Who Will Bail Shale?

A few days ago, I quoted The Economist in a tweet:

A friend of mine saw it, and mailed me:

Hi Sanjay, I just saw your tweet on the above. I have been following this sector quite closely and can claim that I have a P.hd on it because I have managed to lose money on it 🙂 

Nothing concentrates your mind when your head gets handed to you.

That said, I have been following these articles and been thinking of the point which Buffett has made about economics — always ask, “And then what?”

Most of these articles talk about weak balance sheet of Shale oil companies and the need for the various OPEC countries to balance their budgets. This kind of thinking almost seems to be equivalent of wanting to a earn a specific level of income based on the expenses rather than based on what one’s skill is and what the market will pay.

I have invested in a few smaller oil and gas companies and have been following them closely. Some of my observations: 

  • The marginal cost of oil is not a uniform number and varies from well to well. That said, this number is constantly going down as the industry gets more efficient. As oil is a commodity, I would assume that the price has to tend to the marginal cost of production (highest to meet the incremental demand).
  • Most shale companies have large unexplored land and a 10+ year inventory. As they get more efficient, I would think that the overall cost could remain flat even as they use up the better fields (this is an assumption).
  • Even if some companies are over leverage, the worst that will happen is that they companies will either file for bankruptcy or liquidate. However the resource and the cost to produce does not change. At worst a new player which is better leveraged comes along. So in the medium term, if even OPEC manages to drives out some players, the new ones will come with a better capital structure.
  • Some of this has already happened in the natural gas space, where the prices dipped below cost of production and are now back up. As soon as the prices spiked in early 2014, the production came roaring back. I think the same could happen in oil the moment prices cost $80/barrel.

I will stop now 🙂 ..What are your thoughts ?

My reply:

  1. Anytime one invests in any business involved in extraction of stuff from under the ground or the sea, or from the sun, or wind, one needs to wear the skeptical hat. There are huge perverse incentives to over-state reserves. Mark Twain’s quote is the appropriate default position: “A mine is a hole in the ground, with a liar on the top.” 🙂
  2. Even if you are very confident about the reserves, you still have to predict the future price of the commodity. Doing that accurately and consistently on multiple occasions, is beyond anyone’s capability. When oil was at $10 “experts” said it will go to $5 and when it was $140, they said it was going to $200.
  3. When you buy the stock of such a company, then you are implicitly predicting the price of whatever it gets out of the ground, even though you are not making those forecasts explicitly.
  4. There will be all kinds of experts who will sound extraordinarily persuasive with theories like “peak oil” blah blah. Lots of people will believe them and maybe the experts would be right for a while. But then almost all experts will be right for a while. And then they will be wrong.
  5. The value of an Oil company is vastly different when you use a $5 future oil price scenario than a $200 future oil price scenario. They way to not handle this inherent variability in potential future value is by using scenario analysis. That would be functionally equivalent of a man who cannot swim trying to cross a river that has an average depth of 5 feet while he is 6 feet tall. He forgets that the range of depth is between 4 feet an 12 feet. And drowns. Ignoring the range of possibilities is foolish. And in the oil business or any business which involves extracting suff from under the ground, that range is huge. [TALEB]
  6. People will continue getting things out of the ground well after it stops making economic sense. Maybe they have perverse incentives in place. Maybe they like playing Russian Roulette with their competitors. There are all sorts of reasons people will continue to do things for a long time which appear to you to be stupid and dumb. You must not expect the prevalence of sanity across the world in any commodity industry as part of your investment thesis.
  7. In any commodity-type business, it’s not possible to be a lot smarter than your dumbest competitor. [BUFFETT]
  8. Investing in such situations makes sense, if you have enormous staying power. That is, you have no debt and you have lots of patient capital that will never be withdrawn from you at the wrong moment. You’ll also need the capacity to bear pain for a long time which includes the pain of seeing other people who invest in businesses that buy commodities but sell branded products get rich in environments when commodity prices are high or low. Most investors do not fit into this class of investors. I certainly don’t.

31 thoughts on “Who Will Bail Shale?”

  1. this is brilliant! Thank you for the clarity Prof. Bakshi. Am learning every day. A small suggestion: Please write a book asap sharing your insights with other investors and potential investors so that more and more people understand the process of investing and are encouraged to invest.

