[Acknowledgment: Thanks to Edward Worsdell for helpful comments on an earlier draft of this post.]
In a recent post we took a deep dive into the debate over whether the US stock market is expensive or not. We concluded that i) the market is indeed quite expensive, ii) the market is not in a ‘bubble’ territory, but rather higher equity valuations on average should be considered the new normal (on the proviso that this new normal state of affairs should not be used to justify current equity valuations), and iii) historical standards can be a deceptive guide in predicting future equity returns and should be used with caution.
However, the market, taken as a whole, has a wide range of investment opportunities. We can find situations where a sector is cheap for a particular reason (e.g. the US retail sector) or situations where a company is trading at mind-blowing multiples because the market is discounting unrealistic expectations about future growth prospects, as in the case of Tesla, with a market capitalisation now higher than well established competitors like Ford or General Motors.
But this post is not about the fate of investors in a single company like Tesla or whether this is an attractive investment or not (we think it is not). Rather, this post will zero in on a sector that has been gaining increasing media attention, a sector that is considered to be the new pride of American industry, one that is highly leveraged and in which Wall Street investment banks have so much at stake in it.
The frackers: the new darlings of Wall Street
To begin with, consider the financial performance snapshot of the following business over the last four years. We have chosen to focus on free cash-flows (the amount left for capital providers, after investment needs have been covered) because if you remember what your course Valuation 101 said, what matters for valuation is the amount of cash-flows the business will generate in the future. The financials have been obtained from the 10Qs filed by the company to the SEC, and the only refinement we have made is to subtract interest payments from the reported operating cash-flow (under GAAP companies may choose to report interest outflows either under operating or financing activities), so as to achieve a real measure of free cash-flow (FCF):
From the above table (click to enlarge, we could not find any better way to present the data) we can glean a lot of information: i) the company generated $1.4bn in operating cash-flows over the whole period versus total investments of around $6.5bn., which resulted in a free cash-outflow of almost $4.9bn. ii) the business is a growing concern, growing its quarterly operating cash-flows from $16.9M in 1Q’13 to $175.9M in 1Q’17 and iii) the business only generated a positive FCF amount in one quarter (3Q’15) since the first quarter of ’13. In other words, the business does not seem to belong to any cyclical/commodity industry (unless you believe the cycle has lasted for more than 4 years), because it has consistently been a cash-burner, no matter what.
Actually, the company operates in the oil industry – a very cyclical business. And the company is no other than Diamondback Energy (FANG:US), a pure oil producer in the Permian Basin, the most prolific basin in the US according to experts. Diamondback belongs to that exclusive group of oil producers called ‘frackers’, which uses modern drilling techniques (i.e. hydraulic fracturing, horizontal drilling and 3D seismic imaging technologies) to extract oil that was thought to be inaccessible just two decades ago. The multiple breakthroughs (how to frack the shale and how to drill horizontal layers more productively) achieved by George Mitchell, Aubrey McClendon, Harold Hamm, Marc Papa and other innovative wildcatters in the late 1990s to extract natural gas (and oil) led to a revolution in global energy markets.
Although Diamondback is not a large fracker (its average daily production in 1Q’17 was just 61.6 mboepd), it is a very well-known name in Wall Street, beloved in the sell-side analyst community, well-run and boasts to have one of the best acreage among its competitors (but who does not claim to have the best acreage among peers?) with a very large amount of reserves, as you can see in the slide below:
You can find a more comprehensive snapshot of the company below:
Despite being a top-notch producer with the best possible acreage, the company has not been able to generate any cash-flows for its shareholders. Even when the oil was around 100$ in the old good days of 2013 and 2014 and the company was also able to realise a juicy 4$/mcf of gas, it did not generate positive FCF because of the high levels of investment. ‘We are investing for the future’ is the usual answer from the frackers when questioned about such high levels of investment. We will see the same path in other oil producers in a while.
