Shale doesn’t have a cash flow issue …and the limits of expansion…

Yesterday the $WSJ had this article on the economics and cash flows of the shale industry. The overall point is logical that if cost increases continue the cost of capital may go up for shale producers and point to it reaching the economic limits of its expansion. I agree with the general thrust of the article in that if the industry isn’t as profitable as forecast the cost of capital will increase, but this comment is being taken out of context by some:

IMG_0786.jpg

Of course they didn’t… they are investing for even higher production next year… the comment “within their means” is pejorative and not a reflection of economic reality. That is a sign of confidence from the firms and their financial backers that their output can be sold at a profitable price. The price signal from both the oil and the capital markets is strong.

I also received a comment yesterday with a link to this comment. I don’t think this is a big deal to anyone with a basic understanding of finance because they get this… but then again I have lost count of the number of people who repeat back to me that no one makes money from shale.

I wonder if this isn’t becoming part of the great “Gotcha” narrative that aims to prove that shale isn’t a viable production methodology? Like the CEO of Shell is going to wake up next Tuesday and say “after reading the article in the WSJ we are going to stop investing in shale. Thank goodness I read that or I would never have realised we will never make money from it!” As if those investing literally tens of billions had no idea of the cash flow profile of their assets?

The overall article is interesting only in that it points to what appears to be the current “productive efficiency” of shale, not its demise. The point of the article isn’t that you can’t make money from shale it is that at the margin now it is becoming less profitable and that may affect the pricing of capital. Bear in mind before you read the rest of this post the scale of the increase in absolute oil production shown in the graph above and the amount of capital required to finance this.

For those not versed in accounting cash flow negative might seem like a big deal but it’s not. A casflow statement is made up of Cash From Operations [CFO] (+/-) Cash flows from investing [CFI](+/-) Cash flows from financing [CFF]. It balances with the cash at bank at the start of the period and at the end. Free Cash Flow to the firm is simply the sum of the first two… You would expect the number to be negative in a capital-intensive industry, like shale oil extraction, when you are seeking to grow output volumes significantly, particularly when a number of firms are new entrants into the industry and not financing from retained earnings. You are spending capital to get future revenue and you need to borrow or raise equity to do this. Collectively as all the firms in the industry deepen the capital base for ever higher production they are using more cash than they are generating currently. (I am aware that there are a number of definitions of Free Cash Flow but this appears to be the Factset one and the generally accepted one of FCFF).

If you buy an offshore drilling rig for $1bn and get 100m in operating cash flow for year 1 then your (highly simplified and representative) cash flow statement reads: CFO +100m: CFI -$1bn. That is your “Free Cash Flow” [FCF] is -$900m. It is balanced (all going well) by CFF +900. You own an oil rig that lasts for 20 years but in year 1 you were down $900m in FCF. You can buy as many rigs as you want and be FCF negative (like Seadrill) for as long as you can keep CFF >= CFO+ CFI  i.e. you have access to debt or equity markets. That is all that is happening in shale collectively.

If these were operating cash flow negative then there would be a massive issue. But as this research from the Dallas Federal Reserve (March 2018) makes clear there is no problem with operating cash:

des1701c1.gif

Or indeed with profitably drilling wells at the current oil price (i.e. including financing):

des1701c2

For as long as investors believe that in the future the oil price attainable by these E&P companies is sufficient to return capital, and funding markets remain open, then spending more on Operating Income + CapEx combined is no problem. There is rollover risk in the debt but that is a seperate risk and appears to be pretty minimal at the moment.

Pioneer is an embodiment of this: in the first six months of 2018 it generated ~$1.5bn from operations (i.e. selling oil and gas) [CFO], spent ~$1bn on investments (actually nearly $2bn but it sold some stuff as well) [CFI], and then paid back debt of $450m and purchased ~$50m of shares. But some smaller companies who have come in recently will have spent far more on CapEx than they will earn in CFO.

