ShaleCo. The word has become an epithet. To be called a ShaleCo is to be called a fraud, a destroyer of Other People’s Money. It is bandied about with more emotion than seemingly any other term in that dark, murky and largely anonymous world of social media. If a publicly traded oil company committed the mortal sin of taking on debt to the extent it would be problematic paying off should commodity prices fall 50% or more, and stay there, AND if their assets were comprised principally of unconventional reservoirs, the primary asset that actually created investment “gravity” at an increasingly manic pace from roughly 2007 to late 2014, then it has been tainted with Original Sin. Of course, some companies made it particularly easy for the haters to hate… executive salaries, perks, and bonus packages that belied the very idea of effective corporate governance.
Why are these companies SO gut shot? The myriad of issues that contribute are 1) the resource base itself and its impact on global market price, 2) no clear guidance from investors (or ShaleCos) as to what metrics constitute “success”, 3) short or medium term viability of hydrocarbons in competition with “green” alternatives, 4) fundamental well economics, 5) larger pad economics, 6) reserves in all of their forms, 7) confidence or lack thereof in reserve audits, 8) corporate governance, and 9) the unhealthy politicization of energy.
The purpose of this series of articles is to examine each of these to determine if unconventional reservoirs are fundamentally uneconomic and to be avoided at all costs or if there are emerging opportunities to successfully invest in this type of resource.
Babies, Bathwater, and the Size of the Tub
As in life, raw emotion, either uncritical, blind love or unadulterated hate, is a poor indicator of good decision making. Those that got burned investing in ShaleCos are understandably raw. They had a good run for nearly a decade until the music stopped, and when it stopped, it stopped. Market caps after 2015 were down 40-50% from their highs when oil was over $100 per barrel and in a COVID-19 world, where global oil demand is down as much as 30%, are down 70-90+% from those seen during the heady hundred dollar highs.
However, hydrocarbons are NOT hula hoops. The world actually needs them. There are less than a handful of commodities that, if they were to disappear tomorrow, would usher in immediately worse consequences for all humanity than the disappearance of oil and natural gas. Think comet strike or nuclear holocaust level catastrophe.
Hydrocarbons are the fuel that undergirds roughly 60% of the planet’s energy as well as providing myriad other incidental uses. The strategic security consequences of depending upon either Saudi Arabian or Russian oil and gas, the two other “swing” exporters, is written hugely in 20th Century history. But investors don’t care about strategic security, they care about returns. Strategic security is invoked only to secure political support for downside risk abatement to those investment dollars.
The unconventional boom identified and largely unlocked a vast accessible resource base, primarily in North America. Turning resource into reserves has always been a bit tricky. The USGS assessment of oil and gas reserves, historically one of the most conservative assessors of future reserves (for instance, the United States has historically produced it’s “known reserve base” every ten to 12 years, and has been “running out oil” since WWI),
places a minimum/mean/maximum assessment of the Texas and New Mexico Permian Basin at 48/92/151 billion barrels of oil and natural gas liquids and 118/300/584 trillion cubic feet of natural gas. The Permian Basin is the world’s biggest recoverable unconventional hydrocarbon resource today.
When one looks at the estimation of oil from an “oil in place” point of view, the Greater Permian holds a minimum liquids resources of roughly 700 billion barrels to as much as 2.7 trillion barrels as derived from combining corporate presentations containing RockEval studies showing “oil in place” estimates of between 50 million and 180 million barrels per 640 acres in place in the aerial extents of the plays in the Midland and Delaware Basins (Enverus DocFinder), suggsting the recovery factors of the USGS assessment range from less than 2% to as much as 20%, roughly half the recovery of the typical primary recovery factor of solution gas drive reservoirs. Given that the Greater Permian Basin produces roughly 1.5 billion barrels of oil per year, if capped at this rate, the US has AT LEAST some 30 to 100 years of resource yet to be monetized. So resource isn’t the problem… Or is it?
The volume of oil added to markets from unconventional reservoirs most certainly disrupted global oil markets. In fact, for the run between 2007 and 2015, more “available” energy was added to the planet than any other time in history. The US very effectively met every bit (and perhaps more) of global oil demand growth for several years. As one hedge fund investor told a ShaleCo CEO I know, “you (oil) guys have never been really efficient, but my ace in the hole hedge was that the cyclical commodity market would eventually tighten and I could unload it at a profit. I just don’t have that confidence now”.
This clearly WAS a driver in a world awash in equity and debt dollars for any company claiming to have unconventional acreage, but is it now? With capital markets closed to unconventionals, and borrowing rates rising as high as 20 percent for oil and gas projects, compared with as little as 3 percent for clean energy for heavily subsidized “green” projects, the demand for growing out of Free Cash Flow (FCF) has become louder and louder. Prior to the last price crash in 2014 and even in 2016, there was a huge surge in U.S. production due to the fact that capital markets were still open to oil and gas companies. Wall Street was rewarding reserves and growth. By 2019, however, the narrative became “we’re funding your growth, where are the returns?” This phenomenon is no different than what analysts cyclically require of publicly-traded Software as a Service companies to insure that there is a core real gross margin to what is being sold.
Using FCF to reinvest and grow a company makes sense, IF there is a decent return of that invested cash. A demand that the FCF be dividended back doesn’t make sense if the money can be reinvested profitably. Clearly, companies MUST have a transparent method to show that they can both achieve FCF AND reinvest that FCF profitably.
A valuation based solely on free cash flow dividended out is the domain of those who’ve given up. Companies that dividend every bit of cash flow aren’t growing and can’t reinvest; it’s a signal they have no place to put their money. Rather, FCF should be viewed as a tool that expands value… more money to invest in low risk profitable growth using methods that the companies are proficient providing.
But are investors actually following their own guidance? The data suggests not. Coming in to 2020 (and prior to COVID-19), some 40% of the publicly traded ShaleCos were poised to return positive FCF. In the charts below, it suggests that that investors still principally value growth over FCF.
Next: Part 2- Is the End of the Hydrocarbon Age at Hand?