By Anes Alic
Ticker: Just a few years back, the U.S. shale industry was drowning in a sea of hubris, with pompous experts making outrageous claims such as the Permian Shale is a near-infinite resource thanks to the basin’s explosive production growth in the latter half of the last decade.
Investors are now learning the hard way that the key to prognostication is to sound certain even when you know very little.
Analysts and investors who still harbor the “Too Big to Fail” mentality as far as U.S. shale is concerned are, sadly, mired in a depressing cognitive dissonance. The signs of the time are everywhere, and the question is no longer whether shale production can continue indefinitely but rather how much longer before it finally gives out.
One big investor has a rather depressing answer to the latter.
Adam Waterous, CEO at Waterous Energy Fund, says US shale production will peak in 2020 and then begin a steep decline thereafter. He argues that the financial position of Permian oil has clearly become untenable and production is much closer to peaking than many current forecasts suggest.
Waterous has told Bloomberg that few investors are still eager to touch the sector after nearly a decade of underperformance, including negative free cash flow and disappointing returns.
He certainly has a valid point.
Steve Schlotterbeck, former CEO of the largest natural gas producer EQT, claims the average shale company has destroyed 80% of shareholder value (excluding capital) over the past decade. The US energy sector has emerged as the worst performer over the timeframe, with its weighting in the S&P 500 falling from 13% at the peak of the shale boom to just 4% currently–unmistakable signs of capital flight.
Meanwhile, bankruptcies in the sector have soared, with the total number that have gone under since 2015 clocking in at more than 200, including high-profile ones such as Chesapeake Energy, Sanchez Energy and Halcon Resources.
To make matters worse, the fund manager says the usual M&A playbook that smaller producers have increasingly been turning to is a broken model that’s incapable of creating any shareholder value.
Living in Denial
According to Waterous, analysts and investors who don’t believe that the shale bust has already begun are going through the first phase of grief: Denial.
Investors who initially thought that the massive structural changes that kicked off about five years ago were merely a cyclical event with the good times set to return will be disappointed to learn that those halcyon days are gone forever. He has observed that many companies are now in the Bargaining phase as they try to operate within existing cash flows.
The good part for investors: Mr. Waterous says in the fifth and final stage, Acceptance, companies will accept that this is the new norm and will start returning cash payouts to shareholders via dividends to allow them to recoup some of their investments.
A handful of companies have arguably reached this stage as the rank of high-dividend payers in the sector keeps swelling.
That handful includes, according to Kiplinger, the likes of Chevron (NYSE:CVX), which has prioritized dividends over stock buybacks, and Valero Energy (NYSE:VLO), which has more than doubled its payout over the past five years. The list also includes ExxonMobil (NYSE:XOM), which Bank of America insists can fund massive expansion at the same time as it increases its dividend.
Room to Run?
To be fair, Mr. Waterous seems to have vested interests in the shale saga considering that his PE firm has been picking up distressed energy assets on the cheap. Waterous once served as head of investment banking at Bank of Nova Scotia where he had a direct hand in M&A plays that helped reshape the energy sector. He seems to be putting those skills to good use, with his firm buying Pengrowth Energy Corp. in November in a $21 million deal after the company’s shares cratered under a huge debt load.
Certainly not everyone shares Waterous’ “Peak Permian in 2020” view, with BloombergNEF analyst Tai Liu saying the shale oil pessimism is overdone.
Indeed, the general consensus is that the US shale industry still has some room to run, with production in the current year expected to continue to rise, albeit at a slower pace.
Nevertheless, it’s also noteworthy that Waterous is hardly alone in his gloomy shale outlook.
In 2017, Simon Flowers, Chairman and Chief Analyst at Wood Mackenzie, predicted that a slowdown in Permian production would begin in 2021 as drillers hit a cost efficiency ceiling.