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25 January 2021

 
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US fracking for a UK stock picker?

By Brian Cullen, manager, SWMC UK Fund
 











We are often asked how much value we really get from meeting with companies face to face that you can’t achieve by reading a conference call transcript or annual report. I have had an even more sceptical response to my trip to New York, Chicago and Houston. What possible value could a UK investor garner from meeting with businesses in America?

In fact, the benefits are substantial and derived from two areas. First, meeting with the heads of US subsidiaries of UK companies (as I did with BHP Billiton, Pearson, Centrica and Michael Page) can shed a great deal of light on what makes companies tick on an operational level, below the CEO/ Investor Relations level.

However, perhaps more important is the picture than can be constructed from speaking to US competitors, suppliers and customers of UK businesses which we already know or hold shares in. This information gathering is akin to what the great investor Philip Fisher called “scuttlebutt” and can be very educational. On this front, it was meetings with energy companies in Houston which proved most fascinating.

Like many investors, we have had a quite basic (even simplistic) understanding of how shale oil and gas fit into the global energy picture. We knew that shale oil production sat near the margin of the cost curve and, as a result, has been in the cross-hairs of OPEC and Saudi Arabia in choosing to prioritise their market share and production at the cost of a lower oil price. This basic narrative has had pretty negative implications for companies such as the UK’s Weir Group, which has a strong position in the market for pressure-pumping equipment (kit used in the hydraulic fracturing process necessary to unlock shale oil and gas). Weir has seen a collapse in orders as shale activity has slowed. If Saudi Arabia is prepared to “price shale out of the market” then surely a business like Weir’s is structurally challenged?

In fact, a number of things we learned in the US lead us to believe this is far from the case.

First, shale oil producers are achieving quite staggering increases in productivity and efficiency – both in terms of cost and process. For instance, one leading shale player told us that the time it takes to drill a well has fallen from 45 days to 8 days in a matter of a few years. Another cited a record drill time of just over four days. Yet another pointed to cost per well falling from $5-6 million to an average of $3 million. These are huge improvements and represent a phenomenon that pre-dated the fall in oil prices. In effect, shale oil/gas production has been becoming a high volume manufacturing process, and these businesses have been implementing manufacturing best practice. As one player put it to us, “when you do something [drill a shale well] over a thousand times you get pretty good at it”. These wells are not only faster and cheaper to drill, but also are producing more oil - recovery rates have improved steadily in recent years and are expected by most producers to continue to do so.

At the same time, in response to the drop in oil prices, well drilling and completion costs, we were told, are down anywhere between 20 and 50%. The combination of these factors has led to a sharp fall in the breakeven level oil price at which shale wells are economically viable to drill, as the following chart demonstrates, which shows an approximate $20 per barrel drop in breakeven levels over the past year. It also shows the remarkable flatness of the shale cost curve.

While some producers we met “scratched their heads” at people getting back to work at $60-$65 WTI prices (in part for fearing it may tip prices downward once more), clearly this is a level at which a majority of participants believe drilling can recommence. It was also the level cited at which some wells, which had been drilled but were left uncompleted could now be completed.

What does all of this mean in practice? In our eyes, it suggests two crucial implications. One is that oil prices are unlikely to rebound quickly to $80 or $90 a barrel; if large quantities of shale are economic at $60 then that should dampen the likelihood of a price snap back. However, there are a huge number of moving parts in such an equation - not least that any pick up in shale activity might also lead to a surge in costs if skill shortages emerge amongst pumping crews.

The second implication feels rather surer: that a shale industry that is still improving in terms of efficiency and productivity, and is thus moving more and more towards the middle of the cost curve will have a core place in the global energy complex for some time to come.

Returning to our UK focus, it is this implication which is most positive for a business like Weir. To be clear, a lot of what I heard was quite negative for Weir in the short term. While drilling (and subsequent “fracking”) activity may be just beginning to return, there can be no doubt that activity levels remain hugely down on this time last year (the rig count has more or less halved). In addition, although the relatively consolidated pressure pumping equipment market has seen less pricing pressure than other elements of the supply chain, this market has still seen double digit price cuts.

However, much of this is within investors’ expectations already. We know that 2015 will be an annus horribilis for Weir, but if shale oil has a sustainable longer term future, paying circa twenty times depressed 2015 earnings does not feel unattractive.

It was precisely this conclusion that came across quite clearly in Texas; that despite the current turmoil, shale is “here to stay”. We might have reached that same conclusion reading reports in our office in London, but we reached it faster and more convincingly after a few days’ at the coal face (or perhaps I should say well-head).

This confirms, once again, the value of the hundreds of face-to-face company meetings we hold each year – even when we are doing them half way around the world.

brian@swmitchellcapital.com
www.swmitchellcapital.com