The Great Permian Basin Produced Ponzi Scheme

I was having lunch with a former colleague a few months ago and the subject of produced water recycling came up. During the course of the conversation, he asked me: “Isn't this just a reverse Ponzi scheme with produced water? Ultimately, if they stop fracking, they [the operators] are going to have to deal with a lot of dirty water they don't need!”

Bryan Brownlie, Managing Director - De Nora Water Technologies Texas, discusses aspects of water treatment related to the frack water industry in Texas.

It's an intriguing notion, not least because of the analogy, but also because at a high level it intuitively appears to be true. It is something that has stuck with me over the weeks since — and bears a bit of a closer look. There is little question that historically during mass demobilization from other basins, there have been significant water disposal issues. The roads were full of trucks traveling to Ohio to dispose of water that had been produced that no one had deeply considered what to do with.

Costs mounted on profit and loss statements (P&Ls) for water disposal, and people realized that the most expensive part of demobilization was water.

Is that still the case now? Are we drowning in 'clean brine' in the Permian Basin? Will this be a water apocalypse at the very end of the day when the field begins to mature? Given that the number of drilled but uncompleted wells in the Permian continues to rise, signifying huge demand for completions — is this even something we need to think about now?

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The Confidence Trick

To test the analogy, we need to understand a bit about Ponzi schemes. For that, we need to go back 136 years to 1882. In the small town of Lugo, Italy, a man was born who would change the history of financial crime — a man whose name would be immortalized not for feats of heroism worthy of the Iliad, nor for contributions to politics or scientific breakthroughs. This man, slight of build and full of ambition, would be immortalized for running an elaborate confidence scheme, which was at the time the largest-scale investment con in the history of finance.

His approach to defrauding investors persists to this day, every so often being uncovered and toppling investment funds, leaving nothing in its wake but empty pockets and fallen companies.

Over the years, his approach evolved and spawned many similar scams, such as illegal pyramid schemes — and, some would argue, legal pyramid schemes (in the form of multi-level marketing systems employed by, in some cases, major brands). The man with such unassuming beginnings birthed a heritage of nearly 100 years of fraud. This man was the elaborately named, Carlo Pietro Giovanni Guglielmo Tebaldo Ponzi, and the confidence trick that would propel him into legend would become known as the 'Ponzi scheme'.

The irony, of course, is that Carlo Ponzi did not in fact invent this method of investor fraud. He merely applied it on a larger scale ($20 million) than had been previously achieved. It seems probable that the first individual to make use of this approach was a Brooklyn bookkeeper, named William Miller, back in 1899 — some 20 years before Mr. Ponzi made it famous. Stealing a mere $1 million before the scheme collapsed, it apparently wasn't enough to see the confidence trick christened, the 'Miller scheme'.

The general mechanics of the scheme are extremely simple. Investors are induced to invest in a business or a fund with the promise of incredible returns. These initial investors often find their money immediately pocketed by the fund manager. Their returns are actually paid by the money invested by the next round of investors, and so on and so forth. As Bernie Madoff proved, if managed well, and if sufficient new 'investors' can be lured into the fund, these schemes can persist for decades — but their downfall is an absolute certainty. One of three things always takes place:

  1. The initiator of the scheme simply takes the money, and disappears.
  2. The fund manager cannot find more new individuals to invest in the scheme, and as a result cannot pay the existing investors their returns from that new round of investment, and the scheme collapses.
  3. Economic downturns result in a run on the investment cash — which, of course, doesn't actually exist. The scheme collapses when it is realized that there is simply no actual fund, and no new investors to pay off the old investors. Meanwhile, the cash that the investors want back has, in fact, already been spent by the person running the fund.

So what does this have to do with produced water in unconventional oil and gas plays in the U.S.? This concept was briefly discussed in my previous article, and the question is a good one. I will preface all of this by saying that there is no intentional Ponzi scheme around produced water running anywhere, least of all the Permian. As a result, by definition the analogy fails. But there are some elements of drilling in the Permian where there are some analogues (however inadvertent) to the situation a Ponzi scheme creates. Most pertinent is this: The only thing staving off a significant water management challenge is the demand for water created by fracking operations (much like the only thing staving off the collapse of a Ponzi scheme is the demand for investment in that scheme from new investors).

The overall water situation is far from as simple as it appears, or a lot of media suggests. The average unconventional well produces at best 3X and at worst 5X as much water as it does oil. In the Midland Basin of the Permian, for example, for every 85,000 barrels of oil produced, 230,000 barrels of water will emerge from the formation.