  2. This is one of the best articles on oil economics I read just after reading the Economist article on “Winners & Losers” while oil was ruling at $85. However, I remember an economist from Royal Bank of Scotland commenting “The day is not too far when the sheikhs from the marauding countries will be running naked in streets & you will be throwing stones at them”

  3. Superbly summarised Sir…Even the so called experts (Tatas and Birlas and Ambanis) couldnt forecast the top of the cycle and ended up buying wrong assets.

    Plus if we could forecast Commodity Prices, shouldnt we rather trade them on London Metal Exchgane instead buying the companies which would process it.

  4. Dear Sir, low crude oil prices is a blessing for India and if it sustains can do wonder for our economy. In your view, what is the probability of oil prices remaining low for next few years?

      1. Sir,

        After seeing your response – ‘Somewhere between zero and 1.’ I could not control but to LOL.


    1. Oh my head starts spinning when I think about the economics of shale, gas, regular good old crude oil, wind power, solar power and how they interact with geopolitical developments in Russia and USA and Syria and and Iran and Iraq and Saudi Arabia. I could go on and on but I hope you get the point. There are too many variables and too much variability. This one goes in my “too tough basket.”

  5. Very good article prof….Its a price war….it will affect both the party, most of the OPEC nation has budgeted at an avg of USD-75 to 80………lets see how long they can sustain with the current price……..it reminds of detergent price war HUL and P&G.

  6. I think Howard Mark summarised the same thing by saying for commodities like oil its not possible to calculate “expected stream of future income which can be translated into a current value.” Here are the extracts:

    “If it’s so hard to value currencies, commodities and precious metals, why do I think we can invest intelligently in equities, corporate debt and whole companies? It’s because these things generate income, and an expected stream of future income can be translated into a current value. But how do you determine the intrinsic value of a Euro, a bar of gold or a barrel of oil? You can talk about the positives and the negatives associated with these goods. But how do you convert those things into a price?

    For example, the factors that argue for high oil prices are obvious. “The supply is finite.” “We’re using it up at an accelerating rate.” “Environmental issues in the U.S. will constrain the domestic supply.” “Much of the foreign supply is in the hands of hostile or unpredictable governments: Iran’s a worry, Venezuela is turning anti-American, and Saudi Arabia is subject to instability.” Sure they make oil a valuable good, but how valuable? How do we know the current price doesn’t adequately reflect these things already? What’s the right price for it.”

    1. I think Howard Marks is quite right here. Just like Mr. Buffett says about gold, the price is a measure of the fear that people have in their minds.

      I guess in commodities the game being played is not of valuation but of ‘what will the next person be willing to pay’ (Keynes). And that game should not lead to favourable outcomes, generally speaking.

      It’s probably better to own the farm that produces vegetables than owning the vegetables themselves.

  7. Shale boom is one of the biggest ever investment opportunity in listed space post financial crisis. There have been plenty of multi baggers like Chenaire Energy, Westlake, LYB, etc. These are downstream plays and quite easy to analyze following basic rules of value investing with an eye on industry. I think still plenty of winners will emerge in the shale gas boom-particularly from cheap feed stock stand point.

    BTW- Thanks for your note on Castrol. Took a long a falling oil price. Stock is up 25% in less than a month


  8. Dear professor,

    On the statement of commodities one cannot clone Buffett or your approach. You are outside of the 3 sigma in terms of efficient capital allocation. For an average guy who invests in indexes I believe gold is an insurance in the portfolio.

    Especially with all central banks busy with the printing presses 😄… If gold is so easy to get what can’t they give back the 700 tons of gold back to Germany ? Or why the central banks or buying gold…

    Curious to know your thoughts ?


  9. Thanks a lot for sharing it Professor. On the same lines, I think Mr Buffett had once quoted the prediction of OPEC and how horribly wrong it had gone in last 10 years. It goes like this ” When Crude oil was trading at $35, OPEC predicted it to stay in the range of 55-60 and then it went to 140, at which point OPEC predicted 180-200 for next 5 years and it went to 35. Then it came out with stable price at 55-60 and it again went to 115″.
    So my point is, or rather point of Mr. Warren Buffett is, that is OPEC a body which controls 25-30% of oil production can not predict the price for next couple of years with any clarity, how can anyone do it.
    Always a learning to read the blog sir. And Please write book as soon as possible.

  10. OPEC countries have done a wonderful job for themselves at amassing oil wealth in the last 10-15 years. OPEC by the way never had a target of 180 on oil and never a proponent of peak oil. They have moved their price target gradually from 25 $/bbl in 2003 to $ 90/bbl in 2014 based on their fiscal needs.

