To review. Shalecos were built on the concept that a portfolio of in the money options will be converted to cash, eventually paying off all debt and returning cash to investors above their capital cost. To maximize these returns, many have also brought capital intensive services under their umbrella, namely, midstream, well services, and acreage warehousing. The structure looks like the schematic below. The process of converting drilling inventory to a saleable hydrocarbon is supported by a multitude of functions with various asset and personnel requirements. These functions can be outsourced, but many chose to bring them in house because money was cheap, and the assets will be worth a ton down the road.
[Making graphs in Excel and PowerPoint is a grind. Switching to hand-drawn.]
The goal is to achieve a cash flow profile that looks like the graph below via a company comprised of these assets:
- A portfolio of real options
- Various services businesses predicated on the success of those options
- A cash flowing asset that declines and floats on price
- A hedge book managed on behalf of lien holders (this deserves a discussion on its own, but we’ll largely ignore for now)
It is interesting to note that every shale company I’ve seen has chosen an extremely expensive service to bring in-house. Few people talk about inventory warehousing. For the concept above to work, these companies need to convert acreage to hydrocarbons as efficiently as possible. Many companies say they are in ‘manufacturing mode’ or look at themselves as widget makers. Any other manufacturer with decades of inventory, and an enterprise value comprised primarily of that inventory, would be un-investable. It would be a preposterous proposition for Toyota to buy all the steel needed for the next decade of auto production. On a personal level, you get such good deals at CostCo is because you warehouse your own items. This service becomes increasingly expensive the longer you hold the product. A New Yorker living in a 500 sqft West Village walk-up probably has an easier time understanding this concept than a Texan in a 7,000 sqft house on two acres.
The easiest way to walk through this is to draw it out.
These are the assets of a shale company at the peak of the market. Let’s call this late 2013 to the summer of 2014. Also shown is the value of those assets over time while ‘in the money.’
It’s probably hard to remember now, but in 2014 it was common to run a downside case in the $70/bbl range. Maybe some people got draconian and ran cases in the $60s, although I can assure you, they were not transacting running cases at that price. The concept that oil would be sub $50 (much less $40 or $30) was not something in the industry’s collective psyche, but that doesn’t make the situation any less precarious.
We talked about Enron in the past. The same description of events could soon be used for shalecos.It’s probably hard to remember now, but in 2014 it was common to run a downside case in the $70/bbl range. Maybe some people got draconian and ran cases in the $60s, although I can assure you, they were not transacting running cases at that price. The concept that oil would be sub $50 (much less $40 or $30) was not something in the industry’s collective psyche, but that doesn’t make the situation any less precarious.
‘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.’
The shale industry also had a wake-up moment. Thanksgiving 2014, the Saudis announced they were not going to cut their supply to support prices. Prices going from $113/bbl in June 2014 to $36/bbl in January of 2016 shook people awake, but the market went back to sleep soon after when prices ran back up to more sustainable levels. It gave the industry enough time to get back to their old ways and put band-aids on a rickety corporate structure before the next impending price crash.
Enron was a balloon pop when their credit dried up. The shale industry had a slightly different reaction. Its assumptions were no longer valid, but there was no benefit to anyone’s long position to change course. Remember, the whole industry was underwritten based on the following broad assumptions. These assumptions got questioned, but no one needed to admit defeat immediately. The original assumptions are as follows, as well as a devil’s advocate view.
- Oil and gas are scarce commodities controlled by unstable regimes in dangerous parts of the world
- The problem with this assumption is that scarcity is pegged to price. At $120/bbl, there is an avalanche of oil that can come to market. Same with $2.25/MMBtu gas. There are also embedded demand assumptions baked in. It’s difficult for people to accept a terminal altitude, and most people’s version of ‘happily ever after’ is that things stay on the same path they’re on. They don’t. Each commodity has a saturation point, and most consumers can take advantage of relative cost advantages.
