The shale oil and gas industry began to expand rapidly in the 2011 to 2014 time frame in the United States. Hydraulic fracturing technology, also known as horizontal drilling, became the primary means of drilling for oil and gas during this time frame. Pushed by investor demand created by a financial market hungry for investment returns in a zero interest rate environment, investment was plowed into new oil and gas plays. As a result, oil production in the U.S. expanded from 5.5M bbl/day at the beginning of 2011 to a peak of 9.7M bbl per day early in the year in 2015 (EIA oil production data). The world became swamped with the addition of 4.2M bbl/day of additional new supply as the US became more self reliant in oil production. Production has since reversed slightly, currently running at 8.8M bbl day. Natural gas production also expanded during the time period from 1.8T CF/day to 2.2T CF /Day (EIA gas production data).
Over the first quarter of 2017, the oil and gas sector was one of the worst performing sectors. The S&P 500 index (NYSEARCA:SPY) ended the first three months of this year with a gain of 5.5%, the Nasdaq (NASDAQ:QQQ) posted a gain of 9.8% and the Dow (NYSEARCA:DIA) climbed 4.6%. However, the energy sector (NYSEARCA:XLE) fell (7.2%). The fall coincided with announcements of expanding rig counts in the shale sector, along with companies like Exxon (NYSE:XOM) (See article) and Shell (NYSE:RDS.A) (NYSE:RDS.B) announcing major investment commitments to the U.S. shale sector in the coming years. In addition, U.S. oil production data began showing signs of a rebound after falling post the severe capital budget pullbacks in the shale sector in late 2015 and throughout 2016.
Has shale drilling technology become the "kryptonite" that consistently kills any path to financial comeback for the energy sector?
I pose this question in this article because the data I have reviewed as the first boom and bust cycle in the industry has unfolded has lead me to conclude that investing in shale oil companies is a high risk, no reward proposition presently, particularly given the current oil and gas price structure in the US. I read the press, and hear the hype about how shale drillers have lowered their break-even to below $40 per barrel by limiting the upfront investment cost with multiple well drilling from the same location and getting very smart in targeting their directional drilling. The problem with the current sell-side argument is that these changes do not address the fundamental problem causing the negative rate of return in the industry - continued aggressive capital flows into the industry causing short-term bursts in production that constantly keeps prices from rebounding to true economically sustainable levels where investors can actually make a fair return.
There is an old adage, "Fool me once, shame on you, fool me twice, shame on me." We are currently in the fool me twice time frame for the shale industry, and I am not presently buying what the "snake oil" salesmen are selling about the vastly improved business model. My perspective is definitely contrary to many at the present time, as the stock prices of many shale oil company pioneers like Continental Resources (NYSE:CLR) and Pioneer Resources (NYSE:PXD) and others are trading near their mid-2015 levels, just before the market collapsed. The shale business model requires continuous investment to maintain production levels, otherwise the well life and overall production is much shorter than the vertical wells that the industry is much more accustomed to financing. It is akin to buying a 25-year roof for your home, but after 5-7 years, you find out you need to replace over 70% of the shingles just to get another 5-7 years of life.
Digging Deep into Actual Production Data Reveals Industry Achilles Heel
In case you think I am just providing this commentary based on anecdotal information, I have followed this industry since the boom began in 2011. The financials of shale companies are difficult to unravel because of all the moving parts in terms of new wells drilled, wells sold or abandoned or shut-in, and exact age of wells providing ongoing production, and most of the projects are fueled by continual increases in leverage which mask the underlying problem. To get a clearer perspective of the actual returns on shale project investments, several years ago I decided to follow the life-cycle of the wells conveyed and drilled in 5 different oil trusts which were operated by major shale drilling pioneers, Chesapeake Energy (NYSE:CHK) and SandRidge Energy (NYSE:SD).
[Chesapeake Granite Wash Trust (NYSE:CHKR), SandRidge Mississippian Trust I (NYSE:SDT), SandRidge Mississippian Trust II (NYSE:SDR), SandRidge Permian Trust (NYSE:PER), and ECA Marcellus Trust I (NYSE:ECT)]
I have published in-depth research articles following each of these Trusts over the last 4 years chronicling in every case the dismal results relative to the initial expectations and investment required to field the projects. In this article, I share a more comprehensive perspective. The sample size is regrettably small, and therefore suffers from the risk of being negatively skewed, but I do believe that the hardships that these early projects have undergone provide lessons that investors in the sector continue to ignore, or succumb to the hype that the risks are no longer risks.
