These Are Not the Earnings We're Looking For, Part I
I’ve argued that oil and gas is in a state that is in permanent and terminal decline. The way in which I see things is reinforced by the fourth quarter reports of the 23 producers that we follow. I think now is the time to act by making the decision to build and implement the Preliminary Specification and therefore I will be making my case here in this series of blog posts. The first issue we’ll be discussing is the capitalization policies of the producers.
Until recently it was the size of the asset values of the producer firm that was the basis of success in the industry. CEO’s would brag about the growth of their assets and maintaining a “strong balance sheet” based on the large volumes of property, plant and equipment. Cash flow from these investments enabled them to pay the overhead and interest and there was an ever expanding pool of investors that were able to provide future capital to spend to maintain and grow the producers deliverability. Over time producers learned that what was included in property, plant and equipment were large percentages of those interest charges, overhead costs of the accounting and administration of the firm, including the receptionists time, phone service and Post-It-Notes. Few of the producers costs don’t end up in the property, plant and equipment account. Which has been the way of the industry for the past four decades. It is culturally ingrained with the leadership and management and that is the way it is done.
Oil and gas is a capital intensive industry. Therefore the largest cost incurred are the costs of drilling, completion and equipping. Our argument is that recognition of these costs in a timely fashion would be in the best interest of the dynamic, innovative, accountable and profitable oil and gas producer. They would seek to outperform their competitors by recognizing their capital costs as quickly as possible. Converting their property, plant and equipment investments back into cash via increased cash flow that would fund further investments, pay down debt and issue dividends to their shareholders. This assumes they were operating a commercial enterprise that was generating the revenues necessary to cover their costs. The current environment has their capitalization policies leading to high asset values and large profits. Over the past four decades these large profits have attracted overinvestment in the industry, increased the deliverability of the industry and collapsed the oil and gas commodity prices. In reality though, what was believed to be high asset values and large profits were just accounting magic that deceived the producers, industry and investors into believing that value was being generated. When in fact, as a result of these policies, the industry was using the capital generated from new investors each year to subsidize consumers for their consumption of energy. The amount of the subsidy accurately captured on the producers property, plant and equipment balance on their balance sheet. This activity has been able to continue for the past four decades due to the highly distorted policies of capitalization by the producers. This accounting game has now become obvious to the oil and gas investors who are unsatisfied with the performance and are actively withholding their participation in the industry.
The second element of this overcapitalization anomaly is the speed in which these assets are depleted. Currently producers allocate the costs of exploration and production across their known reserves. Therefore only a small percentage of the firm’s property, plant and equipment are recognized as costs in the current year. From an accounting basis this may make sense from a purely theoretical point of view. From a 21st century, high performing organization point of view it doesn't make any sense to be deferring the recognition of your capital costs to as much as 27.79 years as Cenovus has done in the second quarter of 2017. The demands for capital in the capital marketplace, and the performance of the firms that are successful in the 21st century are not provided with such luxuries. If the investors knew that they were being deceived by the accounting magic being discussed here, they would have withdrawn their investments far earlier.
When this overinvestment through chronic annual share distributions created overcapacity. The commodity prices were not going to be adequate to cover the real costs of oil and gas exploration and production. The deferral of the recognition of these costs into several decades therefore caused the producers to destroy value in the industry. The industry today has been hollowed out of its value and is incapable of providing, building or sustaining value. The subsidy to the consumers has quietly and effectively reduced the industry to the point where it demands a subsidy of several billion dollars each and every year to continue just to function. There is no residual value left anywhere. What the producers have done is they have listed on their balance sheets in the property, plant and equipment account the capital costs of past production. It has been easy to manage a firm on this basis. Now with bloated balances throughout the industry, the tough part begins. The recognition of the past productions capital will be difficult for producers to deal with and account for.
