Follow Up on my shale post

I wrote about my thoughts on shale oil here in October.

Over the weekend David Stockman has come out with a great piece on how the shale boom is nothing but a Fed induced malinvestment spree. This is the best quote:

(…) Obviously, what we have here is another massive deformation of capital markets and the related flow of economic activity. The so-called “shale miracle” was not made in Houston with some technology help from Silicon Valley. The technology of horizontal drilling and well fracking with chemicals has been around for decades. What changed were the economics, and those were made in the Eccles Building with some help from Wall Street (…)

This quote says it all. It looks as if the scepticism of my engineer-friends over here was well founded. The “shale-revolution-based-on-new-technology” story seems to have been merely a canard made up by Wall-Street in order to easier raise capital (mainly debt). And there is nothing better than a new technology storyline to sell financial “products” to credulous investors. Surely lots of journalists were “wined and dined” in order to spread the word about America’s innovative capacity here in Europe. Well done!

The anomaly is this: debt finance is mostly unsuitable for a business model like shale oil whose constant drilling with inevitably high failure rates has risk characteristics of a start-up enterprise.

And start-ups should not be financed with debt!

Further, constant drilling is required because of high depletion rates. David Stockman writes that, on average, 90% of a well’s capacity is exhausted after only two years, effectively resulting in a maturity mismatch between assets and liabilities (typically 5 years) – a toxic combination.

As Mises wrote in his 1912 book “Theory of Money and Credit“: it is not only the amount of debt, but also its structure (maturity, covenants) that matters – something which is still not grasped by most mainstream economists (see, for instance, my post about Eugene Fama on Fed QE here).

To be fair: the fact that financing structure during a boom is subject to changes was also observed (although much later) by the now-popular Keynesian economist Hyman Minsky. Of course, Minsky – an empiricist – merely described what he had observed without providing a theory of why market participants behave the way they do (unless you consider”greed” a scientifically valuable explanation) – and of course without ever explaining why/how government officials who are supposed to regulate all this should know better.

Minsky, was on the right track and his work is a useful collection of data. However, without a proper deductive theory he could not connect the dots.


The wrong kind of investments financed with the wrong instruments hints at a malinvestment boom. This not only means that increased defaults are a certainty unless the oil price recovers, but also that a lot of people have gotten the risk assessment on this part of their portfolio holding completely wrong. A large amount of non-natural holders of risk increases the probability of contagion and spill-overs.



  1. I thought your post on russia was interesting, but this one is pretty bad. I don’t understand the skepticism people have on shale oil– at least as far as the money invested in the past is concerned (new investments are a different story).

    If wells mostly deplete in <2 years, isn't it very obvious what the IRR is for wells drilled in 2012 and 2013? The well costs are known, and so is the production data. The latter data is public for every well, and the former can be calculated from public company financials.

    And the IRRs are positive. Quite positive.

    Stockman's comments about the volatility of the oil price are not true– companies can hedge out many years. As recently as 1 month ago companies could hedge at $80-90 a barrel out into 2019… so the volatility of short term oil prices didn't have to effect the economics of the projects.

    1. hi,
      i am not sceptical on the fact that these guys have been pumping significant amounts of oil out of the ground. they have!
      I am sceptical about the sustainability, and not just because of the recent fall in oil prices.
      Stockman argues, and I sympathize with this view, that this was made economical only by insanely loose refi conditions.
      If you have an asset life of, say three years, you should be able to repay your creditors and investors within that time period (payback) for it to be sustainable, otherwise sooner or later, no new capital will be forthcoming. This requires IRRs beyond 30%. And those IRRS should not be computed at the individual well level (as is often done I think), but have to take into account, i.e. deduct, the costs of previous drilling failures.
      I am not sure the industry as a whole has had IRRS of that size over the past few years (individual wells certainly have)…

  2. “Deduct the cost of previous drilling failures”

    I agree with this but that is the thing about the shale boom that Stockman perhaps fails to grasp is that their are almost ZERO dry holes. Each well on its own doesn’t deliver that much oil, relative to “conventional” finds, but you can drill 5, 6, 7 wells right next to each other and each one delivers incremental oil

    See this article– “we don’t drill dry holes” from Pioneer CEO.

    And that claim is backed up by the data– all oil companies must report how many dry holes they drill. Pioneer’s wells are 99% successful.

    The loose financing market has certainly impacted the SPEED at which shale is getting drilled– but the underlying projects are economic regardless.*

    * at old oil prices– things are different in some places now

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