How Producer Bureaucrats Overstate Cash Flow, Part V

 The bigger they are, the harder they fall is the saying. It’s difficult times like these in oil and gas that having the agility of a hummingbird will ensure you have the capacity to meet the threats and realize the opportunities that a producer may face. Much as the resilience and persistence of a startup organization would have. Turning bureaucracies into a larger form of the beast that has brought it to its knees will? I think we’ll find out in very short order. When the world is employing technology to accelerate their organizations to deal with the speed and pace of business. It’s good to know there are still rebels who can shirk that dynamic and show that there are different roads that can be taken. There are many examples in history that show these producer bureaucrats that their grasp of the past will be successful. The former Soviet Union was a basket case and now under Putin? Or how about the doubling down that we’ve seen in Iran? These are the kinds of rebels providing inspiration to our good friends the bureaucrats. Even closer to home we have the pertinent example of Maduro in Venezuela. When so many oil and gas bureaucrats think the same things regarding consolidation, how could they be wrong? And think of the benefits, a single point of contact for everyone for all things oil and gas. What was I thinking of bringing ERP systems based on the Joint Operating Committee to make North American producers dynamic, innovative, accountable and profitable?

We’ve now discussed the allegedly immaterial and irrelevant costs of overhead and interest in the oil and gas industry. Cenovus, post Husky consumption, plans on 25% of their staff being cut, the financial relief from just the staff salaries that are cut will total 100% of what Cenovus reported as G&A for 2019. Yes, overhead is irrelevant in oil and gas and we must always believe that! So the bureaucrats say. Here’s a question I have about these cuts and overhead in general. What is it that these people who are deemed “overhead” do? Do they just sit on their hands all day? Or are they active and productive, in the course of which incurring significant, additional overhead costs in their wake. When you cut the staff, are the activities stopped, or do others just pick up the generation of these other overhead costs? If so, what have you cut?

We move on now to discuss the third category of over capitalization that is used to “build balance sheets,” overstate earnings, attract overinvestment and hence create chronic overproduction. This third item is the line between what is deemed to be capital and what is operations. There is no disagreement that oil and gas is a capital intensive industry. This should apply, in our opinion, to the commodity sales price as well. That commodity prices should reflect the significant capital costs that are involved and included in exploration and production. Producers are facing an acceleration of their costs of exploration and production over the next 25 years. Facilities and infrastructure will need to be either built or extensively refurbished in order to remain in service through this period. The costs of oil and gas contained within each barrel of oil is on an ever increasing trajectory. The effort involved for the exploration and production of each incremental barrel of oil equivalent is higher than the prior barrel was, as it always has been. The logistical, political, environmental and business related complexities and difficulties are accelerating and will continue to do so. Recent history has shown that the industry is uncompetitive in the market for investment capital. Cash can no longer be “put in the ground” for the bureaucratic sport of it. The retrieval of that previously invested cash has to be the primary concern of the producer. This would enable producers to internally generate the funds for their own capital expenditures, pay off their debts and issue dividends which will be a requirement for at least the next decade in order to reestablish themselves with the reputation of profitable, value generating organizations. Until then the only source of cash will be claiming that “cash you have to put in the ground” as producers have been telling their investors these past decades. 

“Shale is a rapidly depleting asset” is the opinion of Wall Street investors. And investors are efficient communicators of the difficulties being faced. There are very high costs associated with shale drilling and completion. All subject to those accelerated decline rates. Extensive reworks and recompletions are necessary in as little as one to one and a half years. Additional laterals may be drilled and completed to expose new reserves to the well bore and enhance the deliverability of the remaining, existing production. These extensive and costly incremental costs are currently tossed on top of the initial drilling and completion costs and depleted over the remaining life of the proven reserves initially revealed and any enhancements exposed through the rework. Which may extend the life of the reserves into the next century. This is contrary to People, Ideas & Objects proposed practice of sourcing and returning previously invested cash for reuse by the producer. It is also contrary to the competitive nature of global capital markets. It is a luxury that no one is afforded and certainly no one is entitled to. An endless supply of financial resources provided by the investors, as a result of questionable accounting, was never acceptable. At the same time the consumer has become accustomed to an energy cost structure which is inadequate, leading them to believe it is cheap and plentiful, leading them to lose all sense of the value the commodities bring to their lives. These attitudes will lead to further political difficulties in the very near future when producers will ultimately have to address the more appropriate costing of their sales. To address these issues producer bureaucrats have stuck their consolidated heads in the sand. It is our opinion that the initial drilling and completion costs of shale should be impaired when additional, extensive work is done downhole. The initial well’s drilling and completion value has somewhat expired. Or, the recompletions and other extensive work needs to be expensed. Having this both ways seems contradictory and is inconsistent with the principle of generating cash, earnings and measuring performance. Which is the last hope for the North American oil and gas producer. The destruction that has been allowed to occur will reveal itself in almost every aspect of the business throughout the next decade. It’s called a reputation, consolidation doesn’t address the bureaucrats diminished reputation.

These solutions of course assume the Preliminary Specification is available to provide the decentralized production models price maker strategy. Where the ability to shut-in unprofitable production is available and hence the commodity markets will have found the marginal costs of oil and gas on a global basis. 