When I have talked about the ‘virtuous cycle’ of capital deepening in prior posts this is part of that network effect of decreasing risks and increasing returns for all involved in the ecosystem. E.g. if Trafigura build an export facility for 2m b/per day it lowers the risk for every E&P company (and their financiers) that they can sell more oil profitably. So more investment comes into the sector in an ever-expanding circle, lower costs, replacing labour with capital. That is what appears to be happening here. The limits of this process are there and are hinted at in the WSJ:

IMG_0787.jpg

Permian production will be up 19-24% according to Pioneer so it’s not all bad. Costs are increasing as the Permian reaches the constraints of labour and capital as has been well documented. Some of these will disappear with new pipelines and other capital deepening, e.g. a replacement of capital over labour as excess surplus is currently trucked or railed out, but some will continue given the huge increase in absolute production volumes. It is no surprise that with such a huge percentage increase in production that at the margin each incremental barrel becomes more expensive in the short-run, but then the capital deepening effect will kick in and the long-run cost curve will decline, as always in mass-production, and then the unit costs drop again… ad infinitum

Pioneer are saying with that statement is that their marginal output on capital is declining slightly this year as cost increases have not kept pace with productivity improvements. That isn’t surprising because the sheer volume of output increased has consistently surprised on the upside. If the project costs increase 10% and this isn’t covered with higher prices and/or productivity improvements then investors will change their price of capital to reflect diminished expectations.

US-Shale-Production-Outlook-Revised-Upward-Repeatedly-20160210-v2

But this production capacity isn’t going away. The rigs have been built. The pipelines have been, or are being, built; the same goes for export terminals etc. The capital base of the industry has increased massively and is facing some teething problems. But in a little 4 over years the US tight oil industry has driven US production up to over 11m b/ per day in 2018, over 6m b/ per day of that from shale up from ~4m b/ per day in 2017.

What should really worry those in the offshore community is that this is an industry that increased production 50% in a calendar year before hitting the limits of economic growth, and it did this while increasing productivity and lowering unit costs. Someone isn’t waking up next Tuesday and realising it has all been a massive mistake and turning the tap of funding or production off. The US shale industry is a deep and entrenched part of the energy mix now. Current forecasts might be out by a few hundred thousand barrels a day but they are not going to be out by millions. This production is real and permanent with profound implications.

The core logic of the WSJ article is surely right: A rise in the costs of shale relative to output signals the limit of the economic efficiency and therefore the diminishing returns to capital may make it more expensive for shale E&P firms to fund new projects. Shale and offshore compete for E&P company CapEx and if the cost of funding shale projects rises (on a productivity measured basis) that should increase relative demand for offshore as a substitute. But the Free Cash Flow from an offshore project is massively negative in the short-run and over time has higher yields, whereas the reduced CapEx commitment, despite its lower margin, is one of the chief attractions of shale. Cash for investment is not the issue.

I think it sits uncomfortably with forecasters who claim that day rates for jack-ups will double within two years, or other such notions, and it does not seem to be incorporated in the strategic planning assumptions of a large number of offshore companies or investors where the logical outcomes of such data sit uncomfortably. The offshore industry built a fleet to handle 2013 demand when shale was producing ~2.5m barrels a day, it is now producing 6m and is growing faster than the overall oil market growth and forecast to do so until 2021 at least.

Hard strategic questions arise for the offshore industry: how do we compete in an industry which faces potentially declining market share for our underlying product at the margin? How do we compete in an industry when a competitor with a different business model has taken 10% of global market share in the space of 5 years and we buy 25 year assets funded on short-term contracts? What level of asset base shrinkage does the offshore industry require to be competitive? How many firms will have to liquidate given this necessary shrinkage? What will the surviving firms look like? How much can they realistically expect to make? What are our assets worth?

There are a lot more questions based around this logic. But if you are simply expecting a day-rate increase and a demand side boom based on shale magically running out of cash at some future point I think you are going to be very disappointed.

One thought on “Shale doesn’t have a cash flow issue …and the limits of expansion…

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s