The quintessential shale company has thrown in the towel with Chesapeake Energy (‘CHK’) finally declaring bankruptcy last week. How did the industry get to its current state of malaise? It’s easy to blame commodity prices, but the real problem with shale companies is the types of assets that sit on its balance sheet, the warehousing of those assets, how, when, and why those assets get converted into cash, and who benefits from the cash flow produced. It seems obvious the current system isn’t working. What is less apparent is how we got here and where we’re going.
Most of the discussions on shale companies assume they exist in a historical vacuum. Someone developed a technology that made previously worthless land worth a lot, a structure was put in place to capture that value, and this would all be fine if prices would just cooperate. I disagree.
To understand how the shale ecosystem stood itself up and perpetuated itself over the past decade, one must understand the period that directly preceded it. US energy has traditionally been a slow, low-innovation industry that accepted its place as a secondary (or tertiary) player in an industry dominated by the Middle East, Russia, and other regions that haven’t traditionally been very hospitable to the United States. The US was a price taker for oil and generally sustained itself on a mix of coal, natural gas, and ‘waste’ LPG, where available, for things like power generation, heating, and industrial fuel. These industries were highly regulated not only in an environmental capacity but also economically by controlling the wellhead price of gas, and who controls, and profits from, the transport and distribution of that gas. The pipeline companies acted as first purchaser, transporter, and marketer/distributer in what was essentially a government-regulated monopoly over natural gas.
In 1983, congress passed a series of amendments to the Natural Gas Policy Act. [1] The most meaningful of these amendments was the formalizing of a transition period to which the final state would be an unregulated natural gas price. Deregulation was finally achieved in earnest in 1989 with the passing of the Natural Gas Wellhead Decontrol Act of 1989.[2] Long and short, these acts decoupled the means of natural gas production from the transport and marketing functions that ultimately delivered gas to the consumer. The pipeline companies were no longer able to aggregate supply and bundle services to their customers. Thus allowing each part of the value chain to find a market price of its own, and for customers to negotiate directly with producers for long term supply deals. These changes opened and energized a market that was virtually left for dead. This also opened the door for new business models, namely, that of standalone marketing and trading. The company that defined and dominated this new business model was a little-known (at the time) pipeline company called Enron.
Enron started small and quickly adapted to the new regulatory environment. Before 1989, the supply of natural gas had precipitously dropped because producers were unable to produce profitably at the government-mandated pricing structure. Precarious supply led consumers to find alternate sources of energy in the form of coal, heating oil, or other refined products they had access to in their geography. There was a dire need for liquidity and price discovery. Enron found its role as a middleman between producers and consumers, usurping the most profitable portion of the pipeline’s aggregation business by originating long term deals with consumers by solving two things: 1. supply continuity and 2. pricing transparency.
For too long, customers were unsure whether they could rely on natural gas to supply because they were legally unable to have a direct relationship with producers. There were also very few individual producers able to produce enough to provide consumers everything they needed. Enron stepped in as an aggregator who took a principal position of buying gas from producers, bundling sufficient supplies of gas to ensure supply continuity to consumers, and arranging transport of that gas across existing pipeline systems. Enron, and companies like them, were much better at facilitating market liquidity for both buyers and sellers than under the previous regime.
The problem with being an aggregator is if you become too good, you eventually need a balance sheet of sufficient size to keep the business solvent and growing. Balance sheets are beautiful things. You can quickly grow them with equity infusions, debt raises, and sleeves from banks. You can also render them irrelevant with special purpose vehicles and other financial structures to keep assets off your balance sheet entirely. Enron, who had expand its business lines into that of financier, developer, and trader, all of which needed access to large balance sheets of their own, chose all of these expansion options and even took it a step further.
Enron Online was a two-sided marketplace for producers, consumers, and traders of natural gas to interact with each other via a proprietary trading platform. In theory, this lessened the need to carry a large balance sheet because Enron Online could merely provide the platform for parties to transact with one another and take a fee out of those transactions. The idea being they could touch, and control, the whole market without warehousing assets on their balance sheet or taking the risk of price swings.
