2 Questions For Every Shale Company: Half-Cycle Costs And Half-Truths
Summary
- We pose two questions for shale, focusing on incentives and full-cycle production costs.
- We use EOG as an example to run through our analysis.
- Understanding management compensation and full-cycle costs reveals why they're the inconvenient truth these days.
When it comes to oil, the bearish thesis has always been the growth of shale. The bear thesis contends that at today's oil prices shale can continue to grow and eventually tip the oil supply/demand balance to the point of overflowing. Said another way, the growth in U.S. shale production alone will both offset and overwhelm declining production outside of the U.S. and increasing oil demand.
While shale production will grow, there's a big difference between saying that shale production will grow versus shale production can grow unconstrained, and that's what the bears have argued. So let's just examine that for a bit since that's a key point for investors on oil prices. We'll use EOG Resources (EOG) as an example and we'll pose two questions. Two questions used by Eric Weinstein, Managing Director of Thiel Capital, whenever he encounters incumbent ideas and/or companies.
Why EOG? Well Texas producer EOG has been held up as the "Apple of the Oil Patch" with its use of apps and technology to push production efficiency. With its focus on the Permian, it's also well situated to take advantage of the growth in shale. So let's get started. Our two questions are:
- How is their bread buttered?
- What is it that they can't afford to say or think?
Buttering Up
This question goes towards incentives. For any economist, or parent of young children for that matter, this will come as no surprise. Incentives matter. So let's take a look at the performance goal for EOG executives for 2016. First there was a set of obligatory production and unit cost targets (i.e., produce +268M barrels of oil at lower than $10.26/barrel in costs, etc.). This is fairly reasonable, and many producers have such metrics. The strategic and other operational goals, however, are interesting. One such goal was "reduce finding cost and operating costs."
Now a quick aside. For oil companies we've called reserves the jelly in a jelly donut, or the cream in a tiramisu (pick your dessert). At some point if you keep pumping your oil, the jelly or the cream will be gone so you always have to find or acquire more. The cost to do this is called finding, development and acquisition costs (FD&A). You do this by drilling, so FD&A is akin to cost of goods sold. In the oil business it's the cost to explore for, develop, and/or acquire the oil and drill the wells. For EOG, the Board of Directors graded the management team as having "exceeded" their goals and stated
"Reduced finding cost (excluding revisions due to price)* more than 50%, to $5.22/Boe . . . ." EOG - 2016 Proxy
Now $5.22 per barrel sounds great because if oil is selling at $47/barrel, and it costs $5.22 to find a barrel and another say $11.56/barrel for G&A, operating expenses, etc., then we're making over $30/barrel, right? That's right, except for that pesky asterisk above. Asterisks are funny things, often they're great little breadcrumbs to find more hidden treasure. Other times they're a form of misdirection, the Jedi mind tricks of official documents: "Those aren't the numbers you're looking for."
EOG's asterisk simply says "See Annex A" -- we sure will, here's what we find:
It's a chart of how they calculated the $5.22/barrel of FD&A. That $5.22/barrel of FD&A was calculated like most FD&A. In 2016, EOG says it spent $2.4B in exploration and development costs, and they found 403.5 million barrels of equivalent of oil, therefore, each BOE cost about $5.22/barrel.
This looks great, but oddly they exclude two things. First, EOG acquired assets, but instead of using cash, they paid for it by exchanging EOG stock. Imagine if you owned a company, and your manager decided to go buy more supplies, but instead of using cash, the manager simply gave out shares of your company. You no longer owned 100% of the company, but 90%; wouldn't you consider that a cost?
Second, EOG's calculation also excludes revisions. When looking at oil inventory, when oil prices fall sometimes your reserves also fall because some barrels can't be economically drilled and extracted (i.e., it costs more to drill for the oil than its worth), thus these reserves are taken off of your books. It works the opposite when oil prices rise because when they increase, then uneconomic reserves become economic and with the rising sun, the land becomes fertile again.
While it's true management doesn't have control over oil prices, it's also true that they should be cautious when buying reserves and developing them. If they overspend and buy reserves that only work if oil prices are over $80/barrel, shouldn't that factor into their bonus? At the end of the day, they should be paid based on whether they have added cost effective barrels of oil to the reserves. Is the jelly donut getting refilled, or will you eventually devour it by your constant drilling.
So this brings us to the second question.
What is it they can't afford to say?
If we recalculated FD&A, and used a three-year average cost (to even out the high oil prices in 2014 with the low oil prices in 2016), the real truth is that the company's unprofitable when oil prices are at $50/barrel.
As illustrated above, it simply costs more to find and drill the oil than the oil is worth at today's prices, and we're using EOG as an example, a company that has been successful at reducing costs. Now EOG did hedge some production (i.e., pre-selling oil at higher prices before they drilled it), but companies never hedge their entire production in case oil prices go up. Hedging also means you're counting on executives to guess correctly as to future oil prices, and they could be wrong. In fact, EOG's board and shareholders apparently doesn't want its management team to consider this too closely as it excludes "revisions" when determining their bonus (see above).
Now if we plugged in "$60/barrel" into the spreadsheet, EOG would be close to break-even. Note that your exact break-even point will largely depend on the components of your production. If you extract more oil as a percentage of overall production then you're average price per barrel of oil equivalent will be higher (i.e., because oil is more valuable than gas or NGLs). Most oil companies typically generate two-thirds oil and one-third gas/NGLs, slightly higher than EOG, but that merely lowers break-even to somewhere around $55/barrel of oil (assuming $3/mcf). Remember this is also just to cover the "true costs" of producing oil. Profitability must be judged over the long-run, and if shareholders want a decent return on capital instead of merely a return of capital, then oil prices need to be even higher.
So the truth for EOG -- and almost all of the other U.S. shale companies -- is that first incentives matter. How you compensate a management team will determine how they judge themselves, and if you exclude certain costs, then they'll present the data accordingly. Second, the real "truth" is easily found, it just takes some digging. If you tune out the sound bites and recalculate the figures yourself you'll learn a more nuanced version of the truth (i.e., that oil prices will likely need to be above $60/barrel for oil companies to break-even and provide a sufficient return on capital). Sometimes looking at the details just confirms your suspicions, and using half-cycle costs is just telling yourself half-truths.
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Analyst’s 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.
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Comments (20)
the answer to your question is invest in companies that spend within cash flow and don't grow for growth sake. most of these companies will be found in canada since lending is more conservative there for E&P's.
HFIR's top pick Gear energy comes to mind.
i chuckled at the " these are not the numbers you are looking for" line, ty. 1 quibble: please use images that you can enlarge when you click on them in the future. current images are too small.