That is a tremendous amount of water, and unlike conventional wells (which actually produce far more water — up to 15 barrels for every barrel of oil), this water cannot be re-injected into the formation as part of an enhanced oil recovery (EOR) approach. That's simply not how ultra-tight formations work. Instead, it is disposed of in non-productive intervals of the plays at issue, in brine disposal wells, or it is recycled.

While the water-to-oil ratio is an interesting fact, it is too often touted as somehow diagnostic of the overall water balance of the Permian Basin. 

In fact, the water cycle in the Permian Basin is significantly more complicated than that single statistic suggests; and just because a lot of water is being produced per barrel of oil, it doesn’t necessarily mean that sufficient water is being produced to sustain all frack operations. After all, the Permian Basin is not being fracked with oil, so water-to-oil ratios don't say anything meaningful at all about water demand, water balance, or short-term NET water production vs. short-term water consumption.

At a high level — and massively oversimplified — the reverse Ponzi scheme analogy appears to hold. This assertion is based on the premise that if this produced water (from unconventional sources) is recycled 100 percent, it will be consumed by frack operations as fast as it is produced. Or put another way, the produced water will be consumed as long as there is another well to be fracked. Much like the investors in a Ponzi scheme will get their money back if another round of investors are found to invest, produced water will have a home by being recycled and used as frack water as long as there is another round of completions to be executed.

If everyone stopped completing complex horizontal wells, there would be a lot of water being produced, recycling it would be fruitless, and there would be a large disposal or reuse issue that would need to be resolved in order to deal with that constant production of water from the Permian Basin. Salt water disposal wells (SWDs) would likely over-pressure, and someone is going to have to treat down to agricultural grade, or river disposal grade, a terrifying amount of water — which would have an enormous cost associated with it.

Water Spend

This water cost increasingly does feature in investor analysis of their position in the play, but seldom does it appear that the complexity of the water management issues (or the ultimate cost at disposal in the case of a mass exodus) have been adequately considered or calculated to make it anything more than an educated guess. The economic targets for treatment-to-discharge grade that many operators have are not realistic based on current technology — and it would appear that, in at least some cases, investors’ long-term return estimates are based on those unrealistic expectations.

Digging into the statistics leads to even more complexity. One such complicating factor is that 50 to 80 percent of the produced water to be expected from an unconventional well over its life is produced inside the first six months, and only 4 to 8 percent of that is the original frack fluid that was injected (per some studies). More optimistic estimates put it at around 40 percent of the initial frack water finding its way back to the surface during flow-back. The rest finds its way out of interval and into non-producing formations. This was less of a concern historically, but as completions become more complex — with longer laterals and more stages — the amount of water required has risen exponentially, with some operators using upwards of a million barrels per completion.

In other studies, looking at the Permian specifically (and looking specifically at unconventional wells), the findings are somewhat surprising. They are, however, very relevant when looking at how water balance actually works in the Permian Basin.

For example: Over its total 20-year estimated ultimate recovery (EUR), an average well in the Midland Basin will produce just 60 percent of the water used to complete (frack) it (as of 2015). Conversely, in the Delaware Basin, an average well will produce 190 to 300 percent of the water required during its completion. In total, the Permian Basin, in 2015, was set to produce only 10 to 20 percent more water in its total life than was consumed to complete the wells — over 150,000 barrels per average well more water than is required to complete it. For the full table of mean well Produced Water EUR vs. Frack Fluids pumped vs. Oil, go to page 544 here.

If these numbers included the likely rates of flow-back water (i.e., frack fluids returned during flow back, which in the Permian range from 10 percent of the fluids pumped to 40 percent of the fluids pumped), those numbers could rise to close to 50 percent more water than is being used in completions operations on average. However, even if that is the case, an average Midland Basin well may still not in reality be a NET producer of water in its first year — and, in fact, may never become a NET producer of water.

While 10 to 50 percent doesn't sound like a huge amount of excess water over a 20-year period, it adds up to tens of millions of gallons more water than will be consumed during completion operations in the Basin as a whole. This excess water has no natural home, unless drilling operations continue in a perpetual ramp-up, even assuming 100 percent recycling. This situation will likely worsen as increased development takes place in the Delaware Basin (which is a much more prolific water producer than the Midland Basin). In fact, as of 2018, it may already be notching the Permian Basin average to 40 percent more water being produced than is consumed in completing the well. With 20-year EURs, that is a long-term water management issue, not an immediate crisis — but it could become one if drilling and completion activity slows dramatically.

