Enron on Mineral Resource Theory (Part II)

By Bruce Stram -- January 28, 2020

Are there really depletable resources? The answer was “yes” if and only if there was an associated “cessation, once and for all, of technological progress.” This is clearly not the case for natural gas development.  Technological progress is alive and well, and technology is the most powerful non-price determinant of supply.  The “theory of the mine” (Harold Hotelling, 1931), not the mine, has been abandoned. (Enron Corp., The 1995 Enron Outlook. Houston, Texas: 1995, p. 8.)

Part I yesterday described my early effort to sell the idea of natural gas as a bridge fuel to environmental NGOs as part of their climate strategy. Behind this effort was Enron’s case for an expanding resource base for gas.

After severe shortages with natural gas during several winters in the 1970s, partial gas price deregulation resulted in artificially high prices, which quickly led to a supply glut and a price crash. Despite low prices, by the second half of the 80’s many experts were predicting a “hard landing” to the glut with high prices and supply issues.

Such analyses came from McKinsey, Cambridge Energy Research Associates (Daniel Yergin’s group), and a local company Groppe, Long and Littell. Ken and I knew if this was right, we had a spot of trouble since our natural gas pipelines would be hurt by insufficient throughput.

My review of these studies found an elementary error. Each extended an observed trend in gas found per foot drilled as a fundamental variable (technically an exogenous variable), when in fact it was driven by price (technically endogenous). When prices seemed to be rising indefinitely, Exploration & Production companies were willing to drill for smaller and smaller targets and found less per foot.

The folks in question couldn’t or wouldn’t acknowledge my point. So I set out to find out why the U.S. Department of Energy’s Energy Information Administration (EIA) got similar results with a much more proper methodology. I consulted with the outside firm that DOE used for modeling. Their run estimated the gas and oil in place in various basins and the degree of difficulty or cost in getting it out.

I soon found out that a critical variable was the pace of technological improvement in the E&P processes, i.e. the costs associated with bringing gas and oil to market. The variable was hard to pin down with data and was largely judgmental.

EIA had set the variable with what thought to be a low or conservative rate of improvement. This is a questionable approach. The better approach would have been to make the best judgement of expected value and then look at sensitivities, i.e. don’t bury conservative assumptions in the weeds.

After spending time discussing this with Enron Oil and Gas’s excellent engineers and geologists, including EOG head Forrest Hoglund, I found ample reason to conclude a much more aggressive value was appropriate.

This allowed us to do two things: reasonably (realistically) project a much more robust gas market at lower prices, and focus on a credible estimate of what we called the resource base, what might be reasonably expected to be ultimately recovered in time. That was a much better reflection of total supply than E&P reserve numbers which were better thought of as a relatively short term inventory.

I illustrated this by developing a concept I called the Resource Pyramid. The idea is the resource base can be thought of as a pyramid with greater difficulty of recovery as the industry digs down into it, but also addressing greater potential supplies. Price then becomes a race between technology, reducing the cost of getting to lower quality resources, and the rate of decline of that quality.

This approach seemed to catch hold and after several iterations, the oil and gas industry undertook a big effort to go over the same ground and came up with similar results.

The result was the Natural Gas Resource Pyramid presented in the periodic Enron Outlook, an industry-side educational effort described by Robert Bradley in Enron Ascending: The Forgotten Years (2019), pp. 52n57, 57–58, et. seq.

Viewed today, it is obvious that not only were the pessimists wrong, even the optimists undershot the technology boom and the abundance of low-cost natural gas. EOG’s experience in the late 1980s and 1990s was just the beginning of what can be called the enhanced hydrocarbon energy age, new chapters of which lay ahead.