For the last decade, shale drillers destroyed billions in capital. They delivered record production growth at the expense of profits and cash flows. But today, the game is changing...
For the first time since the dawn of the shale revolution, we're seeing a widespread shift away from the reckless "growth at any cost" business model towards a focus on restrained growth and shareholder returns. Some of the largest U.S. shale drillers have recently halted production growth altogether in order to maximize cash flow. In short, we're seeing the rise of rational economics in the shale patch. Going forward, this will not only provide a bullish tailwind for energy prices, but it sets the stage for big gains in selected beaten down energy stocks.
In this article, I'll first take a step back to examine how we got here. I'll then detail the growing body of evidence showing that a true sea change in corporate strategy is playing out across the shale patch. Finally, I'll explain why one company, Range Resources (NYSE:RRC), offers investors the chance for 200% upside with a simple change in capital strategy.
Let's get started.
The shale business model was simply one of the many perversions of capitalism born from the Alice-in-Wonderland world of zero percent interest rates (ZIRP). You see, when money is free, the hurdle rate for investments falls to zero. And during the age of ZIRP, a torrential flood of cheap money from Wall Street funded countless speculative business models chasing top-line growth at the expense of bottom line profits. Fast growing, cash-burning companies like Tesla (TSLA), Netflix (NFLX), and the entire U.S. shale industry were simply different manifestations of the same irrational investment landscape.
At the heart of every bubble investment lies a powerful narrative that supposedly justifies the poor capital allocation decision. In the 1990s, the "new economy" narrative led investors to value companies on clicks and eyeballs instead of profits and cash flows. In the 2000s, the "housing never goes down" mantra inspired millions to bid up home prices well beyond the pace of income growth. And during the shale bubble, drillers simply excluded many common costs of doing business to report "adjusted profitability" even as they bled billions in negative free cash flow. They reported ultra-low "breakeven" prices, citing unprecedented efficiency gains. But despite all the supposed efficiency gains in the shale patch over the last decade, those efficiencies never translated into shareholder returns. Here's why...
Perhaps the most commonly cited evidence of efficiency gains during the shale boom came from the sky-rocketing production per rig numbers. And I won't deny that, at least on the surface, these numbers looked incredible...
In the oil-heavy Permian basin, production per rig grew from 55 barrels/day in 2007 to 631 b/d in 2019. Over the same period, gas drillers in the Appalachian basin boosted their output per rig from 0.4 million cubic feet per day (MMcf/d) to 17.4 MMcf/d. So we're talking about gains of roughly 1,000% in the Permian and 4,000% in Appalachia - the most prominent and prolific oil and gas basins in America.
But once you understand the source of these productivity drivers, it's easy to see why they never translated into positive shareholder returns. Essentially, two primary developments fueled the growth in production per drilling rig during the shale revolution:
In the chart below, you can see the two big jumps in efficiency during these periods:
Let's take them one at a time, starting with multi-pad drilling…
Before the rise of fracking and horizontal wells, drilling crews would typically drill one vertical well at a time. After drilling each well, field operators would "rig down" and move the equipment to the next drill site before "rigging up" and drilling the next well. But the advent of multi-pad drilling allowed operators to drill multiple horizontal wells through the different horizontal layers in the shale formation in a single drill site. So instead of going through the tedious and time-consuming process of moving drill rigs for each well, you could suddenly drill several wells consecutively. This substantially boosted the number of wells you could drill with any given rig in the field.
Clearly, multi-pad drilling increased capital efficiency by reducing the amount of idle labor spent simply moving drilling equipment between each well. But here's the problem - this more efficient use of labor did not offset surging input costs elsewhere in the drilling supply chain. In fact, the evidence suggests the exact opposite...
Data from DI analytics indicates that horizontal pad drilling increased from 20% in Q4 2012 to 70 percent by Q1 2014. And as you can see in the chart below, that's precisely when drilling costs (measured by Oil and Gas Producer Price Index) - already on an uptrend during the boom - accelerated:
In other words, multi-pad drilling actually coincided with sharply rising input costs.
The same phenomenon applied to the second class of supposed shale innovations that boosted production per rig starting in 2014-2015: greater fracking intensity. Specifically, the three-pronged approach of longer laterals, more fracking stages per well, and more proppants (i.e. frack sand and chemicals) per fracking stage. The explosion in the fracking intensity of today's wells translates into massive new demand for sand, water, and infrastructure to name a few expenses. The Wall Street Journal reported how these costs prevented shale companies from turning a profit, even at $70 oil:
Shale companies' profitability may also be threatened by rising costs for the immense amounts of sand and water needed for fracking. Modern fracking jobs now require 500 tons of steel pipe, enough water to fill 35 Olympic swimming pools and enough rail cars filled with sand to stretch for 14 football fields, according to Rice University's Center for Energy Studies."
