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.

Only nine of 33 shale oil exploration and production companies reviewed in the report cited above had positive free cash flow for the first half of 2018. This is even though prices had risen all the way from a low of around $30 in 2016 to the mid-$70 range by the middle of this year.

To get an idea of just how bad it has been even through periods when the price of oil averaged above $100 in 2011, 2012, 2013 and most of 2014, here are the annual free cash flows in dollars of those 33 companies combined since 2010 and they are all negative: -14 billion (2010), -21.9 billion (2011), -37.8 billion (2012), -16.8 billion (2013), -33 billion (2014), -34.4 billion (2015), -18.3 billion (2016), -15.5 billion (2017).

Capital expenditures are what companies invest in future production—in this case, the acquisition of new oil deposits and the drilling and completion of new wells and associated infrastructure. Because operating cash flow has not been sufficient to cover the drilling of new wells, companies must either issue new debt or new shares to raise money to do so. The former makes companies more likely to go bankrupt if oil prices turn down and the latter dilutes the value of the company for existing shareholders. Either way, it's not good news for investors.

So, maybe you are asking: "Why don't the companies save up enough money to drill new wells before they go prospecting?" The answer lies in understanding the decline rates of existing wells. After three years most shale wells are producing 70 to 90 percent less oil than when they began. (Compare this to the worldwide decline rate for oil production of between 4 and 5 percent per year which over three years comes to between 11 to 14 percent.) The situation has been likened to trying to run up a down escalator. The faster the escalator is going down (well decline rates), the harder it is to make any progress going up (that is, increase production). In order to keep a company's overall production growing, the company must drill continuously or risk declining production which would lead to a vicious cycle of declining cash flows needed to drill new wells.  Related: The Clock Is Ticking: How Much Oil Will Iran Lose?

To avoid this scenario, such companies seek extra money every year in the form of debt and/or stock issuance in order to fund new drilling. Now here's why this is unworkable in the long run. An example outside the industry will help illustrate the problem: A company engaged in manufacturing might be able to justify negative free cash flow for years as it builds out its manufacturing facilities to make more products in more markets.

After a few years if the strategy works, the company could be well-positioned to dominate its markets and make a handsome profit for investors. Things, of course, don't always work out the way companies want them to. But there is a logic to continuous investment in such a company in the face of negative free cash flow. This is because investors have reason to believe they are building long-term profitability. Factories stick around; they suffer wear and tear, but they don't deplete as oil does. And, those who run them tend to get better over time at making their factories more productive, not less.

The same cannot be said for companies which extract shale oil because of its high decline rate. If operating cash flows are not sufficient to fund capital expenditures relatively soon after the company begins its drilling program, then the company must drill furiously simply to avoid a production decline let alone achieve the production increases which are good for stock prices.

Production increases can actually be achieved for a time with a lot of effort and expenditure. But, here's the problem: As the number of producing wells rises sharply, the number of wells that must be drilled each year JUST TO KEEP PRODUCTION LEVEL RISES SHARPLY AS WELL. At some point, the best most productive places to drill are used up. The company must move on to places that are less productive and so must drill even more wells than it otherwise would have (usually at higher costs) just to keep production level.

The shale oil companies say that technology will solve the problem. But so far, the evidence suggests that the decline curves are getting steeper. Production from new wells is falling faster than before, an indication that companies are already moving away from the best prospects to more marginal deposits. The largest independent oil company operating in the shale oil industry, Pioneer Natural Resources, suffered a decline of 56 percent in the rate of production in 2017 from wells in production at the end of 2016. That means that the company had to replace more than half its production last year with new wells BEFORE it could grow production (which it managed to do). Related: Can Russia Relieve The Iranian Oil Crisis?

But as the herculean efforts to grow production face greater and greater decline rates and the need to replace falling production from a larger and larger number of EXISTING wells, it will at some point become impossible to grow production or even to maintain it. The number of new wells which must be drilled will exceed the number of suitable places to drill them and/or the capacity of drilling equipment available.

That's the point at which the jig is up. That moment could be brought forward for companies if the price of oil crashes or if the economy crashes and investment dollars stop flowing to the shale oil companies. If companies cannot finance extensive new drilling continuously, the illusion of success will be shown for what it is.

Meanwhile, top management keeps getting paid bonuses to burn investor cash and consumers get oil for less than the actual long-term cost of production. It's one of those rare instances in which the top 1 percent (and a lot of other suckers) are lured by an incomplete understanding into an investment that subsidizes the lives of the 99 percent.

But don't count on this arrangement lasting far into the future. The day of reckoning is coming. Those who can figure out precisely when or simply get lucky guessing when can make a fortune on the downside by betting against what some have call the shale oil Ponzi scheme. There is a way, however, to profit from any Ponzi scheme if you are already invested in one and you recognize it: Get out before it comes crashing down!

By Kurt Cobb

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