(1)The Shale Bubble: An Investment Opportunity of a Century

Disclosure: I’m overweight conventional oil & offshore drilling. I’m short specific Shale plays.


It’s Thanksgiving Day, 2014. OPEC leaders meeting in Vienna have not been able to agree on a cartel-wide production cut. Going into the meeting, oil prices had been in a free fall since August, dropping to below $80/bbl. The consensus between analysts had been that OPEC would take the opportunity of the yearly meeting to protect prices by dropping production targets. Even though there were a handful of contrarians not expecting a cut, nobody was expecting that the lack of an OPEC production cut would cause such a sell off, a sell off that would ultimately lead to $30 dollar oil. The first go to response by analysts was to attribute the oil crash to the lack of action by the Saudis, but this lack of action would later show to only be the catalyst, and not the main cause.

Frack baby frack

“Drill, baby, drill!” was a 2008 Republican campaign slogan first used at the Republican National Convention by former Maryland Lieutenant Governor Michael Steele, who was later elected Chairman of the Republican National Committee. The slogan expressed support for increased drilling for petroleum and gas as sources of additional energy and gained further prominence after it was used by Republican Vice Presidential nominee Sarah Palin during the vice-presidential debate.

Starting with the call “drill, baby, drill!,” politicians and industry leaders alike started to support one of the biggest conceptual myth surrounding the energy space: the idea of United States becoming a global energy power equal to those that we know in the middle east: This idea has been stylishly dubbed “Saudi America”, the era of U.S. self-sufficiency in crude oil

Much of this optimism is/was based on the application of technologies like hydraulic fracturing (fracking) and horizontal drilling to reach previously inaccessible Shale reservoirs, and the development of unconventional sources such as tar sands and oil shale. Mark J. Perry, an economics professor at the University of Michigan at Flint, caused a minor sensation on October 22, 2012 when he posted a blog about record-breaking fossil fuel production in the United States. Dr. Perry’s blog post pointed out that the U.S. is closer to energy self-sufficiency than at any other time in the past 22 years. This post was frequently cited at the time as the U.S. was celebrating the success of the Shale revolution. This Shale revolution, we’re told, will fundamentally change the U.S. energy picture for decades to come—leading to energy independence, a rebirth of U.S. manufacturing, and a surplus supply of both oil and natural gas that can be exported to allies around the world.

The Oil Price Crash of 2014

What drives oil prices in the short run is unknown to me, but in the long run, old supply and demand dictates. It shouldn’t come as a surprise that oil prices have crashed because the supply of oil is exceeding the demand of oil, creating an oil glut. A more intriguing question to ask oneself is where did this additional supply come from? The graph below show that the world outside of U.S. & Canada doesn’t produce more crude than it did back in 2005. The grey line in the picture shows that ranging from 2005-2015, the production level outside the U.S. & Canada is close too identical. We can see that almost all additional oil produced now above that level is U.S. oil. Since 2011, over 95 percent of the growth in U.S. oil and gas production has come from the Shale oil & gas boom, meaning nearly all of the world production growth in crude oil since 2005 comes from these shale plays. We can therefore confidently say that: the oil glut was created and is completely dependent on unconventional oil from the U.S.

Don’t look under the rock

As we now know, the recent growth in the World and U.S. oil and natural gas production reflects a move toward shale gas and tight oil extraction. Shale gas is natural gas trapped deep within shale formations, while tight oil is oil produced from low-permeability source rocks deep within the earth. Horizontal drilling and hydraulic fracturing have made these fields accessible.

Horizontal wells typically start vertically and then curve into horizontal at depth to follow a particular reservoir. The first horizontal oil well was drilled in 1929, but the commercial application was not developed until the 1980s.

Hydraulic fracturing (fracking) is the process of inducing fractures in reservoir rocks through the injection of fluids, chemicals, and solids under very high pressure. A mixture of sand and other granular materials creates or holds open fractures in the rock to allow the hydrocarbons to flow freely to the well. The first experiments with hydraulic fracturing took place in 1947 and marginal developments followed.

