The shale oil bust

Crunched by lower oil prices and excess production capacity in the global market, shale oil related stocks are rapidly losing their shine.

Summary: In Australia, an attempt to replicate the US shale boom is effectively over, forcing an exploration switch back to conventional oil and gas. US fund manager David Einhorn has criticised the US shale industry for its low levels of profitability, while the Australian industry is buffeted by strong levels of production and sluggish demand. Some oil majors have walked away from local projects, while BHP Billiton has booked heavy writedowns on its US investment.

Key take-out: Australia’s shale industry might restart if the oil price rises back above $US100 a barrel, but investors would need to be convinced the higher price is sustainable.

Key beneficiaries: General investors. Category: Oil and gas.

 It was fun while it lasted but Australia’s attempt to replicate the US boom in shale oil and gas is effectively over, for now.

A lack of significant success and a realisation that Australia’s geology is different to that in the US has combined with a shortage of essential pipeline and other services in remote areas to force an exploration switch back to conventional oil and gas.

Compounding the challenge for Australian shale explorers are rapid moves in the price of oil which collapsed last year from more than $US120 a barrel to less than $US50 a barrel, but has since risen to more than $US60 a barrel.

The recent oil-price rise is having a positive effect in the US with shale explorers stepping up drilling, partly in the hope of catching the higher price but also because many are under intense financial pressure to generate revenue to service high debt levels.

In time the renewed drilling in US shale fields is expected to trigger a fresh fall in the oil price, triggering another crisis for an industry which needs high prices to survive.

This roller-coaster ride for the US shale-oil industry, caused partly by its own success and partly by a refusal of other big oil producers such as Saudi Arabia to cut production to boost the price, has triggered a critical appraisal of the shale business case.

The most strongly-worded attack on the shale-oil industry came last week from a US fund manager, David Einhorn, a specialist in short selling over-valued assets who made his name (and fortune) by betting against Lehman Brothers and other investment banks in 2007.

Einhorn’s criticism of the shale industry has a touch of his Lehman attacks, starting with a damaging assessment of the industry’s low levels of profitability and its need to constantly raise capital as a substitute for earnings.

He estimates that over the past 10 years the US shale industry has spent $US80 billion more on acquiring and developing reserves than it has generated in revenue from oil sales.

While oil prices remained above $US100 a barrel the shale industry could justify its rapid expansion which required high levels of capital and debt.

But, the fall in the oil price has exposed the fragile financial structure of a large portion of the US shale industry, and caused many one-time supporters to have second thoughts about their exposure.

In many ways what’s happening with shale oil is the same as what’s happening to Australia’s iron ore industry which is also being buffeted by strong levels of production which is flooding a market weighed down by sluggish demand.

High costs oil and iron ore producers are being forced out of their industries by low cost producers.

The problems of the US shale-oil industry are magnified in more difficult countries such as Australia where the geology is proving to be less favourable and costs much higher.

Over the past 12 months hopes for an Australian shale-oil boom have faded thanks to the falling oil price and the failure of high profile exploration projects in South Australia’s Cooper Basin and WA’s Canning Basin.

First out was the US oil major ConocoPhillips, which had teamed up with an exploration minnow, New Standard Energy, to test a theory that the Canning Basin held billions of barrels of oil in deeply buried and tight rock units which might be amenable to the sort of directional drilling and fracturing techniques which have unlocked US shales.

Poor results from two trial wells came at roughly the same time the oil price started to fall, causing ConocoPhillips to abandon its search in a region which lacks easy access to markets and was always going to need prolific flows of oil or gas to succeed.

Six months after ConocoPhillips folded its Canning Basin search the same thing happened with another US oil major when Chevron Corporation walked away from a $350 million joint venture with Beach Energy in the Cooper Basin.

Early gas flows from the Chevron/Beach joint venture had encouraged the industry but the harsh reality was that the flows were too small, the costs too high, and the Australian market too small to justify persevering with the unconventional oil and gas of central Australia.

BHP Billiton, which has invested heavily in the US shale oil industry, is another company having second thoughts. It has already booked heavy financial write-downs on the value of its US investment and is seeking to sell some of its shale assets.

But the more significant development with BHP Billiton was comments last week from the company’s chief executive, Andrew Mackenzie, that he was interested in expanding the company’s oil and gas division – but only in conventional petroleum assets.

Mackenzie did not criticise the shale industry, which is understandable as he is trying to sell shale assets, but the reference to conventional oil and gas as a growth option was important because it represents a return to an easier and more profitable from of production.

There are other examples across the oil world of the shale revolution running out of puff thanks to the combination of difficult geology, expensive extraction and low oil prices.

The search for commercial quantities of oil and gas in shale and other unconventional rocks has failed across Europe and Asia with most of the world’s big oil companies, including Chevron, ExxonMobil, ConocoPhillips and Royal Dutch Shell dropping projects outside the US.

Deals are still being done in US shale, but at a fraction of last year’s values. Noble Resources all-share merger announced last week with Rosetta Resources is an example with the $US3.7 billion value put on Rosetta less than half the company’s value of 12 months ago.

The problem for most shale oil producers is that they are at the high-cost end of a glutted market. They can also be their own worst enemy because when the oil price recovers they rush back into production to generate revenue to service their debts ensuring a future price fall.

While US shale producers see an oil price above $US65 a barrel as an incentive to re-start drilling a much higher price is required in other countries, including Australia, thanks to the lack the infrastructure and small market.

If the oil price rises back above $US100 a barrel Australia’s shale industry might re-start, but investors would need to be convinced that the higher price is sustainable before tipping more capital into a high cost, high-risk sector of the oil industry.