America's Energy Boom is not Shaky

Bethany McLean, writing in The New York Times this morning (The Next Financial Crisis Lurks Underground), took a grim view of shale's prospects.  

Some of fracking’s biggest skeptics are on Wall Street. They argue that the industry’s financial foundation is unstable: Frackers haven’t proven that they can make money.   

Fracking is such a fragile industry that it is not hard to make it go bust. Saudi Arabia almost succeeded in doing so in 2014.It’s all a bit reminiscent of the dot-com bubble of the late 1990s, when internet companies were valued on the number of eyeballs they attracted, not on the profits they were likely to make. As long as investors were willing to believe that profits were coming, it all worked — until it didn’t.

These days, the rhetoric of “energy independence,” meaning an America that no longer depends on anyone else for its oil, not even Saudi Arabia or OPEC, is in perfect harmony with “Make America Great Again.” But rhetoric doesn’t produce profits, and most things that are economically unsustainable, from money-losing dot-coms to subprime mortgages, eventually come to a bitter end.  

Legendary oil fund manager Andy Hall was unimpressed.  In an email this morning, he notes: 

I think this article is light weight. It focuses on Chesapeake Energy which is the AOL of frackers (if we want to stick with the author’s dotcom analogy) and ignores companies like EOG and, perhaps even more importantly, Exxon and Chevron, who certainly are not going to run out of cash. While aggregate free cash flow in the industry has been poor, that is true of many other transformative businesses (commercial aviation, Amazon) which not only survived but thrived. With land acquisition costs behind them and a growing inventory of producing wells, the industry’s cash flow profile is inexorably improving. Finally, the heavy reliance on quotations from Chanos and Einhorn and breathy talk of high well decline rates does not suggest an original, profound or independent analysis. The writer is an editor for Vanity Fair...  

Let me add a few points:

  1. McLean is confusing free cash flow with profits.  These are not the same.  Companies growing production quickly will often be free cash flow negative, because they are using cash from operations and debt to maintain the pace of expansion.  By contrast, accounting profits, which match current period revenues to current period expenses, are actually quite good for some operators.  For example, we estimate underlying after-tax net income / sales at 14% for Pioneer Resources, after adjusting for one-time gains and costs.  Pioneer's underlying breakeven continues to fall, now $51.50 / barrel realized price.  If we include discounts resulting from Permian pipeline constraints, the company's net breakeven rises to around $58 WTI.  Still, nothing wrong with that when WTI is just about $70.

  2. Oil prices are set by US shales.  Since 2005, US shales have contributed 63% of total global supply growth.  By contrast, OPEC has added 20% of total supply, barely enough to cover losses from countries whose production has been declining.  Shales are not the tail, they are the dog.  Put another way, if shales were producing less, oil prices would be higher.  If they were not producing much at all, then oil prices would be well over $100 / barrel, as was the case before the shale revolution.

  Source: EIA STEO

Source: EIA STEO

At any given time, shale companies may or may not be a good equity investment, depending on how hyped the shares are at the moment.  Nevertheless, the economic reality is this: The global economy cannot continue to expand at a normal pace without a commensurate increase in the oil supply.  Right now and for the foreseeable future, that means shales.  Shales are not a nice-to-have, a pets.com, or a fad.  They are the lifeblood of the global economy and absolutely essential to the world's prosperity.