Because the company has burned $4.9bn. of cash over the period (a staggering amount, by the way, for such a small producer), the arithmetic says that that money must have come from somewhere: in this case, the table shows that the company has been able to tap almost $4bn. from the equity markets over the whole period. The company closed the 1Q’17 with a net debt of $3.1bn, which has been refinanced by its creditors in the past.
But this post is not an investment case to short Diamondback. In case you think we did some cherry-picking here, Diamondback is not an isolated example in the industry. We conducted the same analysis with other leading frackers, a group of 8 names (including FANG). The suspects are (in order of production size): EOG (EOG:US), Devon Energy (DVN:US), Pioneer Natural Resources (PXD:US), Continental Resources (CLR:US), Concho Resources (CXO:US), Cimarex (XEC:US) and Whiting Petroleum (WLL:US). Our analysis dates back to the first quarter of 2013, but we could have gone even further back in time and the results would have changed very little – actually, they would have been reinforced.
We chose these companies because:
- they are pure frackers and they do not have any significant international activity (Devon has some assets in Canada, but they are small in comparison with the fracking business). Some oil majors, like ConocoPhillips or Exxon, have significant fracking exposure, but given that most of the time the results are presented in a consolidated fashion, it is difficult to disentangle fracking operations from conventional ones, so no oil majors have been included in the analysis.
- they are leading operators (either in terms of acreage or in terms of production) in their respective basins.
- they have a sufficient number of years of track-record.
- and they have a meaningful volume of production.
The consolidated FCF for the group of companies is displayed in the following graph. As the reader can see, the only two companies who were able to generate a positive FCF were EOG and Devon, whereas the rest of the group was FCF negative. Devon was FCF positive mainly because it has sold several assets recently, which are included in the FCF number. You could argue whether or not to include the acquisition/divestiture of mineral rights to drill the land. We included it, because it is a fundamental part to develop the business and because we suspect that our peer group will sell properties in the near future to the oil majors, who have stronger balance-sheets, in order to trim down their debt. But so far, the frackers have been paying increasing amounts for core acreage (one may come to the conclusion, as we do, that the whole operation is truly fantastic only for the owners of the mineral rights!), because they are investing for the future.
But wait, there is more: once you deduct the outflows from interest payments from the FCF, the remaining cash needed for debt repayments and shareholders’ distributions becomes even more negative, amounting to -$16bn.
There are several reasons why the frackers have not been able to post positive FCFs. The simplest is that the technology to extract all the oil barrels stucked in shale and other tight rock formations in a profitable manner does not yet exist. Some others will argue that we have gone through a very tough period over the last two years, so the numbers of the last five quarters distort the whole picture – but remember that the FCF does not improve if we go back in time – actually, it gets worse. But we think there is another important issue: the product mix coming from the shale well is, in comparison to conventional fields, heavily slanted to gas products, as you can see in the following graph:
The average oil production (as percentage of total production, expressed in barrels of oil equivalent) of our peer group in the 1Q’17 was not even 55%, ranging from as low as 30% in the case of Cimarex, to 75% in the case of Diamondback. These product mix differences are important, because a barrel of NGLs is usually sold at a heavy discount to the WTI oil benchmark. For instance, in 2014 an average fracker could sell oil at around $87 per barrel versus $30 the barrel of NGLs, whereas the same fracker would have sold oil in 2016 at $40 on average versus $13.7 the barrel of NGLs (an expert will tell you that prices in the US are also heavily influenced by the takeaway capacity of a particular region, because it is not the same to sell gas out of the crowded Marcellus basin than out of the Fayeteville one, but you get the point).
