The dramatic decline in oil prices at the end of 2018 has sent shares of many oil companies significantly lower. I have never been a fan of the shale sector due to its endless cash incineration in the quest for greater production and because of the terrible depletion rates in the industry. Yet, I have not felt comfortable shorting any stocks in the shale sector due to my belief that shorting a popular sector in the middle of a bull market is not an easy recipe for success. I believe an opportunity to finally bet against the weaker balance sheets and the least fiscally conservative companies in the industry is presenting itself today with recent comments from E&P executives in the Dallas Federal Reserve's energy survey regarding the capital markets drying up. Until further notice, I view strength as an opportunity to sell short the more vulnerable companies in the industry, and today I will discuss two of them.
Oasis Petroleum (OAS) and Parsley Energy (PE) are two companies that I see as vulnerable going forward. Oasis Petroleum has one of the weaker balance sheets in the industry, and Parsley Energy has been one of the most financially irresponsible companies I follow, with their complete disregard of shareholder's capital in the pursuit of production growth. Unless oil prices continue to rebound, I expect pain ahead for both companies.
A new survey from the Dallas Federal Reserve highlights a big problem for shale
The Dallas Federal Reserve released its quarterly energy survey this month. Inside the release, which can be found here, are surveys given by anonymous executives regarding production and capital allocation. Among the questions in which the answers will surprise no one are questions such as:
Which of the following is your firm's primary goal in 2019?"
Source: Dallas Federal Reserve
As we see, 68% of respondents claim that their goal is to maintain/grow production and to acquire assets. This is no surprise to anyone. It gets more interesting, however, when the following question is asked:
Has the recent drop in oil prices caused you to lower expectations for your firm's capital spending in 2019?"
Source: Dallas Federal Reserve
To that we see a majority (53%) say that lower oil prices are causing them to lower expectations for capital spending in 2019.
But going deeper into the report, we see in the anonymous comments section that executives are making comments such as:
"I expect the dramatic, unexpected and significant drop in oil prices will significantly decrease revenue for the first half of 2019. I intend to mitigate this by stopping all drilling and deferring any new projects."
"It feels like the capital markets (equity and debt) are backing up fairly hard, which will have a noted impact on capital spending if sustained. Coupled with the fall in oil prices in the past six weeks, this could cause 2019 plans to get pared back."
"We are buying old existing production from public companies that are focused on the flavor of the month, which is horizontal plays."
"We are cutting back capital to unconventional resources and increasing capital to exploration for conventional."
"Near-term price uncertainty has made us more cautious going into 2019, which will result in a cutback in capital expenditures."
From these comments, it is clear that there is growing negative sentiment within the industry and specifically, within shale. But the most telling comment is the comment that the capital markets are changing their attitude towards these companies and that their ability to issue new equity and new debt may have rapidly disappeared. If this is, in fact, the new reality, the results could be disastrous for the least fiscally responsible and most over-leveraged within the industry.
Parsley Energy being forced to live within its means will highlight the poor economics of this business
Everyone loves a good growth story. Wall Street loves it. Bankers love it. Executives love it. Shareholders love it. But what happens when that changes? Parsley Energy has shown incredible growth over the years. If growth were all that mattered, no one could argue that Parsley Energy was a bad investment. After all, production has skyrocketed higher over the years, leading to soaring revenue. We can look at the Selected Financial Data section of the 2017 annual report to see that revenues have grown 8-fold in the five-year period between 2013-2017. Not bad. But that's the 2017 annual report. 2018 has seen even more growth and revenues are now approaching $2 billion or 16 times their 2013 levels. Impressive, yes, but let's look further.
At the same time that we have seen revenues soar, we have also witnessed Parsley Energy's debt and share count soaring as well. Since its IPO in 2014, Parsley Energy has seen its share count balloon from 93 million to 316 million. They have piled on billions of dollars of debt over the years as well, with debt rising from zero to $2.19 billion. Nearly all of this wonderful production growth has been funded externally by bankers and shareholders who were all too willing to support the growth story, which was given a seal of approval from Wall Street, who rakes in millions in advisory and underwriting fees, and by executives who take larger and larger salaries as the company grows.