- American ingenuity will allow for technology to continue to improve yielding more hydrocarbons for less money
- This turned out to be accurate but to the detriment of the industry a la TVs and semiconductors. The process of extracting hydrocarbons isn’t particularly difficult, and there isn’t any unique business model or technology that one company can use at the exclusion of another. Google has a unique technology advantage that creates a business advantage. Shalecos would argue their acreage position is that advantage, but touting lower input costs significantly higher than low-cost global providers isn’t very compelling.
- Any land purchased is an in the money option to produce on that land later for excess profits
- Come on.
- This newfound system is repeatable and flows through a simple corporate structure
- Until the above assumptions above prove false and required fixes. If the fix assumes that the above assumptions eventually come back, isn’t the system just adding additional leverage based on assumptions that are currently false? A rusty lifeboat is only helpful land is within rowing distance.
The graph below is the same representation of assets, and their value over time, when drilling inventory is ‘out of the money.’ The #reallife chart says 2020 but could be any time that the inventory portfolio has become uneconomic to drill.
“Great, so now what?” You play for the most valuable asset of all…time. But playing for time is entirely based upon the company’s debt obligations. It was fascinating to watch the markets respond to all of this.
When prices dropped, RBL facilities stopped being sources of drilling capital because banks either pulled back on their determinations (every six months the banks re-determine the amount they’ll lend towards a company’s reserves) or the price decline pushed debt ratios to a point companies couldn’t draw their facilities. With enough bulls and capital still flowing through the market, the product du jour, The DrillCo, stepped in to fill the RBL liquidity gap.
The idea is that companies will be fine long term if given the ability to drill their inventory and increase production. A DrillCo steps in and provides the needed drilling capital. They usually take the last dollar in, first dollar out approach, and offer a cost of capital anywhere between mezzanine debt to private equity depending on the risk associated with the acreage. It’s much more expensive than an RBL, but it allows you to continue with your business plan as term debt matures.
They would say the following about the shale assumptions above: ‘They may not be true right now, but they will be again.’ OR ‘The only reason those assumptions are not true is because the banks pulled liquidity’ OR ‘It doesn’t matter. My terms are so good that I’ll let these guys drill all they want.’ The range of views, and cost of capital, are from true believer to rescue capital to loan shark. Their success generally relies on the same assumptions the Shalecos made in the first place.
These structures work well while a company’s liquidity position is constrained, but their acreage is still in the money. Recently another wrinkle has been thrown in. Debt maturities have come due to companies who either don’t have economic drilling inventory at today’s prices or don’t have enough time to drill their way out and can’t re-term their debt obligation. To solve this problem (which is becoming more common) we’ve seen an old concept employed, but at incredible scale. Bring in the Overriding Royalty.Think of the overriding royalty as uber-debt. The owner takes a piece of every hydrocarbon produced without paying any of the expenses, and the arrangement runs with the land, making it bankruptcy proof. It’s another last in, first out investment but with one significant difference from the DrillCo. It severely impairs the value of any long-dated debt the company may have. DrillCos put money into a company to raise its production profile, which should be a boon to both short and long-term debt holders. The royalty owner takes money out of PDP, and the use of funds have typically gone to pay off impending debt maturities, not drill new wells. This is a stark change from earlier where investors in shale were betting on asymmetric equity gains to come in the distant future. With royalty deals, investors want their money out as soon as possible and to come before other securities in the case of any restructuring.
To other investors, the royalty acts as an effective price decrease to PDP cash flows. Well shut-ins are brought forward because revenues are taken from the top line without any compensation for the expenses contributing to those revenues. The graphs above show royalties and their effects on cash flow and shut-ins.
We’re currently at a point where we’ve come full circle. The initial thesis was simple but based on questionable assumptions. Those assumptions proved to be false, requiring additional layers to company structures. These additional layers fall into two camps. Believers that think better days will come again, and others who feel the only way to get paid back is through bankruptcy proof prompt payments. There’s room for both to be right, but would it make more sense to reimagine the shale business model? I have a few ideas to share next time. We’ll see how well they age. To other investors, the royalty acts as an effective price decrease to PDP cash flows. Well shut-ins are brought forward because revenues are taken from the top line without any compensation for the expenses contributing to those revenues. The graphs above show royalties and their effects on cash flow and shut-ins.