Exploding Myths, Part III

Since the 2009 financial crisis the market rebalancing of natural gas has been one of the consistent claims of the producers. The same has been the case for oil since 2014. What we see in 2020 is neither market has been “rebalanced.” Why is that? How does one go about rebalancing a market? Have these steps been taken by North American producers? Or are the Russians manipulating these commodity markets between Presidential elections?

The fact of the matter, as we’ve described in the Preliminary Specification and our White Paper, is that “market rebalancing” is one of the key myths that producers bureaucrats continue to push so that they can continue to sit on their hands. There is no such concept outside of oil and gas known as “market rebalancing” that goes on. As we’ve pointed out markets do one, and only one thing, which is to provide information in the form of a market price. If the price is adequate to make a profit then a reasonable, rational person would produce. If the market is not providing an adequate price then that same individual would choose not to produce. Market rebalancing is the myth that keeps on giving the producer bureaucrats cover for their “muddle along” and “do nothing” ways. Don’t believe me, go back and check the dates when prices collapsed in these commodity markets. Why would any rational, reasonable person continue for a decade without any response to the destruction being caused by producing at low prices? The answer is at one time they had willing investors duped by specious financial statements.

Natural gas prices are the worst they’ve been for this time of year since 2016. Which doesn’t say very much and isn’t news. Oil prices in 2019 were substantially lower than in 2018. Projections for earnings in the fourth quarter are expected to be a surprise to the downside. The IEA believes that 2020 will see oil supply exceed demand by 1 million barrels per day. Anyone want to guess what natural gas markets will be like? The thing to remember is these bureaucrats when caught in the camera’s lights can say with all confidence that they have this. Just ignore the look of horror on their face.

Maybe producers should look at the bigger picture of what their investors want. Sure free cash flow is the word of the day. And oil and gas bureaucrats have always been able to pick out the one business criteria to make their claims of what they’ll do within a specific year. What they need to learn is that business is about building value year after year, and what I mean by that is not destroying value, which requires real profitability which would generate real free cash flow. Using the cash that is generated in the business to fund all of the necessary capital expenditures, pay dividends and pay down debt. All three, each and every year. Not claiming one of these business metrics they’ll magically perform in the current year, only to come up short again. Investors don’t want to run the business, that’s the producers job. To make them money, that’s what businesses do.

Last year it was share buybacks that were all the rage. Until it was pointed out to them that buying shares on the market, then running those shares through the shredder and burning them was not building any value. Producers purchased their shares on a wholesale basis by diverting their cash that should have been used to pay their suppliers in the field. Members of what we all used to call the “service industry.” The service industry was useful during the initial phase of the investor strike to finance much of the capital expenditures of the producers by having them extend to producers 90, 180 and 270 days to pay. What these producer bureaucrats have deemed here in 2020 is that the service industry is an old and nondescript sort of name. They’ve come up with a better name that suits the producers needs on a go forward basis, one that much better describes their view of the service industry. What they’re now calling them is “unsecured creditors.” Pengrowth in a plan of arrangement, or heck in any arrangement these people really don’t have to be paid! “Unsecured creditors” kind of has a nice ring to it, doesn't it?

Encana was buying $1.6 billion of their shares, then shredding them when they could have easily drawn down their accounts payable. It was the industry trend and the cool thing to do. If they were interested in building value, reducing the liabilities of a business would have made a substantial increase to their investors, instead producers must meet the narrative, there’ll be no deviations. Stock buybacks were the narrative at the beginning of 2019, free cash flow is today’s and later this year it will be defaulting on their “unsecured creditors.” Just as all of the pain that is being experienced by everyone in the general economy that is affected by oil and gas. The producer bureaucrats are the gang that could shoot straight right into their boots. The steep downward trajectory throughout the general economy in oil and gas is a result of the self-interested, conflicted and lazy bureaucrats. But this mistake of not paying those that are rightly owed, if I could call it a mistake, will come back quickly to cause serious issues to the bureaucrats. Producers will now have to get their cash out. Oil and gas will now be an all cash business. Want something done. Get some cash to pay the whole freight up front. And don’t be surprised when the “unsecured creditor” says he thought the producer was paying down their 270 day outstanding balance of accounts payable instead.

