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December 27, 2016
Mr. John Chisholm
CEO & President
Flotek Industries, Inc.
10603 W. Sam Houston Parkway N., Suite 300
Houston, TX 77064
Dear Mr. Chisholm,
We thank Flotek (NYSE:FTK) and MHA for reviewing our Drilling Down to Zero report, and acknowledging its criticism as valid through a restatement of MHA's earlier results for the DJ Basin in a December 21 letter. But your response is underwhelming. After stating at two investor conferences that you would respond to Drilling Down to Zero, you issued interim guidance on your operations for the first time since you have been CEO, but did not address our report in any way. You instead published a letter from MHA which acknowledges that their previous report on the DJ Basin was misleading, because it failed to control for operator, lateral length and location, before summarizing in a single paragraph new results stated in a less than clear performance metric, EUR, which MHA downplayed in its previous report. Neither you nor MHA shared any raw data that could reveal the miraculous properties of CnF.
We want to keep it simple, Mr. Chisholm, and will therefore summarize at the outset what we believe you can do to clear the air and resolve our doubts about the efficacy of your product and the viability of your company in the face of a dramatically shrinking customer base.
- Release a complete list of trade names for frac fluid additives that contain CnF, so that independent third parties - operators as well as investors - can evaluate the performance of the product.
- Release a list of well identifiers (API numbers) used by MHA in its different reports that purport to address the efficacy of CnF, so that investors can verify the results.
- Inform the investment community whether Flotek has ever issued a document indicating that Oil Perm FMM-1 is a CnF product, and let us know whether Energy Chemistry Technology sales figures issued by Flotek treat Oil Perm FMM-1 as a Flotek product.
- Acknowledge or refute the attached graph, which describes a rapidly shrinking customer base, despite statements to the contrary made in your Q3 earnings call.
In their December 21 letter, MHA acknowledged all of the criticism that we leveled at their three CnF reports in Drilling Down to Zero. Results from Colorado were restated to reflect the fact that FDP-S1007-11, which was excluded from MHA's January report on the DJ Basin but included in their July report on the Permian Basin, should have been included in both. Flotek's renunciation of OilPerm FMM-1 as CnF is also discussed, although MHA failed to disclose the impact of this decision on the estimated uplift associated with CnF use, or deal with the subject in a transparent manner. MHA acknowledged that location, operator and lateral length have an important influence on well productivity, although these factors were ignored in all three of the reports released previously by MHA, and shoved under the rug in the December 21 restatement.
This is a step in the right direction, but Flotek and MHA pulled up short. MHA informs investors in a single paragraph on page 2 of their letter that organizing wells from Focus Area 1 and Focus Area 2 into five clusters addresses all concerns about operator identity, lateral length and location, and states that the use of CnF improved EUR in both locations. The choice of EUR as a performance metric is significant because EUR involves modeling assumptions that are proprietary and not transparent, because MHA previously characterized EUR as inferior to production per ft of gross perforated interval, and because we have seen MHA abuse EUR previously in their report on the efficacy of CnF in the Permian Basin. We have spent hundreds of hours with the DJ Basin data, and cannot understand how you could organize five well clusters to obtain the result which MHA states as fact.
You responded to a clearly stated, completely transparent critique of your product with a two-page document issued through a consultant that acknowledges the legitimacy of our criticism but does nothing to address it. And you told investors "We believe the growth in CnF use - from our largest customers to small, independent producers - should be the most important indicator of effectiveness," without pointing out that your customer base is shrinking rapidly, if the leading source of independent information on additive use is even remotely correct.
Shame on you, Mr. Chisholm. Show the world that you do indeed sell a miraculous product by publishing your trade names and well identifiers. Reassure investors about the integrity of Flotek's accounting and commissioned research by assuring investors that your sales data don't reflect OilPerm FMM-1, which you claim is not a Flotek product. And let them know that we are just a pesky hedge fund, rather than a harbinger of doom, by explaining that sales graph.
Our view of Flotek's ECT business may be stated succinctly:
- CnF performs no better as a fracturing fluid additive than "commodity" products available at a fraction of the cost. The estimated uplift in oil production associated with using CnF cannot be distinguished from zero. This fact is readily apparent when you evaluate a large sample of well completions while controlling for operator experience, lateral length and location, which any competent oil professional knows affect oil production.