Looking at the short-term operating conditions, the picture is very different. For an average Permian well, most of its produced water is generated in the first six months but (and this is a big but), in its first 12 months, as of 2015 (when extremely complex and water heavy completions, longer laterals, and more stages began to be the order of the day), a well in the Midland Basin would only output on average 30 percent in produced water vs. the amount of water required to frack it in the first place. In the Delaware it is 90 percent, and in the Permian Basin it generally averages to 50 percent. So in the short term, across the Basin, only 50 percent of the water used in completions for a set of wells is returning to the surface in the first 12 months. Assuming constant drilling and fracking, that results in a Basin-wide water demand for additional water.

In short, if you frack five wells, wait six months, and want to frack five more identical wells — unless you get an unusually high level of flow-back returned — you will not have enough water to recycle in order to frack those five wells. Additional water will be required, and that water is likely to come from freshwater sources. (100 percent recycling does not equate to no need for fresh water!)

If flow-back is favorable, then it could be as high as 75 to 80 percent of the water required to complete the well returning to the surface over a 6- to 12-month period, but it still can result in a short-term deficit in produced water vs. what is required for active drilling. This is exacerbated if more wells are being drilled in the next round of drilling than were initially completed.

The other factor is mass balance. If the water has been recycled, anywhere between 20 and 30 percent of the water that was originally produced has been concentrated as sludge along with the total suspended solids (TSS) and rejected by the treatment regime for disposal. These loss rates during recycling, which are in some cases partially avoidable by more efficient technologies, are ultimately mandated by the laws of physics and can't be lower than 15 percent, as that is the average amount of TSS in Permian produced water.

As a result, in the Midland Basin, NET of reject, it is entirely possible that a well may produce no more than 15 to 20 percent of the volume of effective recycled frack fluid that was required to complete it in the first instance, in the short term. That's a serious water shortage.

Given how the Permian is drilled, it leads to an unexpected problem that renders the Ponzi scheme analogue inadequate in the short term. In some areas (where drilling is at its most heavy) there can be a shortage of water, as the wells in general may be producing far less water than is required to complete the next round of wells to be drilled.

Conversely, in the more mature areas of the basin, older wells — far from the flurries of new drilling activity — will be producing water (up to 50 percent of what they have left) at the rate of between 10,000 to 5,000 barrels per day, without anything logical to do with it other than expensively trucking it to areas where drilling is heavy or disposing of it down an SWD. The infrastructure (although this is changing in some cases, with operators laying down water pipelines) does not necessarily exist to get water where it needs to go, and as active drilling sites move, infrastructure struggles to keep up with the latest 'hot area' of the play.

So the somewhat unexpected situation that forms is that:

  1. In the most actively drilled areas of the Permian (and particularly the Midland Basin) there can be water shortages (even with high levels of recycling) because less produced water comes back than is needed for frack operations in the short term. The balance is filled by local landowners selling water (at around 25 to 50 cents a barrel). This is exacerbated by infrastructure constraints at times requiring disposal down an SWD for want of storage or transportation of water that would have been useful a few months hence.
  2. In the more mature areas where drilling has slowed, there is an abundance of water — which can be more expensive to transport to the active areas than it is to dispose of. And while this water can be recycled, in the areas where there is no pipeline to cheaply move it to the active areas (or at least close to them), it seldom makes sense economically.
  3. In the long term, the Permian Basin will output 20 to 40 percent more water as produced water than was required to complete wells within the formation — and that water must be managed somehow. It is not going to disappear on its own, and that issue will have to be 100 percent solved at some point in the future — with reasonable economics.

The Permian Basin, in summary, has simultaneously a short-term water shortage in some active areas, too much water in other areas, and in the long run will produce far more water than it will consume through fracking. The water picture looks very different in the short term than it does in the long term — and this is what drives water demand for water.

In a perfect world, of course, operators would have perfect infrastructure. The excess water from the less actively drilled sections could be recycled and cheaply transferred to the more active drilling areas and used in frack operations there, leaving just the overall NET excess water to be dealt with in SWDs (along with the output sludge and concentrated brine from recycling operations, due to the mass balance that was discussed in my previous article).

Given the vastness of the play and the drilling continuously ongoing on the fringes of it, it seems likely that there will always be a balance between capital expenditure (CAPEX) on water infrastructure vs. the operating expenditure (OPEX) of hopefully shorter trucking routes that are just short enough. As we also discussed, this makes recycling to the point where the water can be used for fracking — and safely transported in pipelines and stored in ponds — the key consideration for right now.

