How Shale Is Becoming The Dot-Com Bubble Of The 21st Century

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By Leonard Brecken, a portfolio manager and principal at Brecken Capital LLC, a hedge fund focused on domestic equities. You can follow Leonard on Twitter: @Lbrecken13. Originally published at

As I review the financials of one of the largest shale producers in the United States, Whiting Petroleum (WLL), I can’t help but notice the parallels to the .COM era of 1999 which, to some extent, has already returned to the technology and biotech sectors of today. Back then, the faster you burned cash to capture customers regardless of earnings to drive your topline, the higher your valuation. The theory was that after capturing the customers (in energy today, it is the wells) spending would slow and so would customer additions allowing companies to generate cash. By the way, a classic recent case is none other than Netflix (NFLX) which, in the past was exposed for accounting gimmicks that continue even today. It is still following this path of burning cash for the sake of customer additions, while never generating any cash in its entire existence.

Cash was plentiful in 1999 so it could always be raised as the Federal Reserve began its easy money era creating a series of bubbles for the next 15 years. Does this sound familiar to what is occurring now? It will end the same way and that process has already started as currency wars heat up and our economy grinds to a halt proving QE does not, in fact, create wealth (temporary yes for the 1%, short term, until POP) but instead it destroys it by distorting asset prices, misallocating investments, and ultimately creating an equity crash.

We just witnessed this in energy, as all the economic stats that distorted the real underlying economic weakness in the economy led energy producers to overproduce while easy money fueled it and expanded speculation in the futures market. Back in 1999 did the internet companies adapt their business models? Some which still survive today did, but most went bankrupt. The parallels here with energy are simply stunning as most E&P companies need to spend well over their operational cash flow in order to not only grow but to replace the wells that are producing tied to depletion. Money is free right? Well we are witnessing the and it may not last, as junk bond investors in energy can attest.

Further, US equity markets are beginning to “realize” that the US economy isn’t better off vs. Europe and the US dollar begins to fade as it shows signs of correcting as well. The Fed clearly isn’t as accommodative by instantly launching QE4, for a host of reasons, thus potentially opening the door to a deeper correction vs. prior ones in order to get what the 1% wants again: more QE. Yes the Keynesian back loop is real as, in the past, each equity correction was met with more QE.

WLL, in its March quarter, generated over $200M in cash from operations and, with hedges and production expected to be flat sequentially for rest of year in 2015, expects to earn at least $850M in cash from operations, give or take. The problem is though, they need to spend $2B to keep it up because depletion rates are so high. They claim “growth” capital expenditures are discretionary (just like NFLX by the way, in capturing customers), but the realities are that wells in the Bakken deplete 80% in 12 months, so does that really sound discretionary

What is worse is WLL continues to grow production even though prices have collapsed and cash generation is in decline. In fact, year over year cash generated from operations fell 30% despite production growing some 70% percent. Does this sound like a company you want to invest in or like one that is run efficiently? So, let’s review: .com companies did the same and the majority went bankrupt so if WLL and other E&P companies continue to spend cash well above their operation capacity, not because they want to but because they have to, it will lead to the same result as it did in 2000… POP!

Most of these E&P companies who do not adapt will go bankrupt as the money runs dry, unless they spend within their operational CF. As of now, WLL specifically does not seem to be adapting as production rises this year and next. On their EPS call, management did say next year CF would fully cover capital expenditures which is encouraging, assuming current strip. Those companies that do adapt will not only survive but will thrive, as we believe that the ultimate result of all this will be much higher oil prices from here. The shale revolution will see a dramatic period of slow growth/no growth or more likely declining production as marginal players leave and costs to drill overall, outside of most prolific areas (as they run dry), rise. And as a reminder, OPEC does not have the spare capacity in hand to supply the market in prices longer term. In the short term and as a rule of thumb, do not invest in those companies who spend considerably above the operation cash flow and only consider those that respect their limits.