    US unconventionals have spoil the oil party and completely a game changer adding 5 mbpd in the last 4 years expected to grow at similar rate over the next 5 years.

    Difficult part of equation is how US unconventional production will behave at 65/bbl it seems there will be pain and that is OPEC’s game plan

    70-90 is a good equilibrium level for both producers and consumers, which should leave OPEC also happy.

    Low oil price themes could be very interesting in Asia, some lead stocks like Castrol , Asian paints have done very well (leading brands+margin expansion), markets love it.

    1. I think the more interesting question to ask is this: Why have long-term investors in Castrol and Asian Paints done way better over multi-year holdings periods over the last 15 years, than investors in ONGC and HOEC over the same measurement periods? Think about that…

      1. Companies like castrol and asian paints are much better businesses because of pricing power, market share, free cash flow. Upstream is a very complex area with very large capex commitment coupled with lot of uncertainties in difficult countries, markets have hard time assigning decent multiples to ONGC, HOEC kinds of businesses.

        Long term capital allocation is probably easier decision for Castrol & Asian Paints so investors are willing to assign higher multiples.

        Unless one is super trained in upstream sector it is not the area for public equity investing. Other parts of energy value chain such as chemicals, lubes & retail etc are relatively straight forward and have characteristics of moats.

      2. The answer to be simply put is: HOEC and ONGC are commodity plays with no value addition or brand. But Asian paints and Castrol have built brands based on commodity inputs. Any price fall in input would be taken to the bottom line directly. Hence, their outperformance.

      3. As far as I know, only NMDC (a commodity player with cost-advantage and licensing moat) has given 150X returns over the past 10 years. If one had invested 1 Crore in NMDC in 2003 and sat tight the investment will be now worth 150 Crores. Any way, a commodity business is a commodity business, a competitor can’t out-smart each other except if any/some of them is/are blessed by nature with ease of access to the resources (low-cost), good quality/purity of resources and strong support from the Government (license, no red-tapism etc.). NMDC has few important risks though: Naxal issues (Risk: High to medium), Rupee appreciation (Risk: High), fall in global shipping costs (Risk: medium), cut in government iron-ore import duties and Australian miners able to bring down their production costs drastically down due to some “proprietary” technology advances (this risk is low).

  11. Sir,
    What about lowest cost producers? Don’t you feel they have a real competitive advantage and can be good investment opportunities during crisis periods since they are best placed to come out of the crisis.


    1. See point 8 of my reply to the mail I got from my friend:

      “Investing in such situations makes sense, if you have enormous staying power. That is, you have no debt and you have lots of patient capital that will never be withdrawn from you at the wrong moment. You’ll also need the capacity to bear pain for a long time which includes the pain of seeing other people who invest in businesses that buy commodities but sell branded products get rich in environments when commodity prices are high or low. Most investors do not fit into this class of investors. I certainly don’t.”

      You can invest in the lowest cost producers who have zero-debt, and cash rich balance sheets, provided you have a zero-debt, cash rich balance sheet and where all the money is your own which you don’t need for several years or the money belongs to your investors who won’t withdraw it for several years. And you don’t want to notice the opportunity cost of investing in moated businesses which buy commodities and have pricing power which allows them to make money when commodity prices are high, or low.

      1. Thanks for pointing this out Sir. Low-cost producers with strong balance sheet have a moat to survive the commodity cycles much better than their competitors (For the benefit of other readers: Read the book “Little Book that Builds Wealth” by Pat Dorsey previously recommended to us by Prof. Bakshi). For example NMDC is a low-cost iron-ore miner, iron-ore is also a commodity. And interestingly NMDC is investing in a steel plant (value addition and forward integration). Now iron-ore price is reeling under pressure – could it be a good time to analyze NMDC as a business and buy it for long-term if the price is well less than its value? Disclaimer: I am positively biased on NMDC 🙂

  12. People who are bullish on shale tend to forget few basics of economics and human behavior:

    1. Reserves are highly subjective. Proven reserves mean nothing unless the price is high enough to make their extraction profitable. Hence, stats on the size of shale reserves would hold little meaning

    2. Given the high capex and fixed costs involved in shale oil extraction, companies need to maximize production to achieve fixed costs dilution and bring down operating costs. This leads to a situation of the Prisoner’s dilemma, wherein your increased production not only decreases your costs while also contributing to decrease in prices. Everyone doe this and you end up with the same margin. If you don’t others will still do it. damned if you do, damned if you don’t.
    A similar rationale was given by Saudi Arabia for not agreeing to production cuts.