The Trusts span many well known formations. The Granite Wash in the Anadarko Basin and the Mississippian formations are considered high cost, marginal plays. The San Andreas in St. Andrews County, Texas, is located in the Permian Basin, the Basin where Exxon is reported to focus much of its investment, is in a moderate to higher quality oil rich play. The Marcellus play in Greene County is a higher quality 100% natural gas play. Each Trust is now between 5 and 7 years old. The expected life of each Trust is 20 years. A portion of wells were conveyed to the Trusts at IPO in exchange invested cash, and the remaining wells were drilled over time by the operating partner, Chesapeake Energy in the case of CHKR; SandRidge Energy in the case of PER; and SDT, SDR and Energy Corporation of America, a private company, in the case of ECT. The drillers took a subordinated share interest in the Trust that converted to common shares once the drilling contract was completed. The Trusts were structured with oil and gas hedges in place to cover the initial expected production during the drilling phase, but no hedges could be put in place once drilling completed. All the Trusts are now beyond the drilling stage. With the exception of the SandRidge Permian Trust, which has a mixture of well types, all of the wells were horizontally drilled.
The financial results of these Trusts in the first 5-7 years of their life cycle provide unique insight into the return on investment of the shale business model. The results in every case have been dismal relative to initial expectations. Although the projects are but a microcosm of the entire operating driller's portfolio, the Trust results correlate strongly with the financial struggles that have been experienced by Chesapeake Energy and the recent bankruptcy of SandRidge Energy.
Trust Distribution Records Reflect the Industry Challenge to Deliver Positive ROI
Income investors were the primary target market for the shares of the 5 Trusts that I track in my ongoing research. Historically, the shares of oil and gas trusts have been a stable source of reliable income as the base of long-life reserves is depleted through sale in the open market and distributions are paid to shareholders. However, in the case of these Trusts, the record shows a far different result. As shown in the table below, at IPO, a 20-year distribution estimate was provide in each Trust S-1. Looking back at the estimates today, the numbers were wildly optimistic. Across the board the estimates, compiled by Morgan Stanley and Raymond James, foretold a story in which investors should expect close to $40 in distributions over the life of each Trust.
The estimates utilized very high oil (over $110/bbl) and gas (over $6/mcf) price estimates to calculate the expected return. Based on these expectations, the underwriters were able to launch the IPOs of each Trust at aggressive $20+ price levels per share.
The initial years of production were all substantially hedged at close to the price levels assumed in the IPO estimates. The hedges, and additionally the subordination protection afforded common shareholders, created large dividends over the first 3-5 years at each Trust. As you can see in the information above, each Trust has returned $7-10 in capital to its shareholders since IPO. However, the high initial payouts have not been sustainable. Today, the Trusts are expected to return only 22% to 40% of the distribution level estimated at the IPO, with 80% to 90% of the payout already delivered. In short, the capital and expenses required to drill the wells and deliver the oil and gas to the market has far outweighed returns which these shale oil and gas wells have been capable of delivering.
As erroneous as the expected future prices for oil and gas were in the estimates, they were not the most serious error the underwriters made in putting together the Trust prospectuses for investors. The bigger issue in retrospect was the production decline curve assumed in estimating the expected future cash flow. Each Trust provided an expected production decline curve that was associated with the distribution estimate. Based on my review, the decline curves reflect the standard production decline rates typical of long-life oil and gas fields that were vertically, not horizontally drilled. As a result, the amount of actual proven reserves, as well as the composition of reserves (liquid versus gas) was way off the mark when compared to what has actually transpired.
Reserve Estimates Unreliably Overstated by Underwriters
How bad have the horizontally drilled production results actually been relative to the initial results based on the typical vertical well model results portrayed to investors at IPO? It is fair to say they have been a disaster.
