Why The Shale Oil “Miracle” Is Becoming A “Debacle”

Energy is everything. 

This is an amazingly important concept. Yet it's almost universally overlooked.

Sometimes it’s hard to appreciate the magical role energy plays in our daily lives because most of what we experience is a derivative of it. The connection is hidden from direct view.  Because of this, most people utterly fail to detect or appreciate the priceless and irreplaceable role of high net-energy fuel sources (such as oil and gas) to our modern lifestyle.

With high net-energy, society enjoys increasing complexity and technological advances. It's what enables us to pursue massive goals like desalinating billions of gallons of seawater, or going to Mars.  But without high net-energy fuel sources, our capabilities quickly regress to those of decades — or even centuries — past.

Which is why understanding where we truly are in the 'net-energy story' is so incredibly important. Is the US on the cusp of being "energy independent" from here on out? Is the "shale miracle" ushering in a glorious new 'boom' era that will vault America to unprecedented prosperity?

No. The central point of this report is that the US is deluding itself when it comes to energy abundance (generally) and oil (specifically).

Yet that's not what we hear from the cheerleaders in the industry or in our media. From them, we hear a silver-tongued narrative of coming riches — a narrative that contains some truth, some myth, and a lot of fantasy. 

It’s those last two parts — the myths and fantasies — that are going to seriously hurt many investors, as well cause a lot of extremely poor policy and investment decisions. 

The bottom line is this: The US shale industry resembles a fraudulent Ponzi scheme much more so than it does any kind of "miracle".

How do I know that?  Because, collectively, US shale companies have lost cash in every year of their existence.  The burned through cash when oil was $100 — and again when it was $90, $80, $70, $60, $50, $40, and $30 a barrel.  They burned through cash in 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015 and 2016.

You don’t have to be a finance guru to appreciate or understand that any industry that persistently burns through cash is a bad deal.  Especially one whose prime product – shale wells – principally deplete (-85%) in roughly three years.  If you’ve been in business for 9 years drilling wells that mostly run out in 3 years, and you haven’t managed to produce positive cash flow at any point along the way, then it's time to admit that your business model simply doesn’t work.

As even The Economist magazine recently noted:

The [US shale] industry has also lifted productivity. Drilling is faster, more selective and more accurate, and leakage rates are lower. Wells are being designed to penetrate multiple layers of oil that are stacked on top of each other.

 

But the fact that the industry makes huge accounting losses has not changed. It has burned up cash whether the oil price was at $100, as in 2014, or at about $50, as it was during the past three months.

 

The biggest 60 firms in aggregate have used up $9bn per quarter on average for the past five years.

 

As a result the industry has barely improved its finances despite raising $70bn of equity since 2014. Much of the new money got swallowed up by losses, so total debt remains high, at just over $200bn.

(Source)

Let’s run that math. Five years is 20 quarters. That times $9 billion/quarter is $180 billion dollars in cumulative operating losses. This begins to give us a sense of the magnitude of losses investors will face when the music finally stops.

Or we could note the $200 billion of total debt outstanding for the industry.  Hmmmm…with WTIC oil at $47/barrel, a typical wellhead price (that the operators actually receive being less than WTIC, always) might be closer to $40.  $200 billion divided by $40 means that 5 billion barrels of future wellhead production is required just to pay back the debt! 

If the industry decided to use the next 5 billion barrels coming out of the ground to debt reduction (it never would decide this, but bear with me for the sake of this intellectual exercise), we'd also need to include the time value of money (and actual production rates over time) and observe that the debt carries an interest rate of 5% to 8% (depending on the company). Taking that into consideration, then the next 6 billion barrels would be required to satisfy the debt, plus interest payments! 

Oh, right. And then there's the issue of repaying the $70 billion of equity raised since 2014. With some sort of return, if possible, of course.

I hope you see the same staggering disconnect in these numbers I do. Which is why, without have to go too far out on a limb, I’ll state that massive losses are coming to the (bag)holders of all this debt and equity.

So why care? Because you need to understand these details in order to position yourself properly for the future. The implications are enormous.

The Danger Behind Myths and Fantasies

Once you become aware of the magical thinking involved, you then have a chance of knowing why the future is going to be very difficult for the shale industry, its investors, and then the nation(s) depending on its oil production.

Hey, sometimes myths and fantasies are harmless to hold. Like dreaming that someday you’ll be a major rock star.

But some can be incredibly damaging because they lead to poor life choices and decision-making. Like emptying your bank account to bet on the Powerball lottery, where your chances of winning are 292,201,338 to one. Or committing your nation to a ground war in Asia thinking you can "win". 

The promise of US shale oil is a very dangerous siren song. It was so carefully marketed to gullible investors that even Obama’s speechwriter and fact checkers got swept along.  This is from Obama’s State of the Union speech from 2014:

Now, one of the biggest factors in bringing more jobs back is our commitment to American energy.  The all-of-the-above energy strategy I announced a few years ago is working, and today, America is closer to energy independence than we’ve been in decades.

(Source)

What does “energy independence” mean?  It turns out, this crowd-pleasing phrase is a fantasy that lacks any useful grounding in reality.  What  those who claim "energy independence" are doing are lumping all forms and sources of energy into a single bucket, and then asking if the size of that bucket matches our current demand.

This is an inappropriate and dangerously misguided way to look at things is because the various types and sources of energy are not interchangeable.  They don't function the same way. They generally can't be substituted for each other. And they don't cost the same.

For example, your automobile might run on gasoline which costs $2.50 a gallon.  Suppose instead you could buy coal cheaper than gasoline on a BTU basis; is that any help to you as an auto driver?  Would you suddenly put crushed coal into your gas tank instead of gasoline? No, of course not.