This is all accounting, as I’ve been accused of many times. “Accounting will never make a basin profitable or unprofitable.” Yes it is accounting and business doesn’t enter the logic of the producer bureaucrat. How the industry has approached the recording and recognition of their capital costs over the last four decades has been the chief cause of its decline in financial performance. The landscape today is in shambles and the bureaucrats don’t seem to care other than to pick up on the latest industry trend so that they too look good. Now that they have consolidation as their new calling they’ll be able to resume sitting on the couch while things develop, either good or bad, and leave any issues otherwise unaddressed. Until the next crisis arrives, just like the last crisis, which is the same crisis, at which time they’ll think of something new to make it sound good and buy more time. Except no one is listening, and the investors certainly aren’t biting on the creative nature of their “consolidation” plans. This is just more of the cyclical downturn that we’ve been on for decades. 

I do wish I could write about something positive, I do lose a number of readers because they say I’m too negative. It’s not that I’m negative it’s the industry is in shambles. A situation that I am providing a solution to. I don’t know if anyone else is buying what the bureaucrats are selling anymore, in the past, here in Canada, these themes or is it memes were picked up by John Q. Public and parroted with little to no thought behind them. With more layoffs now baked in the cake due to consolidations, will John Q. Public understand that the trend is not their friend?

The misguided nature of personal executive compensation has no basis in terms of the business performance. This has been noted in the Wall Street Journal recently and elsewhere. Yet nothing happens, this entitled group continues on with whatever flavor of the day with no consideration other than “what’s in it for me” and we all know that the moment that things become untenable it will be they who will leave en masse in order to ensure that no one will remember anyone of these individuals names. Third quarter financial reports for our sample of producers began yesterday and will continue for the next few weeks. I’ll be returning with our quarterly review on November 12, 2020 to report on the rolling tragedy. 

In Part II of this series we noted that the adjustments our sample of producers made for overhead, interest and capital vs. operations totaled around $130 billion. Reflecting an overstatement for their market capitalization of $780 billion for about one third of North America's production profile. The motivation to do this, and to do so systemically and consistently throughout the industry by all producers for all this time, with the obvious and highly detrimental consequences being played out today, shows that the motivation I’m alleging is accurate. We noted the Bloomberg quote on Tuesday that had the “Energy” sub-industry value in the S&P 500 fall from 11% to 2%. The value of that loss can be quantified based on the market capitalization of the S&P, which is currently $23 trillion. Therefore the difference between 11% and 2% in terms of quantifiable loss these bureaucrats are responsible for would total $2.070 trillion. Chump change to these bureaucrats, we know, but losses realized by all others concerned with the industry.

There’s a theory in accounting known as the Efficient Market Hypothesis. In a nutshell it suggests that all information is known in the financial markets and therefore is reflected in the price of the participants in that market. When I see that the energy index represents a $2.07 trillion loss. And at the same time, by my calculations, the amount of overstated cash flow of one third of North America's production profile is approximately $130 billion, representing a market capitalization of $780 billion. It is reasonable then to conclude that what I’m discussing in this post is already understood and acted upon by the investment community. Yet, as we see, nothing is being done, nothing is being admitted to and conversely these producer bureaucrats believe they have everyone convinced otherwise. 

In Part III of this series we noted that the hypercritical issue that producers of all sizes are currently facing is the shortage of cash. The inability to replenish the cash float each month was never understood as an issue when the investors were deceived into loading the annual budget of the producer. Now with no investors for the better part of 5 years the drainage of monthly cash these organizations has cumulatively incurred as a result of their capitalization policies, the subsequent “leakage” or “slippage” that occurs, leaves producers with no cash to pay the bills next month. Consolidation is supposed to help this? It may in my opinion help, in that it will finally call an end to this tragic era of oil and gas history. Remove the cause of the problem, the bureaucrats, and commence the developments of the Preliminary Specification. 

The Preliminary Specification, our user community and service providers provide for a dynamic, innovative, accountable and profitable oil and gas industry with the most profitable means of oil and gas operations, everywhere and always. Setting the foundation for profitable North American energy independence. People, Ideas & Objects have published a white paper “Profitable, North American Energy Independence -- Through the Commercialization of Shale.” that captures the vision of the Preliminary Specification and our actions. Users are welcome to join me here. Together we can begin to meet the future demands for energy. And don’t forget to join our network on Twitter @piobiz, anyone can contact me at 713-965-6720 in Houston or 587-735-2302 in Calgary, or email me here. 

How Producer Bureaucrats Overstate Cash Flow, Part IV

 Bloomberg reports that “Energy has slumped to less than 2% of the S&P 500 Index, down from more than 11% a decade ago, even as the wider market rose to record levels.” Reflecting the reported earnings and cash flow of the producers has been questioned by more than just People, Ideas & Objects! Those that have been responsible for this destruction have proven many things during this past decade. They have a litany of excuses, blaming and viable scapegoats in which to draw upon. Executive compensation has never been better. “Muddle along” and “do nothing” are now proven to be viable strategies, when they're focused on the “right” personal objectives. Will it be for these reasons that investors will turn to these producer bureaucrats, who were in control of the firms during this era of destruction, to move them back to the 11% of the S&P they once knew. Well actually no, it won’t be. Why would you place your bet on a field mouse in the Kentucky Derby? 

People, Ideas & Objects noted in our White Paper “Profitable North American Energy Independence -- Through the Commercialization of Shale” that there has been a distinct trend in the industry over the past number of decades. It is also evident in the litany of excuses that are used by all producers singing in harmony from the same hymn sheets. The trend is what I have referred to as the “Keystone Kops.” This first showed itself in Canada during the late 1990’s when “SAGD” (Steam Assisted Gravity Drainage) was suddenly all the rage. Soon it moved on to heavy oil in any of its forms. If you weren't into these assets you weren't in the oil and gas business. Producers would shift their investments overnight into the “next thing” and make the announcement. This trend moved on to unconventional natural gas and then from there…  The rest is history just as pretty much most of the industry is. Today the Kops have a new calling and its consolidation. If you’re not merging with someone this month you’ll be the one left out, as in the game of musical chairs. Shotgun weddings are being arranged every day it seems. This is the future of the oil and gas industry. The great, innovative, creative and intelligent minds of the producer bureaucrats have all received the same precinct alarm telling them to merge or die. They know and understand the math, it's one decimated and financially crippled producer plus another equals the super hero they know they can be. When you’re on the verge of drowning the worst thing you can do is start holding on to someone else. You’ll find that was your final, fatal act. 

