How To Play The Shale Energy Boom’s Premature Demise – NASDAQ.com

Despite its historic bull run, the market is giving investors plenty to worry about.

And I’m not even referring to the many potential triggers for a nasty correction you hear a lot about in the news, like rising interest rates, global geopolitical turmoil or a generally overvalued stock market. No, the issue I’d like to focus on is much less publicized and more sector-specific, but the implications are still far-reaching.

That’s because it involves the so-called shale boom.

The shale boom, as you may know, is the result of hydraulic fracturing (aka “fracking) and other newer drilling techniques. About a decade ago, energy companies began using these techniques to access oil and gas deposits that were previously unreachable, and since then the U.S. has become the world’s #1 natural gas producer and one of the world’s leading oil producers.

If you follow the shale boom, then you’ve likely seen the many impressive estimates about future domestic energy production and heard all the talk about the U.S. finally achieving energy independence. And not only achieving it, but keeping it for decades to come.

But what if the energy revolution ended much sooner than expected?

This might not even seem like a valid question at this point, what with shale boom cranking along in high gear. But there’s compelling evidence it could go bust well ahead of schedule — and this would obviously seriously affect the energy sector and its many stakeholders.

There have already been some warnings about this — for example, a June 2011 New York Times article reporting on skepticism about the shale boom among many energy industry insiders, whose concerns were in stark contrast to the public optimism of drillers.

Particularly poignant was the description of an email exchange earlier that year between a contractor and an analyst at PNC Wealth management in which the latter referred to shale gas as “inherently unprofitable.” The PNC analyst suggested shale gas was being overhyped, much like the dot-coms of the late 1990s, and said well production would likely fall off in the near future.

It appears he was right.

In fact, production from wells using fracking and horizontal drilling has been decreasing very fast, said geoscientist David Hughes in a recent Bloomberg article. For example, production from conventional oil wells only declines about 5% a year, on average, compared with 44% a year from wells in the prolific Bakken shale of North Dakota, one of several U.S. regions where fracking is prominent. There are individual cases of Bakken wells with output reductions of more than 70% in the first year, added Hughes, who recently joined the California-based sustainability think tank Post Carbon Institute after several decades with the Geological Survey of Canada.

And apparently, this sort of thing is common no matter where the shale drilling occurs. In another recent Bloomberg piece, Peter Stark, Senior Research Director at IHS Inc., said output typically falls 50%-to-75% from shale gas wells and up to 78% from shale oil wells in the first year. IHS is a research firm serving the energy and aerospace industries, among others.

Because of this rapid depletion, drillers try to compensate by increasing the number of wells, usually at a cost of $6-to-$12 million apiece. Yet the newer wells are at a disadvantage right out of the gate, typically being placed in less desirable areas because the prime spots are usually drilled first. Thus, many drillers are racking up huge costs and debt while posting major losses as they scour the landscape for increasingly elusive oil and gas deposits.

If this continues, the energy sector could be in for quite a shock. As shale oil and gas patches produce less, the weakest producers will become insolvent and the cheap energy the United States has enjoyed will begin to rocket back up in price. Indeed, some prominent industry experts see the shale boom going bust surprisingly soon, including Hughes, who predicts this will occur with shale gas in just 2-to-4 years.

The ‘God of Oil Trading,’ British investor Andrew Hall, who has made billions by accurately predicting energy prices, believes U.S. energy production will peak by 2016 and crude oil will soar to $150 a barrel within five years. Hall, who runs the hedge fund Astenbeck Capital among other investment operations, has been betting big on an eventual shale oil bust through long-dated futures contracts.

Such a bust could cause some major hurt, beginning obviously with the bottom lines of the many companies large and small involved in shale oil and gas exploration and production. Those already saddled with huge debt and mounting losses would be at high risk of going under. Stock prices across the industry could take a severe hit as investors rushed for the exits.

Risks to Consider: Just as shale oil and gas proponents may be far overestimating the shale boom’s lifespan, critics may be incorrect in their predictions of such a speedy demise.

Action to Take –> Hype and publicity may be giving investors the impression that the end of the shale boom is nowhere in sight, when it may actually peter out fairly fast. To protect themselves from this possibility, investors should monitor the situation and be prepared to sell stocks that could be affected, including those in ancillary industries.

Those who prefer more active portfolio management might at some point consider put options on the Powershares Dynamic Energy (NYSE: PXI ) — an exchange-traded fund with 60 energy stocks, most of which are involved in fracking to some degree and many of which are big names in the shale boom. Shorting PXI could be appropriate at some point, too.

via How To Play The Shale Energy Boom’s Premature Demise – NASDAQ.com.