Energy is everything.
This is an amazingly important concept. Yet it's almost universally
overlooked.
Sometimes it’s hard to appreciate the magical role energy plays in our
daily lives because most of what we experience is a derivative of it. The
connection is hidden from direct view. Because of this, most people
utterly fail to detect or appreciate the priceless and irreplaceable role of
high net-energy fuel sources (such as oil and gas) to our modern lifestyle.
With high net-energy, society enjoys increasing complexity and
technological advances. It's what enables us to pursue massive goals like
desalinating billions of gallons of seawater, or going to Mars. But
without high net-energy fuel sources, our capabilities quickly regress to
those of decades -- or even centuries -- past.
Which is why understanding where we truly are in the 'net-energy story' is
so incredibly important. Is the US on the cusp of being "energy
independent" from here on out? Is the "shale miracle" ushering
in a glorious new 'boom' era that will vault America to unprecedented
prosperity?
No. The central point of this report is that the US is deluding
itself when it comes to energy abundance (generally) and oil (specifically).
Yet that's not what we hear from the cheerleaders in the industry or in
our media. From them, we hear a silver-tongued narrative of coming
riches -- a narrative that contains some truth, some myth, and a lot of
fantasy.
It’s those last two parts -- the myths and fantasies -- that are going to
seriously hurt many investors, as well cause a lot of extremely poor policy
and investment decisions.
The bottom line is this: The US shale industry resembles a fraudulent
Ponzi scheme much more so than it does any kind of "miracle".
How do I know that? Because, collectively, US shale companies have
lost cash in every year of their existence. The burned
through cash when oil was $100 -- and again when it was $90, $80, $70, $60,
$50, $40, and $30 a barrel. They burned through cash in 2008, 2009,
2010, 2011, 2012, 2013, 2014, 2015 and 2016.
You don’t have to be a finance guru to appreciate or understand that any
industry that persistently burns through cash is a bad deal. Especially
one whose prime product – shale wells – principally deplete (-85%) in roughly
three years. If you’ve been in business for 9 years drilling wells that
mostly run out in 3 years, and you haven’t managed to produce positive cash
flow at any point along the way, then it's time to admit that your business
model simply doesn’t work.
As even The Economist magazine recently noted:
The [US shale] industry has also lifted productivity. Drilling is faster,
more selective and more accurate, and leakage rates are lower. Wells are
being designed to penetrate multiple layers of oil that are stacked on top of
each other.
But the fact that the industry makes huge accounting losses has
not changed. It has burned up cash whether the oil price was at $100, as in
2014, or at about $50, as it was during the past three months.
The biggest 60 firms in aggregate have used up $9bn per quarter on
average for the past five years.
As a result the industry has barely improved its finances despite
raising $70bn of equity since 2014. Much of the new money got swallowed up by
losses, so total debt remains high, at just over $200bn.
(Source)
Let’s run that math. Five years is 20 quarters. That times $9
billion/quarter is $180 billion dollars in cumulative operating losses. This
begins to give us a sense of the magnitude of losses investors will face when
the music finally stops.
Or we could note the $200 billion of total debt outstanding for the
industry. Hmmmm…with WTIC oil at $47/barrel, a typical wellhead price
(that the operators actually receive being less than WTIC, always) might be
closer to $40. $200 billion divided by $40 means that 5 billion barrels
of future wellhead production is required just to pay back the debt!
If the industry decided to use the next 5 billion barrels coming out of
the ground to debt reduction (it never would decide this, but bear with me
for the sake of this intellectual exercise), we'd also need to include the
time value of money (and actual production rates over time) and observe that
the debt carries an interest rate of 5% to 8% (depending on the company).
Taking that into consideration, then the next 6 billion barrels would
be required to satisfy the debt, plus interest payments!
Oh, right. And then there's the issue of repaying the $70 billion of
equity raised since 2014. With some sort of return, if possible, of course.
