While politicians and the mainstream media trumpet fracking as a great American energy revolution, it has in fact been a financial disaster, writes Justin Mikulka of DeSmog blog. The American shale oil and gas boom, he writes, may be “one of the largest money-losing endeavors in the nation’s history”. Courtesy DeSmog blog.
In 2008, Aubrey McClendon was the highest paid Fortune 500 CEO in America, a title he earned taking home $112 million for running Chesapeake Energy. Later dubbed “The Shale King,” he was at the forefront of the oil and gas industry’s next boom, made possible by advances in fracking, which broke open fossil fuels from shale formations around the U.S.
What was McClendon’s secret? Instead of running a company that aimed to sell oil and gas, he was essentially flipping real estate: acquiring leases to drill on land and then reselling them for five to 10 times more, something McClendon explained was a lot more profitable than “trying to produce gas.”
But his story may serve as a cautionary tale for an industry that keeps making big promises on borrowed dimes — while its investors begin losing patience, a trend DeSmog will be investigating in an in-depth series over the coming weeks.
From 2008 to 2009, Chesapeake Energy’s stock swung from $64 a share under McClendon to around $17. Today, it’s worth just $3 a share — the same price it was in 2000. A visionary when it came to fracking, McClendon perfected the formula of borrowing money to drive the revolution that reshaped American energy markets.
An industry built on debt
Roughly a decade after McClendon’s rise, the Wall Street Journal reported that “energy companies [since 2007] have spent $280 billion more than they generated from operations on shale investments, according to advisory firm Evercore ISI.”
As a whole, the American fracking experiment has been a financial disaster for many of its investors, who have been plagued by the industry’s heavy borrowing, low returns, and bankruptcies, and the path to becoming profitable is lined with significant potential hurdles. Up to this point, the industry has been drilling the “sweet spots” in the country’s major shale formations, reaching the easiest and most valuable oil first.
Business media and conservative think tanks are still selling the story that the fracking industry has produced an economic and technical revolution
But at the same time energy companies are borrowing more money to drill more wells, the sweet spots are drying up, creating a Catch-22 as more drilling drives more debt.
“You have to keep drilling,” David Hughes, a geoscientist and fellow specializing in shale gas and oil production at the Post Carbon Institute, told DeSmog. But he also noted that with most of the sweet spots already drilled, producers are forced to move to less productive areas.
The result? “Productivity goes down and the costs remain the same,” he explained.
While Hughes understands the industry’s rationale for continuing to drill new wells at a loss, he doubts the sustainability of the practice.
“I don’t think in the long-term they can drill their way out of this,” Hughes told DeSmog.
While politicians and the mainstream media tout an American energy “revolution,” it is becoming clear that — like the housing bubble just a few years earlier — the American oil and gas boom spurred by fracking innovations may be one of the largest money-losing endeavors in the nation’s history. And it caught up with McClendon.
When you lose money on each barrel of oil you pump and sell — the more you pump, the more money you lose
In 2016, the shale king was indicted for rigging bids at drilling lease auctions. He died the very next day in a single car crash, leading to speculation McClendon committed suicide, a rumor impossible to confirm. However, the police chief on the scene noted: “There was plenty of opportunity for him to correct and get back on the roadway and that didn’t occur.”
The same could be said of the current shale industry. There is plenty of opportunity for these energy companies to correct their path — for example, by linking CEO pay to company profits rather than oil production volumes — but instead they are plowing full-speed ahead with a business model that seems poised for a crash.
But hope springs eternal
Of course, business media and conservative think tanks are still selling the story that the fracking industry has produced an economic and technical revolution.
In 2017 Investors Business Daily ran an opinion piece with the title, “The Shale Revolution Is A Made-In-America Success Story.”It was authored by Mark Perry of the American Enterprise Institute — a free market-focused think tank funded in part by the oil and gas industry.
How does the author measure success? Not via profits. The metric Perry uses to argue the success of the fracking industry is production volume. And it is true that the volumes of oil produced by fracking shale are increasing and currently at record levels.
But here is the catch — when you lose money on each barrel of oil you pump and sell — the more you pump, the more money you lose. While it is true that the industry has been successful at getting oil out of the ground, its companies have mostly lost money doing it.
