Shale looks more like dotcom boom than Lehman debt bubble

In November 2007, hedge fund manager David Einhorn gave a presentation at the Value Investing Congress in New York, raising concerns about Lehman Brothers. He queried the bank's accounting and suggested it might have to recognise as-yet undisclosed losses. "If they do, everyone will be surprised," one of his slides read. Within a year, the bank had collapsed, and the bets against the investment bank, called shorts, taken by Mr Einhorn's Greenlight Capital paid off lavishly. Reputations are made by such bold calls, and Mr Einhorn made his.

So when he stood up on Monday at the Ira Sohn investment conference in New York and turned his fire on US shale oil production companies, people paid attention.

His presentation is essential reading for anyone interested in energy. If he is right, there are profound implications not just for investors in US exploration and production companies, but for the world.

His broadside had three principal elements. First, he criticised earnings reporting by oil companies, especially bespoke measures such as Ebitdax, which "basically stands for earnings before a lot of stuff".

Second, focusing on cash as a more reliable guide to the true health of the industry, he highlighted how the large shale producers had since 2006 spent $80bn more in acquiring and developing reserves than they have made from selling oil. They were kept in business only by a constant inflow of capital.

Third, he observed that investors who believe oil prices are going to rise would do better to invest in the commodity itself than in shale producers' shares.

All those points are justified to some degree. Are they proof that shale oil is a bubble that is about to burst? Maybe not.

Looking at shale companies' cash flows is vital, as Mr Einhorn suggests, but the picture is not as bleak as he paints it. His suggestion that the companies have nothing to show for their $80bn net cash outflow is misleading: they have been building up lease positions in oilfields that they can drill out in the future, and they have been acquiring expertise in how to extract that oil.

Moreover, their cash position had been on an improving trend. Last summer, before oil and gas prices plunged, leading US exploration and production companies were collectively on course to reach cash flow break-even in 2015.

The oil crash has moved that point further away, of course, but shale companies have kept it within reach by cutting their costs sharply. Pioneer Natural Resources said on Wednesday that by the end of this year its cost for drilling and completing a well would be 20 per cent lower than last year.

It is clear that even after the rebound in US crude prices from below $43 per barrel in March to above $61 today, the shale industry still needs a higher price if it is to start growing again. It may not be all that much higher a price, though. EOG Resources has talked about resuming growth at $65 or more.

Mr Einhorn is also right when he points out that shale oil companies' equity valuations imply higher crude prices than the futures market. Some enterprising hedge funds may already be exploiting that arbitrage opportunity. Still, as anyone who knows the commodity markets will tell you, a futures price is not a forecast, still less a reliably accurate one.

With growing global demand, reduced investment jeopardising future supplies, and the risk of future geopolitical disruptions, it is certainly possible that oil prices will carry on heading higher.

The shale oil revolution looks more like the dotcom boom than the debt bubble that brought down Lehman. The technological progress in oil production is real. But Mr Einhorn has identified important weaknesses in the shale oil business model, and there are likely to be further casualties, even if the industry itself manages to survive and grow.

As in any commodity business, the decisive factor will be costs. If shale production is more expensive than other sources of oil, it will not survive, and producers need to be able to undercut other high-cost areas such as Brazil's deep water and Canada's oil sands. Lower-cost shale producers can be the Amazon and Google of this new world; the higher-cost ones will be Pets.com.

[email protected]

© The Financial Times Limited 2015. All rights reserved.
FT and Financial Times are trademarks of the Financial Times Ltd.
Not to be redistributed, copied or modified in any way.
Euro2day.gr is solely responsible for providing this translation and the Financial Times Limited does not accept any liability for the accuracy or quality of the translation