What if you had a micro hydro plant operating in your backyard and could extract a more Kilowatt hours of electricity from it each week than you needed. Would that make you “energy independent?”

Not if you drive a car that requires gasoline. Or cook on a gas-powered stove. Or heat your house with an oil-burning furnace.

The same is true for the US (or any country). A country is not "energy independent" unless it can meet all of its national energy demands with enough BTUs in each of the needed fuel types. Just looking at oil alone, the US still imports millions of barrels per day — even with the "shale miracle". I'll get into this more deeply in just a moment.

But first, back to the myth of "energy independence". The EIA itself has been a major proponent of this useless data glob as seen in their most recent 2017 Annual Energy Outlook:

(Source)

So, when the US lumps all of its various sources of energy into one spot – including hydropower, wind, solar, coal, oil and natural gas – nothing useful emerges from that method.  We cannot know from it if we will have too much or too little of any one type of energy, or how much we’d be under or over budget in selling the surplus of one and buying to cover the deficit of another.

The delusion has only gotten worse under Trump. The useless and misleading clumping of energy into a single bucket has morphed into an even larger error; one shared by many otherwise intelligent "experts". 

See if you can spot the error (I bolded it so you shouldn’t have too much trouble):

Trump Hails 'Energy Revolution' as Exports Surge

June 27, 2017

 

WASHINGTON (AP) — President Donald Trump on Tuesday hailed an energy revolution marked by surging U.S. exports of oil and natural gas.

 

Trump cited a series of steps the administration has taken to boost energy production and remove government regulations that he argues prevent the United States from achieving "energy dominance" in the global market.

 

"Together, we are going to start a new energy revolution — one that celebrates American production on American soil," Trump said in a statement, adding that the U.S. is on the brink of becoming a net exporter of oil, gas and other energy resources.

(Source)

It is a massive error to state that the US “is on the brink of becoming a net exporter of oil.” While I can see how that conclusion follows logically from all the disinformation provided about “energy independence” and the hype spouted by Wall Street and the shale companies — it’s totally false.

The US is NOT on the brink of becoming a net oil exporter. And it almost certainly never will be. 

Here’s the data: 

(Source)

The above chart tells us that, to become a net exporter, the US would have to both hold demand steady (i.e. not increase consumption at all) while also boosting production by nearly 5 million barrels a day (mbd).  That is, the entire current output of the shale “revolution” would have to be replicated, because current total shale oil output in the US is around 5 mbd

But it would actually be harder than that. As already mentioned, shale wells have ferocious decline rates; so an additional 5 million barrels per day would require adding to new production aggressively each year to offset this ongoing extreme loss of production. 

Well, before another shale 'miracle' comes roaring out of the gate we’d need two things: enough new places to drill and more massive injections of capital.  Both are suspect at this point.

One analyst doing a superior job looking at the details is Rune Livkern of Fractional Flow, who made this excellent chart estimating that in the Bakken play, one of the best-performing  shale basin darlings of the entire “revolution,” the cumulative negative cash flow between 2009 and 2016 (a full 7 years of history) totaled some -$32 billion in losses:

(Source)

Now why do shale oil operators keep burn cash in every time period?  Especially given the hype that they're constantly becoming better and more efficient at drilling.  Better productivity should mean better profitability, especially when you have the big operators like Pioneer Natural Resources (PXD) constantly saying things like this (from their last investors conference call):

"Our break-even oil price is $20 a barrel," Frank Hopkins, Pioneer’s senior vice-president, told an industry conference in London this week. "Even in a $40 world, in a $50 world, we are making good returns.

(Source – Bloomberg)

A company breaking even at $20 should be rolling in cash with oil at $45.  But they aren’t.

Here’s the cash flow chart from PXD. 

(Source)

Ouch.  What explains the huge gap between the company’s own statements and its actual performance?  How can the entire industry be doing so poorly?

This mystery is solved by some basic research showing that as the price of oil moves up or down, so too do the breakeven prices:

Dr. Anas Alhaji, an economist and oil industry consultant based in Texas, along with Al Rajhi Capital, compiled the breakeven points for the largest shale producers between 2014 and the start of 2017. When placed alongside a graph of the spot price of WTI oil from the end of three quarters prior, it appears the breakeven points for shale are actually a function of the past price of oil itself.

 

This indicates that because shale costs are not fixed or even stable, the industry will likely struggle to achieve consistent profit unless the labor market and vendor markets are transformed.

 

Essentially, shale should struggle to achieve sustained profitability, no matter the price of oil.

(Source)

Here’s the chart produced by that study. It’s plain ugly for shale investors, for a couple of reasons:

(Source)

First, the blue line is the weighted average breakeven cost to produce oil from shale wells.  Second the orange line is the WTI price of oil — it's usually below the blue line. 

Keep in mind: the WTI price is always higher than the price the operators actually receive at the well head for their produced oil because of shipping and other costs.

So mystery solved. Costs higher than revenues = Losses.

This chart says “These companies do not make money doing what they do.”  The companies' own financial filings say the same thing.  There’s no real mystery here.  These companies are losing money and they have been for years.

So, when will this really start to matter? And how will it likely play out?

What can investors do to position themselves to hedge against or profit from the inevitable losses that will be realized in this industry? Given the size and the importance of this sector and its product (oil), the repercussions will be felt far beyond the share companies themselves, up to and including sovereign assets.

In Part 2: The Coming Shale Debacle we detail out our projections and strategy for investors to consider in their portfolio positioning. The investment world rarely provides opportunities with as predictable a result as the correction coming to the shale industry.

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