The IEA Gets Shale Right

 | Nov 14, 2013 | 3:39 PM EST
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The International Energy Agency has been woefully behind the curve on most of the major energy trends of the last two decades.

But its latest report on crude supplies has me thinking that the IEA and its chief economist, Fatih Birol, have gotten much right and are finally in front of the curve on the most important trends that investors in the oil patch must keep in mind to be successful.

The first major point in this latest report is the ramping U.S. production of crude supplies from shale. The U.S. is not just one of the leading nations with the potential for shale crude production, but clearly in the lead in the application of the capital and technology to get that oil out and to market. The major headline to come from the report, which was picked up by the news media, was the prediction that the U.S. would become the leading producer of crude by 2015.

The prospect of energy independence wrought obvious and predictable headlines like "Saudi America." While that's an interesting and important trend, it's of marginal importance to investors.

More important was the second point in the IEA report, the part where Birol really shines, recognizing the fast ramp up in production of the oil shale plays but also predicting the increasing capital required to keep that growth going and the ultimately limited resource base of the shale plays. In other words, not only is shale oil far more limited a resource than most shale hype would have you believe, but oil from shale will grow increasingly difficult and expensive to find and produce.

While the limitations of shale oil in the U.S. are still decades away, there are indications that the IEA has gotten this trend right in the Bakken shale, where production growth has just begun to show signs of leveling off, even after only five or so years of parabolic drilling.

Even in the Bakken, this production plateau is several years away, but it very much affects how we should view investments in the shale plays -- valuations are often determined by a very rapid rate of production growth, an acceleration that cannot possibly be sustained.

As traders, we need to keep this in mind while still being able to suspend reason when it makes sense to do so. Witness the example of Pioneer Natural Resources (PXD), which has tripled on Wolfcamp shale results so that even Mark Papa, the outgoing CEO of EOG Resources (EOG), admits it cannot likely be sustained.

Despite industry consensus, we still need to benefit from the ramping of these "hot" stocks, which generate smart short- and medium-term winners that can boost returns. A simple stop on the downside is protection from the "end of the honeymoon" effect of a plateau in production.

The last variable that the IEA report doesn't begin to address is commodity prices, something I'm well aware of as a longtime oil trader. Each shale play as it emerges also delivers a cost per barrel in both the overall play as well as the specific and more active sections inside of the play. The likely future market price for oil will dictate the viability and the profitability of each section, sharply defining the value of the companies engaged there.

That's the subject of my next column, and it's equally important as the dynamic nature of the shale plays we're covering: What's the outlook for the price of crude and which companies are likely to benefit the most?

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