For Parsley Energy, between 2015-2017, the company generated $1.1 billion of cash from operations, yet spent 2.0 billion to develop their oil and gas properties. On top of this, Parsley made $3.6 billion of acquisitions, which resulted in $4.5 billion of cash outspend. How was this funded? Through the issuance of $5.2 billion of equity and debt. For 2018, we don't have the full-year numbers yet, but in the first three quarters of 2018, Parsley Energy burned another $500 million, leaving them with just $167 million of cash and leading them to divest non-core acreage in order to raise cash going into 2019.
At the end of the year, as oil prices were falling, Parsley put out a press release stating that their intentions for 2019 were to only outspend their cash from operations by $250 million. So even after years and years of incinerating shareholders capital with nothing to show for it but higher production that can't be sustained without spending every internally generated penny they can find, Parsley is now choosing to outspend just a little bit more even in this low price environment.
I am almost certain that most readers of this article will disagree with me. I am also certain that many of them will tell me all the ways in which they believe I am wrong. But at the end of the day, all that matters for a company is the ability to generate distributable cash flow. Selling at a loss and making it up on volume is not a sustainable business model. For a company that has to spend all of its operating cash flow in order to maintain stable revenue is a company that is not worthy of investing in. The only savior is higher commodity prices, which, while great, haven't stopped the endless torching of cash. Remember, Parsley Energy has burned cash in good times, and they've burned cash in bad times. Now they are potentially going to be forced by bankers to live within their means. At current commodity prices, there won't be any distributable cash flow or the ability to strongly outspend cash from operations, and I'm not convinced that even in a higher price environment, Parsley Energy won't still spend 100% of its cash from operations on drilling and production. After all, this is all the industry has ever done.
So, where does this leave shareholders? If the debt and equity markets are closing their doors and all that remains is cash from operations in a weak commodity price environment and your depletion rates are extreme, who is the next incremental buyer of this company's shares?
Oasis Petroleum is a company that has also witnessed rapid growth in production and revenues over recent years. This company has a weaker financial position than many in the industry, however, evidenced by the fact that they have resorted to drawing more than $500 million from their revolver as they continue their cash-burning ways. Interest expense alone for Oasis Petroleum is in excess of $150 million per year, which is nearly 10% of their revenue. In essence, this means that Oasis Petroleum needs to sell 10% of its annual production just to pay the interest on its debt. In a weak commodity environment and with a history of negative cash flows and with the equity and debt markets closing their doors, debt burdens like that can be deadly.
While Oasis Petroleum doesn't have immediate maturities to fund, the lack of additional financing and current interest burden coupled with the fact that they are already well into their revolver puts a lot of pressure on them to reduce spending, which will inevitably hurt production, revenues, and cash flows. The entire thesis of this industry is one of growth. And the last time I checked, the old Wall Street saying "If you're not growing, you're dying" still applies.
Dark skies ahead for Parsley Energy and Oasis Petroleum
I believe that the massive price declines in the share prices of this industry are only partly explained by lower commodity prices. Instead, I believe that the smart money, long aware of the industry-wide problem of negative cash flows, is now fully aware of the capital markets closing their doors to new equity and debt issuance. The traders and investors who were ahead of the situation have cut shares of Parsley Energy and Oasis Petroleum by more than half. In fact, at recent price levels, Parsley shares trade significantly below that of their 2014 IPO, in spite of the massive increases in production, we have witnessed since that time. And I believe that this time may, in fact, be different. If the capital markets don't reopen and commodity prices don't rise meaningfully, this industry will be forced to live within its means. And with depletion rates far higher than that of conventional resources, the ability of Parsley Energy and Oasis Petroleum to even maintain production while not outspending their internally generated cash is now in question.
Risks to this short thesis are, as always, that commodity prices rebound strongly and cash from operations rise. There is also the risk of mergers within the industry. But given these companies' past history of burning cash in all commodity price environments, I do not have an optimistic view of the future.
Disclosure: I am/we are short OAS, PE. 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.