Shale Boom Still Alive and Kicking

Energy prices have collapsed. Domestic rig counts have plunged. Energy loans have been going bust. The price of oil is stuck in the $40-50 range thanks to declining global demand, and U.S. natural gas prices remain weak in the face of rising LNG exports and increased demand from electric utilities. There is nothing on the horizon that might point to higher prices. Foreign oil and gas producers are not willing to cut back for fear of a permanent loss in market share, while global demand shows no signs of picking up the slack.

Amid such bleak conditions for the energy sector, you would not expect the shale drillers to engage in a land rush where they try to outbid each other for drilling rights in Texas and New Mexico. Yet that’s exactly what is happening in the Permian Basin. This unique situation speaks volumes about technology disruption and how it is creating abundance out of scarcity.

The Permian Basin, one of the oldest and most widely recognized oil and gas producing regions, covers about 86,000 square miles in West Texas and New Mexico. Its complex geography was initially considered a disadvantage, but in recent years oil and gas firms have discovered that its stacked layers of shale are an ideal match for long horizontal runs at multiple depths. And because these multiple runs can be drilled from a single vertical well, the return on investment can be significantly higher than “traditional” shale wells. BP, after drilling a two-lateral test well that tripled the output of other gas wells in the area, went on to drill six tri-lateral wells – according to a recent article in The Wall Street Journal. While these wells resemble a chicken foot today, it’s conceivable future shale wells could look like wagon wheel spokes. It may only take a few years to see an order of magnitude jump in oil output per well.

Tellingly, oil output in the Permian Basin has continued to climb since mid-2014, even though the region has been operating with only a third as many rigs. That contrasts with other oil shale regions which have seen output declines of 20-40% over the same period.

Economic Implications
What used to happen with silicon wafers is now happening with oil and gas production. The U.S. is on track to become one of the world’s lowest-cost producers, benefitting simultaneously from low energy costs and rising exports of oil and LNG. There are positive implications for employment, manufacturing, balance of trade, and tax revenue.

There is little economic benefit outside the U.S. and Canada. Other countries are trying to develop shale resources, but most face higher drilling costs, marginal geography, and the lack of a royalty system that compensates property owners. And the economic implications are downright negative for many emerging countries that depend heavily on oil and gas exports (including Russia, which already reduced its natural gas prices when the U.S. began LNG exports to Europe earlier this year).

Environmental Implications
Hydraulic fracturing (fracking) became an environmental scapegoat early on, thanks to a deceptive “documentary” that came out of Hollywood. The EPA looked into complaints of drinking water contamination, but later put its investigation on hold after chemical analysis of methane molecule signatures debunked those claims. The industry is regulated by state and local agencies. These days most of the focus is on wastewater injection wells, which may be linked to earthquakes in some parts of the south.

Ironically, the gasoline additive MTBE has contaminated thousands of water supplies all over the world, a fact that escapes most fracking opponents. MTBE continues to be mixed into gasoline in many countries, including some that have imposed a ban on fracking.

Most likely, fracking is doing the planet a favor. Cheap shale gas is displacing coal on the grid, while shale oil has all but ended investment in Canadian tar sand projects. If the cost of shale oil goes low enough, fracking may someday eliminate the need for deep water drilling.

Investment Implications
A continuing shale boom suggests the U.S. stock market will continue to outperform most other major markets in the world, with smaller stocks benefiting more than large-caps (the former depend more on foreign revenue). Low and stable energy costs should help keep inflation low. Reduced oil imports and increased LNG exports will help close the U.S. trade gap, leading to a stronger dollar, higher tax revenue, and lower-than-expected interest rates.

From a sector standpoint, the shale boom is favorable for the consumer, technology, and industrial groups; neutral for financial, health care, real estate and telecommunications; negative for energy, materials, and utilities. But even within the groups that are negatively affected, there may be good opportunities. This may be especially true in the energy sector, where a relatively small group of disrupters stand to benefit at the expense of many other players.

Third Quarter Review
The market climbed a "wall of worry" in the third quarter as investors shrugged off risk and began to think about the types of stocks that would prosper over the long run in a low-inflation and low-interest-rate environment. Technology stocks were the winners because the Fed’s hesitation in raising short-term rates resulted in a slightly weaker dollar, which tends to help technology earnings more than other sectors (in addition large-cap technology stocks were cheap considering their above-average growth potential). It was also a good quarter for smaller stocks. Low borrowing costs, along with low and stable energy prices and rising consumer demand, helped firms that derive most of their revenue from the domestic economy.

The S&P 500 rose 3.9% for the third quarter, bringing its year-to-date gain to 7.8%. The Russell 2000 jumped 9.0%, bringing its year-to-date gain to 11.4%. The favorable small stock environment gave a lift to Fidelity funds in general and our model portfolios specifically. All of our stock models outperformed the S&P 500, and most of our lower risk portfolios managed to do so as well.

Our results were strong on the bond side too. The Barclays US Aggregate Index rose 0.5% in the third quarter, for a year-to-date total return of 5.8%. Our income-oriented models were substantially ahead of the index. The portion of our portfolios devoted to high-yield bonds generated stock-like returns during the quarter, making it well worth the added risk (relative to the bond index) that we incurred.

Outlook
The Fed continues to scratch its head when it comes to stubbornly low inflation readings, but it’s no mystery to us. The U.S. shale revolution in the energy sector is just one example of how technology disruption is creating abundance out of scarcity. The world today has too much food capacity (thanks to agricultural biotech), too much mining capacity (thanks to automation that has reduced costs), too much ocean shipping capacity (thanks to supersized vessels), too much steel capacity (thanks to an innovation in China that allows the use of low-grade nickel ore). And thanks to Uber and Airbnb, the world will soon have too much ground transportation capacity and too much hotel capacity.

The upshot is we are in a new era of low inflation and increasing competition, and it is likely permanent. The entire global economy could look increasingly like the technology sector, which has seen five decades of deflation. So it should come as no surprise if U.S. inflation edges toward zero, and interest rates remain very low.

From an investment strategy standpoint, we are in the process of increasing our weighting to growth stocks and reducing our exposure to value stocks. In effect we are betting that inflation will remain at very low levels, making for a wider valuation spread between the two groups. Bond-wise we are sticking with our heavy bet on the high-yield sector on the belief that credit spreads will continue to narrow as profits return to the oil patch, and because the U.S. economy should continue to see an increase in consumer spending. In our view, the Fed seems likely to postpone its tightening moves as inflation continues to come in below 2%.   

Jack Bowers
President & Chief Investment Officer