The purpose of these consolidations is to provide synergies between the two firms assets administration. Or in other words they can cut overhead further. When did overhead become an issue in oil and gas? It seems that the Preliminary Specifications ability to make all of the producers' costs variable, and particularly the overhead costs of administration and accounting, based on production, is not understood by the producer bureaucrats. Or they have no desire to learn. It will be interesting to see what the outcome of these mergers will be in terms of their accounting treatment. The focus of building balance sheets may be ending as the bloated values of those producers that are acquired may be written down to their market value at the acquisition date. No such luck on writing down the debt though. This will be further evidence of the Keystone Kops type of management. Not knowing fully the implications of their actions. I guess this is why muddling along and doing nothing was always so attractive. 

Regarding the Preliminary Specification we’ve also heard from these bureaucrats that “there is no issue, they have it under control and their plans and vision on how to remedy everything are beginning to be prepared now.” In 2025 they’re promising you’ll be impressed. I just checked, the first document I published regarding the use of the Joint Operating Committee was the Preliminary Research Report in May 2004. I started writing this blog in December 2005. After 2,906 blog posts; all to do with the use of the Joint Operating Committee and the research associated with how the producer and industry would use that innovative organizational construct in order to provide the most profitable means of oil and gas operations. Just as Qatar’s Oil Minister Mana Saeed Oteiba saw and warned of the dire consequences to the North American producers business as far back as July 26, 1986. Both OPEC and People, Ideas & Objects have tried to work with these bureaucrats to avoid this outcome. Maybe I should add the producers’ investors to our little group as I’m sure they’ve had some disagreements with the way things have been moving these past years. I think I now agree with the bureaucrats, they do have bigger issues to deal with, but those would have to be classified as personal issues. What I can assure my readers is that I was in no way part of this disaster. Once I published the Preliminary Research Report that was it for me. I was clientless and in retrospect it seemed like it was almost overnight. Which means I’ve earned no revenue from these producer bureaucrats who see nothing but threats of disintermediation and I’ve done no work for oil and gas outside of this project since May 2004. I therefore have clean hands, as they say, but probably could use a manicure.

Back in the 1980’s interest rates were designed to punish and destroy anyone who came within a 100 yards of a bank. Topping out at over 20% for most loans it was no time to be in debt. Therefore the motivation for producers to “innovate” on the basis of capitalizing more costs to property, plant and equipment. As with all innovations of such characteristic the tradition across the industry became an inherent part of its culture that continues today. It’s interesting to note that since we began questioning the validity of capitalizing interest, these types of adjustments to property, plant and equipment have become more transparent in the producers financial statements. The percentage of interest that is capitalized appears to also have been scaled back. Overhead however has achieved no such transparency and nothing has been scaled back there I can assure you. 

In almost all cases I was able to determine what the producer incurred in terms of interest from the financial statements. Many only show the net interest costs after the capitalization and netting of any earned interest income. I was only interested in the gross interest paid. Today with interest rates falling into the negligible category this “feature” of capitalizing interest has become less of an issue. Possibly the reason for the transparency and the scaling back of the amount of capitalization. Nonetheless the amount of interest recorded by our sample of producers in 2019 was $7.8 billion. If we add accounts payable, deferred liabilities and bank debt of $338.3 billion we see the producers incurred a total interest cost of 2.31%. Basing these interest costs just on the bank debt of $152.4 billion the interest rate is 5.13%. Which is inline with the expectations of the investment community for a producer to be paying in terms of an interest rate. However, I know that interest is not just charged on the bank debt. The producers are successful in general not paying any interest on the accounts payable debts owed to their suppliers. There are times in which they are unable to avoid the paying of interest on debts other than their bank debts. These costs are fought with a fierceness that is rarely seen in bureaucrats. Increased charges for interest will set one's career off in another trajectory. They are generally avoided. 

Capitalization of interest follows the same route as the overhead costs we’ve documented earlier in this series. Initially overstating assets and earnings are well understood and the follow on consequences of these over reported earnings is they become excessively attractive to investors which eventually leads to chronic overproduction and unprofitability. The interest cost deferrals in this process are substantially higher than the amount of interest that would be deemed to have been included in depletion. If we take a non-GAAP measure of the total capital expenditures and divide it by the amount of depletion for that year we come up with a figure indicating the number of years it would take to deplete the remainder of the balance holding all things equal. A situation that would never occur. What we do see by calculating this amount over time is that in 2016 it was 6.18 times, 2017 is 6.74 times, 2018 is 7.71 times and 2019 is 8.01 times. A number that never quite seems to be lower than the prior year. In specific cases producers can have this factor as high as 26 times. There is a constant growth in the amount of property, plant and equipment due to the fact that rarely is depletion larger than capital expenditures, and sometimes materially so. This “leakage” or “slippage” is the differential of what is imputed for depletion for overhead and interest, vs the actual overhead, interest and what we’ll be discussing tomorrow that occurs in the fiscal year that is capitalized. It is this leakage or slippage that I suggest is material and as a result overstates cash flow in addition to the earnings and assets. 

