This Einhorn thing has me a bit spooked, no doubt about it. At the Sohn conference, the master of the Greenlight hedge fund trashed the business model of the major US shale oil exploration and production companies – and I think his analysis is almost completely right, with a few caveats.
It's astounding, as I get ready to release my new book, “Shale Boom, Shale Bust”, how many of the themes I write about are starting to make headlines with 'the more powerful' – besides Einhorn, the NY Times has recently written about the transfer of 'swing barrel' responsibility from Saudi hands into the hands of producers here in the US, another major theme of the upcoming book. I must be on the right track. But back to Mr. Einhorn.
His arguments on the shale industry stem from development costs that outrace the enterprise value of the resultant business – in other words, costs sunk into getting oil out of the ground only serve to deplete the product you've paid to develop. He's got a problem with current low prices too.
Now, the oil business is always going to be based upon a depleting reserve model, so that was an immediate rebuttal to Einhorn – but shale is admittedly much different. It develops fast and for less per well than any other kind of oil, which leads to an incredible lack of development discipline, and it continues to sit at the upper end of breakeven costs, even with recent efficiency gains. Worst of all, the production is supremely front-loaded, allowing accounting tricks and overconfidence that oil companies take advantage of in securing more development capital to fund the next well and the next. Projections on initial well results are consciously and unconsciously extrapolated forward to yield far, far too rosy a picture to investors on Wall Street. I talked about this a few months ago in my book excerpt “Shale is a Ponzi Scheme”.
Don't get me wrong, I'm not in Mr. Einhorn's camp that Pioneer Natural Resources (PXD), along with EOG Resources (EOG), Continental (CLR), Concho (CXO) and Whiting (WLL) today represent the mother of all shorts (well, maybe Whiting), but you should be aware of the calculus that I do in the presentation of my columns and stock recommendations, especially since I agree so much with so much of Mr. Einhorn's presentation.
Yeah, OK, so David's right – but since when did the stock market give a damn about right? You and I could both list several hundred stocks that have carried multiples in the 40's that have still managed to triple – and the cycle in US shale is in its absolute infancy and prepared to consolidate, yet grow strongly for at least the next 3 years – a continuing upcycle I don't think you can afford to ignore.
On the very strong plus side for shale players, and why I maintain that big money will still be made in many of these stocks are three points that Einhorn forgot to make: One, that the strongest set of prime acreage in the Eagle Ford, and particularly the Permian (Delaware, Sprayberry, Wolfcamp) has only begun to be harvested and will generate fabulous results for years. Two, efficiencies in drilling, infrastructure, spacing, crew size and a dozen other factors are slashing completed well costs (CWC) even more quickly than the most optimistic oil companies have been predicting. And three, I am convinced that oil will – and not more than two years from now – see $150 a barrel, obviously turning the Einhorn financial analysis into rubble.
For traders, timing is everything. The analysis is important and worthy of respect, but the timing of the trade is always what counts the most. And while I almost completely agree in David Einhorn's long-term characterization of shale oil, I almost completely disagree with the timing of his presentation and therefore timing of his trade.
But I'm still a bit spooked. The short thesis comes from conclusions I've reached myself. And Allied, Lehman Brothers, St. Joe's, Green Mountain Coffee and now Pioneer – there are some pretty good trades in that list – from a pretty smart guy.