And, of course, drilling capex is only one part of the huge capital requirements for shale drillers. Other major costs include land leases, SG&A, and transportation costs - all of which have increased over the last 10 years in response to the flurry of new activity in the shale patch. These all represent very real costs of doing business, yet many shale executive conveniently excludes some of these factors from their reported adjusted net income and "break even" prices.
These accounting maneuvers provided the appearance of positive returns in company presentations, even as shale drillers burned through billions in cash flow each year. I wrote about this in my original piece on the space last April:
If U.S. gas producers were generating real economic returns at current prices, it would show up in the form of positive cash flows. Unlike the income statement, which can be adjusted into faux-profitability with accounting shenanigans, cash flows never lie."
Today, even the mainstream media has caught onto these accounting shenanigans. In December, the Wall Street Journal explained:
The disconnect between the figures cited by companies and their corporate returns lies in the widespread use of a metric called a break-even, often defined as the selling price frackers say they need to generate a small profit on individual wells or projects. While the figure can be quite low for some companies in certain hot spots, it can be a misleading measure of their overall profitability...For one, break-evens generally exclude such key costs as land, overhead and even at times transportation."
The bottom line is clear: when you perform an honest assessment of the all-in cost of doing business, the basic math shows why the old shale business model simply didn't work. The Wall Street Journal reports:
Since 2007, shares in an index of U.S. producers have fallen 31%, according to data provider FactSet, while the S&P 500 rose 80%. Energy companies in that time have spent $280 billion more than they generated from operations on shale investments, according to advisory firm Evercore ISI."
And therein lies the rub…
Despite all the supposed innovation and efficiencies developed in the shale patch over the last decade, these businesses have collectively destroyed hundreds of billions in shareholder capital.
And that brings us to today, where the irrational investors supporting these unprofitable business models have finally retreated from the sector. The Wall Street Journal explains how investor funding appetite for energy funds completely dried up in 2018:
About $800 million flowed out of energy-focused equity funds for the year through November, compared with inflows of more than $6 billion in 2016, according to data from fund-data tracker EPFR Global."
The investor exodus from the energy sector continued in January, with Bloomberg reporting that "More than $3 billion flowed out of ETFs tracking the energy sector in January, the largest monthly outflow since at least 2012."
This reversal in funding appetite is the hallmark of market bottoms. With the easy money no longer flowing into the sector, shale drillers now have no choice but to live within their means. The hot money growth investors have left the sector, leaving behind only the most die-hard value-oriented investors in their wake. So, instead of lofty growth targets and future profitability, the new class of investors demands more cash flow and positive returns on investment, even if that means cutting back on growth altogether. This change in funding dynamics is the primary driving force behind today's rise of rational economics in the shale patch.
Today, we're seeing a 180-degree shift in the shale patch. Corporate executives have shifted their focus from growth to cash generation, including some of America's largest energy producers like EQT (NYSE:EQT) - America's largest natural gas producer. In a recent interview with Natural Gas Intelligence, EQT CEO Robert McNally explained:
It's time for the companies to start acting like grown-up companies, generating returns for shareholders and not just consuming capital, not growth just for growth's sake"
McNally isn't just paying lip service. In late January, EQT announced a complete halt in production growth for 2019 versus the company's Q4 2018 exit rate. The reason? To reduce capex needs and generate positive free cash flow. Simply put, this is a big deal…
You see, EQT became the single largest dry gas producer by a wide margin when it acquired Rice Energy back in 2016. In the chart below, I show the combined RICE + EQT production since 2012, where these two entities combined grew production at a 32% compounded annual growth rate through last year. But now, everything has changed. Thanks to the rise of rational shale economics...
EQT isn't alone. In early January, Appalachian shale driller Antero Resources (NYSE:AR) slashed its long-term guidance to just 10-15%. Since its inception through last year, Antero grew its production at a compounded annual rate of more than 40%. And while the company still plans to grow output by 17-20% in 2019, it guided for a longer-term growth rate of 10-15% from 2020-2023. That's down as much as 70% from its previous growth rate. A few days later, Chesapeake Energy (NASDAQ:CHK) announced a 20% reduction in its rig count on the company's earnings call in early January in order to preserve cash flow.
We're also seeing capital discipline among the oil supermajors, like ConocoPhillips (COP), which announced a 2019 capital budget flat compared with 2018. In their capital budget press release, the company explained:
We no longer think of our value proposition as merely disciplined, we view it as the new order. We are running our business for sustained through-cycle financial returns, which is necessary for attracting investors back to the E&P sector."
Those companies that resist this new order in the shale patch face the growing threat from investor activism. Gas producer Gulfport Energy (NYSE:GPOR) provides an example of the kind of activism that I think we'll see much more of going forward.
