I want to do something a little different this week.
Before I get to that, a few housekeeping notes. First and foremost — thanks once again to good folks at BNN for having me on this week to talk molybdenum, platinum and met coal. Great discussion as always with Andrew Bell, you can see the full segment here:
At the 2021 SALT New York conference, which was held earlier this week, one of the panels on the main stage discussed the best macro shifts coming out of the pandemic and investing in value amid distress. The panel featured: Todd Lemkin, the chief investment officer of Canyon Partners; Peter Wallach, the managing director and Read More
Between that and everything else going on, it’s been a busy week — including discussions on the emerging City of Gold project I’ve mentioned in Myanmar, as well as a promising new gold project in Africa and a past-producing platinum mine (yes, finally managed to find one!).
And to top it all off, I’m getting ready to fly to Asia today.
One thing I did make time for the last few days was reading an article sent by my friend, Brad Parkes. Bearing the intriguing subject line: “The Real Reason Energy Companies Are Going Bankrupt”.
Brad is a person I love to read, because he’s a rare breed with a foot in two different worlds — having started life as a stockbroker in Calgary’s energy scene, and then returning to school to complete a geology degree. He’s thus one of the few people I know who intimately understands both stocks and rocks, which makes his perspective on resource markets always intriguing.
This week’s piece is a case in point — where he breaks down why valuation of oil and gas reserves has basically turned into a Ponzi scheme in North America. Whether or not you agree with his thesis, this is an issue that’s vaulting to the forefront of the energy world, evidenced by this week’s Attorney General investigation of ExxonMobil mentioned above.
Below is the full-text of the article originally published over at Macro Charts (Brad is also an analyst after my own heart in that his writing is mercifully short and direct, with lots of show-don’t-tell illustrations). I hope you find it as thought-provoking as I did…
The reason oil companies have gone bankrupt over the past few years is not due to “historically low oil and natural gas prices” as stated in this article.
Here is a long-term inflation adjusted price chart for oil:
Does the current price look historically low on an inflation adjusted basis?
Here is the chart not adjusted for inflation.
Natural Gas prices are closer to the lower end of the price range. Below is the inflation-adjusted long-term natural gas price.
However, for as far back as the above data goes the price of natural gas is regularly between $2-4/mcf. This is the natural range. The higher prices have all been “spikes” due to hurricanes, La Nina events or other short term phenomenon.
Here is the non-adjusted price chart. As you can see these are not historically low prices.
It appears the 2006-2011 period for oil and natural gas were HISTORICALLY HIGH prices. The opposite of what the article states.
The real reason energy companies are going bankrupt is more technical.
Reserve-based lending for unconventional reservoir projects became a Ponzi scheme. This is how it works:
Step 1) An oil company borrows money or issues equity to drill a well.
Step 2) The well “discovers” oil. The reason I put discover in quotations is that the resource (not reserve, there is a difference) potential of shale source rocks has been known for decades.
Step 3) Estimate the resource and reserve potential.
NB: Resource is properly defined as uneconomic at the current price. Reserve is properly defined as economic at the current price.
Step 4) Book the reserve as an asset on the balance sheet as per SEC legislation.
Step 5) Borrow money against the reserve.
Step 6) Drill more wells and book more reserves and borrow more money.
Step 7) Repeat until you cannot repeat again.
This process was not always a Ponzi scheme. Before the mantra of peak oil and the fear the world as running out of oil, this practice was done conservatively. But with the idea that the world was short of crude supply, the thinking became that oil was a one way trade.
This gave Wall Street the confidence that lending money against high-cost reserves to develop more high-cost reserves was a sound practice. On the other side of the transaction little thought by producers was given to the scenarios that would cause these reserves to revert to resources and be treated differently on their balance sheet.
Furthering the Ponzi scheme were Central Bank policies of zero percent interest rates. This cheap source of funds decreased the discount rates for cash flow streams, increasing the net present value and distorting the time value of money calculation for these type of projects.
Under this strategy, developing more reserves meant more debt. When prices reverted to the mean, reserves became resources and these companies became insolvent as resources are not the same quality asset as reserves, and are treated differently under SEC legislation.
Exacerbating the problem was the fact that now these producers have to maximize cash flow to cover the interest cost. Which creates more excess supply and more downward pressure on prices, turning more reserves back into resources, and impairing more balance sheets, strengthening the negative feedback loop.
The bankruptcies happening today are the result of historically high oil prices, a this-time-is-different type thinking, and central bank distortions, but not low prices.