The term unsecured may begin to take on a much larger than life image in 2020 than the producer bureaucrats may have wanted. The other area where unsecured seems to be applied this year is in the employees of the producers. As in unsecured employees are on the street. Occidental is the first that I’m aware of out of the gate this year. Sort of like the first new years baby. Think of these layoffs as a post acquisition / Christmas gift. Occidental had been offering a voluntary retirement program since the acquisition of Anadarko however this is an increased cut in the unsecured employees. No numbers were announced. Apache chimed in the next day to make sure they were being seen as prudent with the hacking of 500 people and an announcement of the closure of their San Antonio office. This closing will bring on another 270 unsecureds when it occurs. Discussing the larger cuts being made in the general economy as a result of the irresponsibility of these producers would be redundant and melt down the Internet. The question that I guess I have is who gives a damn about what the price of oil or gas is in 2020?

One thing we can be assured of is the safety and security of the bureaucrats. Their ability to deliver on free cash flow is unknown and unknowable. It was the Saudi’s fault or the winter wasn’t cold enough as their reason for non-performance. None of this has been their fault in anyway, they’re innocent. With the designated unsecured classification being established, diverting that cash to source the funding of the bureaucrats personal empires in 2020 is secure. They always seem to have the winning hand, not caring has its benefits. It certainly is dark and gloomy outside in oil and gas. This is as I have been saying for many years and offered the Preliminary Specification as the means to mitigate these damages. There is no need to sugar coat any of this now, it’s only going to become much worse.

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. 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 Telegram @piobiz or Twitter @piobiz anyone can contact me at 403-200-2302 or email here.

Exploding Myths, Part II

One of the myths that we’re hearing being chanted is that free cash flow is now the focus of the producer bureaucrats. Feeling the pressure from disgruntled shareholders, bureaucrats are lining up saying that free cash flow is what they’re all about. For the record free cash flow is the remaining amount of operational cash flow after the deduction of capital expenditures. In oil and gas this number has generally been negative for many decades. It’s difficult for me to discern whether there is more authenticity in this claim than the litany of other excuses they’ve used. Excuses like waiting for a cold winter, capital discipline, yada yada yada. We’ve always stated that the methodology of accounting in oil and gas is that balance sheets and income statements are overstated due to the policies used to capitalize costs to property, plant and equipment, these past four decades. Capital costs are seemingly never recognized in the price of the commodity to the consumer. These costs, in a capital intensive industry, are stored for generations on the producers balance sheet. We have argued that cash flow is therefore overstated when the capitalization of every possible cost is undertaken, those costs then being allocated to each and every molecule of oil and gas reserves, and only the current productions portion of those capital costs are recognized as depletion. The nuance of overstated cash flow is not one that is easy to understand. Changing the amount of depletion from one number, by increasing the recognition of capital costs in an accelerated manner, does nothing to the amount of operational cash flow recognized in an accounting period.

You do however have an overstatement of operational cash flow due to the overhead costs being recorded at 2 - 4% instead of the probable real incurred costs of 20% of revenues. The difference here being the overhead that is capitalized. Have a producer prove me wrong if you don’t believe my percentage of overhead in the industry, or read Exploding Myth, Part I. This point alone seriously overstates the amount of cash flow generated by the producer and industry overall. When producers are evaluated at six times cash flow, would it not be prudent to boost cash flow? The fact is that in the Preliminary Specification producers will begin recognizing the cash that is being burned in the form of overhead in the organization each and every month. Our method of recognizing and costing the actual overhead as part of the price of the commodity instead of storing these overhead costs on the balance sheet for decades. Why would we do this in the Preliminary Specification? To ensure that these substantial overhead costs were immediately passed on to the consumer in the form of higher commodity prices and therefore the cash incurred on those overhead items are returned to the producer through the establishment of a 60 day float in order to have the money to pay the overhead costs in the subsequent month. This currently doesn’t exist in oil and gas. These overhead costs would also materially affect the balance sheet as we’ll be recording none of the overhead as capital from the point of when the Preliminary Specification becomes operational. This method will materially affect the earnings of the producer by increasing the costs that are recognized in any period. These costs of the operation will be substantial, overhead being upwards of 20% of revenues, which would offset the minor costs of recognizing the amount of overhead that is being depleted from property, plant and equipment. Therefore operational cash flow would be substantially reduced in comparison to today's method, as would free cash flow. It would however leave the same choice that producers face today in determining if they should pay dividends and never having cash again.