I hope you see the same staggering disconnect in these numbers I do. Which
is why, without have to go too far out on a limb, I’ll state that massive
losses are coming to the (bag)holders of all this debt and equity.
So why care? Because you need to understand these details in order to
position yourself properly for the future. The implications are enormous.
The Danger Behind Myths and Fantasies
Once you become aware of the magical thinking involved, you then have a
chance of knowing why the future is going to be very difficult for the shale
industry, its investors, and then the nation(s) depending on its oil
production.
Hey, sometimes myths and fantasies are harmless to hold. Like dreaming
that someday you’ll be a major rock star.
But some can be incredibly damaging because they lead to poor life choices
and decision-making. Like emptying your bank account to bet on the Powerball
lottery, where your chances of winning are 292,201,338 to one. Or committing
your nation to a ground war in Asia thinking you can "win".
The promise of US shale oil is a very dangerous siren song. It was so
carefully marketed to gullible investors that even Obama’s speechwriter and
fact checkers got swept along. This is from Obama’s State of the Union
speech from 2014:
Now, one of the biggest factors in bringing more jobs back is our
commitment to American energy. The all-of-the-above energy strategy I
announced a few years ago is working, and today, America is closer to
energy independence than we’ve been in decades.
(Source)
What does “energy independence” mean? It turns out, this
crowd-pleasing phrase is a fantasy that lacks any useful grounding in
reality. What those who claim "energy independence" are
doing are lumping all forms and sources of energy into a single bucket, and
then asking if the size of that bucket matches our current demand.
This is an inappropriate and dangerously misguided way to look at things
is because the various types and sources of energy are not
interchangeable. They don't function the same way. They generally can't
be substituted for each other. And they don't cost the same.
For example, your automobile might run on gasoline which costs $2.50 a
gallon. Suppose instead you could buy coal cheaper than gasoline on a
BTU basis; is that any help to you as an auto driver? Would you
suddenly put crushed coal into your gas tank instead of gasoline? No, of
course not.
What if you had a micro hydro plant operating in your backyard and could
extract a more Kilowatt hours of electricity from it each week than you
needed. Would that make you “energy independent?”
Not if you drive a car that requires gasoline. Or cook on a gas-powered
stove. Or heat your house with an oil-burning furnace.
The same is true for the US (or any country). A country is not
"energy independent" unless it can meet all of its national energy
demands with enough BTUs in each of the needed fuel types. Just
looking at oil alone, the US still imports millions of barrels per day --
even with the "shale miracle". I'll get into this more deeply in
just a moment.
But first, back to the myth of "energy independence". The EIA
itself has been a major proponent of this useless data glob as seen in their
most recent 2017 Annual Energy Outlook:
(Source)
So, when the US lumps all of its various sources of energy into one spot –
including hydropower, wind, solar, coal, oil and natural gas – nothing useful
emerges from that method. We cannot know from it if we will have too
much or too little of any one type of energy, or how much we’d be under or
over budget in selling the surplus of one and buying to cover the deficit of
another.
The delusion has only gotten worse under Trump. The useless and misleading
clumping of energy into a single bucket has morphed into an even larger
error; one shared by many otherwise intelligent "experts".
See if you can spot the error (I bolded it so you
shouldn’t have too much trouble):
Trump Hails 'Energy Revolution' as Exports Surge
June 27, 2017
WASHINGTON (AP) — President Donald Trump on Tuesday hailed an energy
revolution marked by surging U.S. exports of oil and natural gas.
Trump cited a series of steps the administration has taken to boost energy
production and remove government regulations that he argues prevent the
United States from achieving "energy dominance" in the global
market.
"Together, we are going to start a new energy revolution — one that
celebrates American production on American soil," Trump said in
a statement, adding that the U.S. is on the brink of becoming a net exporter
of oil, gas and other energy resources.