A relevent question to ask oneself is – how come the Shale boom took a shy of 70 years to start when these “profitable” technologies have been available for the worlds entrepreneurs for ages? The truth is that even though these technologies have been available in the best economic environment for allocating resources in the world, namely the United States, the Shale boom needed a lot more than the good old American capitalistic spirit to start. Wall Street and the Shale companies likes to propagate that the dramatic increase in production in the U.S. shale became possible by new technological breaks true. This is to misdirect from the real reason how the Shale boom was made possible. The truth is that experiments with horizontal drilling date back several decades, but the development have never before been profitable at a large scale. Due to the high cost of unconventional wells, energy companies had little incentive to broadly employ sophisticated, expensive, and capital-intensive drilling techniques when prices were low. Rising energy prices in the 2000s made these technologies profitable for commercial oil and gas production.

But rising energy prices alone were not enough to start the Shale boom. What really kick started the boom was FED’s decision to lower the federal funds rate to effectively zero percent in the wake of the subprime crisis. With the financial system in disarray after 08, the Fed began quantative easing (QE) and forward guidance initiatives as a way to bring the dislocated markets back to life. The Fed’s low rates & QE fomented risk appetite that saw the Shale oil E&P markets to soar. Summarizing, the Shale oil & gas capital intensive nature required both high oil prices and money printing to get started. Putting the pieces together, the main point we can draw is that; without U.S. Shale oil, which required cheap money from quantitative easing, the world would be in a deep oil crisis.

When The Boring is Made Exciting

While oil companies were rushing to gain from higher oil prices and easier lending requirements, exploration and production absolutely exploded in the three main Shale plays, the Bakken; the Eagle Ford Shale and the Permian Basin. These three Shale plays, along with half a dozen smaller ones, almost doubled U.S. oil production, from under 5 million barrels a day to more than 9 million barrels per day by early 2015.

As the public started to noticed this incredible increase in production, investors started to rush into the Shale oil & gas companies, valuing the Shale companies like the hottest growth stocks on the market. Under this period, the Shale gas and tight oil companies was given access to almost infinite capital with no performance requirement other than to avoid debt covenants. The initial increase in supply from the U.S. and the Canadian producers were matched by a reduction in supply from Libya, Iran, Syria, Sudan and Yemen etc. Throughout 2014, supply exceeded demand because continued North American production increases were not matched by further politically driven reductions. While euphoria over the ongoing Shale revolution and the celebration of the energy independence of the U.S. continued, trouble was on the horizon.

U.S. Shale oil peak

As prices collapsed, the so-called U.S. Shale oil revolution got stuck in 2015. Even though both production in Eagle Ford and Bakken started to fall, Wall Street kept their bullish view on Shale. Stories about how the sector is showing resilience despite volatile oil prices become extremely popular. This caused investors to speculate that the U.S. Shale industry could/had adapted to the depressed environment. In a time when conservative values were urgent investors instead gave into their appetite for seeking high bond yields and continued to let the upstream Shale oil and gas companies to exploit the ultra-low interest rate environment. In March 2015 we saw a record month of equity raisings by U.S. E&P companies, worth $3.8 billion. At the time, U.S. companies in the energy sector had high yield, or junk, bond debt worth $238 billion. That is equivalent to 14 percent of the $1.7 trillion U.S. high-yield market, making energy the fourth biggest sector overall. Narrowing down the energy sector further, specifically exploration and production (E&P) companies have outstanding $127 billion of high-yield bond debt.

Oil Stocks at Tightest Correlation in 26 Years

The bullish sentiment for Shale quickly turned around as the Chinese stock market turbulence began on 12 June 2015.  By 8–9 July 2015, the Shanghai stock market had fallen 30 percent over three weeks as 1,400 companies, or more than half of the listed, filed for a trading halt in an attempt to prevent further losses. In the midst of this global sell off, oil futures and equities started to trad in an unusual lockstep, with crude appearing to lead the way for the S&P500. This baffled the majority of the investment community as oil and stocks typically has an inverse relationship.

Leo Chen, quantitative analyst at Cumberland Advisors wrote “while random walk theory argues that market price is unpredictable, empirical evidence suggests that asset prices tend to be correlated during periods of downside movement. Downward drift is often observed, which accounts for negative momentum.

