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Investing in shale can be a sweet spot or sink hole

The upward trajectory of the share price chart tracking Emerge Energy Services gladdens the hearts of long-time holders of the oilfield services partnership, which is among the firms that have benefited from the US shale boom.

Although it has fallen from its peak in recent weeks, it has moved from about $15 in May last year to more than $132 this week.

It is a stark contrast with Endeavor International, which acquires and develops energy reserves in the US and the UK, whose shares have fallen 90 per cent since February, sinking below $1 after it recently missed interest payments - even though analysts just upgraded their valuation of those reserves.

Energy investing has always been a binary proposition, the sweet spot for some and a sink hole for others. This is especially the case when it comes to investing in companies involved in the shale revolution, an extremely volatile class of stocks which can represent both opportunity and trap. Energy is also subject to a host of risks - geopolitical, geological, technological, execution, legal and regulatory - in no particular order.

"There is no such thing as a dry hole but there are wells that don't make money," says Edward Westlake at Credit Suisse in New York. "And because it is so capital intensive, and so cyclical, the financial leverage adds to the difficulty. Both the variability of shale and the capital intensity creates opportunity on both sides."

For the three years to the end of 2013, the MSCI world energy index underperformed the broader market by almost 20 per cent. But in 2014 "there are a few signs that sentiment is starting to shift," says Poppy Allonby, a London-based managing director for natural resources with BlackRock Asset Management. "This year it is outperforming by a couple of percentage points. There was a lot of investment in the past five years and now that investment is beginning to generate cash flow that is available to shareholders."

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> Still, analysts are divided on both the demand side and the supply side of the equation. Some believe that demand may slow as a result of greater efficiencies across a host of industries including cars, buildings and smart grids as well as less commodity intensive demand in voracious China as that dragon moves to a more consumer and service-led economy.

"The easy money has been made," says Fadel Gheit, energy analyst for Oppenheimer in New York, who believes that current prices are inflated and do not reflect true supply and demand factors.

Others disagree. Primary energy demand is expected to grow by up to 40 per cent by 2035 with about $50tn in capital needed for investment, according to a recent study from Bank of America Merrill Lynch. That huge amount of capital is necessary "both to meet demand and make the transition to a lower carbon economy," the report adds.

<>The (usually) smart money in private equity loves the energy sector and executives at the leading firms say they plan to put more money to work in energy than in any other sector in coming years. The average Blackstone energy transaction has made six times its money for investors.

At the same time, though, distressed investors and restructuring advisers also love energy. At Blackstone, for example, executives anticipate more bankruptcies from coal companies, (some experts believe there will never be truly clean coal which could save the industry), at power companies and among exploration and production companies.

It is impossible to know the future economics of any particular shale play. So some investors believe the sweet spot for betting on the sector lies in those businesses that provide services to those taking the risks - the exploration and production companies - and whose business model is safer and less capital intensive. That, of course, creates its own problems because too much capital as well as booming demand has led to rising costs.

BlackRock's Ms Allonby believes that the offshore services companies that provide drilling services and equipment to the big oil majors may face a rougher patch. That is precisely because the latter have become more disciplined and are tightening up on outlays for expensive equipment while massive amounts of new rigs are still being built in the shipyards of Asia.

All this suggests that too often the perpetual quest for black gold can lead to a lot of fool's gold.

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