- The CnF customer base has been shrinking rapidly as both major operators and smaller independents have stopped using the product. Sales volumes have been maintained by the purchases of two large users. A re-pricing of the product that is consistent with its demonstrated performance and shrinking customer base could make the business unprofitable.
On December 21, MHA issued a statement concerning their work on the relationship between CnF use and well productivity in the DJ Basin. A reader who limits their attention to the first two paragraphs and final paragraph of the restatement might walk away with the conclusion that MHA offered unqualified support for their previous work. But in the body of the document, MHA acknowledges that a substantial part of the sample was misclassified, shows that this reduces the estimated uplift from CnF use by 80 percent in Focus Area 1, and acknowledges that operator best practices, lateral length and location all affect well productivity. These are major changes.
MHA states new results in terms of percentage variation in EUR, without describing the number of wells considered, their location, lateral length or operator. We are simply provided with ranges, in the absence of any supporting evidence. They couldn't even be bothered to divide EUR by lateral length, so that we might compare the new numbers to those presented previously.
The Performance Metric
MHA's use of EUR as a performance metric is inconsistent with the following statement from their January report: "As stated previously, it is the opinion of MHA that the most meaningful comparison parameter in the above three tables is the normalized 12-month cumulative oil volume per foot of gross perforated interval". A reader of the restated analysis must surely wonder why an alternative metric was chosen in the current situation, and why the results were not stated in production per unit of wellbore.
MHA's July report on CnF use in the Permian Basin provides a hint. MHA discussed performance in the Permian in terms of both EUR and production per foot of gross perforated interval. We are informed that EUR statistics are available in 19 focus areas, while production per foot of gross perforated interval is available in only 14 cases. A note to Table 1 in the July report explains that the difference is accounted for by the fact that in the five cases where EUR is available but production per foot of gross perforated interval is not, NO wells had 12 months of data. This means that MHA used a model to generate evidence of performance where incomplete raw data were available.
Is this just nit picking? MHA's discussion of Permian Basin performance would suggest otherwise. Average uplift in EUR per foot of GPI was 13.4 BBLs in the 5 cases where no production data are available, vs 5.6 BBLs per ft GPI in the 14 cases where both EUR and production per ft GPI are available. In the Permian Basin, the use of EUR instead of production per ft GPI boosted estimated performance by more than 2X.
MHA added one new trade name to the list of additives acknowledged as CnF products in their January report. It would have been difficult to avoid this change, since the product was identified in a second report that MHA published in July. The revision reduced the estimated uplift from CnF use in Focus Area 1 from 58.4 percent to 16.0 percent. A location correction, consistent with the methodology presented in Drilling Down to Zero, further reduced the estimated uplift to 10.4 percent. The 82 percent reduction in the claimed benefit of CnF use precedes any correction for lateral length or operator.
A second problem with the data is mentioned in the December 21 restatement when MHA informs us: "Flotek has advised us that while FDP-S1007-11 is a CnF fluid and should have been included in the original evaluation, Oil Perm FMM-1 is not a Flotek CnF product and, therefore, the 97 wells containing that product were correctly characterized in our original January 2016 report." GasPerm 1100, OilPerm FMM-2, OilPerm FM-7, OilPerm B and now FDP-S1007-11 are all Flotek CnF products, according to the MHA reports on the DJ Basin and the Permian Basin and the MHA Letter from December 21. All of them are marketed under a Halliburton label. OilPerm FMM-1 sounds a lot like OilPerm FMM-2 and has a similar chemical signature to the products named above, which are all consistent with the CnF patent, but Flotek has renounced ownership of just the OilPerm FMM-1 product.
We can't tell you the impact of this claim in terms of MHA's EUR calculation, but we did present an estimate in Drilling Down to Zero that was stated in units of production per foot of gross perforated interval. We applied MHA's methodology to our sample, and found that wells treated with products that MHA identified as CnF produced an average of 11.7 BBLs per ft GPI during their first 12 months of operation, vs 9.6 BBLs for wells that were treated with products including OilPerm FMM-1. The 21.9 percent difference collapses to 2.8 percent when the OilPerm FMM-1 wells are included in the CnF group. The difference in performance is associated with a t-statistic of 0.38, which means that there is no measurable difference in performance.