However, much like with the U.S. housing boom, this false narrative persists that the fracking industry is a money-making, rather than money-losing, venture.
A Wall Street Journal headline published in early 2018 projected this eternal optimism about the fracking industry: “Frackers Could Make More Money Than Ever in 2018, If They Don’t Blow It.”
This headline manages to be, at the same time, both very misleading and true. Misleading because the industry has never made money. True because if oil and gas companies make any money fracking in 2018, it would be more “than ever.”
“Ultimately, you hit the wall. It’s just a question of time”
However, the nuance comes in the sub-headline: “U.S. shale companies are poised to make real money this year for the first time since the start of the fracking boom.”
Poised to make “real money” for “the first time.” Or to put it another way, the industry hopes to stop losing large amounts of real money for the first time this year.
In March 2017, The Economist wrote about the finances of the fracking industry, pointing out just how much money these businesses are burning through:
With the exception of airlines, Chinese state enterprises, and Silicon Valley unicorns — private firms valued at more than $1 billion — shale firms are on an unparalleled money-losing streak. About $11 billion was torched in the latest quarter, as capital expenditures exceeded cashflows. The cash-burn rate may well rise again this year.
Some historic money-losing has been going on, and is expected to continue, as reported by the Wall Street Journal: “Wood Mackenzie estimates that if oil prices hover around $50, shale companies won’t generate positive cash flow as a group until 2020.” However, Craig McMahon, senior vice president at Wood MacKenzie, notes, “Even then, only the most efficient operators will do well.”
U.S. oil produced via fracking is priced as West Texas Intermediate (WTI), which averaged $41 a barrel in 2016 and $51 in 2017. The consensus is that WTI should average over $50 a barrel in 2018, thus providing the industry another reason to keep pushing forward. However, even in 2017 with the average over $50 a barrel, the industry as a whole was not profitable.
Irrational exuberance
In the introduction to The Big Short, Michael Lewis’ book-turned-movie about how the 2008 financial crash unfolded, he describes the finances of the housing bubble:
“All these subprime lending companies were growing so rapidly, and using such goofy accounting, that they could mask the fact that they had no real earnings, just illusory, accounting-driven, ones. They had the essential feature of a Ponzi scheme: To maintain the fiction that they were profitable enterprises, they needed more and more capital to create more and more subprime loans.”
If you substitute “shale oil and gas development companies” for “subprime lending companies,” it becomes an apt description of the current shale industry. These companies are losing more money than they make and can only sustain this scenario if lenders continue to bankroll their efforts, allowing the fracking industry to drill more wells as it points to production increases, rather than profits, as progress. Which — for now — Wall Street continues to do in a big way.
This article is the first in a series investigating the economics of fracking and where the vast sums of money being pumped into this industry are actually going. The series will look at how fracking companies are shifting these epic losses to the American taxpayers.
It will review the huge challenges facing the industry even if oil and gas prices rise: the physical production limits of fracked wells, rising interest rates, rising water costs, competition from renewables, OPEC’s plans, and what happens if Wall Street stops loaning it money.
Until analysts and investors start talking about profits instead of growth, this time is likely to end, at some point, in a completely familiar and predictable way: bust
The oil industry has always been a boom or bust industry. And during each boom someone inevitably declares that “this time is different,” assuring everyone there won’t be a bust. The sentiment about the early 2000s housing bubble was much the same, with critics being drowned out by the players claiming that, this time it was different, arguing “Housing doesn’t go down in value.”
And what about for shale production? Is this time really different? Some in the industry apparently think so.
“Is this time going to be different? I think yes, a little bit,” energy asset manager Will Riley told the Wall Street Journal. “Companies will look to increase growth a little, but at a more moderate pace.” There is little evidence of restraint or moderation in the industry.
Until analysts and investors start talking about profits instead of growth, however, this time is likely to end, at some point, in a completely familiar and predictable way: bust. A fate even Aubrey McClendon, the highest-paid CEO, the shale king, eventually met.
David Hughes summed up his take on the industry’s financial outlook: “Ultimately, you hit the wall. It’s just a question of time.”
