The Contradiction of Shale

Patrick S. Kaser, CFA, Managing Director & Portfolio Manager, Brandywine Global (a Legg Mason affiliate)

Patrick Kaser

“Black gold,” like the precious metal it borrows its nickname from, has caused investors a lot of pain in the past decade. But whereas the precious metal no longer impacts the world economy like it once did, oil prices dramatically impact consumer behavior, employment, and the budgets and fortunes of many nations. It can even impact industries far beyond energy, from autos to airlines, and chemicals to utilities. Very few people saw the collapse in oil from $100 to sub-$30, many didn’t foresee the rise back to $50, and the market has much more fear than conviction in the next move.

Part of this fear comes from the growth of U.S. production—the rise in shale has disrupted the world of oil producers, leading the U.S. back to a position of relative strength. And yet globally, the industry still seems to be plagued by problems balancing supply and demand. While the best guess is that the problems could get resolved by higher prices, that may not necessarily be true. Let’s look at what seems to be the leading scenario: shale production will increase above expectations, and oil will move closer to $40 than $60. This is, on the surface, good for the United States. More production means more service jobs, more infrastructure, fewer imports, and lower prices for consumers if the $40 forecast is correct.

One problem is that certain parts of the supply chain—sand and truck drivers—are already getting very tight at current levels of production. There isn’t enough infrastructure in terms of rails and pipes, to get a lot more out of certain basins, such as the Permian. This dearth suggests that costs will rise, against a scenario where oil companies are not making much money or producing extra cash flow with prices in the low/mid-$40s. In some cases, companies would be burning cash again.

A second problem is that we already have data suggesting massive underinvestment outside of the U.S., such that there appears to be a potential supply shortage in the coming years, assuming reasonable demand growth. We know that oil-producing nations are running massive deficits at $50 oil. It is unlikely that U.S. shale production can increase by 3-5 million barrels in the next few years, which might be needed if the underinvestment thesis is correct. While there are a handful of countries aside from the U.S. with technically recoverable shale oil and natural gas resources, successful production is still a long ways off. We recently saw Poland try and fail at shale production. While the geology is supportive in many places, the infrastructure—including pipelines, services, takeaway facilities—simply does not exist where needed. Additionally, many countries lack the mix of large and liquid capital markets, legal mineral rights, and abundant water resources that the U.S. has in place.

Finally, we have concerns about the behavior of the Organization of Petroleum Exporting Countries (OPEC). Will members stick to their production curtailment? Following OPEC’s announced production cuts in May, U.S. inventories have fallen less than hoped while oil prices have not risen—unfortunately the organization’s pledge did not have its intended effect. They all want higher prices, and Saudi Arabia especially seems to want $55+ for a possible Aramco initial public offering, but they also all need cash flow. If OPEC members believe prices aren’t headed higher, the incentive to maximize cash flow becomes appealing.

This leads us to the contradiction of shale: higher shale production means more supply and lower oil prices globally, while increasing the cost of production for shale. Lower oil prices lead to better economic growth globally, meaning more demand for oil. Lower prices keep inflation under control, holding down interest rates. Lower oil prices lead to continued underinvestment outside of shale, meaning as demand rises, a supply gap likely arises in 2-4 years.

And then, what happens? It seems that more low-cost shale production ultimately sets up the world for an eventual spike in oil prices—potentially at $100+ a barrel—which would choke off growth. Or, low oil prices could lead to geopolitical crises and unrest in rentier states, which could also result in a price spike. Alternative energy is unlikely to fill the void in the next five years. The consequences of this tail scenario impact yields, currencies, global growth, geopolitics—essentially everything!,/p>

The best, most stable outcome seems to be a fine line where shale production increases some but not excessively, and oil prices hover in the low $50s, so that enough non-U.S. investment can happen to develop future supply. We think markets see the lower $50 range to be the sweet spot, at least for now, but have skepticism as to whether that can be maintained. The problem is that this fine line, while seemingly walked so far, has no party incented to control the path. As a result, investors should probably take an unexpected outcome into consideration at more than minimal odds. Even though energy companies look to be in better shape than they were six months ago, there is this prevailing fear that inventories will not draw lower—a sentiment that has encumbered energy stocks in the short term but may present a longer-term opportunity.

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