We aren't oilmen here at the Superinvestor Bulletin. In fact, we are pretty pleased when we successfully hammer a nail.
We don't know how to "frack" a well or which completion fluids are going to work best. In fact, we haven't even been at a drilling site.
Despite that, we are going to go out on a limb today and say that we think we could run Continental Resources (NYSE:CLR) better than its current CEO Harold Hamm.
We couldn't improve things operationally. No sir, that isn't what we are saying. What we do think is that Hamm and almost every one of his shale brethren are strategically impaired and that these companies are in need of a fresh start.
We believe we have a better strategy for how these companies should be run
Before you jump all over us, give us a chance to explain. Then, you can let us know what you think in the comment section.
Is The Objective Production Growth Or Return On Capital Invested?
We are hardcore fans of Warren Buffett. Our love of investing came from reading his shareholder letters and much of what we believe is based on his teachings.
One thing Buffett taught us is the power of being able to repeatedly invest capital at high rates of return. That is the key factor that will eventually drive share price returns over time. The underlying business doesn't matter, the rate that the business can earn on its capital does.
We have taken this high return on capital invested lesson from Buffett and tried to apply it to shale producers. What we have found are a bunch of companies that are great at spending a lot of money and growing production. But not so great at maximizing the return on capital.
That isn't just our opinion. Continental says the exact same thing in its most recent presentation with the following slide that it strangely seems to be proud of:
Source: Continental Resources Corporate Presentation
Continental is promoting its industry-leading recycle ratio for 2015 of 1.0. Yes, in fact, that does seem to be higher than the rest of its peers that are included in the chart (produced by Seaport Global Securities).
But let's consider exactly what Continental is bragging about.
The slide defines a recycle ratio as being the operating profit from producing a barrel of oil equivalent divided by the finding and development cost of developing that oil.
A ratio of 1 means that Continental is breaking even. That isn't very good, especially when you consider that the number excludes the cost of actually running the company (G&A expense), the cost of paying the interest on Continental's debt and any tax expense the company has.
What that recycle ratio of 1 actually tells us is that Continental is losing a considerable amount of money producing oil.
For students of Buffett who are interested in companies that earn high rates of return on capital you can see our problem with Continental. The company was creating a negative return on capital invested in 2015. We realize that 2015 wasn't a banner year for oil prices, but we think the returns on capital of these shale producers were challenged in the prior years as well.
Yes, Continental has had a lot of production growth in the years leading up to the oil crash. But is that really all that impressive when you consider the table below, which details the company's cash flows over the past six years.
Operating Cash Flow
Negative Free Cash Flow
Source: Continental 10-K filings at SEC.gov
Over those six years, Continental has outspent the $10.7 billion of cash flow generated by $7.15 billion. That is why it was able to grow production so quickly. The company has spent 70% more money than it actually had. Much if not all of this growth came from debt and equity issuances.
It makes us think that the only people earning high rates of return on capital from Continental's production growth are the investment bankers who helped subsidize this massive overspending.
Oh those bankers always getting their grubby little mitts involved!
If You Haven't Made Any Money On Your Existing Plays Why Brag About Adding More?
We shouldn't be too hard on Continental specifically. Most of the company's peers do the exact same thing. They chase growth first and think about return on money invested later.
We even understand why these companies have done this. Growth is what the analyst community on Wall Street rewarded. Figuring out how much an oil producer is actually earning on what it spends is incredibly difficult anyway.
What annoys us a little bit about Continental in particular is when we see the company issue press releases about the incredible IP (initial production) rates on new wells in Continental's new plays.
Like this one which announces a "Record STACK Oil Well":
OKLAHOMA CITY, May 17, 2016 /PRNewswire/ -- Continental Resources, Inc. ("the Company") today announced the completion of an industry record well in the over-pressured oil window of Oklahoma's STACK play. The Verona 1-23-14XH flowed at an initial 24-hour test rate of 3,339 barrels of oil equivalent per day, comprised of 2,345 barrels of oil, or 70% of production, and 6.0 million cubic feet of 1,370-Btu natural gas (British thermal units). The Verona is producing from the Meramec reservoir through a 9,700-foot lateral at a flowing casing pressure of approximately 2,400 psi, on a 34/64-inch choke.
Seeing this press release makes us want to ask someone at Continental why we should care about another new oil play when they haven't made any money for shareholders from the first one (the Bakken)?
Our follow up question or request would be please don't tell us what the production is for 24 hours, show us the return you are going to earn on the money you poured into this well at various oil price scenarios.
Our eyes gloss over when we hear about these shale producers announcing exciting new acreage. We don't think these companies need more drilling locations. We think these companies should be focused on maximizing the profitability of the drilling locations that they already have.
Here Is How We Think It Should Be Done
We think that these shale producers would do much better by their shareholders if they had a complete strategic makeover.
Here is what we suggest.
Stop pouring money into chasing new plays where you have to continually spend on new infrastructure (roads, drill pads, pipelines, processing equipment) and perfecting drilling and completion techniques. Instead, focus on the acreage that you have already invested in and are experts at so you can start maximizing return on capital through the use of secondary recovery methods.
Secondary recovery is where the really big returns on capital are made in this business. Methods of secondary recovery would include water, natural gas or Co2 flooding. This is where water or one of the gases is pumped into the reservoir to create pressure, which forces more oil and gas to the surface.
Source: California Resources Corp.
The reason that returns on capital are so high from secondary recovery is that all of the infrastructure involved has already been paid for when the primary wells were drilled.
For very little incremental capital, the producers can get more oil and gas out of the ground. The operating profit per barrel produced under secondary recovery is far superior to these shale wells with the boomer IP rates that Continental is so happy to tell us about.
The means the return on the capital invested is much higher.
But you have a question for us don't you…
If this is so obvious, then why aren't these companies doing it?
We believe that there are a couple of parts to that answer. The first is that the secondary recovery isn't going to result in production growth. It is instead going to offset production declines and hold production steady. This will result in lots of free cash flow and would allow companies to have much better balance sheets. But these companies haven't been worried about trying to have a free cash flow generating business nearly as much as they are interested in growth.
Growth is what the stock market wants.
The second part of our answer is that companies have not spent enough time on secondary recovery in shale plays to be fully comfortable with it. They have been too busy chasing growth and new acreage that they had to hold by production. We believe that efforts to get secondary recovery up and running should have been made much earlier in the shale game.
Our dream shale oil producer is one that is committed to living within cash flow no matter what the price of oil is. What we would want this company to do is get one good core property and then focus on squeezing every last drop of oil out of that land at the highest rate of return possible.
In our next article (if Seeking Alpha is kind enough to publish it), we are going to show you a producer that we have found that is focused on doing exactly that. Click the follow button at the top of this article to make sure you don't miss that.
If you are itching for a couple of new investment ideas now that we have written up for our premium subscribers, you can join them via the link below. One of these ideas is trading at 1x EBITA and is a 10% weighting in the portfolio of two separate legendary Superinvestors.
Thanks very much for reading.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.