There are cash-rich companies in the oil sector sitting in a great position to take advantage of this generational collapse
Do you think that most of the executives at American shale producers forgot that they operate in an extremely volatile and cyclical business?
Or do you think they just believed that the cyclicality had come to an end and that $90 per barrel and higher oil prices were here to stay in perpetuity?
It has to be one of the two because how else can you explain so many of these companies leveraging up their balance sheets and massively outspending the cash flow that they can generate at $90 per barrel oil?
As a whole the shale industry was not the least bit prepared for the possibility of an oil crash that lasted longer than six months. Shouldn’t these companies have drawn up a plan for a worst-case scenario?
These companies that weren’t even close to living within cash flow at $90 per barrel oil are now forced to do so at oil prices in the $30s. Meanwhile they have balance sheets that were heavily leveraged against cash flow when oil was still $90 per barrel.
While this industry is to be commended on how it has transformed the business by figuring out how to produce oil from shale and tight rocks, the abysmal job management teams and company directors have done at managing risk is shocking .
An example – Continental Resources
Harold Hamm’s Continental Resources (NYSE:CLR) is essentially the U.S. shale revolution. This company has done a fabulous job pushing forward better techniques and technologies to develop the Bakken.
The company has also been run in a manner that is a perfect example of how the industry has botched this shale revolution.
We present “exhibit A,” Continental’s cash flow statement from its Dec. 31, 2014 10K.
Please compare the “net cash provided by operating activities” line with the “net cash used in investing activities” line.
| In thousands | 2014 | 2013 | 2012 |
| Cash flows from operating activities: | |||
| Net income | 977,341 | 764,219 | 739,385 |
| Depreciation, depletion, amortization and accretion | 1,368,311 | 965,437 | 694,698 |
| Property impairments | 616,888 | 220,508 | 122,274 |
| Non-cash (gain) loss on derivatives, net | (174,409) | 130,196 | (199,737) |
| Stock-based compensation | 54,353 | 39,890 | 29,057 |
| Provision for deferred income taxes | 584,677 | 442,621 | 405,294 |
| Excess tax benefit from stock-based compensation | — | — | (15,618) |
| Dry hole costs | 23,679 | 9,350 | 767 |
| Gain on sale of assets, net | (600) | (88) | (136,047) |
| Loss on extinguishment of debt | 24,517 | — | — |
| Other, net | 7,637 | 2,037 | 5,007 |
| Changes in assets and liabilities: | |||
| Accounts receivable | (129,634) | (166,138) | (91,791) |
| Inventories | (65,919) | (7,697) | (7,165) |
| Prepaid expenses and other | (57,489) | (11,537) | 14,381 |
| Accounts payable trade | 85,540 | 107,250 | (8,487) |
| Revenues and royalties payable | (18,022) | 28,401 | 40,030 |
| Accrued liabilities and other | 58,880 | 44,260 | 40,309 |
| Other noncurrent assets and liabilities | (35) | (5,414) | (292) |
| Net cash provided by operating activities | 3,355,715 | 2,563,295 | 1,632,065 |
| Cash flows from investing activities: | |||
| Exploration and development | (4,604,468) | (3,660,773) | (3,493,652) |
| Purchase of producing crude oil and natural gas properties | (48,917) | (16,604) | (570,985) |
| Purchase of other property and equipment | (63,402) | (62,054) | (53,468) |
| Proceeds from sale of assets and other | 129,388 | 28,420 | 214,735 |
| Net cash used in investing activities | (4,587,399) | (3,711,011) | (3,903,370) |
| Outspent cash flows by | 1,231,684 | 1,147,716 | 2,271,305 |
Because the name of the game is growth, growth and more growth, Continental has massively outspent the cash flow that the business generates. To do that the company had to issue debt and equity worth billions. In total from 2012 through 2014 Continental outspent cash flow by an incredible $4.65 billion despite having the benefit of very high oil prices.
Total cash flow generated during that time was $7.5 billion versus $12.2 billion of total capital spent.
By levering up like this and spending so much, companies like Continental have done three things:
- Made their companies extremely vulnerable to oil price declines with balance sheets that carry a lot of debt.
- Collectively destroyed the price of oil by putting growth ahead of sustainability.
- Drilled wells sooner rather than later and thereby drilled more wells with older and already antiquated drilling and fracking techniques.
By making growth the primary focus of operations instead of sustainability, companies like Continental have destroyed an enormous amount of shareholder value.
We get the concept of trying to maximize present value by bringing cash flow and production forward, but we can’t believe that sustainability was so collectively ignored.
What kind of oil company would an investor want to own today?
The good news for the industry is that the depressed price of oil can’t last forever. The price is simply too low for anyone who produces oil. That includes the shale producers, oil sands producers, deepwater producers and all of OPEC.
Yes, OPEC can drill profitable wells at lower prices, but it can’t balance its budgets.
