Why Hedge Fund Manager David Einhorn Says Shale Oil Producers Are Doomed

It’s no secret why oil prices have fallen so far in the past year: increased production from the United States. To be more specific, the United States has increased oil output by roughly two million barrels per day in the last two years. That’s caused prices to plunge by roughly 40% in the past year, despite a recent recovery.

This boost in production has mainly come from the “shale boom,” which involves drilling horizontal wells into unconventional formations.

Now, with oil prices so low, many believe the shale boom cannot last. And if shale oil production does indeed collapse, it could be the key to an oil recovery. This would be welcome news for Canadian energy producers like Suncor Energy Inc. (TSX: SU)(NYSE: SU) and Canadian Natural Resources Ltd. (TSX: CNQ)(NYSE: CNQ).

So, why do so many believe that shale’s best days are behind it? And how should you react as an investor?

You don’t want to ignore this man

David Einhorn is one of the world’s most famous hedge fund managers, and for good reason. He’s best known for some very successful short bets, including Allied Capital (which he eventually wrote a book about) and Lehman Brothers before its collapse. Now, he’s targeting the shale oil drillers.

According to Mr. Einhorn, shale drillers aren’t really profitable. In fact, they weren’t profitable when oil was trading for US$100. Rather, they spent way more than they made and covered up their losses by raising billions of dollars on Wall Street. Some made up new metrics—like EBITDAX—which excluded some very legitimate costs from profit calculations. To quote Mr. Einhorn directly, he said that shale oil companies have “negative development economics.”

By this logic, these shale oil producers are in trouble. And eventually, that should lead to falling production, and higher oil prices.

Others are backing him up

Mr. Einhorn is not alone in his beliefs. Hedge fund manager Andrew Hall believes the shale oil boom has already ended and that U.S. oil production is declining.

Meanwhile, the risk of supply disruptions in the Middle East are expanding, and low oil prices are boosting demand. For these reasons, Mr. Hall expects oil prices to keep increasing.

Not so fast

So, does that mean you should buy shares of Suncor and CNRL? Well, not necessarily.

As noted by Canadian portfolio manager Eric Nuttall, both of these companies trade based on US$95 oil. In other words, these stocks are only fairly valued if you assume that oil trades for US$95 per barrel.

Even Mr. Einhorn thinks this is unrealistic—he expects the price of oil to reach US$68. Thus, I would still not bet on the Canadian oil producers. Instead, I would just make a bet on the crude oil price. The simplest way to do so is with an exchange traded fund, such as the Horizons NYMEX® Crude Oil ETF (TSX: HUC).