The following chart plots the steep downward revisions in proven reserves (MBOE) which each Trust has made since its IPO. As shown in the graph, the actual proven reserves now expected to be recovered in 4 out of the 5 Trusts over their 20-year life is approaching 50% of the IPO estimate. The Chesapeake Energy Granite Wash Trust is the worst performer, currently expected to deliver only 48% of the initial estimate. The Trust has been plagued by poor well performance in Washita County. The early drilling results showed the typical high initial pressure results I have documented across all of the Trust wells drilled with a rapid decline rate thereafter. The CHKR Trust also experienced a problem where drilled wells were spaced too closely together in the AMI, reducing life expectancy of many of the drilled wells. This actual field experience runs counter to the current efficiency hype in the industry today where the sell-side research is touting the usage of the same rig to drill 5 horizontal wells without actually moving the rig. Operators may get the oil faster with this technique, but it does not mean that the total reserves recovered will be any higher.
The SandRidge Energy Trust have all shown results similar to Chesapeake Energy. The porosity of the AMI in the Mississippi Lime formation where SDR and SDT are located is low, as is the case in many horizontally drilled areas. As a result, the long-life recovery in the wells that have been drilled is dwindling much faster than initially estimated - but probably not unexpectedly. The wells are also showing a rapid dissipation of oil reserves, with a long-term reserve composition shifting to less valuable NGL and natural gas faster than initially expected. The Permian Trust, which is showing slightly better, but still dismal results, provides some insight into why drillers have turned to the Permian Basin recently as prices have tumbled. The Trust is maintaining a slightly higher initial and longer term life expectancy of reserves. This could be due to the fact that all of the conveyed wells were vertically drilled, and therefore have a more stable production life cycle. However, the many of the drilled wells are horizontal and the results parallel what has been experienced in the other formations. The Permian Trust is also located in an AMI that was initially estimated to be 96% oil and 4% natural gas over the life of the wells. However, the current results are showing more gas and less oil than expected at a rapid pace.
Only ECT has been able to hold off a major drop-off relative to the IPO estimate, although they are still experiencing similar problems as the other Trusts. The difference at ECT is that the Trust operator has continued each year to invest in "new system enhancements which should decrease the production declines from those declines experienced with production flowing through the existing higher pressure gathering lines." (See ECT 10-Qs) Based on published financial information, none of the other Trusts have made similar investments through time, most likely due to the financial difficulties being experienced at both SandRidge Energy and Chesapeake Energy. However, the ongoing investments through time are not free. In the case of ECT, the well operator (Energy Corporation of America) is passing the cost through in the form of higher trust expense levels which lower shareholder payouts.
The shortening of the life cycle of the horizontal drilled Trust wells becomes very evident if you study the amount of reserves now expected to be delivered through Trust end of life.
With the exception of ECT, which is investing in ongoing system enhancements to preserve production rates, the other Trusts are now estimated to deliver only 20% to 40% of the estimate made at IPO. Even ECT, with wells drilled in a higher quality Marcellus formation AMI, has suffered a high downward adjustment in the longer term reserves it expects to recover.
Shale Drilling Technology Caps Oil & Gas Prices
A question I continue to analyze as I review industry trends and expectations is why the long-term futures market outlook for oil and gas is so depressed given the data which shows the negative business case for shale E&P at present price levels. When you look at the futures market for WTI oil as of 3/30/2017, the curve is virtually flat for the next five years. The curve remains well below the level it collapsed from in August of 2015, but remains well above the lows logged in February 2016.
The futures curve on 3/30/2017 for natural gas looks slightly different than oil in the short term as the front end of the curve has recovered to August 2015 levels; however, the long end of the market remains skeptical that any price above $3.00 per mcf is sustainable.
The short-term burst in oil and gas supply that hydraulic fracturing technology can quickly deliver, combined with a financial market flooded with Fed liquidity, has created a very bearish energy market long term. I believe investors, given the known dismal returns on shale investments at present price levels, should not rationally plow money into the sector unless they believed prices are going to rise, and remain high in the future. However, the market shows irrational resilience in holding the stock prices of many shale drillers high, even as rig counts increase and large integrated oil companies like Exxon and Shell increase their shale E&P budgets dramatically.
