Energy Complex Upended
- High oil prices and cheap credit fuelled ramp in energy exploration and production (E&P)
– Shale in the US
– Large Liquefied Natural Gas (LNG) projects in Asia, Australia, and Africa - OPEC cracks
– Members have competing interests
– Politics pressuring economics - Tensions rise as budgets are under pressure
– Higher breakeven costs for government promises
– Social stability at risk
Jim Chanos – US Shale Revolution
- Shale revolution was a game changer
– Crude oil production in the US rose by 55% between 2009 and 2014
– Net crude imports fell by 20% between 2009 and 2014
– The US is the world’s largest oil and gas producer - Production of unconventional wells has high initial production followed by steep decline rates
– Wells can see production declines by 70% in year 1, 50% in year 2, and 30% in year 3
– Creates need to invest continually in order to maintain production levels - As global supply of oil has outgrown demand, oil price has plunged
A Gusher Of E&Ps
- Shale E&P in the US is an unconsolidated sector with little control over production and pricing
– Largely funded by low Fed rates - Short term management compensation plans are tied to production growth
– Return on capital metrics are rare
– Well participation agreements are common - Public valuations are tied to production growth
– Investors relied on NAV and EV/EBITDA, both of which are heavily dependent on production growth - Most E&Ps need to spend 120% of cash flow to grow production with prices between $50-60/bbl
E&Ps Reduced Costs In An Unanticipated Fashion
- High cost US oil was expected to cut production to balance the market
- Rather than cutting production, E&Ps optimized cost per barrel and lowered 2015 costs by 30- 50%
– Squeezed service providers
– Retreated to core areas
– Focused on drilling efficiency - US production is expected to grow 6% in 2015 despite a 59% drop in the US rig count since September 2014
- Production expected to decline 4% in 2016 at the current strip
E&P Accounting Allows Flexibility
- Widespread use of full-cost accounting
– While drilling and completion is always capitalized, businesses vary in how aggressive they are in capitalizing costs
– Drilling and completion, exploration, unsuccessful drilling/exploration efforts, gathering and transport, G&A and interest expenses can all be capitalized
– Allows E&Ps to defer depreciation of capitalized costs associated with unproven reserves
– Flatters EBITDA and leverage ratios - Due to the variation in capitalization policies across businesses, it is important to know how aggressive the policy is when evaluating cash costs and margins
– It is equally important to watch out for changes in policy - GAAP reserve testing and PV-10 methodology in a deflationary price environment can lead to overstated reserves and valuations
– Assumed selling price for all reserves is based on a trailing twelve month average (1st day of each month)
– Cost structure used in reserve tests reflect current cost environment
E&Ps Squeezed
- US oil and gas supply currently cannot tap global demand
– Despite price declines, production continues
– Federal approvals for exporting limited quantities of US oil and petroleum products are beginning
– E&P company executives are lobbying Congress to lift the export ban on crude - High yield producers are challenged to fund capex in a low price oil environment
– Equity issuance decreased to $1.8B in 3Q15 from $7.4B in 1Q15
– Debt issuance decreased to $4.0B in 3Q15 from $12.8B in 1Q15
– Small and medium-sized E&P company liquidity is dependent on reserve-based credit facilities and borrowing bases are expected to drop as much as 15% in October 20151
– The weakest companies are starting to collapse under the weight of debt, as 8 bankruptcies have been announced in YTD15 vs. 3 bankruptcies between 2012 and 2014
E&Ps Do Not Generate Cash
- Leading E&P companies show fallacy of shale economics
– Cash flow from operations has not covered capex since 2010
– Return of capital is funded by debt, asset sales, and equity
– Leverage levels have increased across the industry - Investors focused on production growth, not returns
– Economic returns are not as high as believed
– Forward estimates show significant decline in returns - Despite significant investment, proved reserves have not grown meaningfully for most companies
- E&Ps benefit from tax deferrals as long as drilling continues