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13 comments

  1. NotSoSure

    They are praying hard that ISIS will take down the House of Saud. That’s their only hope.

    1. RUKidding

      Possibly, except I thought the House of Saud worked with the CIA to create ISIS. But then again, the CIA could unleash ISIS back at SA. Anything goes!

    2. PlutoniumKun

      All it would take would be one small ground based anti-ship missile fired by Houthi’s from Yemen at any fat tanker in the Gulf of Aden (the absence of these missiles – which Iran have supplied to Hizbollah, is one more bit of evidence that Iran is not in fact providing significant military support to the Houthi’s).

  2. Brooklin Bridge

    It remains to be seen how those “much higher prices” are going to drive up demand. Will the .01% tooting around in tank like affairs be enough?

  3. Larry

    So in the short term stay away, but in the long term, won’t these shale plays be nice to acquire at rock bottom bankruptcy prices. Then just sit back and collect the money when oil prices sky rocket again.

    1. PlutoniumKun

      Nope. The point the Saudi’s have been making is that they have the power to swat away competitors in high cost oil (i.e any oil which costs more than $70 or so a barrel to produce). It would take several years and billions to revive shale plays if they have been abandoned. That would be plenty of time for the Saudi’s to open up the pipes again and drive prices down below Tight Oil costs again.

  4. vegeholic

    Tight oil / shale oil is only “profitable” if you are successful to push the costs of the externalities onto others: society, neighbors, future generations, etc. For example, if a company had to pay immediately for the cost of detoxifying the fracking fluids, they would get into another line of work. On the other hand if you are allowed to just dispose of these fluids into an injection well, then the toxicity and other effects become someone else’s problem. Witness the rise of Oklahoma and Ohio to leadership in the ranks of seismically active regions (linked to the dramatic rise in use of injection wells for disposal of waste fracking fluids). Are the oil companies stepping up to pay for damages from the resulting earthquakes? You have to be kidding. So you can plan to sit back and collect the profits from a revived shale industry as long as we all agree to divert our eyes and pretend not to see the consequences, and have our checkbooks ready to pay for them.

    1. RUKidding

      Well diverting/averting our eyes from what’s truly happening is as American as apple pie, mom & something something, isn’t it? Aren’t most US citizens in total denial about just about everything that’s *really* going on? Seems that way to me.

      Earthquakes in OK an OH? Why that’s an act of “God,” and the 99s can just damn well pay for it. After all the .001% pays no taxes at all ever. In fact, the 99s pay taxes to the .001%. And so on…

  5. RUKidding

    Thanks. Good article. Pretty much confirms what I’ve been witnessing with my lying eyes. Tech is in another bubble, and fracking has never ever really made sense. At to that, we are in another RE bubble – at least in certain parts of the US. Hold onto your hats, my friends. It’s gonna be another bumpy ride.

  6. Luke The Debtor

    I don’t follow the narrative. If its the Fed’s easy money policy (low interest rates) causing the shale boom, then why is it that an oil price drop in the absence of a rate increase is the cause for the major recent pullback by operators?

  7. kaj

    I have mixed feelings about your prediction of higher prices from here on. I believe that the new fleet of autos is going to do more damage to consumption than you anticipate. I recently drove a rented Ford Focus (was it or some other cheapo from Ford) from SFO to Oregon and it gave an incredible 49 miles to the gallon;;; I just couldn’t believe it. I was thinking of buying a Prius, but now I plan to be more thoughtful in choosing. Consumers by the drove are replacing their old buggies because of low interest rates and recent numbers suggest auto purchases in the 16.5 million/year rate. A down turn in the economy which I don’t anticipate will just keep the rates low; low enough for the auto sector to continue to sell their highly efficient semi-electric cars and lower oil consumption. No wonder the producers want to export gasoline, especially the refiners.

    Forecasting the future is a hazardous game;; the zone of uncertainty is huge, and one has to be careful going on the limb.

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