For the Internet of Oil, It’s 2002

Explaining last Friday’s $29 per barrel oil price is on the face of it easy: global supply is exceeding demand by around a million barrels per day. But $29 oil has undammed floods of explanations because the price doesn’t make sense: at $29, new drilling is economic almost nowhere and oil exporting countries (who used to restrict production in periods of oversupply) are scrambling to support and sometimes even feed their populations. People in the oil business, stunned by the worst industry conditions in 30 years, are comforting themselves with cheap drinks and old clichés: the cure for low prices is low prices, etc. But as bone-breaking as today’s prices are for oil company profits and fatal for some competitors, their greatest comfort should be this: $29 per barrel is a normal step in the reorganization of an industry that has been disruptively shocked.

The shale revolution has been the Internet of oil, and what has happened over the last year and a half is equivalent to what happened when the first dot-com bubble popped in 2001–2002: the economy and markets are absorbing something unimaginable; the exuberant, wild capital allocation that initially came with that disruption is adjusting; and that adjustment (in prices, in the consolidation of players, in the rationalization of investment) paves the way for the next phase of growth.

Everyone knows that the U.S. oil and gas shale revolution is important — see $29 oil, $2 per thousand cubic feet natural gas, and U.S. producers starting to export this month both liquefied natural gas and oil, as if we’ve suddenly turned into Qatar. Yet the popular understanding of the shale revolution is sometimes simplified as a morality tale about grit and Texas exceptionalism (and, okay, Oklahomans too): that the world forever changed because, starting in 1998, stubborn coots and debt-drunk wildcatters like George Mitchell, Harold Hamm, and Aubrey McClendon found new ways to frack and drill horizontally in nutty places like North Dakota.

This country-fried, overly personalized explanation has some truth in it, but it ignores the fact that the shale revolution fits into the business world’s favorite explanation for everything today: Harvard Business School professor Clayton Christensen’s “disruptive innovation” theory of how market leaders lose their crowns. In the 1990s oil business, just as you’d expect in Christensen’s theory, smart money technology leaders like ExxonMobil and Shell had largely abandoned U.S. onshore fields, especially third-tier impermeable shale reservoirs. Smaller, low-tech U.S. independents began experimenting with these abandoned reserves because, well, they couldn’t afford the big kids’ toys. Then through long trial and error, using off-the-shelf technologies and some clever new adaptions, operators made the shales competitive with the cost structure of other sources of oil and gas. And just as the dot-com boom took off in the mid-1990s even though AOL and Prodigy had been around long before, production from the low-cost shales post-2009 exploded from further technical adaptations and powder kegs of capital. For five years, the shales grew faster than almost all other new global sources oil and gas, were cheaper than most of those other sources, and also “better” — coming in simpler projects, with quicker return of capital, and more flexible cash outlays.

The U.S. shales are the Internet of oil not only because they completely changed everyone’s understanding of how the oil business must forever be — no longer were oil and gas fated to be ever more expensive, coming from ever harder to reach reservoirs, driving us all into practicing our Charlize Theron moves for the next Mad Max — but because they opened up the business to smaller operators, with democratized technology, producing oil and gas more effectively than Big Oil.

It’s puzzling that Christensen’s explanation has not been commonly applied to one of the world’s biggest recent industrial changes. This is due in part to a techie, Teslan bias against the oil business, an industry Silicon Valley yearns to disrupt from engine block to well. There are also idiosyncratic factors to the shale revolution, which doesn’t make it an obvious case of disruptive innovation. “Disrupted” companies like Statoil have bought shale assets, blurring lines. And the product of the disruptive innovation is a commodity: your car, as patriotic as you may be, doesn’t care whether it’s burning gasoline refined from oil from Saudi Arabia or the shales. The disruptive innovators of the oil business moved upmarket not by producing better oil but by producing oil better.