Capitalizing operating costs is an effective tool to overstate balance sheets, income statements and cash flow. In Canada producers became very effective at this method when they also include royalties in the calculation of what would be capitalized. I have little evidence of this activity other than the SEC prosecution of executives of Obsidian’s former persona of PennWest. We haven’t seen any of this activity in the industry since the SEC launched their litigation. Todd Takeyasu was the CFO that the SEC is most enthused about in their litigation. I can understand why. I knew Todd when we conducted audits together in the late 1980’s and early 1990’s. I can assure you Todd will have the nicest audit file put together in terms of the discussions and documentation regarding the capitalization of operations, overhead and royalties. Who authorized it and what was said. What he doesn’t seem to understand is it’s the CFO’s role to stop such nonsense from happening.

The Preliminary Specification also looks at the capitalization of assets from a different perspective in terms of what is or should be a capital asset in property, plant and equipment. Throwing everything that is spent into property, plant and equipment is only an effective business model when there are investors who can be deceived by these actions. A more nuanced accounting will now be necessary and that is what we’re bringing with the Preliminary Specification. Most of the work done at the well site is intangible in nature. Yet intangibles are not treated any differently than tangibles on the financial statements. We think they should be and as a result subject to a much more rapid method of depletion or depreciation. Again what producers will find here in this accounting change is hoards of cash when using the Preliminary Specifications decentralized production models price maker strategy. Which ensures only profitable production is produced everywhere and always. In addition we believe only the initial drilling and completion should be capitalized, particularly when dealing with shale wells. The majority of the capital costs incurred to drill and complete those wells should have been retired by the time the wells have had to be heavily reworked with additional laterals drilled and multiple completions on these new laterals. Shale has a rapid decline rate that demands significant rework where new capital needs to be employed to maintain deliverability. What is the effective accounting policy for such a property? The other characteristic of shale is that the proven reserves that are exposed are orders of magnitude higher than what oil and gas has ever been familiar with. Is allocating all of the capital costs equally across the entire proven reserve base, which will be produced over the next century, with each of the subsequent reworks costs added to those original costs the most effective business model? Or is this just the best way to bank cash in the ground?

If the producers continue with their myth that they’re providing free cash flow then they’ll have to provide an understanding where it is exactly that all of their cash is going. What should be obvious to most people in the industry is that cash only goes in and never comes out. This fact is being realized now that the investors and bankers are protesting. The myriad excuses and myths that have been peddled by these producers are more to deceive one another now. They’re the only ones that still believe in what they’re doing is right, or is it that they have to keep their story straight?

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. 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 Telegram @piobiz or Twitter @piobiz anyone can contact me at 403-200-2302 or email here.

Exploding Myths, Part I

We return to 2020 with an interesting point of view being reflected by our good friends the bureaucrats of the oil and gas producers. The two things that I noticed the most were the continuation of the exits, the most prominent of which being Mr. Harold Hamm giving up the CEO post at Continental Energy. The second point seems to be a desperate attempt to seize the narrative. As a result I’ll be running this “Exploding Myth” series countering the arguments in the producers narrative. First up at bat is Chevron’s write down of $10 to $11 billion in the fourth quarter of 2019 for their natural gas properties. Chevron had $169 billion in property, plant and equipment as of 12/31/2018, a 7% write down doesn’t seem material enough to me when natural gas prices are down 26% since that time. Granted Chevron’s property, plant and equipment includes oil, downstream and international assets, it just isn’t a prosperous time in oil and gas. My argument has always been that the majority of these “assets” are better described as the unrecognized capital costs of past production.

One of the differences between the Preliminary Specification and the manner in which the industry is operated today is the management of property, plant and equipment. We believe as a capital intensive industry oil and gas should reflect a large portion of capital as part of the cost of the commodities price in providing the product to the consumer. Current producers believe capital assets are to be used to bloat the balance sheets in order for the CEO to strut about town with the biggest balance sheet. We believe the Preliminary Specifications timely recognition of capital costs in the commodity price would provide producers with the return of the previously invested cash resources necessary to fund future capital expenditures, dividends and pay down debt. Current producers seem to think that investors enjoy the brilliance of the deployment of their cash in the development of state of the art engineering experiments. We believe oil and gas has not been profitable for four decades as a result of these policy differences, which has created a management culture that is systemic, unchangeable and terminal for the status quo. A culture that knows no difference and is unwilling to accept responsibility. We also believe that the value that oil and gas provides the consumer, the 23,200 man hours of labor per barrel, is significant and ask: why would we ever sell any oil and gas that is unprofitable? How would we justify such actions to future generations? At least if it was profitable then we would know it was not used inappropriately or wasted. Asking if renewable energy, a substantial energy user during its development, had to pay the real cost of oil and gas producers exploration and production would they ever become economic?