This is an explanation I’m not buying. The reasons crude oil and stocks became highly correlated under the market sell off was because investors were worried that the Shale players would default and drag the whole market with it. A substantial portion of Shale junk offerings had been purchased by issuers of collateralized loan obligations (CLO). Just like in 08, these CLOs had been rated up to AAA level, securitized and distributed to an audience of investors who did not understand the underlying asset or the risk involved. Many of these investors may not even have been aware of their high exposure to the energy related debt. CLOs have been issued at a record pace, and 2014 set a new record of issuance per year ever, exceeding the pre-crisis peak in 2007 of $93 billion. Despite the problems related to the Shale junk bonds, the problem would show not to be as serious as first thought. As a result, the equities-oil correlation faded the weeks that followed.

Buy When There’s Blood in The Streets

On March 1, 2016, McClendon, the former CEO and co-founder of Chesapeake Energy, was indicted by a federal grand jury on charges of conspiring “to rig bids for the purchase of oil and natural gas leases in northwest Oklahoma”. After his indictment McClendon released a statement denying all charges, arguing that for 35 years he has worked to create jobs and help Oklahoma’s economy while providing plentiful energy for the entire country. McClendon died the following day in a single-vehicle collision. McClendon died instantly. His car burst into flames. He was identified by his teeth. Police have not definitively concluded that McClendon committed suicide and they refuse to speculate further. McClendon’s death has by some investors been coined as “the bottom in the Shale patch”, referring to the old expression “Buy When There’s Blood In The Streets”. As oil started to recover, The Streets had now convinced themselves that the Shale operators were profitable under $30 a barrel.

With the support of this rumor, the majority of the Shale operators negotiated waivers, new covenants terms and debt-for-equity swaps with their creditors. As the Shale companies now appeared protected from bankruptcy, investors contributed with more capital flows to the E&P companies than during 2013, the previous record year when oil prices were more than $100 per barrel. Pioneer and Diamondback raised almost $1.5 billion in share offerings in January 2016, probably the darkest time for oil markets since 1998.

The case

The success of the U.S. Shale producers has been the consensus ever since. This, however, didn’t hinder a handful of contrarian investors to take the completely opposite position. The case was based on that when Shale players run out of the availability to cheap money on hot capital markets, they will bankrupt and the oil prices will moonshot. Going long the best of conventional oil and short the worst of the Shale plays will therefore work like wonders. U.S. Shale oil is todays “swing producer”: Turn off the U.S. Shale taps and the market would be brought into balance with prices rebounding. Keep pumping oil, prices stay low. As the malinvestment (the Shale operators) also serve as the swing producers, the market is trapped in a strange scenario. If the lenders let the Shale players survive, Shale will ramp up production, prices will crash again, and Shale will essentially kill themselves.

Shale economics 101

For years, a handful of people has been warning that the economics of the U.S. Shale revolution is suspect. Oil and natural gas production in Shale formations depends heavily on the initial production (IP) of unconventional wells—that is, their production rate when first drilled. Unconventional wells have steeper production decline rates than conventional wells. In conventional oil fields, annual production decline rates typically range from 5 to 10 percent. A conventional well can go through a longer period of steady, flat production between its peak and decline. In unconventional wells, however, production falls rapidly in the first three years and then enters a sustained period of low production.

A typical Shale well yields around 85,000 Bbls during the first 12 months and then depletes by around 70% in the first year alone. The average well experiences a YoY decline of 40% and is down around 80-90% after 3 years. In the Bakken, one of the top tight oil fields in North Dakota and Montana, production in an average well declines 69 percent in its first year and more than 85 percent in its first three years. In the Eagle Ford tight oil field of south Texas, production in an average well declines 60 percent in its first year and more than 90 percent over its first three years.

As a result, new and high-producing wells have to be drilled constantly to maintain steady production across unconventional fields. Oil analyst Rune Likvern coined this constant battle to outrun the decline profiles of the prior wells the Red Queen syndrome, after the Alice in wonderland queen that remarked that you have to run faster and faster just to stay in place. In plain language this means that a high number of new wells needs to be brought to production to sustain total production.