Professional accounting firms have never heard of anything so comical in the business world before. The deficient level of sophistication in my analysis is wanting and I agree with them that it is not within their understanding of what is appropriate accounting, its analysis. We do however need to keep in mind that it is these Professional accounting firms that have been signing off on the financial statements of these producers for the past four decades. I therefore question their motives in their alleged criticism of my analysis. The point I would like to make is that 8.01 in 2019 minus 6.18 at the end of 2016 reflects 1.83 years of capital expenditures having been increased over the course of those 3 years (2017 - 2019) over depletion. Showing the leakage or slippage here is in effect for a three year increase of $183 billion in capital expenditures. Therefore our factor of 1.83/3.0 = .61 shows that $111.63 in capital expenditures qualifies as the leakage or slippage that we’re discussing. Go big or go home should be the motto of the oil and gas industry bureaucrats. 

The producers will claim they have the reserves to back up their property, plant and equipment. Those values are not prepared by the company but by independent reserves engineering firms. Using industry standard engineering principles. I am in no way suggesting that is inappropriate. What I am suggesting is that accounting is about performance and not valuation. The competitive producer would want to ensure that their sales were cost appropriately to ensure that their assets, profits and cash flow were stated on the basis that they were real and could be relied upon. Not “build balance sheets” for whatever reason. What we can clearly see now in the decimated landscape of North American oil and gas is that the investors have been paying for the capital costs and the consumers only ever paid for the operating expenses. For evidence of all this, just look at the balance sheet of any producer and note that the only thing that sticks out is that property, plant and equipment might have been transplanted from another company. They are disproportionately, in material ways, weighted to long term assets, negative working capital, heavily in debt particularly from the point of view of leverage if we adjust for the “bloated” aspect of property, plant and equipment. And shareholders equity is a comedy routine. We recommend a pro forma adjustment be made to move 65% of any producers property, plant and equipment account directly to retained earnings. That will provide readers with a better understanding of the situation of any North American oil and gas producer.

The Preliminary Specification, our user community and service providers provide for a dynamic, innovative, accountable and profitable oil and gas industry with the most profitable means of oil and gas operations, everywhere and always. Setting the foundation for profitable North American energy independence. People, Ideas & Objects have published a white paper “Profitable, North American Energy Independence -- Through the Commercialization of Shale.” that captures the vision of the Preliminary Specification and our actions. Users are welcome to join me here. Together we can begin to meet the future demands for energy. And don’t forget to join our network on Twitter @piobiz, anyone can contact me at 713-965-6720 in Houston or 587-735-2302 in Calgary, or email me here. 

How Producer Bureaucrats Overstate Cash Flow, Part III

What producers fail to account for is the impact that shale has had on their business. Oil and gas is a business that we could all agree, I would think, is suffering as a result of an abundance of unprofitable production. And as I’ve documented in this blog, throughout the Preliminary Specification and in last year's White Paper, a business that has been suffering from a cultural propensity to produce everything, everywhere and always. With no idea, no understanding and no regard to the performance of the property. The business model of the oil and gas business has been in jeopardy since at least July 26, 1986 (newpapers.com) where we’ve noted The Calgary Herald on that day documented the effects of the oil war OPEC had declared on mostly North American producers. This article oddly reads as if it were written for today, and in my opinion, the issue we have been dealing with every day since. We have defined overproduction as unprofitable production as that is what it is. Throwing the prolific nature of shale reserves on top of this business model, a model that was suffering from a lack of performance for many decades. Only proves there is no future for anyone outside of the chosen few who have taken control of the oil and gas producers themselves. If overproduction is the chronic issue underlying the steep downward trajectory that we’ve been on these past 34 years, shale bends that curve further and accelerates the destruction of the oil and gas industry and all those associated with it. It is therefore inevitable that the demise of the industry is within the current foreseeable future. Unless there is a fair and equitable method of production allocation such as the Preliminary Specifications choice of profitability, based on a standardized accounting of the properties performance. We will be riding this downward trajectory to the point where North American supply falls into jeopardy. Only People, Ideas & Objects provide a fair and equitable method of production allocation through our decentralized production model’s price maker strategy. 

 “My assets are bigger than yours!” says one bureaucrat, “Oh yeah,!” says the other. 

And that is in essence how we got into this mess. The desire to have the producers' balance sheet bigger than anyone else's. The purpose was to ensure the CEO’s could strut down mainstreet. That eventually became the sole purpose of the industry and we see that today parroted by these same CEO’s when they state they have to “build their balance sheets.” Apple’s objective is to “make insanely great products.” Chick-fil-A's core values comprise “customer first, personal excellence, continuous improvement, working together, and stewardship.” The slogan "Moving at the speed of business" referred to the swift delivery of packages but also described the rapid manner in which UPS continually adapted to the changing needs of its business customers. These last two examples are provided by Google. We see in these examples that all businesses have a corporate objective focused on providing something of value to their customers. Each one is different and are as unique from all others as one could possibly imagine. Yet the entire oil and gas industry is consumed by the corporate objective of “building balance sheets.” Even I can come up with a better one than that. People, Ideas & Objects provide oil and gas producers with the most profitable means of oil and gas operations. It’s not that hard after all.