The Wall Street Journal wrote about the Chevron write down, Chevron’s CEO Michael Wirth comments.

Chevron Corp. is writing down the value of its assets by more than $10 billion, a concession that in an age of abundant oil and gas some of its holdings won’t be profitable anytime soon.

The com­pany is also un­der­tak­ing a re­struc­tur­ing, go­ing from four global pro­duc­tion units to three. “Com­pa­nies that wait un­til change is forced upon them fail,” Mr. Wirth said in a video sent to em­ploy­ees last week. “We’re not go­ing to let that hap­pen at Chevron.”

We have to make the tough choices to high-grade our portfolio and invest in the highest-return projects in the world we see ahead of us, and that’s a different world than the one that lies behind us.”

This sounds to me to be a capitulation of any responsibility for the past development of sub-grade assets, and the desire to do anything about them! People, Ideas & Objects have argued that our business model provides oil and gas producers with the most profitable means of oil and gas operations. Is this the response to our business model? It also appears to me that Chevron’s CEO is unwilling to take his own advice to make the necessary changes before changes are forced upon Chevron.

I mentioned in our White Paper the analogy that I draw to the bureaucrats in the oil and gas producers. These bureaucrats as Keystone Cops are always running around to the next best thing in oil and gas. Heavy oil, SAGD, unconventional gas, shale… Once everyone jumps on board and the “new” thing is determined to be uneconomic, they all run to the next great thing. “High grading” Chevron’s portfolio is them running down the back alley to the next great thing. The Preliminary Specification looks at the producers portfolio of properties and evaluates them on the basis of a standardized accounting that determines the properties profitability based on all of their actual costs. Revenue, royalty, capital, operations and actual overhead. Then if the property is profitable it will continue to produce, otherwise it will be shut-in where it will incur no profit but also no loss. Enabling the producers to focus on their shut-in properties and innovatively bring them back onto production. While these properties are shut-in they will be leaving their reserves in place for a time in which they can be produced profitably, not adding the incremental losses to the cost of the reserves to be captured in the future, ensuring the producer reaches their highest profitability when only profitable properties are produced and allowing the commodity markets to find their marginal cost. Instead the narrative to refute our logic is that we’ll ignore the assets that aren’t as pristine from an engineering “high-grade” point of view, as they aren’t as entertaining to us? Maybe Chevron’s write down should include those assets they are no longer interested in.

In our White Paper we documented how producers alleged the business model in our Preliminary Specification is collusion. We argued these past years that it’s not, and anyone making independent business decisions to shut-in production based on actual, factual accounting data to determine profitability was not collusion, otherwise we are the new Soviet Union. It’s actually good business and what most industries do that don’t have investors lined up around the block. Those were the good ol days weren’t they? Our argument seems to have permeated the craniums of the bureaucrats and they’ve now come up with the “high grade” reasoning to refute our claim of providing the most profitable means of oil and gas operations.

It’s our argument about their storage of cash in the ground that the producer bureaucrats refuse to listen to. By capitalizing everything for decades they’ve locked the investors cash into the ground until such time as they recognize it as depletion. However, this game has gone on for four decades now and the revenues being generated by these assets are so pale in comparison to what they should be, they’re not generating adequate cash due to the heavily discounted commodity prices producers created for themselves and have been selling their products for. Storing these capital assets on the balance sheet also reflects the amount of the capital subsidy consumers have enjoyed which the producers investors have unwillingly provided. If oil and gas was a business they would begin to treat all properties somewhat the same. If they’re profitable then they’ll produce but oil and gas hasn’t been a business for many decades. It’s been an exercise in destruction, whose purpose is almost complete and will not be resolved constructively or judiciously.

The other aspect of the cash deficiencies these producers are unwilling to accept or listen to is the fact that most of their costs are capitalized. We point out this has become so extreme that the receptionists time, telephone service and Post-it-Notes are all capitalized and left as property, plant and equipment for decades too. This therefore has turned the producers into chronic spending machines wholly dependent on continuous outside funding, until these past few years that is. Their oil and gas revenues have become poor in comparison to what they should be. And whatever is earned is inadequate to cover all of the current costs of the producers as they continue to sink every dollar they find in the ground each month. When you had willing investors lined up down the block and breaking down the door this was not an issue. Now however, the cash drainage each month is epic. Money goes in, and never comes out. Then the search for next months cash begins, and so on. Hence we have the producers stuck in a never ending cash drain of their own making, refusing to admit they have an issue and only refuting the claims that we’ve made in our Preliminary Specification and White Paper. This cash issue will be the terminal factor that they’ve refused to address over the past five years of diminished investor interest. Now with severely deficient working capital, time has become their biggest enemy. Time remaining in which they can keep the doors open.