Editor’s Note:
This article was first published on DeSmog blog and is republished here with permission.Â
Justin Mikulka (@JustinMikulka) is a freelance writer and video producer.
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The Comanchero Group says
It appears that Justin has no concept as to the analysis of long term capital projects. He focuses purely on the current financials and totally omits any consideration for the project’s residual value after payout.
In general, shale oil/gas projects do not achieve positive cash flow in the year of drilling but in later years,depending on the price of crude oil and natural gas. So, a company drills a well for millions of dollars, production commences and cash flow, in excess of operating costs, begins to payback the capital expenditure. Once payout of capital occurs, free cash flow then accrues to to the drilling project and legacy production continues for many years. The complete economic valuation of the project considers the total production life of the well together with the associated revenue and costs. Economic metrics such as discounted net asset value and rate of return may then be calculated together with the appropriate risk factors to provide a rigorous analysis of the shale oil/gas well’s profitability or loss.
Justin has neglected to consider the value of legacy production after payout. This is similar to buying a house and calculating how much the mortgage payments have cost without giving consideration to the home’s residual value after the mortgage has been paid out.
Oil/gas companies build future cash flow by expending current capital dollars. I contend that Justin’s analysis is superficial and misleading to the uninformed masses. He utilizes quotations from industry experts, which are out of context, to further his biased viewpoint that fracking oil/gas wells has never, and never will be, fiscally prudent.
It’s time for Justin to give some consideration to the fundamentals of economic analysis.
Dennis Coyne says
The math is pretty simple. A rule of thumb for profitable oil producers is that a well should pay out it’s capital cost in about 36 months, at $55/b (EIA’s expectation for oil price), the net revenue for a barrel of oil after production and overhead costs, as well as royalty payments, taxes, and transportation costs is about $30/b.
Typical full cycle capital cost for a well are about $9 million so payout in 36 months requires 9,000,000/30=300,000 barrels of oil to be produced over a three year period. The average US LTO well in the most productive plays (Bakken and Permian) produces maybe 325,000 barrels over 20 years and perhaps 200,000 barrels over the first 5 years of production. Oil prices of $80 to $90/b might allow these wells to be profitable, but only for a company that has zero debt and thus no interest payments. There are very few if any LTO focused companies with no debt.
John says
Interesting.
To get a sense of the average loss per barrel, would be interesting to put the 280 Bn$ in perspective with the production volume (in now) since 2007 to measure how many $/bbl it makes.
G Skeen says
Finally, someone speaking the truth about this false reality
Big Al says
“residual value after payout”
@The Comanchero Group
Mate / mates, it’s only shale, when we find shale that is considered to be mother rock, we look for Sandstone / porous limestone / or porous chalk for the reservoir.
Period.
We don’t extract oil from shale because it contains none (oil). C1 – C5 the most, all the heavies (the big molecules) are in the conglomerate / sandstone reservoirs (or trapped in the limestone).
Shale is considered to be a stratigraphic trap, not the reservoir. It can only seep gas (so it is a transit zone).
If you want to understand oil, you need to get your BOSIET course, pack your belly in survival suit and SPEND SOME TIME ON THE RIG.
ELSE:
Shush.
comanchero group says
Of course, shale oil is a misnomer. However, the media talks shale oil when the correct technical term would be light tight oil. I’ve been in the oil patch since ’76 all the way up from basic engineering through exec positions as well as mergers and acquisitions. Nobody, and I mean nobody, would rely on your inaccurate and incorrect analysis to characterize the valuation of light tight oil companies.
Dennis Coyne says
Comanchero group,
This is what privately owned oil companies use to get a decent return on investment for projects they pursue.
Some less conservative companies might use a 60 month payout rule rather than 36 months, but that tends to reduce the ROI.
One would have to be a little more specific about why the analysis is “incorrect and inaccurate”.
Using average well data from state agencies to fit a hyperbolic well profile to estimate future production and running a DCF with a discount rate of 10% and realistic estimates for well cost, LOE, gathering and transportation expense, and G&A expenses, the simple rule of thumb works out pretty closely. $50/b at the well head doesn’t result in profits, doesn’t matter how many wells you drill, without higher oil prices it’s a losers game.