With the comprehensive industry adoption of this “objective” firmly in place the “need” to increase the balance sheet to the highest level that could be attained became the only competition in the industry. The calling of “having to put cash in the ground” and other such nonsense was derivative of it. This “need” then settled in for the long term to become the comprehensive culture that now consumes the industry. Does anyone wonder how it is that oil and gas is suffering through a catastrophic depression, or is it just a collapse, and nothing is ever done other than to blame others, and of course build balance sheets. When it comes to running an oil and gas business the only thing producers need to be able to do is to prepare a budget, then spend it. That’s it, and that is why there is no business understanding or knowledge being applied anywhere that I can see. Only clinging on to the overall corporate objective of “build the balance sheet” augmented by today’s “protect our balance sheet.” The Preliminary Specification, our user community and their service provider organizations are able to provide an alternative. A corporate objective that is worthy of the people who work in oil and gas companies, the service industry and all the associated businesses that support them. Our focus on profits everywhere and always has been laughed at, ostracized and ignored for the past decades by those who drove the industry into the ground for what they could gain in terms of unearned personal financial compensation. We don’t need those that have caused so much destruction. We need to begin the redevelopment process of rebuilding the industry brick by brick and stick by stick in the vision of the Preliminary Specification. 

Overhead is capitalized at high percentages across the North American oil and gas industry. And when we talk about overhead we’re discussing any and all of it including the receptionist time, the phone service and the Post-it-Notes that are used. All of the producers overhead costs are adjusted to the tune of 85% on average, in one accounting entry to property, plant and equipment. The accounting principle behind this is that producers should include costs that are involved in putting the asset in place and operational. Which these overhead costs would certainly qualify. And that is what oil and gas companies do. Without consideration of any other factor and to the exclusion of all else. But why, and is that the best way? Has never been asked. What would be the most competitive posture of the producer firm? Have the producer cost product sales with the appropriate costs when almost all of the overhead is deferred in this manner? Where will the cash come from, or float, to pay next month's overhead if they’re not included in the commodity prices that producers charge consumers? The search for the Holy Grail in oil and gas is to have the asset value in property, plant and equipment resonate with the value represented in the reserve report. Why? This is defined by the SEC as the outer limit of what is acceptable for a producer to report on their financial statements. I don’t think this was set out as an objective for each producer to attain each and every year. The claim “you have to put cash in the ground” which our good friends the bureaucrats sang in harmony to the investment community these past few years shows the obscenity that oil and gas has become. 

Once they’ve achieved bureaucratic nirvana the world becomes their oyster. Not only are they a god at the local Ferrari dealership they’re able to control the variables like no one else before. Producer bureaucrats proudly claim they’re able to know the market supply situation throughout the globe. Using Artificial Intelligence and satellite imagery they’re able to determine the volume of oil in floating roof storage around the world. They’re then able to predict the market response and the future pricing of commodities. What I don’t understand is why they weren't able to anticipate the market prices turning negative in April 2020. Or didn’t see the buildup in inventories responsible for the overall decline in prices since 2014. When they have a ready supply of unlimited cash provided at no cost to the bureaucrat or producer, other than a larger number of shares outstanding each year. Producers become a spending machine that loses perspective of what is and isn’t valuable. The only thing that the Preliminary Specification looks to is if the property is profitable based on the price received and using a reasonable accounting of all of the costs of the operation. Here the price received is providing all the information that is needed to be known regarding the world supply and demand of oil. A property is or is not profitable, then act accordingly as the Preliminary Specification provides. Markets inform us of one thing and only one thing, information in the form of its price. Producers contrive great science experiments with other people's money for reasons that could never be justified as part of the business. Just imagine with today’s technologies what else they’ve got going and are thinking about?

When producers have a willing and engaged investment community buying the financial statements that showed profits and cash flow throughout the industry, investors followed. But it wasn’t real. The specious nature of the numbers has always been difficult for me to understand who was winning and who was losing. It looked to me as if anyone involved in the business was spending money lavishly in year one, all to have it go egg shaped by year three. If asked about the money that was spent last year or the year before that, investors received the same commentary that those were all “sunk costs.” There was never any accountability anywhere for any of the prior spending. The point I’m getting at is the industry has lost the ability to fundamentally understand that financial statements are to record performance, not replicate value. A producer that is performing at a high level would want to reduce their capital costs by recognizing them quickly, if commodity prices enabled them to. A producer with zero capital costs would be seen as the high performer that they are. They’ve paid for all their costs. They would then continue to be profitable at reasonable prices. All of the earnings that are achieved will be returned to the producer in the form of cash that will fuel growth in future earnings, and get this, without having to dilute the shareholder base at any time in the next decade! In fact producers could dividend out the proceeds of these earnings and still have their capital budget funded. And if executives decided to buy shares, think of their motivation and compensation. It might actually be productive! This is me thinking of sugar plums and such again with this scenario being the polar opposite of the current industry operations. Somewhere between would be the scatterplot of performance achieved by each producer. Something that the financial statements would reflect, the hero’s and the zero’s. Today financial statements are homogenous between all the producers. Those that retired their capital costs would also have higher volumes of short term assets having traded property, plant and equipment for... cash.

The Preliminary Specification, our user community and service providers provide for a dynamic, innovative, accountable and profitable oil and gas industry with the most profitable means of oil and gas operations, everywhere and always. Setting the foundation for profitable North American energy independence. People, Ideas & Objects have published a white paper “Profitable, North American Energy Independence -- Through the Commercialization of Shale.” that captures the vision of the Preliminary Specification and our actions. Users are welcome to join me here. Together we can begin to meet the future demands for energy. And don’t forget to join our network on Twitter @piobiz, anyone can contact me at 713-965-6720 in Houston or 587-735-2302 in Calgary, or email me here. 

