Red Flags on U.S. Fracking - Update October 2018

Red Flags on U.S. Fracking

Disappointing Financial Performance Continues

Executive Summary 

Despite two and a half years of rising oil prices and growing expectations for improved financial results, the U.S. fracking sector continued to spill alarming amounts of red ink during the first half of 2018. 

Key findings of this briefing note (the first in a series on the financial metrics driving the industry):

● Even after two and a half years of oil price increases, U.S. fracking-focused oil and gas companies continued their eight-year losing streak in the first half of 2018.

● These small and mid-sized U.S. exploration and production companies (E&Ps)
reported $3.9 billion in negative cash flows through June.

● E&Ps dipped into cash reserves in the first half of the year to fund capital 
expenditures and shareholder payouts.

A cross section of 33 publicly traded oil and gas companies at the center of the U.S. fracking boom continued to post negative free cash flows through June. Collectively, these companies spent $3.9 billion more on new capital projects in the first six months of the year than they realized from selling oil and gas.

These disappointing results come on the heels of a decade of bleak financial performance as the fracking sector has failed consistently to produce enough cash to satisfy its thirst for capital. 

Time and again, as frackers have returned to capital markets for new infusions of cash, these companies have racked up enormous long-term debts.

The ranks of frustrated investors are growing.

The first-half cash flow results, though disappointing, represented an improvement over early 2016 and 2017, when the companies in question racked up negative free cash flows of $11 billion and $7.2 billion, respectively. The run-up in oil prices during the third quarter of this year may help oil and gas companies improve cash flows.

Yet as oil and gas companies prepare to release third quarter results, a key question remains:

Will fracking companies produce enough cash—and for long enough—to cover both capital outlays and payouts to investors?

By definition, a healthy, mature industry consists of companies that generate enough cash to pay for new capital spending, while also paying down old debts and rewarding equity investors. With the fracking sector producing weak cash flow, however, investors will struggle to identify individual firms that can produce blue-chip results. 

Until oil and gas companies prove that they can sustain abundant free cash flows, investors have ample reason to remain wary of the sector as a whole.

A Financial Bust Within a Production Boom

To outward appearances, the U.S. oil and gas industry is in the midst of a decade-long boom. 

Hydraulic fracturing, or “fracking,” has unleashed a torrent of oil and gas production, lifting U.S. output to all-time highs and fueling dreams of American energy dominance on the global stage.

Yet in financial terms, America’s fracking boom has been a world-class bust.

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Can U.S. Shale Overcome Its Cash Flow Problem?

I'm tempted to say the following to the writers of two recent pieces (here and here) outlining the continuing negative free cash flow of companies fracking for oil in America: "Tell me something I don't already know."

But apparently their message (which has been true for years) needs to be repeated. This is because investors can't seem to understand the significance of what those two pieces make abundantly clear: The shale oil industry in the United States is using investor money to subsidize oil consumers and to line the pockets of top management with no long-term plan to build value.

There is no other conclusion to draw from the fact that free cash flow continues to be wildly negative for those companies most deeply dependent on U.S. shale oil deposits. For those to whom "free cash flow" is a new term, let me explain: It is operating cash flow (that is, cash generated from operations meaning the sale of oil and related products) minus capital expenditures. If this number remains negative for too long for a company or an industry, it's an indication that something is very wrong.

. . .

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18 hours ago, Tom Kirkman said:

There is no other conclusion to draw from the fact that free cash flow continues to be wildly negative for those companies most deeply dependent on U.S. shale oil deposits. For those to whom "free cash flow" is a new term, let me explain: It is operating cash flow (that is, cash generated from operations meaning the sale of oil and related products) minus capital expenditures. If this number remains negative for too long for a company or an industry, it's an indication that something is very wrong.

. . .

My understanding is that cash flow and profit are different things. To illustrate this point, let's consider nuclear power plants.  Nuke construction is planned to take 5 years from order to first operation.  That assumes everything goes perfectly. For those first five years, a nuclear power plant is cash flow negative. As soon as operation starts - and assuming things went according to plan - it becomes cash flow positive. Some years later, it pays for itself and achieves profit. 

Nukes are an extreme case of immediate negative cash flow.  The best projects are scalable: bring a small capacity online almost immediately, and use cash flow from that to support the rest of the project.  I.e. not all projects will have the same cash flow profile. 

The question is, "Given the nature of shale fracking, when should it be cash-flow positive?"  Investors may get jittery because shale isn't behaving like other projects, but shale isn't other projects.  The long term goal is profit; what short-term cash flow expectations should we have to meet long-term profit goals? 

Also, does continued investment & increasing production affect our expectations?  Has the industry been spending money on R&D, exploration, and other important activities that, unfortunately, kill cash flow?  Are they continuing to spend knowing that temporary bottlenecks will be removed (E.g. will the wellhead price increase once Permian pipelines come online?)?  What's the full picture here? 

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