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 many consider to be the definitive account of Enron and its unraveling.
Much of the attention, including some criticism, regarding McLean’s piece centers on its title: “The Next Financial Crisis Lurks Underground.” The author admits it likely overstates things, and anyone who reads the piece will find it’s not her central thesis.
McLean’s real message is that growth in America’s shale-oil production may not be sustainable. On this count, she might be on to something—at least in terms of questioning the all-in financial returns of companies leading the revolution.
There’s no arguing 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 public markets, spending beyond their means with little regard to the amounts of capital they consumed. There are plenty of reasons why this was the case, but the “wildcatter” mentality that has endured in the industry clearly was a factor.
Eventually, after years of prodding by fed-up investors, larger public E&Ps led by the likes of Exxon got religion, installing leaders with greater financial sophistication and discipline. Today, these E&P heavyweights remain reasonably attentive to the issue of financial returns.
But it’s small and medium-sized E&Ps driving today’s shale revolution. These players 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. For these would-be sellers, it’s the “kicker” at the end that matters.
But here’s the rub: We’re not aware of any analysis that shows these premium exits are sufficient—in number or magnitude—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 weird game of musical chairs in which excesses remain obscured—until the music stops.
If for every star like EOG and Pioneer Natural Resources there are inevitable train wrecks like Linn or Chesapeake Energy, are projections for aggregate shale-oil production overdone? And if so, is crude fairly priced?
There’s also the question of how to define the shale industry. If you include the oilfield supplier segment, it’s almost certain participants aren’t covering their cost of capital. We wrote about the low returns of suppliers late last year. 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%. Over the same period, oilfield supplier indexes are down approximately 56%. E&Ps can’t continue to survive 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, traveling roads that are straight and clear. But the truth is certain risks are often ignored or wished away when the focus is on growth.
The problem with insufficient “takeaway” capacity in the Permian Basin is one example. In most E&P companies, the responsibility for the procuring of 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 issues can be overlooked.
Even when pipeline constraints are known, decision-makers tend to believe they will resolve themselves. But in areas of concentrated drilling with many participants it’s often not the case. The result can be unexpected curtailments to production—and a damming effect on financial returns.
All this suggests the need for better 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 pervasive to be underpinned by anything other than transparently sound economics.