G. Allen Brooks takes a closer look at the data used in a recent article claiming shale E&P companies will be generating free cash flow next year.
This opinion piece presents the opinions of the author.
The world continues moving toward one where everything can be defined by data, thus enabling analysts, bureaucrats and politicians to model and predict outcomes from shifts in policies. From the early days when computers first debuted, however, the concept of “garbage in, garbage out” was born to describe those situations where programmers entered bad data into a computer program that then produced answers that made no sense. We still suffer from that phenomenon despite the best efforts to avoid such situations. Usually, these failures reflect times when the people inputting the data fail to assure its accuracy. We think that may have happened in an assessment of the profitability of shale explorers.
A recent article in the Financial Times discussed the future of the shale revolution in the United States. The title of the article was: “US shale: What lies beneath,” but the thrust of the article could be best summed up in the tag line under the headline that read: “An innovation boom is bringing lower costs and higher productivity, but how long will it last?” The question the article’s author poses has been and continues to be actively debated with important implications for the future of the U.S. economy and our energy industry that will reverberate throughout the world.
The article presents data points and comments from companies active in the shale formations highlighting the operating and technical improvements they have made in the past few years that explain the dramatic increase in U.S. oil and natural gas production. It also quoted analysts critical of the nation’s reliance on a never-ending shale boom along with those who hold to the optimistic view of shale’s contribution to energy independence. A key point made by the author was that “No oil boom can last for ever,” so conditions will change at some point in the future. He went on to try to figure out how that future might look by asking analysts about their view of the trend in future oil prices as well as the economics of shale wells. An important point he made was that the exploration companies active in the shale formations are now seeing their financial positions improving rapidly. This is where we found a problem with the article. It is not that things aren’t improving as higher production and healthy commodity prices are boosting companies’ cash flows, but the chart used to illustrate this point may have some flaws that possibly undercut that conclusion.
The chart in Exhibit 8 on the next page shows the free cash flow per share for the exploration and production companies included in the Standard & Poor’s 500 Stock Index. We noticed the chart showed a steady rise in that measure following the collapse associated with the financial crisis of 2008. Recently, free cash flow per share, which was level during the second half of 2013, started climbing sharply higher during the first half of 2014. We knew that E&P companies were producing better financial results, but interestingly some of that improvement was driven by activist shareholders pressuring managements to cut spending, sell assets and focus on returning more capital to shareholders. We decided to investigate which E&P companies were in the S&P 500 to better understand the movements in the chart. What we found was surprising.
Source: Financial Times
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G. Allen Brooks works as the Managing Director at PPHB LP. Reprinted with permission of PPHB.
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