The other important point about Shale plays is that they are expensive plays, and will always be so. Constructing a Shale well happens in two stages. First both the vertical and horizontal sections of the well are drilled. Once the well is drilled and perforated, millions of gallons of water, proppants (materials, like sand, introduced to keep the fracture open), and chemicals are pumped down the hole to fracture the formation and allow the oil to flow back into the pipe to be pumped out.

An unconventional well can cost from $5 million to $9 million. In 2012, the average cost of a new well across the top 10 tight oil fields was about $8.3 million In 2013, a well in the Eagle Ford cost about $6 million. Similarly, wells in the Permian and Bakken fields cost, on average, $5.5 million and $8 million, respectively. In contrast, a conventional vertical well can cost from $1 million to $3 million.

As we now know, Shale fields require significant drilling activity and thus significant ongoing capital investment to increase, much less maintain, production levels. Moreover, the cost of an unconventional well could be as high as five times the cost of a conventional well. With this information in mind, lower oil prices should result in that the Shale players simply would not be able to operate profitably. No profitability should lead to lower capital expenditures, and production should drop exponentially because of the Red Queen Syndrome.

Why people believe Shale is profitable

Using the traditional corporate income statement, it is difficult to determine if Shale drilling companies make money. To illustrate my point, lets simplify the calculation of income after the equation below.

Income = (1) Revenues – (2) OpEx – (3) DD&A

  • Revenues: barrels of oil sold * the price of oil.
  • Opex: operating expenses. In Shale, this includes all the other expenses the business has:
  • Well operations: insurance, repairs, maintenance, pumping costs, etc
  • G&A: general & administrative costs – including paying the CEO
  • Interest expense: for bonds, bank loans, preferred stock dividends
  • Transport: getting the oil to market
  • Royalties: paying the landowner a chunk of your revenues
  • Production taxes: paying the state a chunk of your revenues

Separated from operating expenses is capital expenditures. Capital expenditures for the Shale companies is all the costs involved in drilling and completing wells, purchasing equipment, land drilling rights, and other long-lived assets required to run the business. If an expense is classified as a capital expenditure, it needs to be capitalized. This requires the company to spread the cost of the expenditure (the fixed cost) over the useful life of the asset. The cost is spread by depreciation, or what is known as DD&A for the energy operators.

  • DD&A: Depreciation, Depletion and Amortization is a common operating expense item for energy companies. Shale companies DD&A generally consist of 95% depilation of the oil fields. Where depletion should be the decline rate of each well multiplied by the cost (decline rate * (cost of the land + the cost too drill & complete)).

Here is where the problem is originated. If you want your company to appear profitable, you will tell your accountant to underreport deplitiation. Instead of having her use your actual 60-70% well decline rate, you will instead tell her to use, let say, 30%. This will make your DD&A a lot lower than it actually is, and boost profits in the short run. Over time, the DD&A needs to increase to represent its true value. This will show in a gradually increasing DD&A, causing a slow growing erosion of the operating margin, or it will be presented as a single amortization charge. The Shale operators insist that they invest for growth. Meaning their Capex is continuously growing. As long as the Shale operators continue to underreport DD&A in relations to their Capex spending, gross profit will grow faster than the decline in operating profit, causing a Ponzi type of effect. As long as the company is given more money to spend on Capex, the income statement will have the appearance of a profitable and expanding company. But as a true Ponzi, the scheme will fall when money is stopped being invested.

Einhron’s big short

During the 2015 Ira Sohn Conference, Hedge fund manager David Einhorn, probably most known for his early short position in Lehman Brothers, disclosed that he was short Pioneer Natural Resources (NYSE:PXD). The reason for the short is that Einhorn believes that in the current environment, PXD earns a negative return on capex. In his presentation, Einhorn emphasized that equity investors and lenders lures to focus on non-GAAP numbers like EBITDAX. EBTIDAX is an earnings-based number, modified to get the characteristics of a cash flow metrics. Because EBITDAX is an earnings-based measure, EBITDAX suffers from many of the same kinds of creative accounting problems that plague net income. These include premature or fictitious revenue recognition, aggressive cost capitalization, and understated accruals etc.

Continue to part 2

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