Will Shale Rise From The Dead?

I received considerable pushback last January when I asked whether U.S. shale oil had entered a death spiral. The almost constant refrain of the cheerleaders for the shale oil industry has been that increasing production demonstrates there is something wrong with my analysis and that of others who have been skeptical of the industry's claims.

We skeptics have certainly been wrong about how long the boom could go on. We could not fathom why investors kept funneling capital into businesses that were consistently consuming it with no hope of ever providing a long-term return.

I can remember when Alan Greenspan, the former U.S. Federal Reserve Bank chair, opined in December 1996 about "irrational exuberance" in the U.S. stock market. His speech turned out to be only an inflection point for the technology sector boom. The tech-heavy NASDAQ stock exchange rose 288 percent between the day Greenspan spoke and the index's peak in March 2000.

In the subsequent bust the bankruptcy courts were littered with companies that had never made dime.

So far this summer season we have heard two unthinkable utterances come from shale oil industry executives. The first linked above was that the industry has destroyed 80 percent of the capital entrusted to it since 2008. This came from a CEO no longer in the industry.

The second, however, came from one of the largest players in the Permian Basin, the hotbed of shale oil activity. Pioneer Natural Resources CEO Scott Sheffield said that the industry is running out of so-called Tier-1 acreage. That's oil-speak for "sweet spots." Those are the circumscribed areas in shale deposits within which extraction costs are low enough to justify drilling.

Outside the sweet spots there is oil, but it is much more costly to extract. The industry at one time likened shale oil production to a manufacturing operation, claiming the one could drill practically anywhere in a shale deposit and get oil out profitably. No one is making such claims credibly any more.

Now, just two years ago the same Scott Sheffield mentioned above compared the Permian Basin to Saudi Arabia. To be fair to Mr. Sheffield, his job is to attract investors so he can drill more wells. So, I fault mostly the investors for not looking carefully at the economics of shale oil which have been free cash flow negative for the industry as a whole for almost a decade.

Some have called shale oil a Ponzi scheme. In a Ponzi scheme the books of the Ponzi operator are kept hidden from the investors so as to make sure they don't catch on that money from new investors is being used to pay exorbitant returns to old ones. In the case of shale oil, the financials were published quarterly by the publicly traded companies for all to see. And, the wealth extracted by company managements could be calculated practically to the penny.

So, why didn't investors understand what they were looking at? One possible explanation comes from an oil company executive who explained to me way back in 2009 that oil and gas companies often promote themselves as so-called "asset plays" to investors. They drill a lot of very marginal prospects to get reserves on their books and then tout the growth in their reserves. But much of those reserves will never be exploited at a profit. They are essentially a mirage.

Resource investing is tricky and most investors, even sophisticated ones, can be fooled by the hype. It's very difficult to know whether something a company calls a reserve is actually a reserve—even more so since 2008 when the Securities and Exchange Commission allowed companies to use "proprietary methods" to determine reserves that are not subject to disclosure.

It's true that the amount of oil in any one formation can be huge. But that is of no practical consequence if you can't get the oil out at a profit and do that consistently.

To illustrate, there is enough gold dissolved in the world's oceans to make all those who are reading this piece millionaires. But the gold remains far too costly to extract.

It seems now that investors are finally realizing that the promise of most of these "asset plays" is never going to be realized.  Even a cheerleading trade publication last week ran a piece entitled "Is the US Shale Boom Winding Down?"

We skeptics said shale oil would not work on the so-called "manufacturing model" asserted by industry. It turned out we skeptics were right. The industry actually focused on "sweet spots" that allowed lower-cost extraction.

We skeptics said that a large portion of the sweet spots would probably be exploited within a decade or so depending on the pace of drilling and the price oil. Now one of the industry's most prominent CEOs is lamenting in public about the paucity of sweet spots remaining.

We skeptics said that investors would at some point realize that shale oil was a long-term money loser. A former industry CEO did the math and calculated the damage as minus 80 percent for investors in the industry as a whole since 2008. Lately, investors seem to be reacting to facts rather than the hype.

Will shale oil rise again from the dead as it did after the 2014-2016 price decline? That will happen only if two things occur: 1) The oil price rises significantly and 2) investors have a serious bout of amnesia.