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Are Shales a Bubble?

Hype works. Particularly when monetary and economic benefits are promised. Hype has been the primary tool used by the oil and gas industry with regard to shales and it has worked brilliantly. There is just one problem. When considering shale economic viability, hype was the only aspect that actually existed.
Interestingly, the past year has brought massive write downs in shale assets and a frenzy of asset sales. Some companies, such as Shell, admitted that their divestment of North American shale properties was to stem the financial hemorrhaging and to distance themselves from disappointing well results. Others, like Exxon Mobil, claim to still be true believers in spite of their losses.
According to a Bloomberg article dated May, 2014:
“The recent battering of Forest Oil (FST) shows how the borrow-drill strategy can backfire. Forest generated $1.3 billion by selling assets in 2013 to pay down debt and finance its drilling as it focused on its Eagle Ford acreage. In February the company reported disappointing well results. Forest didn’t have enough revenue coming in to keep from running afoul of its debt agreements. Both S&P and Moody’s cut its credit outlook to negative. The way the shale boom is being financed is “a perfect setup for investors to lose a lot of money…The model is unsustainable.’”
Nevertheless small investors are racing to get in.
In financial bubbles, hype plays a key role, frothing investors, both large and small, into giddily throwing their money at companies. As the cycle matures, a couple of things begin to occur. Larger, more sophisticated investors quietly begin to exit while less sophisticated investors become ever more indiscriminate in their choices. Small investors, who might normally be circumspect, start to place their hard earned monies with companies which demonstrate virtually no proven track record and/or whose credit quality is not only less than stellar, it is actually junk. Literally.
Bloomberg reported:
“Rice Energy (RICE), a natural gas producer with a low credit rating, raised $900 million in a bond sale in April, $150 million more than it originally sought. Investors snapped up the bonds even though the Canonsburg (Pa.)-based company has lost money three years in a row, has drilled fewer than 50 wells (most named after superheroes and monster trucks), and said it will spend $4.09 for every dollar it earns (before interest, taxes, depreciation, and amortization) in 2014″
Is this a good risk even if your wells are named after Super Heroes? S&P recently stated that of the 97 energy exploration and production companies it covers, 75 are rated below investment grade. This is what is known in the investment world as “junk”.
Examining shales since the beginning of 2013, we saw mergers and acquisition activity fall to its lowest level in years with a decline of about 52%. This means that deals were drying up and the large banks were no longer generating exorbitant fees from shales. Then we saw large private equity money move away from the sector plunging over 90%. Companies which had been running operations for years on borrowed monies suddenly lost adequate access to easy capital. Hence the sale of assets such as those by Forest Oil as mentioned above and virtually all other operators. Very large write downs also ensued. At times, acreage monetizations appeared to be hitting fire sale levels.
During this time, big money was quietly moving elsewhere into investments with more potential than shales. The small money, however, was becoming ever more reckless.
Mike Kelly, an energy analyst at Global Hunter Securities in Houston, told Bloomberg, “This is a melting ice cube business. If you’re not growing production, you’re dying.”
A melting ice cube is the perfect analogy for shales. The production declines are so steep that the only way to keep the game going is to drill and drill and drill a lot of very expensive wells with most having rather marginal performance and very short lives. Spending four dollars for every dollar you make simply doesn’t work over any meaningful period of time. It is inevitable that you will hit a financial wall.
Asset sales and write downs are good indicators that things aren’t working as they should. Unfortunately, small investors continue to blatantly disregard these warning signals which, of course, is another good indicator of a mature investment cycle.
In spite of all the hype, all the sophisticated jargon and all the fantastical prognostications about shales and energy independence, if your cash runs out, there is no where to hide. Even if you’ve named your wells after Super Heroes.
Superhero flash image via Wikimedia Commons.
Melting ice cube image via dolkin/flickr. Creative Commons License 2.0.

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