By late 2001, the company had a principal trading strategy in markets ranging from oil and gas, currencies, power, and even the weather. It managed a portfolio of long cycle developments that included domestic and international pipelines, powerplants, fiberoptic networks, etc. It also ran an online platform that facilitated the buying and selling of natural gas futures. All of this was complicated. The ideas were complicated. The people involved were brilliant and did not speak simply. The balance sheet was a financial Rube Goldberg contraption.
Few people know in full the details and milestones that lead Enron’s fall, but if one were looking for a single event, September 11, 2001 is easy to point to. The events of that day caused liquidity to dry up overnight, and that lack of liquidity was the perfect storm for a company like Enron, with a complicated balance sheet and a broad spectrum of liquidity requirements, to implode.
On a personal note, I was in high school while this final chapter of Enron took place. In an upper-middle-class neighborhood outside of Houston, I saw first-hand the effects this saga had on families around me. Some were innocent bystanders who had gone to work every day, saved in their 401(k)s, and woke up one morning having to tell their spouses they had lost everything in their retirement accounts, had no job, and had no idea what to do next. Others in our neighborhood found their names going into books and spending time behind bars for crimes like securities fraud and insider trading. It was a dark cloud over the city for what seemed like years. It wiped out individual lives and created a void in the oil and gas industry that wasn’t immediately obvious would ever be filled.
That was the stage in the early 2000s. The industry’s biggest, most innovative company created a business supported by a large, complicated balance sheet (grown, borrowed, and warehoused) to support their principal finance, trading, trading platform, and development businesses. As the firm moved from a market maker to a hard asset developer, the velocity at which the balance sheet was able to be drawn on to generate new cash flow slowed down significantly. Meanwhile, the obligations required to support that balance sheet stayed in place in the form of debt payments, credit covenants, and JV partnership agreements. The bottom fell out once liquidity evaporated after 9/11, and the ability to maintain credit obligations disintegrated. No one traded with their traders. The bid/ask spreads on their platforms never crossed. They couldn’t pay for the long lead items needed for asset development, and the money put into projects up to that point got washed away. Creditors circled to recover what they could. Fraud, and self-dealing, that was brushed over in high tide was laid raw for all the world to see.
The collective takeaways were evident to everyone and drilled into industry psyche. Companies should be simple, easy to understand structures that produce real, tangible things. If you cannot explain it to the layman, you are probably up to no good. If you cannot touch the product, then no value is being created.
Plodding behind this industry backdrop was a native of Galveston, TX, who was performing his seemingly never-ending science experiment. George Mitchell loved long-cycle projects. He started developing a still growing master-planned community in the 1970s. His company, Mitchell Energy, drilled 1,000s of oil and gas wells all over US. But, his claim to fame was developing a way to fracture gas wells in the Barnett Shale. This new technique, combined with the ability to drill horizontally, opened the door to a new group of oil and gas crowd. Real builders of real assets.
Having learned the Enron lesson, the companies that formed around this new technology produced something tangible, were simply constructed around a simple premise, and were created by Americans in America (a non-trivial tidbit amongst the Middle-East wars of the late 2000’s when this started taking off). There were several individuals and companies that immediately ‘got it.’ But, like Enron before it, one company, and one individual, personified this new shale business model. He was the chief evangelist of the benefits of the product it produced and the wealth it would create.
Aubrey McClendon and Chesapeake were the most aggressive buyers in the biggest land rush since the opening of the West. The value proposition is simple with understandable assumptions:
- Oil and gas are scarce commodities controlled by unstable regimes in dangerous parts of the world
- American ingenuity will allow for technology to continue to improve which will yield more hydrocarbons for less money
- Any land purchased is an in the money option to produce at a profit
- This newfound system is repeatable and cash flows through a simple corporate structure ultimately enriching investors
The idea can quickly be drawn on a standard cocktail napkin and explained on the shortest elevator ride. It struck a chord. The industry was able to deploy close to $1T over the next decade to aggregate land positions, ‘prove’ those positions, and produce actual oil and gas. But does something easy to explain mean it’s built more solidly than the system that just imploded? We’ll have to dive into that next time.
[1] A more detailed summary of the act is here: https://www.congress.gov/bill/98th-congress/senate-bill/1715
[2] FERC’s explanation of the Decontrol Act is here: https://www.ferc.gov/sites/default/files/2020-04/natural-gas-wellhead-decontrol-1989.pdf