(Source)
It is a massive error to state that the US “is on the brink of
becoming a net exporter of oil.” While I can see how that conclusion follows
logically from all the disinformation provided about “energy independence”
and the hype spouted by Wall Street and the shale companies -- it’s totally
false.
The US is NOT on the brink of becoming a net oil exporter. And it almost
certainly never will be.
Here’s the data:
(Source)
The above chart tells us that, to become a net exporter, the US would have
to both hold demand steady (i.e. not increase consumption at all) while also
boosting production by nearly 5 million barrels a day (mbd). That is,
the entire current output of the shale “revolution” would have to be
replicated, because current total shale oil output in the US is around 5 mbd
But it would actually be harder than that. As already mentioned,
shale wells have ferocious decline rates; so an additional 5 million barrels
per day would require adding to new production aggressively each year to
offset this ongoing extreme loss of production.
Well, before another shale 'miracle' comes roaring out of the gate we’d
need two things: enough new places to drill and more massive injections of
capital. Both are suspect at this point.
One analyst doing a superior job looking at the details is Rune
Livkern of Fractional Flow, who made this excellent chart estimating that
in the Bakken play, one of the best-performing shale basin darlings of
the entire “revolution,” the cumulative negative cash flow between 2009 and
2016 (a full 7 years of history) totaled some -$32 billion in losses:
(Source)
Now why do shale oil operators keep burn cash in every time period?
Especially given the hype that they're constantly becoming better and more
efficient at drilling. Better productivity should mean better
profitability, especially when you have the big operators like Pioneer
Natural Resources (PXD) constantly saying things like this (from their last
investors conference call):
"Our break-even oil price is $20 a barrel," Frank Hopkins,
Pioneer’s senior vice-president, told an industry conference in London this
week. "Even in a $40 world, in a $50 world, we are making good returns.
(Source – Bloomberg)
A company breaking even at $20 should be rolling in cash with oil at
$45. But they aren’t.
Here’s the cash flow chart from PXD.
(Source)
Ouch. What explains the huge gap between the company’s own
statements and its actual performance? How can the entire industry be
doing so poorly?
This mystery is solved by some basic research showing that as the price of
oil moves up or down, so too do the breakeven prices:
Dr. Anas Alhaji, an economist and oil industry consultant based in Texas,
along with Al Rajhi Capital, compiled the breakeven points for the
largest shale producers between 2014 and the start of 2017. When placed
alongside a graph of the spot price of WTI oil from the end of three quarters
prior, it appears the breakeven points for shale are actually a
function of the past price of oil itself.
This indicates that because shale costs are not fixed or even stable, the
industry will likely struggle to achieve consistent profit unless the labor
market and vendor markets are transformed.
Essentially, shale should struggle to achieve sustained
profitability, no matter the price of oil.
(Source)
Here’s the chart produced by that study. It’s plain ugly for shale
investors, for a couple of reasons:
(Source)
First, the blue line is the weighted average breakeven cost to produce oil
from shale wells. Second the orange line is the WTI price of oil --
it's usually below the blue line.
Keep in mind: the WTI price is always higher than the price the operators
actually receive at the well head for their produced oil because of shipping
and other costs.
So mystery solved. Costs higher than revenues = Losses.
This chart says “These companies do not make money doing what they
do.” The companies' own financial filings say the same
thing. There’s no real mystery here. These companies are losing
money and they have been for years.
So, when will this really start to matter? And how will it likely play
out?
What can investors do to position themselves to hedge against or profit
from the inevitable losses that will be realized in this industry? Given the
size and the importance of this sector and its product (oil), the
repercussions will be felt far beyond the share companies themselves, up to
and including sovereign assets.
In Part 2: The Coming Shale Debacle we detail out our
projections and strategy for investors to consider in their portfolio
positioning. The investment world rarely provides opportunities with as
predictable a result as the correction coming to the shale industry.
Click here to read the report (free executive
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for full access)
