Shale boom leaves investors underwhelmed

January 5, 2014 4:33 pm

Shale boom leaves investors underwhelmed

By Ed Crooks

Revolution offers benefits to consumers rather than shareholders

Lamenting the airline industry’s perennial unprofitability, Warren Buffett observed that “if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favour by shooting Orville [Wright] down”.If equally prescient investors had seen George Mitchell’s pioneering experiments with shale gas production in the 1990s, they might similarly have been tempted to pull the plug.

To be fair, the US shale boom has richly rewarded those shareholders who were smart or lucky enough to be in at the beginning. Later arrivals who picked the right companies – generally the ones such as Continental Resources and EOG Resources that focused on oil rather than natural gas – have also done well.

Overall, however, the US independent exploration and production sector has achieved spectacular feats in developing shale production, but done nothing to excite its shareholders for years.

Like other technological advances, the refinements in horizontal drilling and hydraulic fracturing that made the shale revolution possible have delivered more of their benefits to consumers than to producers or investors.

The boom is a decade old, dating it from the first production achieved by Devon Energy in Texas after it bought Mr Mitchell’s company in 2002, and the period falls broadly into two halves.

In the first, as the potential of shale was becoming apparent, the US independent oil and gas sector roared ahead. From the start of 2002 to the end of 2007, the S&P US exploration and production sector index quadrupled, while the S&P 500 as a whole rose just 27 per cent.

Since the start of 2008, though, the exploration and production sector has underperformed, rising 16 per cent while the market rose 28 per cent.

The industry has been a victim of its own success. Abundant US gas supplies have sent prices tumbling, and even after a recent bounce helped by cold weather, the US benchmark gas price is still only one-third of its peak in 2008.

Oil prices, too, are being held down by surging US production. With supplies taken off world markets by unrest in Libya and sanctions against Iran, among other factors, rising US production helped hold prices steady when they might otherwise have risen sharply.

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As prices fell, the companies that were more dependent on gas have come off worst.Chesapeake Energy and Encana, for example, have been forced into asset sales and cuts in capital spending. Oil-focused companies have fared better, but their profitability has also been squeezed. Even EOG, one of the success stories, earned a return on capital employed of only 12 per cent last year. ExxonMobil, the best performer of the big integrated oil groups, made a 25.4 per cent ROCE in 2012.

For some opponents of shale production, the poor returns are proof that the whole industry is a bubble that must eventually collapse. The US exploration and production sector’s capital spending has for years exceeded its cash flow, and been financed by selling assets and issuing equity and debt. If that flow of capital dried up, the argument goes, then drilling and hence production would slump.

Such a crash does not look imminent. There is evidence that shale companies are “returning to spending within their means”, as analysts at Bernstein Research put it, with capital spending for large independent producers exceeding cash flow by just 1 per cent in the third quarter.

All the same, the bubble case is a useful reminder to investors that making money from shale has not been easy, and is not getting any easier. Unless the world economy really takes off, oil prices will be under continued downward pressure this year, with the US government’s Energy Information Administration expecting the country’s crude production to rise by another 1m b/d.

While Mr Buffett’s Berkshire Hathaway has benefited from the oil boom through its BNSF railway and its tanker business, it has steered clear of taking large stakes in shale production companies. Their hunger for capital and the intense competition are uncomfortably reminiscent of the airline business.

Last year, though, Berkshire bought 40m shares – worth about $4bn – in Exxon, the world’s largest listed oil company by market capitalisation.

Exxon was slow to catch on to shale, but with its vast financial firepower will be well-placed to pick up assets and companies on the cheap if the industry’s condition weakens.

Mr Buffett has been wrong about oil and gas in the past, making a disastrous investment in ConocoPhillips in 2008. But for frustrated investors wondering how to profit from the shale revolution, he may have shown the way.