How Producer Bureaucrats Overstate Cash Flow, Part II

Generating profitability everywhere and always will be the producers most effective means of ensuring their cash flow is covering all of their costs and providing the cash resources necessary to operate their business. The reorganization of the industries administrative and accounting resources into the service providers defined in the Preliminary Specification enable this transition to take place. Changing the producers fixed costs of administration and accounting into an industry based variable cost of administrative and accounting capability. Variable based on production within each Joint Operating Committee. Making all of the producers costs variable and allowing them to shut-in any unprofitable production without incurring a loss. These “null operations” will then be the focus of the producer's innovations in order to return them to profitable production. Null operations that will no longer dilute the profits of the producers profitable operations. Saving the reserves for when they can be produced profitably and keeping the losses that would otherwise have been incurred from increasing the costs of producing those reserves in the future. This also removes the marginal production from the commodity markets allowing them to find their marginal price. Our decentralized production models price maker strategy, which is based upon the Preliminary Specifications actual, factual and industry standards based accounting determination of profitability, is the only fair and reasonable method of production allocation. These are key features of the Preliminary Specification and are what are necessary to deal with the current industry difficulties. 

We are at the beginning of the third quarter 2020 financial reporting season. It will be very interesting to see the impact that events have had on the producer firms. The one thing that we can note consistently throughout North America is the layoffs happening in the greater oil and gas economy. Which I guess makes sense since we’re at what are believed to be very low levels of drilling activities. It may be that our drilling activity is just slightly better than 1898. Reflecting just how bad it is in the service industry. What we know is that producers have never been the ones to produce free cash flow. That’s cash flow less their capital expenditures. Where are those willing investors these days? It is therefore reasonable to assume that reduced capital expenditures would lead to strong free cash flow in the third quarter of 2020. The question that I have then is, why so many layoffs? 

Yesterday we discussed the motivation that producer bureaucrats would have in misrepresenting their cash flow numbers. When producers are evaluated at six times cash flow they’re able to quickly increase the value of their options and stock holdings through this bit of accounting wizardry. In this series that is focusing on cash flow. We’ll talk about the specifics of that process and how it has evolved over the past four decades. In subsequent posts will go into the details of the individual accounts that are affected, those being overhead, interest and the excessive capitalization of field activities. As we’ve discussed the current process is for producer bureaucrats to have these costs avoid hitting the income statement in a timely manner and place those costs on to that big, bad, beautiful balance sheet account of property, plant and equipment. This has a direct impact on cash flow in the following ways. First the earnings are higher than they actually are due to the deferment of large portions of overhead and interest and moving the cutoff between operations and capital so that capital receives more of the share of these costs of the organization. The question then becomes are these deferrals material enough to severely overstate the earnings beyond the change that occurs in depletion? I am suggesting that it is, and the material nature of these adjustments need to be considered in order to better understand how cash flow is over reported through this mechanism. 

Back to the question at hand, will cashflow be enhanced in the third quarter reports or will something else be consuming cash? Owning a growing small business is one of the most difficult issues to manage in business. Sales are increasing which would indicate that accounts receivable are growing and expanding. It’s the owners responsibility to finance those receivables some way and somehow. They’ll have to pay for the product they’re selling, whether that is payroll or products, and wait 60, 90, or 120 days to be paid for these sales. It feels like they’ll never catch up when they’re in that situation. We’ve discussed how the producer bureaucrats extended the payments of the service industries accounts payable beyond 180 days in order to continue with their capital expenditure programs. This was their last desperate act to have their capital programs continue. A despicable and abusive act but that was what they did. This was also part of the reason that working capital for the producers declined so precipitously in the past year. No investors, minimal working capital and spending on short term credit caused all the working capital to be extinguished and moved into negative territory.  Now those chickens have come home to roost, accounts payable may have been paid down in the third quarter at these producer firms. And as a result, a similar situation is occurring to the producers that happens when a small firm is growing and they’re faced with having to finance their receivables. Producers are having to pay for their prior sins. Cash maybe only headed one way, and that is out.

Cash flow is also diminished as a result of the producers business model that doesn’t provide for what I would call a “float.” I call it a float as that is the best way to describe it. It is the cash on hand that the business uses each month to pay the bills, payroll and keep the operation running. Usually a business has the float being replenished each month by the proceeds of the sales of their products, and as such the next month's float will soon be replenished for next month's expenses and so on. In oil and gas there is nothing coming back from the sales of oil and gas that is an adequate amount of cash to cover off the current expenses. People, Ideas & Objects claim that the energy consumer is and has only paid for the operating costs and the investors have been on the hook for the capital costs so they could sit on the big, bad, balance sheets, in what we can all agree is a capital intensive industry. What has happened prior to the investor strike is the capital budgets were set, usually in September and then the bureaucrats went to the markets to raise these funds. It is these investor funds that were used to keep the operation liquid enough throughout the year when in September the bureaucrats would just rinse and repeat. Moving all of their spending onto property, plant and equipment. Except there are no more investors or banks to replenish the capital budgets and the producers never generated adequate amounts of funds from their operations to support their wild spending plans. They also spend enormous amounts on their lavish executive compensation. As time passed, the investors left, and any cash that has been scrounged up was used to keep the lights on. Therefore it’s certainly not that the producer bureaucrats are seeking to increase the performance of their organizations by reducing their staff count. They’re only trying to make sure that whatever cash on hand covers the next payroll, that is this week's payroll. 