On December 10th, hedge fund FireFly Value Partners disclosed a 7.7% active stake in Gulfport. The hedge fund noted that they were in discussions with Gulfport's board on ways to enhance shareholder value through better capital allocation strategies. Six weeks later, the fund released the specifics of their plan in an open letter to the company's board. Firefly laid out their case in very simple terms...
We believe that Gulfport shares are trading at a massive discount to their intrinsic value and may be worth more than $30 per share over time."
They then examined two future paths for the company's capital allocation strategy:
In our view, buying back shares is the Company's optimal use of capital. Let us compare two capital allocation options:
(1) Accelerated Drilling: Gulfport spends an incremental $500 million in capex to pull drilling forward into 2019; and
(2) Share Buyback: Gulfport moderately slows drilling in the near-term and uses $500 million to buy back shares at today's price."
Finally, the letter went on to explain how option number two - pulling back on growth and simply using excess cash flow to repurchase shares - created significantly more value today than pursuing a growth strategy. So their advice was very simple: stop growing and start returning free cash flow to shareholders.
Lo and behold, management and the board heeded this advice. When Gulfport published its 2019 capital budget, the company announced it would hold 2019 production flat compared to Q4 2018 levels. By holding back on growth and possibly selling non-core assets, the company will generate positive free cash flow to support a $400 million share repurchase program.
In summary, the rise of rational shale economics means less production, more cash flow, and more shareholder returns going forward. Shale drillers will increasingly face the choice of exercising capital discipline on their own or having it forced upon them by activist investors. There's simply too much value on the table to allow business as usual to continue.
Against this new backdrop, the one company I believe has the most upside is Range Resource. The entire thesis will require a fully fleshed out article, but here's a high-level overview of why I see tremendous upside in Range's shares…
The key to understanding the value in Range's shares today is all about distinguishing between "maintenance capex" versus "growth capex". Just like the names sound, maintenance capex is the amount of capital spending required to hold production flat at current levels, whereas growth capex is the spending required to increase production over time.
Every company has a different proportion of maintenance versus growth capex, but Range's situation is perfectly suited for today's environment of maximizing cash flow over growth. Thanks to a large inventory of low-depletion wells, Range's maintenance capital levels fall to roughly $600 million per year in 2019 and beyond. You can see this in the chart below, where the company shows how much total capital spending is required to hold production flat versus grow at the targeted 11% annual compounded growth rate:
Now, Range generated roughly one billion dollars in operating cash flow last year. So let's do some simple cocktail napkin math regarding two potential scenarios for Range's capital allocation strategy over the next four years:
The first strategy represents the capital-incinerating strategy pursued during the old shale era. It would generate more top-line revenue growth, but essentially no meaningful free cash flow and thus no returns for investors. Meanwhile, the second strategy of holding production flat could generate roughly $400 million per year in free cash flow - or a 15% free cash flow yield at today's market cap or $2.7 billion. That's three times the 5% free cash flow yield of the S&P 500.
More importantly, with option number two, Range could immediately begin reducing debt and returning capital to shareholders. By 2022, the company could theoretically buy back 60% of its entire market capitalization.
And I'm not saying give up on growth forever. I'm simply saying today's oversupplied market does not justify production growth. Further, the incredibly depressed share price and leveraged balance sheet clearly indicate that paying down debt and buying back shares would be a much better use of capital. Growth should only be pursued AFTER cleaning up the balance sheet and AFTER prices rise to the level where the incremental cash flow generation exceeds the return from buying back shares at today's depressed price.
Since we're nowhere near any of those conditions, I submit that Range executives and the board would be abdicating their fiduciary responsibility to shareholders by pursuing any growth whatsoever in today's environment. Going forward, if management and the board can't demonstrate their ability to act as responsible stewards of shareholder capital, I expect activist pressure on the company. All it would take is one large investor to come in and demand a halt to production growth and a focus on cash flow generation, and the company could immediately begin generating a 15% cash flow yield.
That's why I see a future scenario unfolding where Range halts growth and begins optimizing its free cash flow generation - either through current management getting religion or through activist pressure. If that happens, there's no reason why Range shouldn't trade at price/free cash flow parity with the S&P 500, which would yield an equity valuation of $8 billion - or roughly $30 per share.
In summary, the new age of capital discipline in the shale patch is incredibly bullish for both energy prices and energy producers who can adapt to the new reality. Those who continue living in the old regime of reckless production growth will face increased pressure from investors and potential shareholder activism. In this environment, I want to find the hidden value opportunities where a simple change in corporate capital strategy can unlock tremendous shareholder value.
I believe Range Resources offers the greatest upside and the lowest downside risk, given their current ability to generate a 15% free cash flow yield by simply halting production growth and focusing on paying down debt and returning capital to shareholders. If Range management fails to recognize the opportunity for creating shareholder value, I expect the company to become a juicy target for activists in the near future.
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Disclosure: I am/we are long RRC AR EQT. 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.