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On shale and Shell

On shale and Shell
October 8, 2015
On shale and Shell

But what if the 'supercycle' effect works on the way down, and low prices are here to stay? This is the conclusion drawn by Neptune Investment Management in a provocative analysis of oil industry dynamics. With a 'high conviction' bearish stance on the oil and gas sector, the boutique fund manager is betting that "the oil price has changed for a generation".

Neptune's argument is that the US shale industry has been a long-term game-changer. By triangulating the latest evidence from the major producers - ExxonMobil (us:XOM), ConocoPhillips (us:COP) and EOG Resources (us:EOG) - head of research Chris Taylor estimates that the marginal cost of production in the US shale sector has fallen to roughly $36 a barrel. This is much lower than the cost of offshore extraction that has influenced most recent estimates of the long-term equilibrium price for oil.

Mr Taylor points out that the conventional oil industry has been around since the 19th century, so productivity gains are now minimal. But the unconventional industry has only existed since the late 1990s, so explorers are learning very fast how to extract more oil and gas with the same resources. Increasing returns on investment are thus driving up production even as the rig count falls - a widely quoted measure of supply he dismisses as "irrelevant".

BP's latest Energy Outlook 2035 - a comprehensive attempt to chart and predict the course of supply and demand in the sector - confirms the significance of the shale revolution. The US boosted production by about 1.6m barrels of oil equivalent per day in 2014, which ranks as the fourth largest annual production increase of any country in history (topped only by Saudi Arabia in 1991, 1973 and 1986, respectively). The US is now the top producer globally, ahead of both Russia and Saudi Arabia. Crucially, BP estimates productivity growth in US shale oil - as measured by new-well production per rig - at an astonishing 34 per cent a year between 2007 and 2014.

This has shifted not just the balance of supply and demand but also the balance of trade. With North America due to become a net exporter this year, oil is starting to travel from West to East rather than vice versa, the historical norm. As Saudi Arabia and Russia have struggled to find new markets, oil inventories have piled up, weighing on prices.

Western oil groups have responded by ditching major capital projects. But the US shale industry continues to attract investment: Concho Resources, a West Texan producer, raised $712m before fees in a share sale last week. The implication is that it remains profitable even with the West Texas Intermediate spot price at $46.

The key risk to Neptune's thesis is that Saudi Arabia scales back its output. The desert kingdom's motivations are complex - cutting production would shore up prices but probably reduce the revenues on which its government depends. The BP Energy Outlook cites the response of Opec to reduced demand for its oil as a "key uncertainty". Mr Taylor's view is that any cuts to Saudi production would have to be on an improbably "heroic" scale to offset increases in US output.

Another risk is that most US frackers have higher costs than the likes of Exxon and ConocoPhillips, and so go out of business. The latest figures hardly paint a picture of boom times. US production rose 1 per cent to 9.36bn barrels in July, but that followed two months of declines.

If Neptune is right, however, UK investors should be worried. Together, Shell (RDSB) and BP (BP.) account for about 11 per cent of the FTSE 100, which is widely owned through tracker funds. As regular readers of this column will know, I also have direct exposure, having purchased Shell shares for my Isa back in May. My "modestly contrarian low-risk buy" is now showing a 17 per cent paper loss.

Shell is often regarded as a 'widows and orphans' stock - as resilient as they come. The company weathered the low oil prices of the 1980s and 1990s without cutting its dividend, so why can't it steam through the current troubles? Chief executive Ben van Beurden told Bloomberg this week he was "pulling out all the stops" to safeguard the payout, but he has also repeatedly cited an oil-price floor of $70 a barrel, which seems increasingly backward-looking.

Still, the dividends remain well covered by earnings and give a yield of 7 per cent. It seems like a crazy time to sell. I'm holding for now.