We recently learned that Houston’s office vacancy rate has hit 26% which represents 60 million vacant square feet. Calgary has over 30% vacancy rate with 15 million vacant square feet. Meaning Houston has more vacant square footage than Calgary has square footage. Nonetheless I’m always called to prove my claim that overhead is in the range of 20% of revenues. No one knows what the overhead is in oil and gas. The question I have, if the producers claimed costs of overhead at 2 to 4%, why would they shut down so much of their head offices? The best they could be saving here is 0.6% to 1.2%. Seems to me to be too much grief and pain being realized for a 1% cost reduction? Maybe bureaucrats find layoffs to be the best part of their job!

This working capital issue is more than just what the operational producers will concern themselves with. During bankruptcy a “client” will always command respect from the justice and the administrators when they have strong cash flow. Oil and gas is a cash flow industry. Until it is realized that the cash flow that is produced is incapable of providing the day-to-day operations of the producer. The administrator will assess these firms on the basis of their cash generating capabilities. Which we have seen in the past 5 years and even in the past 10 years since natural gas collapsed, doesn’t exist. I would argue that the accounting has been suspect since the late 1970’s but then I’m alone with only the facts on that. I leave you with one question: how does an industry, a primary industry at that, become worthless?

Here’s a clue as to where all the value went. This graph from the WSJ’s Lev Borodovsky was included in the White Paper. It accurately captures the attitude in oil and gas. It states when a producer would shut-in a property and it’s breakeven point for a variety of shale properties. (Note, never have I seen a property shut-in for its lack of economic performance. Ever.) Assuming if we could that the shut-in price in this chart is the variable operating costs of the property that were not capitalized. The well breakeven price is a fundamental misunderstanding of what breakeven means. Nonetheless, we’ll take their numbers and assume the amount is the capital and operating costs of the property. Essentially the graph proves that the producers will always produce as long as they were covering off the variable operating costs. Now this is what I said in the White paper that captures the fallacy in this thinking.

What People, Ideas & Objects provide in our Preliminary Specification, if we could assume the accuracy of this graphs numbers, is the point at which the property would be shut-in would be at the breakeven point and below. The reason for this being the production discipline gained through knowing that producing any property unprofitably only dilutes the producers corporate profits. Producing below the breakeven point is the point where unprofitability begins. Producing below the breakeven point for one producer, in an industry who’s commodities are price makers, will have the effect where the price of the commodities will be dropped below the breakeven price for all producers. When all producers continue to produce below the breakeven price for four decades you have an exhaustion of the value from the industry on an annual and wholesale basis. Times were only “good” when investors were willing.

We have also argued the allocation of capital costs to each and every barrel of oil in reserves is inconsistent with the capital investment market. Whether the barrel is produced today, this decade or even this century, we believe this SEC allowed outer limit of what is allowed is unacceptable for each producer to reach each year. Therefore the actual cost of these shale production volumes capital costs would be substantially higher if allocated in a manner consistent with a market economy.

As we look toward the next 25 years in this industry we know we can’t get through this period with the producers that we have today. The legacy of their bloated balance sheets will haunt them from this point forward. Their capital structures are permanently destroyed through decades of not recognizing adequate costs of capital in the products they sold. Now they’ll be forced to compensate for that with revenues and cash flows that are wholly inadequate due to their destruction of commodity prices. They’re incapable of surviving today’s business environment, how bad will it be in just three years? The only way to approach this next phase of oil and gas is through a redefined industry and producer structure. One based on succeeding always and everywhere, where producers are dynamic, innovative, accountable and profitable. Where everyone can depend on the primary industry that oil and gas is to fuel the careers, prosperity and quality of lives that have not been provided in the past 29 out of 34 years. At least I think we’ve had 5 good years. Where the next 25 years capital expenditures demand the $20 to $40 trillion necessary for the next phase of North America’s development, will be sourced from the commodities sales themselves. Investors are saying it won’t be them. This is beginning to almost sound like a plan! And what is the industry’s plan? Much like Chevron’s, ignore the majority of their non-performing properties, they cover the overhead, and look for gleaming, state of the art, engineering projects. After all it’s what they do.

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. 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 Telegram @piobiz or Twitter @piobiz anyone can contact me at 403-200-2302 or email here.