It should be questioned and asked why the producers are laying off personnel at this time or anytime for that matter. In 2019 our sample of producers who represent approximately ⅓ of the productive capacity of North American oil and gas production. Incurred 2.91% of their revenues in overhead! If overhead is so low why are they cutting 10, 15 and 20% of their staff? At best they are only going to produce a 0.582% decrease in their total costs. Unless of course the representation that 2.91% somehow distorts what it is the producers are actually paying? It has been People, Ideas & Objects contention that overhead is capitalized to the tune of 85% on average. I’ve invited bureaucrats to prove me wrong, and there is no one as of yet willing to provide me with the facts and figures to prove to me otherwise. Until then I’ll stick with 85% as it is the closest to the truth based on my experience. At 85% the overhead for the producers would actually be 19.4% of total revenues or $45.6 billion in total overhead for all of 2019 instead of the reported $6.8 billion for our sample of producers. This makes more sense and will be discussed in detail in tomorrow's post. Overhead therefore in itself is a material misstatement of the scope and scale of the operation in terms of the capitalization policies. I am approaching the recording of capital assets from the point of view of minimizing the amount recorded in order to a) increase the producers monthly cash float. b) have the prior invested capital recorded in property, plant and equipment returned quickly and in a manner that is competitive across all industries. c) establish for the producers an independence in terms of their capital structure by depending on “real” cash flow and not outside financing. Oil and gas is a capital intensive industry. Which implies to me that the commodity prices should reflect that the majority of its costs are capital. Currently they are not, and have not been for many decades. “Building balance sheets” is the aberration and cultural distortion that shows this has been the case for a significant period of time, and it isn’t doing anything for anyone at this time. 

The sum total of these changes to overhead, interest and drawing a different line between operations and capital is that the severity of overreported cash flow for our sample of producers has the potential to exceed $131 billion just for the fiscal year 2019. This would translate into a market capitalization adjustment for 2019 of $789 billion for our sample of producers representing ⅓ of Canada’s and the U.S. productive deliverability. The issue unfortunately today is that these producers' market capitalization at the end of 2019 was $362.5 billion and their market capitalizations as of today total only $168.8 billion. Who would have thought that they’d lose almost $200 billion in market capitalization in 2020?

This is the reason that the Preliminary Specification is necessary in the industry. Recording the appropriate amount of capital based on a competitive offering on the North American equity markets is where the thinking of the producers has to be. “Building balance sheets” in reality has been a blatant and tragic misrepresentation of the performance of these producers and was used to grossly distort the scale of executive compensation. Our decentralized production models price maker strategy is the only method in which they’re going to be able to compete in those equity markets. Recognizing the appropriate amount of capital within each barrel of oil equivalent now in their current financial condition would only show the tragedy that has gone on here. (Reflecting massive losses due to very low prices.) An organizational reconfiguration and effort to deal with this past is the only way that they’re going to get through this and be able to compete in future capital markets. What they’re doing today is clearly not working and hasn’t for four decades. 

The Preliminary Specification, our user community and service providers provide for a dynamic, innovative, accountable and profitable oil and gas industry with the most profitable means of oil and gas operations, everywhere and always. Setting the foundation for profitable North American energy independence. People, Ideas & Objects have published a white paper “Profitable, North American Energy Independence -- Through the Commercialization of Shale.” that captures the vision of the Preliminary Specification and our actions. Users are welcome to join me here. Together we can begin to meet the future demands for energy. And don’t forget to join our network on Twitter @piobiz, anyone can contact me at 713-965-6720 in Houston or 587-735-2302 in Calgary, or email me here. 

How Producer Bureaucrats Overstate Cash Flow, Part I

 The Preliminary Specification demands change. After all, as you can see, we're not talking about minor changes to the floor plan for accounting. We are exercising wholesale changes to the oil and gas industry by adopting the Preliminary Specification, and fully utilizing the Joint Operating Committee. Change that is as significant as that which is represented by the changes in energy prices, the global energy demand structure, shale reserves and the impact of Information Technologies ability to disintermediate old and bureaucratic organizational structures. People, Ideas & Objects will enable the oil and gas industry to compete in the capital markets with all other industries. Provide the producers with a substantial stream of internally generated cash flow, capable of independently approaching what can only be described as its most challenging future. Our vision sees a dynamic, innovative, accountable and profitable oil and gas producer dealing with an unknown future that will feature far greater risks, yet far greater rewards for those with the footprint necessary to act quickly and effectively throughout the greater oil and gas economy. We are not there yet, but the demand to be so will begin very soon. This industry has none of the requisite capacities or capabilities to approach their future and are stuck in a past of delusion and myths. It is only the Preliminary Specification of People, Ideas & Objects, our user community and their service provider organizations that are able to act upon this oil and gas vision and make it real. The alternative of waiting or “muddling through” and “doing nothing” has been a failure.

I believe it is now evident to everyone that the producer bureaucrats are not going to do anything to deal with the issues at hand. Time in which to do so passed many years ago. In the short term, if they can get past the American Thanksgiving the pressure will be off until mid January. They’ve been able to get by in the mid term on a handful of excuses and are now waiting for the inevitable process of bankruptcy to terminate themselves from their post and have the judiciary deal effectively with their shareholders. This would give them the excuse in any subsequent litigation that it was due to forces that were beyond their control as to why the industry failed. It’s time for us to be wise and to deal with the oil and gas industries issues ourselves and return this industry to real profitability with the business model of the Preliminary Specification. I don’t know how many times I’ve heard from others outside the industry that the current business model has failed, which it has, and if we can agree that’s the case then action is required. It should be noted that throughout 2020 not one of these bureaucrats has reached out to contact me. Evidence I would think that either I’m not with it, or they’re buying time as described.

