Sometimes It Pays to Bet against the Experts

In December of 2006, the New York Times printed a page one article mocking the idea of oil production derived from U.S. shale deposits. The story focused on R. Glenn Vawter, “an executive [who worked] for many of the losers” in U.S. oil production. Vawter, considered by many to be a “glutton for punishment,” maintained a shale rock garden and had shale paperweights commemorating the many bankrupt companies for which he had worked. After speaking to industry experts and noting the cautious approach investors were taking to shale oil in 2006, the reporter concluded that “shale oil will not be arriving anytime soon, until at least the 2020s.”

This was the consensus among industry insiders. U.S. domestic oil production had peaked in 1970. Other than a brief rebound during the 1979 oil crisis, production declined by a steady 1.5–2% every year through 2006. The trend was evident.

Figure 1: US Domestic Oil Production 1970-2006

Source: EIA

U.S. oil analysts were confident this decline would continue in perpetuity. The eggheads at the EIA, the statistical arm of the U.S. Department of Energy (DOE), issued a reference case suggesting that U.S. oil production would decline through 2030. “The remaining onshore conventional oil resource base is not expected to provide significant new supplies of oil,” they wrote. 
 

Figure 2: EIA Reference Case from 2006 EIA report

Source: EIA

As a result of this general pessimism in 2006, the median U.S. domestic energy exploration and production company traded at a mere 6.5x EBITDA. There was simply no growth story in U.S. oil to justify higher valuations — particularly with volatile commodity prices. Yet there some who were willing to buck conventional wisdom and bet in favor of shale oil production — taking a bold stand in the face of a 30-year trend and the combined wisdom of the experts at DOE and the New York Times.
 
And sometimes, as in this case, betting against the experts pays — welcome hydraulic fracturing. 

There was a small set of innovative U.S. energy companies experimenting with a new technology — hydraulic fracturing — and they made a discovery that gave birth to a revitalized U.S. energy landscape. The process uses horizontal drilling and hydraulic fracturing, allowing energy producers to tap the vast amount of oil locked up in U.S. shale formations. Over the next few years, they revolutionized domestic oil production, shocking the analysts at the EIA (and probably a certain reporter from the New York Times).

By 2007, the EIA had drastically changed its tune, speculating that “more rapid technology advances could raise U.S. oil production” to as high as 5.7m barrels per day by 2030 (2007 EIA Report). Though still worried about the “considerable uncertainty” about U.S. shale and unconventional oil, the EIA raised its forecast in 2008 to 5.9m barrels per day. 

In 2009, U.S. oil production rose for the first year since 1991; by 2015, the United States was producing approximately 10m barrels per day of oil thanks to the revolution in shale drilling. The EIA didn’t include a single scenario with oil production higher than 9m barrels per day until 2013! 

Innovative U.S. energy companies proved the prognosticators wrong (a common trend of its own in the field of professional prediction), and shareholders who boldly bet against the odds (i.e., a perpetual decline in U.S. oil production) were richly rewarded.

Figure 3: Performance of US Energy Producers vs. S&P500

Source: Google Finance

The moral of this story is that betting against the conventional wisdom — no matter how firmly entrenched that wisdom is —can be more profitable than betting with the herd, because, more often than you might think, the best and the brightest get it wrong.