Demand for oil will grow steadily, and production will stagnate and slide. The market will balance and likely slip into a deficit.
If you believe as we do that the rebound in oil is coming, what kind of companies should you be looking at today?
We have a suggestion.
Forget reserves and forget production. Focus on cash.
The type of oil company that an investor should want to own today is one that is sitting with a significant amount of dry powder.
With zombie producers across the industry doing everything they can to survive, today has to be the best buying opportunity in decades in the oil and gas business – if not ever.
There are a couple of companies of which we are aware that by chance are positioned with nothing but cash here at a generational bottom and are aiming their attention at the fish swimming in a barrel.
Company No. 1 is called Renaissance Oil Corp. (RNSFF) (ROE), which is currently looking to stake a claim in Mexico where assets are being offered to companies other than Pemex for the very first time. Renaissance has no production, no reserves and no debt. All that the company has is cash.
Renaissance has a CEO named Craig Steinke who previously was involved in building and selling Realm Energy and making his shareholders a lot of money in the process. Also involved with Renaissance as chairman of the board is Ian Telfer, who was involved with Steinke at Realm and is chairman of the board at the much larger Goldcorp (GG). Telfer’s connections in Mexico could be a key for Renaissance.
Adding some more appeal to Renaissance is the technical team involved. These gentlemen were last together at Mitchell Energy where they were involved with “cracking the code” on the Barnett Shale.
Yes, this is the team that is profiled in the book called “The Frackers,” a group that played a huge part in letting the shale genie out of the bottle.
Daniel Jarvie is the chief geochemist of the group; not only does he have Mitchell Energy in his background, but he was also chief geochemist at EOG Resources (EOG), which is the largest and likely most respected shale oil producer in North America.
Director of Engineering Nick Steinsberger was the completions manager at Mitchell Energy and the specific individual who recommended the implementation of slick water fracks in the Barnett Shale. Those slick water fracks provided the perfect combination of cost and elevated production that took the Barnett from being an uneconomic play to one that produced almost 6 billion cubic feet of gas per day in 2012.
The appeal of joining Renaissance for this accomplished team isn’t hard to fathom. Mexico offers a huge opportunity, having been massively underexploited by state-controlled Pemex for decades. Low-hanging fruit for a talented oil and gas team that hasn’t existed in the United States for decades exists in Mexico.
Company No.2 is Petro River Oil (PTRC), which like Renaissance is cashed up and looking to take advantage of others’ misfortune. Petro River is a little different in that it has both cash and has also just acquired 20% interest in a private company called Horizon Energy Partners.
The majority of the funding for Horizon Energy Partners has come from seasoned oil and gas industry professionals, including several former senior oil industry executives who have run both major and large independent oil and gas companies, including Royal Dutch Shell (RDS.A)(RDS.B), Texaco, Burlington Resources and Pogo Producing.
This industry’s veterans are clearly eager to take advantage of a once-in-a-lifetime buying opportunity.
Horizon Energy Partners is managed by Jonathan Rudney, who has more than 30 years of senior executive experience in the upstream portion of the business and has helped build several private E&P companies.
So far Horizon has acquired two assets located in the United Kingdom, adjacent to the giant Wytch Farm oil field. The Wytch Farm oil field is the largest onshore oil field in Western Europe, having produced approximately 500 million barrels of oil and 175 billion cubic feet of natural gas since first production in 1979.
Horizon has also gotten involved with the redevelopment of a large oil field in Kern County, California, and the development of a recent discovery in Kern County. The field to be redeveloped was discovered in 1933 and has produced over 90 million barrels of oil to date and 90 billion cubic feet of gas from approximately 600 wells and 12 discrete pools.
Petro River itself also closed a second transaction on Oct. 30 with Fortis Property Group to make various equity and debt investments in oil and gas related projects. Under the terms of the joint venture, Fortis contributed assets valued at an estimated $28.3 million for a 41.5% equity interest in Megawest Kansas, and Petro River contributed its legacy 50% interest in the Pearsonia West Concession for a 58.5% equity interest in Megawest Kansas. One of the objectives of the joint venture is to develop the vertical drilling program for our Pearsonia West Concession, consisting of 106,500 contiguous acres in Osage County, Oklahoma.
Speculative, yes; crippled by debt, no
Both of the above named companies are small and quite speculative in nature. Please note the word speculative, as well as note that we are not recommending these stocks to readers. But compared to the rest of the industry today they are refreshing. While most shale producers are crippled by balance sheets that weren’t particularly pristine when oil prices were three times where they are today, these companies have the opportunity to be aggressive.
The price of oil will turn around, but for debt-laden producers it might not turn around soon enough. Opportunistic companies with cash on their balance sheets will be there to pick off the assets of those that don’t make it through.
Disclosure: The author doesn’t own any shares in any company mentioned.