Pumping Red Ink

Jim Brown
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Shale producers drill $12 million wells with production that declines 95% over the first three years. Are they really making money?

Everyone is probably ready with a quick answer that shale drilling is unprofitable at the current WTI price of $45. It may surprise you to learn that they were not really making any real money even when oil was over $100 a barrel.

The top 50 U.S. producers spent over $200 billion on capex over the last two years. In order to do that they increased their debt by more than $150 billion. Free cash flow is a rare commodity in the shale drilling business. I am defining free cash flow as the available cash after subtracting finding and development capex spending from operating cash flow.

Basically if you have $50 in cash from operations but it cost you $100 to find and develop the wells that produced that $50 then your free cash flow is -$50. If you spend $1 to make 50 cents you are not making any money. In the rest of the business world, it is free cash flow that identifies a successful company. In the drilling business it "has been" the number of new wells you drilled and the amount of reserves you added. Unfortunately, those new holes and new reserves have to provide you some cash at some point in the future or the bank accounts will run dry.

Shale drillers have been running dry every year because expenses are higher than income but the accounting is focused on developing reserves. In today's market, they cannot produce those reserves because it costs them more to produce the oil than the current market value. This causes the accounting exercise to fail.

According to IHS Cera and Citigroup the free cash flow from the top 50 US producers has been negative for years. In the graphic below, all the numbers are in the billions. The average free cash flow has been a negative $36 billion a year. Since the prior 5 years saw oil prices significantly higher we know 2015 is going to be really ugly.

Basically shale producers have been pouring cash into the ground in hopes of a future return and going deeply into debt to do it. With oil prices at $45 and falling and Goldman Sachs warning about the potential for $20 oil the banks are not likely to be loaning a lot of money in the near future.

Banks loan based on the value of the reserves. If a company has 1 million barrels of reserves and WTI is $100, the banks will discount that based on the term of the loan minus your development costs. If it costs you $50 to produce a barrel of oil the bank may loan you $25 a barrel against your reserves. If WTI falls to $45 and it costs you $50 to produce then a bank is not going to loan you anything against your reserves.

The Anadarko Petroleum CEO said last week, "it is raining really hard and it is going to keep on raining for a long time. Some companies are going to drown. Anadarko is not one of them."

Some companies are going to drown in red ink. If they cannot borrow more money to fund their deficit spending, then spending will have to stop. If they are not drilling new holes with high rates of initial production then the rapid depletion rate of shale wells is going to sink them.

According to the Anadarko CEO production from a shale well declines 50% in the first 90 days, 60-75% in the first year and up to 95% over three-years.

Multiple producers including Conoco and Continental Resources recently announced they were scaling back on expenses in order to reach cash flow neutrality. That means they are not going to spend more than they receive from oil sales.

That is a major diet for producers. For shale producers it is a diet that will become increasingly harder to maintain because their cash flow is dependent on depletion. That means cash flow from relatively new wells is going to decline 65-75% in 12 months while older wells are declining 20-25% per year. If oil prices do not suddenly rocket higher that cash flow diet is going to be very painful 12-18 months from now.

The Federal Reserve has been stress testing the banks and the drop in the price of oil is stress testing the shale producers. There have been 8 bankruptcies in the energy sector already in 2015 and many more companies are starting to show up on the list of potential candidates. If Goldman is right about oil prices declining sharply over the next several months it will tell us who has been living on borrowed time and which company has a sustainable business.

Without access to the debt markets, the only options left to raise cash are secondary offerings of equity and asset sales. Private equity firms have raised billions in cash to acquire assets but so far, they are keeping that cash in the bank rather than putting it to work. This suggests they believe there is more pain ahead and they are waiting for the right entry point.

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Active Rigs

Active drilling rigs declined -16 to 848 for the week ended on Friday and that is a 10 year low . Oil rigs fell -10 for the week to 652. Active gas rigs declined -6 to 196 and a new 18-year low. Active rigs have now declined -1,083 since the high of 1,931 in September. That is a -59.5% drop. Active offshore rigs fell -2 to 31 and down -35 from year ago levels.

Oil Inventories

Crude inventories rose +2.6 million barrels to 458.0 million.

Refinery utilization declined from 92.8% to 90.9%. That is down from the high of 96.1% on August 7th.

U.S. production declined -83,000 barrels to 9.135 mbpd, down from the 9.61 mbpd and 40-year high in June. Demand fell -279,000 bpd.

Cushing inventories fell slightly to 56.4 million.

Gasoline inventories rose +0.4 million barrels to 214.5 million. Gasoline demand fell -421,000 bpd now that the Labor Day weekend is over.

Distillate inventories rose +1.0 million barrels to 150.9 million and a three-month high. Demand fell -196,000 bpd.

In the graphic below green represents a recent high and yellow a recent low.

Jim Brown

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