are squeezing blood from a stone and as long as prices are high we will squeeze a little more. And that’s it. I mean I like to talk about these shale plays as not a revolution, but a retirement party. This is the kind of bittersweet celebration you have when you are almost out the door and are going to sit around the house and watch Duck Dynasty or whatever for your remaining days. It is not really cause for a celebration. It is cause for some sobering concerns and taking stock about what does the future have in store for us as a country, as a world?

Chris Martenson:    You know, there are a lot of interesting points in there. The one I want to speak to right now is—here is what I hear some people say, they say "look, Chris, nobody really predicted how much and how fast we were going to get oil out of the Bakken or the Eagleford plays and so probably we can’t predict where we are going to find the next source of oil," as if there were something out there more. This is where I get driven a little bit nuts. Here is what I love to do – I went once to Midland and made it to the oil museum there, which is like the Louvre of oil museums. It is fantastic, right? And it is just very clear that geologists have done a great job of mapping all the basins in the world where oil could have possibly formed, right? Sedimentary basins, they had to have the right conditions and then geologically things had to work out. The shale plays really represent source rocks that have been mapped, drilled through, tantalizingly poked at for a long time. We always knew there was oil there. In your mind, is there a next big set of finds that could really surprise us that might change the story?

Arthur Berman:       There is always a certain unknown out there that gee you know the United States' oil production peaked in 1970 and then Prudo Bay was discovered a few years later and then we had another kind of resurgence of oil for a couple of years, not ever reaching the peak levels we did before. And people say "oh well see there is always something out there." For sure, Prudo is the biggest oil field ever found in the United States. But, again, it’s way up in the Arctic. It’s super expensive oil so it is really exactly what the models of peak oil would predict that once your conventional production peaks, then you are going to be increasingly driven to more expensive, lower quality kinds of sources and that is exactly what we are seeing. The answer then is: Sure, we will find something more than what we have. Will we find the equal of what we found so far? Highly unlikely. Like you say, I mean, these shale basins are not news. We have known about them—the industry has known about them for decades. The big companies have had teams of geologists and geophysicists and engineers studying them for decades and asking themselves the question: "Could these things ever be commercial? At some oil price and with some new technology could they be commercial?" And so when the prices got high enough and the technology arrived as it did with horizontal drilling and hydraulic fracturing companies knew exactly where do go. It wasn’t a big mystery.

So will there be more outside the United States? Sure there will. I follow, I mean there is the Shannoff[ph] shale in Russia, there is the Vaca Muerta in Argentina, there is the Duvurnet in Canada and there is probably a handful of others, but are there infinite opportunities? No. Look at all the source rocks that we have in the United States and all of our basins and how many of them actually work? Two. It is the same with shale gas. We got gas that has been produced in every basin in the country has a gas source rock. How many of those plays have been anywhere close to commercial? Five. The subset of what is potentially commercial versus everything that is out there is a tiny, tiny number. So could there be another tight oil play in the United States? Probably. There's probably one. Will it be as good as the Bakken or the Eagleford? I can’t say because I don’t know what it is. Let’s just say it could be. What does the next one look like? Well, we already know where they are and they are small. If they were any good they would be being developed today. That is the problem.

Chris Martenson:    You had another very excellent point in there that I just wanted to parse out for people and this is – because this is part of the narrative that gets put out there all the time, this idea of energy independence. This is where I think it came through, Arthur, maybe it was 2010, 11 somewhere in that zone again the EIA switched from reporting on our individual subsets of energy like how energy independent are we with respect to coal, oil, gas stuff like that. They put it all into one spot, measured all the BTUs at once as if they were all equivalent  BTUs and said "oh, we are going to achieve energy independence." But the thing that I’d love for you to talk to is this idea of when you mention we are still importing 5.5 million barrels per day, what are the odds that the United States will find a way to produce an additional 5.5 million barrels per day to completely 100% remove us from oil imports and then sustain that level of production?

Arthur Berman:       Zero, to be just as blunt as possible. You know, if you are talking about crude oil—and that is what I am talking about. I’m not talking about all the add ons that also get included in those estimates, the natural gas liquids and the bio fuels and the refinery gain and all that kind of silliness. But realistically we might see another million or two barrels in addition to the about nine that we are producing right now. That is optimistic. I think it’s realistic. I think EIA is still sticking to its story that we are going to – that US production is going to peak at something like 10 million barrels a day, which is not all that much farther; it is about a million above where we are right now.

So the only way that the United States will become energy independent was many ways, but one is that we find another six million barrels a day on top of the 10 million because that is how much we use and I frankly just don’t see that as being a very likely outcome, or we just use a heck of a lot less. We just decide the price of oil is just too expensive and we decide to fundamentally modify the way that we consume the stuff and you know, transport is the big ticket item here. Something like 70 or 75% of all the oil used in the United States is used for driving cars, flying airplanes, you know other uses of basically gasoline, jet fuel and diesel. So we could become energy self sufficient if everybody stops driving around in their personal cars. I don’t see that as being something that sells very well.

So there are ways of being energy independent but not I don’t think by producing our way to energy independence and continuing to live the kind of extravagant lifestyles that we do. So you talk then about well, we got a lot of natural gas you know we got coal we got all sorts of other things that we could use. Yea, that is all true. And the technology does exist, for instance, to use natural gas to power automobiles and buses and things like that. But there are big issues that never really get talked about like how long might it take to do that if we decided that we wanted to do that aggressively? And what kinds of infrastructure would be required in order to accomplish that? You know, we talk a lot about renewables and I’m 100% in favor of renewables, but I also have to be realistic. Wind and solar are something like less than 3% of our total energy consumption in the United States. Regardless of cost and technology breakthroughs, adoption is a big issue and we are not going to get from 2 or 3% to 20% next year or next decade. It is going to take a long time. These things take time. And then you start talking about the efficiencies involved. Again, I am a fan of renewables, but on a realistic basis back to net energy, wind is like I don’t know 7:1 in terms of energy out versus energy in and solar is a lot less, solar is two or three. These are much less efficient. Much less dense forms of energy than fossil fuels. As much as I understand and appreciate that some people just really want to get off of fossil fuels as soon as possible, we have to be realistic and we have to look at well, what are you willing to give up? That is really what we are talking about. And I don’t see a lot of people standing in line to stop driving their personal cars. I give talks all the time at universities, and students in universities are very green oriented and they always say "well couldn’t we do this?" I ask the question "okay how many people in this audience drove to this talk in a gasoline powered car?" And like 99.9% of them raise their hands. Then I say "how many of you drove yourself versus shared with a friend?" And almost everybody raises their hand. I say my case is rested. Until this group of very ecologically environmentally minded people start adopting the technologies that get us away from so much wasteful use of oil, first of all, but energy overall, then what possible hope is there that everybody is going to follow through and make these changes?

Again, I’m not trying to be pessimistic and I’m not saying that I’m in any way against renewables or natural gas powered vehicles. I think they are all part of the solution. I just think that we got to really be honest and realistic as we move forward because if not, we are going to make some big mistakes.

Chris Martenson:    I couldn’t agree more and let me also preface by saying I am a huge fan of renewables. I believe in 100 years we are going to be living 100% on renewable energy one way or another. Wheth