Our last blog post of September 24, 2020 entitled “The Geologist is in Flight” noted the days in which the producer bureaucrats were left to continue in their peaceful and comfortable ways may also be coming to an end sometime soon. On October 2, 2020 The Wall Street Journal published an article entitled “Shale Companies Had Lousy Returns. Their CEO’s Got Paid Anyways.” One of the points of the WSJ article was a comparison of the salary earned by CEO’s in all industries and it was here that it was noted that shale producers achieved the fourth highest level of compensation. Of the few oil and gas bureaucrats that spoke to reporters, they made the comment that they too had lost value in the stock options they were granted and in their shareholdings. 

“You’ve had 10 years of consistent value destruction with management teams getting paid for it,” said Ben Dell, managing partner at private investment firm Kimmeridge Energy Management Co.

In response to inquiries from the Journal, some companies said their CEOs had also suffered due to the decline in the valuations of their companies, noting that the bulk of their compensation came from long-term stock incentives.

“We share their [investors’] frustrations, frankly, because the bulk of our compensation does come through stock awards,” Mr. Hager [CEO of Devon] said.  

Which of course is true, but whose fault is that? We didn’t hear any reason as to who they attributed these losses to. Which is odd though, not having an excuse, someone to blame or any viable scapegoats seems to be a development that People, Ideas & Objects have consistently requested these bureaucrats undertake. Which is good, however the loss of excuses and such has now been replaced by blindingly stupid commentary that they believe will be acceptable to those that have lost so much at these ridiculous people’s hands. Clearly running a scam and a fraud requires no business sense or personal moral character that would show empathy towards the victims that have been hurt by their methods. But let's not worry, we know these bureaucrats are well insured.

Before our break we also noted that these producer bureaucrats don’t have any money, can’t raise any money and don’t make any money other than for themselves. What I think we’ve learned since that time, and will be confirmed in their third quarter reports, is that they have no idea how to make money. What purpose did management and planning take within the oil and gas producer when everything they spent bloated their asset value and everything they produced was almost pure profit. Why would there be a need to plan or manage the business? The more spending they’d incur the better off they’d be. Whatever could be the issue? This has been the case since the late 1970’s when the SEC implemented their regulations regarding the recording of capital assets in oil and gas. These regulations define what the outer limit of what a producer firm is able to record as capital assets. Keeping the amount recorded below the threshold of the reserves value. If their assets on the balance sheet exceeded the reserves value, they would be subject to the ceiling test write down. However our friends the bureaucrats have determined this outer limit as the goal and objective of their spending with each producer seeking to attain that value each and every year. Over the course of these past decades this has eroded the standards and expectations of those within the industry and set in place a culture that knows no difference and understands none of the reasons why it violates the standard business principles that would otherwise attract investors. 

The methods necessary to boost the amount of capital assets that are recorded has increased over the past four decades as we mentioned. The areas where I see these changes are in the areas of capitalization of overhead and interest, and in determining the line in which field activities are defined as either capital or operations. Everyone can see and fully appreciate the effect on asset values and reported profits of the over capitalization policies by the producers. It is simply the well known chronology of over reported assets beget over reported profits, which attract overinvestment which generate overproduction. And what is the issue in today’s oil and gas market, chronic overproduction, or as we call it unprofitable production. Unprofitable in the sense of the reported profits are not real profits, they are bloated and distorted. It has been People, Ideas & Objects assertion that the cash flow is also overstated, and in material ways. This blog series seeks to clarify how this is done and the reasons for that. The cash flow implications are not as simply stated and are far more subtle as a result of over reporting of the capital assets of the producer. And with producers being evaluated on the basis of six times cash flow by the equity markets, there are no incentives for our good friends the bureaucrats to want to boost their cash flow numbers. Unless of course they could do so in material ways, which leads me to declare the fraud, scam and ponzi scheme that it is. Effectively removing their excuse of attempting to claim that it was due to forces that were beyond their control, in any subsequent shareholder litigation. 

For purposes of this discussion why are we concerned with cash flow? We believe it will be the only source of cash available to producers in the near to mid term. Capital structures have eroded to the point where they no longer support the operations that demand them. It is questionable if the capital structure ever did support these operations without annual infusions of new investors. Investors and bankers are expressing a refusal to continue on the basis of a lack of producer performance. Therefore performance, particularly in the form of real cash flow is going to be required for the producers to source their cash needs and most particularly fund their future capital expenditures. Leaving capital assets on the balance sheet for excessive periods of time only subsidizes the consumers of the oil and gas commodities at the expense of the investors who financed them. The capital assets are nothing more than the unrecognized capital costs of past production. Therefore the only source of capital these producers will be able to source will be the return of the “cash they had to put in the ground” and distribute that appropriately between dividends, payments of debts and capital expenditures. The capital assets that are recorded as property, plant and equipment should be considered their bank accounts for their viable future, if such a thing exists. This assumes that they are using the Preliminary Specification decentralized production models price maker strategy where they’ll be able to pass these previously unrecognized capital costs of prior production on to the consumer and retrieve that cash.  

The Preliminary Specification, our user community and service providers provide for a dynamic, innovative, accountable and profitable oil and gas industry with the most profitable means of oil and gas operations, everywhere and always. Setting the foundation for profitable North American energy independence. People, Ideas & Objects have published a white paper “Profitable, North American Energy Independence -- Through the Commercialization of Shale.” that captures the vision of the Preliminary Specification and our actions. Users are welcome to join me here. Together we can begin to meet the future demands for energy. And don’t forget to join our network on Twitter @piobiz, anyone can contact me at 713-965-6720 in Houston or 587-735-2302 in Calgary, or email me here.