Ponzi Or Not?

So is there ultimately some kind of inadvertent water Ponzi scheme running when it comes to produced water? The answer is not just a simple yes or no. In the short-term, no. What is running is complex management of an extremely complex water supply vs. demand situation driven by how unconventional wells produce water. Rapid, cost-effective, and 'good enough' recycling, combined with effective water transportation, is the key.

In the long run, the answer is probably also no. What exists is a formation that will ultimately produce, over the next 20 years, more water than it will consume through the formation loss of frack water — and no clear plan to address how to resolve that in the future at the moment. These two problems (one water demand, the other long-term water overproduction), have radically different solutions.

Done correctly, effective recycling and the right infrastructure could obviate the need to take water from aquifers almost completely (which just adds more water to the mix), solving the short-term issue. With the right technologies, as discussed previously, this is very possible. How realistic it is for this infrastructure for transportation to be put in place and effective enough to obviate 'top up water' to enable frack operations may be a different matter. However, it is theoretically possible, and there are a number of solutions around 'commoditizing' recycled water which may ultimately prove to be effective.

Water would, in many cases, need to flow from the Delaware to the Midland Basin — and those are longer pipelines, crossing much larger areas, and multiple operators and landowners’ acreage. There are also a number of operators leading the charge in terms of both recycling and water transportation, proving out this model. Whether they provide the infrastructure to some of the smaller operators will determine whether it reaches a critical mass point and becomes truly effective Basin-wide.

As to the question of a slowdown if oil prices fall once again, or if the production rates begin to fall? That is where longer-term factors come into play. There is significantly better brine disposal infrastructure in the Permian Basin than ever before. There are many more SWDs. There are also areas of the formation that are extremely accepting of excess water, and other areas of the play where SWDs are already beginning to creak just with the water they are disposing of at the moment. Ultimately, with proper planning, it’s possible that enough SWDs could be drilled in the right places to cope with a tremendous amount of water, and vastly limit the need for trucking and disposal. That said, it would be experimental in the extreme as to how much the formation could take, and seismic issues, subsistence, and sinkholes are already becoming topical.

In the long run, if drilling does go through a slowdown as occurred in 2015, there will be a significant water problem. Producing wells will continue to produce more water than oil, and infrastructure (including SWDs) will begin to 'fill up'. When that happens, choices will need to be made. Produced water can either be trucked somewhere or treated to agricultural grade — or to the point it can be disposed of in a river. These processes have already been pioneered to an extent in the DJ Basin in Colorado and other more sensitive areas; however, given the scale of the Permian, the costs will be significant.

The economics for treatment to discharge grade are not necessarily incredible at the moment. Evaporation, although extremely expensive, is the safest way of handling TDS. Reverse osmosis (RO) also could be used, but it requires significant protection in pretreatment from the other constituents in produced water. Whatever is used, one has to deal with several thousand railcars full of complex salts that form, which will need to be transported and disposed of somewhere. In all cases, the economics may be better than the trucking and disposal cost of water, but it is going to be well over $1 per barrel to treat. In fact, it is likely closer to $3 or $4. Adding it up, it runs into the tens of billions of dollars.

A balanced approach to this — combining SWDs, some trucking, beneficial use of byproducts, and discharge — is likely where the outcome will land, but it's going to take some very slick water management and some great technologies to make it possible. It's also going to take companies entering the market that are serious about making something of excess produced water and commercializing those byproducts. While some companies are claiming this capability (and some may well have it) — as we discussed in the previous article — evaporation costs will not be offset by selling salt.

There are water technology companies out there that can manage this process through to completion. Whether the industry, and the Permian in general, is left with a huge water bill at the end of it all will come down to those drilling in the Basin and how they are reacting today. If I had a position in the Permian, my expected rate of return would consider the fact that somewhere between 20 and 50 percent of the cost of operating a well in the Permian is in water management as it stands at the moment per some studies. If drilling does slow, that number is only going one way — up, and quickly — and finding cost-effective means of addressing that is going to be critical for ultimate returns.

If the worst happens and one or more of three factors come into play — operators abandon ship, no new wells need to be drilled, or external economic factors cause a collapse in activity — then, much like a Ponzi scheme, it will be the investors left paying the tab. In this case, however, with no shadowy figure at the center of it and a number of talented people working on solutions, the crisis can likely be avoided altogether. It's just going to take some serious planning.

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