    3. While most people remember and acknowledge that most of shale activity is funded by debt, they still believe that companies can continue funding their activities the debt. Any fall in oil prices is likely to increase the risk perception of oil companies, and likely to make their debt more expensive (this is likely to happen even if the benchmark rates do not go up, just think what happens when they do).

    4. A basic investor psyche is that most investors including institutional investors are short term oriented. Whenever the industry is doing well, they seem content with the growth and have no issues with no/low dividend. Trouble start whenever the industry hits a rough patch. The clamor for dividends grows as shareholders try to get whatever they can lay their hands on, and companies are forced to increase dividends even though they can ill afford to pay them. The Management also has its own incentives to increase dividends and maintain the share price. Ironically, the shareholders bleed the company of its cash and hasten its downfall.
    The above scenario has been playing out in case of mining giants which post the iron ore price cash have been forced to cut spending/ increase debt to maintain or increase dividends.

    The truth is that in good times, none of these rationale seem to apply, but once the bad times set in, all of these factors combine to work in a reflexive manner.
    The future of shale is not as bright as some say it is.

    1. Thank you for that insightfull reply! It is pure enjoyment to see multiple mental models applied – especially 2 (combining fix cost dilution to prisoners dilemma) and 4 (doubling down) were new to me.

      On 1 & 2 I can add information. The economical exploitable reserves are completely overstated, as they are at best guesses (e.g. EIA) [1]. Second the wells deplete exponentially [2]. Fracking companies have to spend more and more money just to offset depleting wells – its a race to the bottom fueled by cheap money. As a private investor I just do not know how to profit from this situation.

      [1] http://www.nature.com/news/natural-gas-the-fracking-fallacy-1.16430
      [2] http://www.pnas.org/content/110/49/19731.full

  13. On resource prices including oil and commodities, everyone should read the extensive research done by GMO LLC. And this extensive research has been condensed in very readable and interesting reports by Jeremy Grantham and very kindly made available for all to read. These are:

    • Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever – April 2011
    • Resource Limitations 2: Separating the Dangerous from the Merely Serious – July 2011

    I will not go into the details; the title of the first report summarizes the research quite succinctly. Mr Grantham had had a caveat for the resource limitations though – “Excellent long-term investment opportunities in resources and resource efficiency are compromised by the high chance of an improvement in weather next year and by the possibility that China may stumble.” As we all know, China has stumbled and so have the commodities and energy prices. The reports might have been ill-timed and are certainly not very popular right now, but only time will tell if they are accurate. But I would like to position myself on the right side of the trend in case their forecast does turn out be correct.

  14. Many theories around on the impact of low oil prices on the shale industry. Some of them seem to suggest that the industry will be hit very hard while some seem to suggest that the shale is here to stay due to technological advances. The output that was possible with about 5 wells a few years back is now being achieved with just one well due to advanced technology. Possibly the smaller players may get taken over by the bigger ones in the shale industry but the shale is here to stay it seems.

    One of the countries that has been hit hard by the low oil prices is Russia. Already reeling under the western sanctions they have been hit a double blow with the low oil prices due to their heavy dependence on oil revenues. American administration will be happy with this outcome and possibly the Saudis too as Russia has been supporting Assad’s regime in Syria while the Saudis are against Assad. In the murky world of oil industry, OPEC’s decision may have more to do than with just attacking the shale industry.

    If the oil prices and the share prices of oil companies continue to fall some of the consistently dividend paying oil majors may become attractive from an investment point of view. Many oil majors out there with a good dividend track record and one of them is Exxon who have paid dividends for more than 100 years and have increased their annual dividend for 31 consecutive years. The big man Warren Buffett holds about 1% stake in Exxon. Exxon is just one example and there are other oil majors who have much higher dividend yield than Exxon. My two cents worth on this discussion.

  15. Your friend, in my opinion, should invest more in companies which have higher debt.

  16. Good points professor. However, a dramatic fall in a consumption commodity is always an opportunity as well. So one option is to start investing small amounts in a diversified sector fund and continue to buy as it falls further. I have personally started investing in VDE – Vanguard Energy ETF and will buy on further dips. Putting your money in a fund as opposed to a specific stock is better unless you are already an expert in this sector and know the players intimately well.

    I do completely agree that this is a long long term investment and merely betting on a V shaped recovery is stupidity. However, commodities are cyclical and in consumption commodities’ case, “What goes down does come up” also applies. 🙂

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