We will follow up on OilPerm FMM-1 with an analysis that will be presented in a post on our website. As you will see from that analysis, we remain highly confident OilPerm FMM-1 should be treated as a CnF product - it contains your chemistry, is consistent with your patent, in a loading concentration consistent with products you call "Flotek CnF products". However, if we simply exclude OilPerm FMM-1 from the Focus Area 2 sample, and implement the methodology described in Drilling Down to Zero, we find that the estimated impact of CnF use on production is 0.52 BBLs per ft GPI. The difference is associated with a t-statistic of 1.04, which indicates that the gain is background noise. Both the magnitude of the estimate and the lack of statistical significance are consistent with results reported for Focus Area 1 and the Permian Basin.
We demonstrated in Drilling Down to Zero that location, lateral length and operator identity are all important determinants of well production. MHA acknowledges this tangentially in the penultimate paragraph of their December 21 restatement.
Groups of wells within Focus Areas 1 and 2 which were located immediately adjacent to one another were evaluated using our original January 2016 database. Because of the immediate proximity of the wells, many of the variables which influence productivity were removed from the equation. For example, the wells were drilled by the same operator, the wells were completed at the same time, the lateral length of the wells was the same, and the quality and thickness of the productive reservoir was the same. The primary variable remaining which influenced oil production was the use of, or lack of, the CnF additive in well completion. Three localized areas were studied in Focus Area 1 and two localized areas were studied in Focus Area 2 using our original data set. The results indicated an improvement in oil EUR per well of 6% - 33% in Focus Area 1 and 9% - 36% in Focus Area 2.
We have been scratching our heads over this one, because we have spent hundreds of hours with the very same data and cannot understand how to organize the wells in the manner described above. Specifically, we can't identify five clusters of wells completed in the same location, by the same operator, at the same point in time, with the same lateral length, containing wells completed with CnF and non-CnF additives. That is the reason that we used regression analysis and Generalized Additive Models in Drilling Down to Zero. Flotek could put this concern to rest, enlighten us, and reassure investors by instructing MHA to release the API's of the wells included in each cluster. It is difficult to see how this might compromise confidentiality, since we have already shared our list publicly and your information was generated from public sources.
An Important Example
We want to make sure that investors understand that our concerns are very practical. An important example from the DJ Basin illustrates many of our points. MHA concluded that CnF wells in Area 1 outperformed non-CnF wells by 46.9 percent - this was THE ONLY study MHA produced where concluded efficacy of CnF was in the range of Flotek's own marketing statements. Let us simply show you why this conclusion is pure fantasy.
Our data set has 267 wells in Focus Area 1. 122 of these, or 46 percent, were completed by Noble. We identified 145 CnF wells in Focus Area 1, where OilPerm FMM-1 is not an issue (no wells in our Area 1 data set use OilPerm FMM-1 - all 97 OilPerm FMM-1 wells are located in Area 2). Noble accounts for 73 percent of these completions. Noble is by far the largest producer in the DJ Basin and the most prolific user of CnF products in the area. Mr. Brown, your fellow Board member and former head of DJ Basin operations for Noble, can confirm these assertions.
- Chart 1 shows that Noble's CnF wells underperformed its non-CnF wells by 7.8 percent.
- Chart 2 shows Noble, on average, outperformed other operators in Area 1 by almost 64 percent.
- Ignoring performance by operator leads to the conclusion that CnF improves performance in Focus Area 1, but this is ONLY because 73 percent of the wells completed with CnF in Focus Area 1 were completed by Noble - the most productive operator. However, Noble's own performance shows no evidence that CnF use provides any uplift in production. Adjust Area 1 for operator and "poof" 46.9 percent efficacy suddenly approaches zero.
- We point out in Drilling Down to Zero that much of Noble's superior performance is due to their use of short completions rather long completions (more typical for Whiting) and access to a sweet spot in Focus Area 1 that was unusually productive for Whiting and Carrizo as well as Noble.
Albert Einstein admonished us to "make the truth as simple as possible, but never more so." This example illustrates why it is important to pay attention to simple, intuitive features of the data that consistently explain performance across operators and locations.
We look forward to your timely response.
Disclosure: I am/we are short FTK.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.