But the U.S. shales have been tremendously disruptive to the global oil and gas business, far beyond the 5% of the world’s oil and 11% of its natural gas supply they currently represent. Every oil and gas company lives in a shale-shaped world, of an ever present risk of oversupply and $29 oil again, of the need to measure capital invested in a shale well against any other type. 
Thinking about the shales as a disruptive force, like the Internet, helps us process the brutal, fight-to-the-death state of the oil business today. Business disruptions, whether in the Christensen model or from new technology (as in the case of the Internet), can be sloppy — and should be sloppy, confusing, jarring, and rude. Hundreds of billions invested by old paradigms are no longer true. Saudi Arabia’s decision in November 2014 to abandon its role as a swing producer, the precipitating factor of the long collapse in oil prices, was rational. The country was facing competition from a new disruptive supply. It couldn’t ignore the shales any more than Barnes & Noble could have decided that Amazon was a Seattle fad.

When considering last week’s market turmoil, with oil prices (and/or China) blamed for knocking the global economy in the teeth, it’s important to remember that capital markets can — maybe inevitably — magnify business disruptions and disequilibriums by overcapitalizing opportunities. In the most extreme cases, that overcapitalization inflates market bubbles that interact with the “real” world. Too much capital is force-fed into limited opportunities. Sometimes that misallocation of capital is absolute: there can be too many cupcake shops in Manhattan. And sometimes the misallocation occurs because the capital came too early. The valuation of Internet companies at the peak of the market in April 2000 was likely “correct” for all the unicorns, Internet giants, and near incalculable intrinsic value of the Internet today. And, in the long view of the Internet, who really cares about the 2001–2002 crash except people who lost their one chance then at the golden ring?

As I lay out in my new book, The Green and the Black, we are all affected by the shale revolution, as consumers and citizens. The shales’ long-term resiliency and growth mean that we will be wrestling for years with their mixed impact on climate change, in the displacement of coal, in the elongation of the era of fossil fuels. The shales — and a period of abundant oil and natural gas they brought — will continue to scramble the economic and political might of America, Russia, Brazil, the Middle East, and others.

And for investors? How does one capitalize on the shales’ long-term growth without getting clobbered if $29 oil soon becomes $21? There aren’t easy answers. In investing, timing is often everything. Those who rushed into shale producers’ debt and equity in the first half of 2015 regretted it a few months later, as the inevitable triumph of the shales doesn’t mean that that triumph will happen in any given year — or that equities aren’t already pricing in a rebound. But just as Google is still superior to the Yellow Pages whatever the daily close of Google’s shares may be, a shale well is still superior to one in deepwater Angola.

Shale 2.0, the resumption of production growth of the world’s best source of new oil and gas supply, will happen when production from competing, naturally declining sources of supply moderates (or goes bust) — whether in 2016 or 2019. It will happen even if the global economy, coughing so hard last week, grows modestly, given that the current global oversupply of oil is only about 1%, a fraction of the oversupply of web portals or pet food verticals in 2000. So before buying some SUV so big that even the cup holders have cup holders, remember that the prices of oil and gas will gravitate over the life of that beast to whatever is necessary to incentivize new U.S. oil and gas shale drilling.

Investors are asking: if it is now 2002 for the Internet of oil, which companies will be the Google or Amazon of Shale 2.0, winners of the first land rush that used the market downturn to consolidate their position, or buy cheap tuck-in acquisitions, to become even more dominant in the next phase? Which companies will be the unicorns of Shale 2.0 (if Internet unicorns are not bubbling over right now as the next big joke), the Ubers that didn’t even exist in the 2002? And, sweet billions, could there be a Facebook of Shale 2.0, a colossus that emerges from nowhere, and fast? For me, at least, the metaphor breaks down here, given the finite amount of land that is prospective for the best shales, the commoditized nature of oil and gas, and the fragmentation of U.S. oil and gas producers.

Then again, in the Internet too, few in the bleakest days of 2002 saw clearly the changes, growth, and dominance to come — maybe even Mark Zuckerberg, who in 2002 had just graduated high school.