So the discounts between oil and NGLs are more than 60% most of the time, and the same goes for the discounts between natural gas and oil. But because all these producers report barrels of oil equivalent in their headlines, lazy investors (and financial journalists in general) will never find out that the average realised price for these equivalent barrels is actually much lower. In general, as a rule of thumb, we have seen that the average price realised out of these equivalent barrels is between 75-85% of the WTI price at that moment, which means that the discount is huge and that even if you believe that these producers breakeven at $50 per barrel as they usually claim, what they really mean is that they are able to breakeven at around $40, which from our point of view is completely ludicrous for most of the shale plays.
The fracking story needed to entice investors
Although we highly doubt the previous numbers are widely known by the investment community, the analysis we have presented here is well-known, at least, by some very good investors. David Einhorn presented an investment thesis against the frackers some years ago along very similar lines, adding that it does not matter how large their reserves are: they have negative net present value because they cannot be extracted at a profit. The present analysis may be regarded as a modest update of Einhorn’s original thesis. Since then, as you can see, very little in terms of profitability has changed.
But not only some wise investors and yours truly think that most shale is not competitive under $50 or even $55, as if you take a look at recent Goldman Sachs’ reports, you can see that new US shale developments only start being profitable, on average, at $55/barrel:
However, there has to be some story behind to support the appetite of the market to constantly finance non-profitable operations. We know that we live in the brave world of low yields and high leverage, but investors have to see something (or rather, not see) in order to finance such businesses. They cannot see cash-flows because they are not there. Actually, in most of the frackers’ presentations they don’t event mention the FCF evolution (check the Diamondback’s latest investor presentation referred to above). This is one of the reasons we chose to focus on FCFs rather than on the nitty-gritty details of fracking extraction: we think that investors have had enough of that in corporate presentations.
In any case, the story to support such an appetite is the promise of future efficiency gains. What do ‘future efficiency gains’ mean in the fracking world? They mean:
- The ability to drill longer lateral wells (from 5,000 ft. in the last few years up to 13,000 ft. currently).
- The ability to introduce more frac sand stages (the number of times the rock is fracked over the same length) per lateral well (from 20-25 stages to 30 currently), and
- More volume of sand per well (from 2,000-3,000 tons per well to around 5,000 tons currently).
Most of these advances are real and we do not have any doubt that they have brought significant gains to the industry. For instance, the increasing cost derived from pumping more sand to the well (for instance, an increase of 2,000 tons at an average sand price of 50$/ton. yields a $100,000 in additional costs) is more than offset by the increase in oil and gas production.
But in many instances, it is difficult to disentangle the cost-savings coming from pure efficiency gains from the savings coming from squeezing the margins of oil service companies. In the last couple of years, upstream companies have been playing hardball when negotiating fees with oil services companies (with the threatening prospect of not being able to give any job at all), but as rig utilisation and production goes up we should expect the cost for the frackers to go up too, as oil services companies regain some of the margins lost during the crisis.
And finally, there are also some other technical disadvantages coming from the efficiency gains. As lateral wells have lengthened, the amount of water recovered from the wells has also increased. On average, between 6 and 8 barrels of water are recovered from 1 barrel of oil (the Permian basin has one of the highest ratios). It means that, if you start from the oil production in the Permian as of today (around 2,3 million of barrels/day), the daily amount of water to be disposed in a safe place is around 14 million barrels, which is a considerable amount. And as production grows, it would not be a surprise to see how producers struggle to find proper places to dispose such quantities.
As you can see, the debate gets murkier when you dig into the technicalities of the operation. That’s why we think that a bird’s-eye view, focusing on FCFs, helps a lot. So, whereas the ‘business story’ is not as simple as it was back in the dot-com bubble, the kernel of the matter is that the industry cannot yet generate positive FCF at reasonable oil price levels. Using an analogy from the theory of perfect competition (from which the oil industry is a bit far), the fracking industry does not control its own destiny: the more productive it gets, the cheaper the price of oil in the market. They may be able to cover drilling costs, but most of the leasing rights expenditures will be lost (sunk costs). Only a concerted effort by the OPEC and Russia to reduce supply in a long-lasting way can counterbalance frackers’ hazardous dynamics.
