Posted by Doug Sheridan - EnergyPoint Research
The New York Times recently published an Op-Ed on the American shale industry that garnered significant attention within the oil and gas community. The piece was written by Bethany McLean, co-author of The Smartest Guys in the Room—the book-turned-documentary that many consider to be the definitive account of Enron and its unraveling.
Much of the attention, including some criticisms, related to McLean's piece centers on its title: “The Next Financial Crisis Lurks Underground.” The author herself admits this likely overstates things, and anyone who reads the piece will find that its not her central thesis.
The real message of the article is that growth in America's shale-oil production may not be sustainable. On this count, McLean could be on to something, at least in terms of questioning the financial returns of the companies leading the revolution.
There's no arguing that the oil and gas industry has a spotty track record when it comes to financial stewardship. In the 1980s, E&Ps were considered the “drunken sailors” of the public markets, spending beyond their means with little regard to the amounts of capital they consumed. There are plenty of reasons as to why this was the case, but the “wildcatter” mentality that existed and was rewarded for so many years in the industry clearly had something to do with it.
Eventually, after years of prodding from fed-up investors, large E&Ps led by the likes of Exxon got religion, installing leaders with greater financial sophistication and discipline. Today, the largest companies remain relatively attentive to the fundamental issue of returns.
But it's small and medium-sized E&Ps driving the shale revolution. These companies seek to simultaneously grow production while proving up reserves. For many, the end game is the eventual sale of their companies to larger players, who are typically more focused on developing proven assets than finding new ones. As a result, for many shale operators, it's the “kicker” at the end that dictates returns.
But here's the rub: we're not aware of any analysis that shows these premium exits are sufficient in number or magnitude to boost the segment's overall returns enough to offset losses from restructurings and bankruptcies, which can soar when oil prices don't cooperate.
Moreover, as McLean points out, many sales of private-equity backed shale companies are to other private equity firms. It's a game of musical chairs in which any excesses remain obscured—that is, until the music stops.
If for every EOG and Pioneer Natural Resources there's a bookend Linn or Chesapeake Energy poised to reveal itself, are long-term shale-oil projections too high? And if so, is crude underpriced?
There's also the question of how to define the shale industry. If you include the oilfield supplier and midstream segments, it's almost certain that the shale industry isn't covering its cost of capital. We wrote about the low returns in the oilfield supplier sector late last year. Sadly, things haven't changed much since.
A comparison of E&P stock-price performance versus suppliers illustrates the point. Since July 2014, when oil prices began their free fall, E&P indexes are down approximately 13% while oilfield suppliers indexes are down approximately 56%. E&Ps can't continue to survive indefinitely on the backs of suppliers.
Old-fashioned myopia is also a problem. Many shale operators like to portray themselves as well-oiled machines built for growth with roads before them that are straight and clear. But the truth is certain risks are often ignored or wished away when the focus is on growth above all else.
The current problem with insufficient “takeaway” capacity in the Permian Basin is a good example. In most E&P companies, the responsibility for procuring the pipeline capacity needed to move produced oil and gas to market falls outside of the operations and supply-chain functions. As a result, pipeline capacity can be taken for granted by those responsible for operations.
Even when pipeline limitations are known, decision-makers tend to believe they will get resolved. But in areas of concentrated drilling with many players, that's often not the case. The result is unexpected curtailments to production—and a damming effect on returns.
All this suggests the need for more complete information. If McLean's suspicions are correct, it wouldn't be the first time the propensity to drill first and ask questions later came back to bite the industry. Either way, the assumption of continued growth in the shale industry is too important and too pervasive to be underpinned by anything other than transparently sound economics.
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