The present set of market circumstances makes it very difficult to create bullish expectations for oil and gas prices in the industry over the near and long term. The irony of the shale business model is that as long as the market continues to over-supply capital into the negative return shale model on the false hope that the technology has somehow magically lowered the E&P break-even point for finding oil where it was previously uneconomical to recover, investment will continue to be shoved down the proverbial "black hole" and energy prices will remain depressed. In a nutshell, this is the new rational, irrational shale business model pricing paradigm created by the zero interest rate Fed model. Oddly enough, if the Fed ever removes excessive liquidity from the market, and investors began to rationally expect a positive return on their capital rather than just pushing more and more money to company stocks that have access to the largest liquidity pool, oil and gas prices would likely inflate to economically justifiable levels.
Current Trust Fair Valuations Show Speculative Optimism
In line with my view that the shale energy sector is currently irrationally overvalued, the five Trusts I track on an ongoing basis currently trade at expensive price levels that I consider to be fueled by speculative optimism regarding a rebound in future energy prices. The optimism is counter to the futures market. As of 3/30/2017, a discounted cash flow model I use to calculate Trust fair value showed that if oil futures remain in the $50/bbl range and natural gas at $3/mcf over the next 5 years, with the exception of the SandRidge Permian Trust, all of the Trusts have an intrinsic fair value of about $1. And yet the market for CHKR shares is hyper-inflated to $2.70.
The most recent Trust PV-10s, published in their March 2017 10-Ks, reflect similar speculative froth in the market. All of the Trusts are trading at or above 1.5 times the most recent PV-10, with CHKR being the major outlier.
I performed price sensitivity on the valuations to get an idea of what market prices need to average going forward in order to justify the market premium. At the present levels, the market is pricing in a upsurge to the $70+/bbl range for oil and $4+/mcf for natural gas. (For CHKR, prices would need to climb to over $100/bbl for oil and $5/mcf for gas). At the present time, the only event I see that could possibly cause such a change in market prices is the implementation of the border tax by the US Congress. If the tax becomes law, the tax differential on imported versus domestically produced oil would likely cause WTI prices to jump by 20%. However, if in the process the capital market plows money into the sector with abandon, as Exxon and Shell have announced, any price rally is likely to be short-lived as excess supply continues to drown the market.
There are other outcomes possible as well in the border tax scenario, such as an immediate strengthen dollar due to Fed tightening to counter fiscal policy changes. In this case, the market price would not recover as much initially; however, over the long term, capital discipline would return to the sector as a real rate of return on investments might become a requirement to raise capital once again.
Shale Play Bearish for Exxon Long Term
The pioneers get the arrows, and then the cavalry shows up to clean up the mess. This adage is likely to apply to the US shale sector as Exxon shifts 35% of its capital spending from long-life projects to short cycle shale projects. Will Exxon be able to get better returns than the early adopters? The company certainly brings a much larger balance sheet to the market. They also are likely to be more disciplined in their processes and site selection, and the market is likely to continue to believe that sector costs will come down.
However, all of these advantages that Exxon has will not magically make shale drilling a high return business, when so many other companies like Chesapeake Energy, SandRidge Energy, Linn Energy (OTCQB:LNGG) and many others have struggled to make the business model work. I think the only way that Exxon will achieve success is if capital discipline returns to the industry and price levels increase to levels that can cover the full cost of doing business, not a level that requires capital to be constantly burned. This outcome is not a near-term proposition. It will require a consolidation cycle.
At the present time, I do not see the Exxon shale play as bullish for the stock. In fact, if energy market prices remain at similar levels as today for the next 5 years, which the futures market is forecasting, I suspect Exxon will suffer many negative ROI projects just like so many other shale drillers have experienced. Exxon's stock is presently trading at $82.86 and has an astronomical P/E of 43. This valuation is nonsense unless energy prices recover dramatically. Capital intensive oil and gas companies cannot trade like tech software companies, particularly if the company is chasing fool's gold. A 20 PE is more appropriate given the current industry backdrop. However, Exxon's stock is part of the inflated DOW, ginned up over the past 8+ years of hyper Fed, ECB and JCB financial market meddling. However, shorting the stock until there is more market turmoil is probably a fruitless trade (watch-out when the ECB begins to taper).
Presently, investors should play Exxon for upside gains on the border tax possibility, but I would not own the stock at these prices for the long haul. The border tax possibility should continue to keep a bid in the shares through the summer. Once there is clarity on tax reform, I would sell the news, regardless of whether or not the border tax becomes law.
Daniel Moore is the author of the book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.
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.