Huge CAPEX = Free Cash Flow? Not In Shales

By Deborah Lawrence Rogers

The oil and gas industry has made tremendous promises regarding shale gas and oil, most of which are, unfortunately, dropping by the wayside. We were promised production “for decades to come” though actual production numbers belied this. We were promised energy independence while the wells were screaming down their decline curves. We were promised jobs, while renewables were quietly booking considerably more jobs per kilowatt than oil and gas. Three times as many to be exact. Perhaps such poor performance from oil and gas is precisely the reason for the hyperbole.

Nevertheless, an interesting article from Bloomberg touches on another aspect of shale production: sustainability. Fiscal sustainability.

Bloomberg quotes Mike Tims, the Chairman of Canadian investment bank Peters and Co.:

“Increased crude output from U.S. shale isn’t “sustainable” production. Producers need to invest too much to sustain production from wells in the Bakken and Permian basins, which falls as much as 70 percent in the first year.”

This bears scrutiny.

When looking at company’s financial statements there are certain metrics that are useful in judging the health of that company. One of these is free cash flow. Not cash flow but free cash flow. Why? Because it is difficult for company management to fudge free cash. The veracity of any statement can easily be checked against bank balances. That is not to say that there is no way to manipulate it but it is more difficult.

Free cash flow can be defined as operating cash flow less capital expenditure (CAPEX) less any dividends paid.

Taking a universe of 5 shale companies, some primarily with shale gas assets and others with shale oil, it is of note that there has been a significant deterioration of free cash flow since 2010. But what is even more interesting is that some of these companies are reporting that net income has been growing though free cash is falling.

Not wishing to bore everyone with an esoteric discussion of financial statements, it is of note that when a company shows a growth in net income with a concomitant deterioration of free cash flow, it may be an indicator that management is taking aggressive steps to boost earnings artificially. Not always. But possibly.

So how much deterioration has there been in free cash flow? It is impressive.

When you adjust the figures to include capital expenditure (and dividends where appropriate), their free cash available is negative. Significantly negative.

This is highly problematic because if a company cannot generate cash from operations then it has to go outside and get the monies through borrowings or equity offerings. In other words, debt or dilution for investors.

Free cash flow of Continental Resources, a big player in the Bakken, has dropped from ($430M) to ($2.4B) since 2010, all of it negative. And Continental is not the only one. Devon Energy’s free cash flow has dropped from ($1.2B) to a significant ($3.5B) over the same time frame. Range Resources, who are drilling primarily in the Marcellus, booked a negative free cash flow of ($556M) in 2010 and this has deteriorated to ($1.0B). Kodiak Oil and Gas, another Bakken player, had negative free cash flow in 2010 of ($170M). It has now deteriorated to ($1.0B). Chesapeake is interesting because its free cash flow for 2012 ($3.3B) is now roughly equivalent to its level in 2010, ($3.4B). But over the last two years Chesapeake has liquidated approximately $13 billion in assets with no commensurate gain to free cash flow. Management still needs to move outside the company to generate cash to continue operations. And yet, shareholders have had their underlying assets disappear to the tune of $13B to pay down debt.

Clearly there is a pattern here of severe deterioration. But that is not all. CAPEX has exploded during this time which means that companies have spent enormous sums of money drilling wells that are not providing enough cash to continue drilling operations on their own. Not even close. For instance, Continental’s CAPEX grew from $1.0B to $4.1B. Devon’s CAPEX grew from $6.4B to $8.2B. In total, these 5 companies spent approximately $56B in capital expenditure since 2010 while the free cash generated from this $56B spending spree is non-existent. In fact, it is worse than non-existent because it is alarmingly negative.

This is not sustainable. It could be argued that it is not even moral. It is a failed business model of epic proportion. While companies could make the argument at one time that this was a short term downtrend, that no longer holds water because this pattern is long term.

The most troubling aspect of this is that we are fast tracking exportation of this commodity in spite of the glaring financial anomalies. It is extraordinary that some members of Congress proclaim whole heartedly for fiscal responsibility while turning a blind eye to fiscal irresponsibility among their campaign donors and promoting exportation.

I believe this is commonly known as hypocrisy. Or is it politics?