Doomsaying Falls on Ears Deafened by Latest Oil Rally

 

Money manager David Einhorn’s doomsday outlook for shale oil drillers so far is failing to resonate with investors.

A pessimistic assessment of the industry by the president of Greenlight Capital Inc. on Monday briefly shook the stock of the companies Einhorn targeted, dropping EOG Resources Inc. by as much as 2.8 percent after he spoke out and Concho Resources Inc. by as much as 3.5 percent.

By the end of the day, though, both companies recorded gains, probably reflecting continued investor confidence that oil’s price plunge from more than $100 a barrel in 2014 is spurring cost cuts and new drilling strategies in an industry long known for its profligate spending. Crude prices have risen by 36 percent since March 17, eliminating much of the decline of the preceding nine-month oil-market rout.

The oil price drop “sped up the ‘reset’ process,” said Andrew Cosgrove, an energy analyst for Bloomberg Intelligence. He cited “lower service costs, drilling times, and better technology that allows companies to target the most profitable hydrocarbon-bearing layers/areas of the rock.”

Einhorn’s comments at the influential Sohn Investment Conference in New York Monday revamped a recurring topic of debate in oil-investing circles: are the billions of dollars in expenses required to discover and pump crude justified by the years it can take to recoup those costs and begin earning a profit? In shale, the hottest growth area for the international petroleum industry, Einhorn said the answer is no.

Negative Economics

“These companies have negative development economics, meaning that aside from a few choice locations, they don’t earn a positive return on capital, but have a nearly infinite supply of negative return opportunities,” according to Einhorn. The share prices are “poised for a fall,” he said.

Investors support these companies for their reserves growth, according to Cosgrove, not their cash flow. “Until the cheap money runs out and interest rates are much higher than where they are today, do not expect capital to stop funding these drilling programs,” Cosgrove said.

Although the data underlying Einhorn’s analysis appears sound, his conclusions assume an overly bleak outlook for the oil industry, said Subash Chandra, an oil analyst at Guggenheim Securities LLC in New York. Investors value a company largely on their future production prospects.

Future Payoff

“I don’t think he made up any of the numbers,” Chandra said. “If investors are valuing barrels in the distant future, it’s because they think that over that time period the companies will be able to monetize them and sell them.”

The deflation of crude from more than $100 a barrel last year means a lot of shale fields — and their owners — no longer make economic sense, Einhorn said. He singled out Texas shale explorer Pioneer Natural Resources Co. for particular attention, estimating the company loses $12 on every barrel it pumps.

“That’s like using $50 bills to counterfeit $20s,” Einhorn said. “A business that burns cash but doesn’t grow isn’t worth anything.”

The value the market places on oil fluctuates wildly, and shale producers who were squeezed when crude tumbled as low as $42.03 less than two months ago are already feeling some relief as prices recover.

Producers responded to the slide in prices by laying off tens of thousands of workers, postponing project investments, consolidating offices and shutting down drilling rigs. The number of rigs drilling for crude in the U.S. tumbled 58 percent in the past seven months. But because there’s a lag between the idling of rigs and production declines, output only began to drop in late March.

Crude Rebound

The benchmark grade of U.S. crude, West Texas Intermediate, closed at $58.94 on Monday, close to the 4 1/2-month high of $59.63 touched on April 30. If the bust is over, even oil producers who borrowed heavily at high interest rates to finance the last decade’s boom will have room to resume growing.

That may not be a good thing, according to Einhorn. Last year alone, when U.S. crude averaged $101 a barrel through the first seven months, the top 16 shale producers burned through $20 billion, he estimated.

“They responded to higher oil prices with even more aggressive capital spending, financed ever more cheaply by Wall Street,” he said.

Cash Treadmills

Although Pioneer boosted oil and gas output by 70 percent in the last five years, that came as a result of a six-fold surge in development spending, according to data compiled by Bloomberg. Pioneer executives have said the investment will pay off in future years as wells continue delivering oil long after they’ve paid for themselves.

Pioneer fell as much as 5.3 percent for the biggest intraday decline since Feb. 11 after Einhorn’s comments triggered a sell-off. The shares later recovered, closing down 1.9 percent.

“A lot of people see exploration and production companies as treadmills that require more and more cash to keep production growing,” said Mark Hanson, an analyst at Morningstar Inc. In Chicago. “But there certainly are firms out there making a decent return on capital, and Pioneer is one of them.”

Hanson said Einhorn’s comments haven’t shaken him from his $140-a-share fair-value estimate for Pioneer. More broadly, “I didn’t see anything that would make me rethink how I would view the industry,” he said.

In addition to Irving, Texas-based Pioneer and Midland, Texas-based Concho, Einhorn assailed EOG Resources Inc., Whiting Petroleum Corp. and Continental Resources Inc. as examples of shale explorers that spend too much and generate too little cash.

Tadd Owens, a spokesman for Pioneer, didn’t respond to a voicemail seeking comment. EOG spokeswoman K. Leonard also didn’t respond. A Concho spokeswoman said she wasn’t immediately able to comment; spokespersons for Whiting and Continental didn’t immediately respond to requests for comment.

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