Consciousness of Sheep
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There is a mismatch between the fracking companies’ investment brochures and the cash flow recorded in their accounts. In the years after the financial crash, this did not seem to matter too much. In the face of near zero percent interest rates elsewhere, the fast-growing US fracking industry offered one of the best rates of return around. And so long as the Wall Street banks continued to be permitted to conjure currency out of thin air to invest in fracking, nobody seemed too bothered about actual profits.
So long as oil prices remained high, the industry could get by on the claim that technological advances would eventually lower the break-even price; leading to the promised profitability. However, from mid-2014 a crash in oil prices resulted in several high-profile “restructurings” together with the apparent suicide of one of the leading proponents of fracking. Nevertheless, the industry did appear to be getting its costs under control.
What was sold to investors as technological efficiency, however, turned out to be a combination of:
- A retreat to known sweet spots
- Service companies lowering their prices in the face of falling demand
- And occasionally drilling into other people’s wells.
Following the OPEC-Russia agreement to curb global oil production in 2016, oil prices began to increase once more. Unfortunately, as the oil price rose, so too did the cost of fracking. Wall Street began to focus more on actual returns on investment today than in the promised future wealth in the fracking company brochures.
In 2018, with oil prices heading toward $80 per barrel and in the face of widespread rumours of $100 per barrel in the near future, the fracking industry breathed a sigh of relief. At $100 per barrel at least some fracking companies would be able to generate positive cash flow. And then it all went pear shaped. Predictably, higher oil prices coming on top of rising interest rates resulted in falling demand. In addition, the feared US oil sanctions on Iran and Venezuela proved to be far less disruptive than anticipated. The result is that global oil prices have crashed back down.
Faced with this blow to their bottom lines, the fracking companies were quick to claim that they could still break even at $50 per barrel. But for many observers, this claim seems wildly outlandish. For example, Bradley Olson and Rebecca Elliott at the Wall Street Journal note that:
“For years, the companies behind the U.S. oil and gas boom, including Noble Energy Inc. and Whiting Petroleum Corp., have promised shareholders that they have thousands of prospective wells that they can drill profitably even at $40 a barrel. Some have even said they can generate returns on investment of 30%.
“But most shale drillers haven’t made much, if any, money at those prices. From 2012 to 2017, the 30 biggest shale producers lost more than $50 billion.”
Are the fracking companies lying to investors?
Well, yes and no. Olson and Elliott point out that:
“The disconnect between the figures cited by companies and their corporate returns lies in the widespread use of a metric called a break-even, often defined as the selling price frackers say they need to generate a small profit on individual wells or projects. While the figure can be quite low for some companies in certain hot spots, it can be a misleading measure of their overall profitability in periods of lower prices.”
To the casual observer, the break-even price for doing business would be the price required to cover all of the business’ expenditure. If it cost you or I $50 to produce a widget, and we needed an additional $25 per widget to cover the interest and repayments on our initial capital, then we would expect our break-even price to be $75 dollars. More than that and we make a profit, less and we make a loss. Simple!
In the oil industry, however, break-even has a more precise – and highly misleading – meaning:
“Historically, the break-even number is rooted in an industry benchmark used to help executives decide whether to drill a well. Given that funds may already have been invested in land, infrastructure or overhead, it helps companies evaluate what price is needed for a new well to make economic sense…
“For one, break-evens generally exclude such key costs as land, overhead and even at times transportation. Companies also frequently tout the low break-even price point of a portion of their holdings, without citing the higher price for crude needed to profitably exploit the rest, or adjusting for the inflated cost for drilling contractors and other services that come with rising oil prices.”
Using break-even prices based on this meaning of the term, there are, indeed, fracking companies drilling wells in (certain sweet spots within) the Permian Basin that can generate a return at a mere $37 per barrel. However, as Olson and Elliott point out, add in all of the overhead and land costs and it turns out that even the lowest cost fracking wells on the planet still require an oil price above $50 to turn an actual profit:
“Chris Duncan, an energy analyst at Brandes Investment Partners who helps manage $28 billion in diversified assets, said he usually ignores companies’ claims about the price at which their wells break even. ‘You always scratch your head as to how they can have these well economics that can have double-digit returns on investment, but it never flows through to the total company returns,’ he said.”
In the good old days when the world was awash with cheap and easy conventional oil, this accounting practice was relatively harmless; not least because a conventional well can continue producing for decades. As the world falls back on increasingly expensive and difficult unconventional oil and gas, it becomes a highly politicised discrepancy. In the UK, for example, several companies have begun fracking and, apparently, have managed to return at least some shale gas to the surface.
Economist and UK government energy reviewer Dieter Helm, who was once a big supporter of UK fracking now argues that Britain is better off leaving its shale gas in the ground:
“The world is absolutely awash with gas. There’s no shortage of gas globally, including fracked gas from the United States, some of which is being imported into Scotland already. Do we have to produce it ourselves? No.”
The question for investors (which probably includes our pension funds) is not how low the break-even price of gas from a particular well needs to be; but how high the price will have to go to return the fracking companies as a whole to profitability. For the foreseeable future, that price is likely to be far higher than the price at which Norwegian, Russian and Qatari gas can be bought on the international market. A similar problem faces the US oil frackers. A strategic industry that depends on the far from friendly support of OPEC and Russia to maintain its profitability is no strategic industry at all.
As you made it to the end…
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