A few days ago, I quoted The Economist in a tweet:

"OPEC would like to do to shale firms’ balance-sheets what high-pressure hydraulic fracking does to rocks." http://t.co/bhjVs6imrb — Sanjay Bakshi (@Sanjay__Bakshi) December 4, 2014

A friend of mine saw it, and mailed me:

Hi Sanjay, I just saw your tweet on the above. I have been following this sector quite closely and can claim that I have a P.hd on it because I have managed to lose money on it 🙂

Nothing concentrates your mind when your head gets handed to you.

That said, I have been following these articles and been thinking of the point which Buffett has made about economics — always ask, “And then what?”

Most of these articles talk about weak balance sheet of Shale oil companies and the need for the various OPEC countries to balance their budgets. This kind of thinking almost seems to be equivalent of wanting to a earn a specific level of income based on the expenses rather than based on what one’s skill is and what the market will pay.

I have invested in a few smaller oil and gas companies and have been following them closely. Some of my observations:

The marginal cost of oil is not a uniform number and varies from well to well. That said, this number is constantly going down as the industry gets more efficient. As oil is a commodity, I would assume that the price has to tend to the marginal cost of production (highest to meet the incremental demand).

Most shale companies have large unexplored land and a 10+ year inventory. As they get more efficient, I would think that the overall cost could remain flat even as they use up the better fields (this is an assumption).

Even if some companies are over leverage, the worst that will happen is that they companies will either file for bankruptcy or liquidate. However the resource and the cost to produce does not change. At worst a new player which is better leveraged comes along. So in the medium term, if even OPEC manages to drives out some players, the new ones will come with a better capital structure.

Some of this has already happened in the natural gas space, where the prices dipped below cost of production and are now back up. As soon as the prices spiked in early 2014, the production came roaring back. I think the same could happen in oil the moment prices cost $80/barrel.

I will stop now 🙂 ..What are your thoughts ?

My reply:

Anytime one invests in any business involved in extraction of stuff from under the ground or the sea, or from the sun, or wind, one needs to wear the skeptical hat. There are huge perverse incentives to over-state reserves. Mark Twain’s quote is the appropriate default position: “A mine is a hole in the ground, with a liar on the top.” 🙂 Even if you are very confident about the reserves, you still have to predict the future price of the commodity. Doing that accurately and consistently on multiple occasions, is beyond anyone’s capability. When oil was at $10 “experts” said it will go to $5 and when it was $140, they said it was going to $200. When you buy the stock of such a company, then you are implicitly predicting the price of whatever it gets out of the ground, even though you are not making those forecasts explicitly. There will be all kinds of experts who will sound extraordinarily persuasive with theories like “peak oil” blah blah. Lots of people will believe them and maybe the experts would be right for a while. But then almost all experts will be right for a while. And then they will be wrong. The value of an Oil company is vastly different when you use a $5 future oil price scenario than a $200 future oil price scenario. They way to not handle this inherent variability in potential future value is by using scenario analysis. That would be functionally equivalent of a man who cannot swim trying to cross a river that has an average depth of 5 feet while he is 6 feet tall. He forgets that the range of depth is between 4 feet an 12 feet. And drowns. Ignoring the range of possibilities is foolish. And in the oil business or any business which involves extracting suff from under the ground, that range is huge. [TALEB] People will continue getting things out of the ground well after it stops making economic sense. Maybe they have perverse incentives in place. Maybe they like playing Russian Roulette with their competitors. There are all sorts of reasons people will continue to do things for a long time which appear to you to be stupid and dumb. You must not expect the prevalence of sanity across the world in any commodity industry as part of your investment thesis. In any commodity-type business, it’s not possible to be a lot smarter than your dumbest competitor. [BUFFETT] Investing in such situations makes sense, if you have enormous staying power. That is, you have no debt and you have lots of patient capital that will never be withdrawn from you at the wrong moment. You’ll also need the capacity to bear pain for a long time which includes the pain of seeing other people who invest in businesses that buy commodities but sell branded products get rich in environments when commodity prices are high or low. Most investors do not fit into this class of investors. I certainly don’t.