Some broader (macroeconomic) implications of the fracking bubble for the rest of the world
Given our natural macroeconomic slant, we cannot help but to conclude with some brief thoughts on why this Wall Street bubble is so different from the two previous ones (namely, the dot-com bubble and the real estate one), and why it is so important for the rest of the world to understand these differences.
We do not want to give our readers the impression that we are against the fracking industry from a macroeconomic point of view (the pressing environmental issues generated by the fracking techniques will not be discussed here). Far from it. We root for the industry success, because as we will explain its success can have important implications for the global economy, especially for Europe. This post simply wanted to stress that from an investor’s point of view, the economics of the industry are poor, and sooner or later investors will regret to have given so much money to a cash-burn industry.
How is this bubble different from the previous ones? The first aspect is, obviously, its size. Although the oil industry is one of the biggest industries in the world, the US oil industry does not have the same importance from a macroeconomic point of view as the real estate market. But we think there are several substantial reasons why this bubble is (and will be) different:
- First, from a US point of view, the increase in shale production has been able to improve US trade account, reducing the need for energy imports. The US trade account almost reached a staggering 6% deficit in 2006, and since the Global Financial Crisis the trade deficit has never surpassed again the 4% threshold; and all that despite a stronger dollar and a lackluster global income growth. But most of this narrowing comes from the evolution of the oil and related products deficit, which has improved considerably and is now almost non-existent:
- Second, from a rest of the world perspective, the ‘fracking bubble’ has not had (and, we bet, will not have) the deleterious effects the two previous bubbles had on the global economy. Here, the financial balances approach helps a bit in understanding why. In the periods 1999-2001 and 2004-2007, the US was running small government deficits (and even small surpluses during the Clinton years, see graph below) coupled with sizeable current account deficits. The accounting implication is that the private sector was running deficits, and those deficits were being financed by foreigners. In contrast, the balance of payments has shown smaller deficits, of around 3%, over the last few years, whereas the government sector has been running deficits of around 5%, which means that basically foreigners have been buying US government debt, rather than questionable private debt. So, in case all these oil assets turn sour, the bulk of the losses will be burdened by US investors, not international ones, as was the case in the two previous bubbles.
- Third, although the fracking story will not be pleasant for investors and banks, for the time being it is incredibly good for the global economy. Unlike the dot-com and real estate bubbles, the fracking revolution has brought real improvements for many countries (did your life improve because of the creation of useless IT companies or CDOs-squared? Probably not). A lower oil price is a blessing for most economies, and the savings from cheaper oil can be important. For instance, for our country, Spain, a back-of-the-envelope calculation tells us that the savings have been around $15 billion per year (Spain daily consumption is around 1.3 million barrels, and assuming that frackers have been able to reduce the global cost curve in $25, a $25 price reduction means 25*1.3*365=$12 billion), or 1% of Spain’s GDP.
- And fourth, in an era where we usually complain about how unequal income and wealth are distributed, the frackers have been important elements of income redistribution and effective demand creation: first, redistributing flows from investors and banks to the oil companies (that as we have seen have a very high marginal propensity to spend!), and second, from oil producing countries to oil-dependent ones – where income and wealth distribution is not as bad as in the former case.
Summing up, although from an investors’ point of view we think the shale revolution will prove to be a disaster, from a macroeconomic point of view we strongly disagree with those who argue that the burst of the sector will have profound consequences for the global economy. First, the losses will be mostly burdened by US investors and, second, the stability effects that the shale industry has had on the global economy so far have been far more important than any potential investors’ losses. The growth in the global economy has been fragile in the last few years, and the last thing the world needs is another round of oil price increases like the ones we witnessed at the beginning of the 2000s, in 2007-08 and in 2012-2014 – the period in which the breakup of the Eurozone loomed closer. The shale patch is thus one of the crucial battlefields where the war for the destiny of the global economy is taking place.