Bureaucrats will claim these are just accounting charges. They do not affect the cash flow of the producer. Ok, we’ve heard that before and they have the accounting mechanics correct. What they’re essentially saying is keep the spending machine going. Let them issue more stock and continue spending that to “build” the organization. What they never want to do at any point in time it seems, is account for that money that they keep spending and recording in property, plant and equipment. It’s a great game until the investors get wise to it. I truly don’t see where the producers go from here. Oil and gas has not been a commercial operation for the past four decades. This spending machine is becoming more obvious to more people every day. As that is what it is, a spending machine, nothing more.
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 America’s energy independence. People, Ideas & Objects Revenue Model specifies the means in which investors can participate in our future Initial Coin Offering (ICO) that will fund these user defined software developments. It is through the process of issuing our ICO that we are leading the way in which creative destruction can be implemented within the oil and gas industry. 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 403-200-2302 or email here.
Until recently it was the size of the asset values of the producer firm that was the basis of success in the industry. CEO’s would brag about the growth of their assets and maintaining a “strong balance sheet” based on the large volumes of property, plant and equipment. Cash flow from these investments enabled them to pay the overhead and interest and there was an ever expanding pool of investors that were able to provide future capital to spend to maintain and grow the producers deliverability. Over time producers learned that what was included in property, plant and equipment were large percentages of those interest charges, overhead costs of the accounting and administration of the firm, including the receptionists time, phone service and Post-It-Notes. Few of the producers costs don’t end up in the property, plant and equipment account. Which has been the way of the industry for the past four decades. It is culturally ingrained with the leadership and management and that is the way it is done.
Oil and gas is a capital intensive industry. Therefore the largest cost incurred are the costs of drilling, completion and equipping. Our argument is that recognition of these costs in a timely fashion would be in the best interest of the dynamic, innovative, accountable and profitable oil and gas producer. They would seek to outperform their competitors by recognizing their capital costs as quickly as possible. Converting their property, plant and equipment investments back into cash via increased cash flow that would fund further investments, pay down debt and issue dividends to their shareholders. This assumes they were operating a commercial enterprise that was generating the revenues necessary to cover their costs. The current environment has their capitalization policies leading to high asset values and large profits. Over the past four decades these large profits have attracted overinvestment in the industry, increased the deliverability of the industry and collapsed the oil and gas commodity prices. In reality though, what was believed to be high asset values and large profits were just accounting magic that deceived the producers, industry and investors into believing that value was being generated. When in fact, as a result of these policies, the industry was using the capital generated from new investors each year to subsidize consumers for their consumption of energy. The amount of the subsidy accurately captured on the producers property, plant and equipment balance on their balance sheet. This activity has been able to continue for the past four decades due to the highly distorted policies of capitalization by the producers. This accounting game has now become obvious to the oil and gas investors who are unsatisfied with the performance and are actively withholding their participation in the industry.
The second element of this overcapitalization anomaly is the speed in which these assets are depleted. Currently producers allocate the costs of exploration and production across their known reserves. Therefore only a small percentage of the firm’s property, plant and equipment are recognized as costs in the current year. From an accounting basis this may make sense from a purely theoretical point of view. From a 21st century, high performing organization point of view it doesn't make any sense to be deferring the recognition of your capital costs to as much as 27.79 years as Cenovus has done in the second quarter of 2017. The demands for capital in the capital marketplace, and the performance of the firms that are successful in the 21st century are not provided with such luxuries. If the investors knew that they were being deceived by the accounting magic being discussed here, they would have withdrawn their investments far earlier.
When this overinvestment through chronic annual share distributions created overcapacity. The commodity prices were not going to be adequate to cover the real costs of oil and gas exploration and production. The deferral of the recognition of these costs into several decades therefore caused the producers to destroy value in the industry. The industry today has been hollowed out of its value and is incapable of providing, building or sustaining value. The subsidy to the consumers has quietly and effectively reduced the industry to the point where it demands a subsidy of several billion dollars each and every year to continue just to function. There is no residual value left anywhere. What the producers have done is they have listed on their balance sheets in the property, plant and equipment account the capital costs of past production. It has been easy to manage a firm on this basis. Now with bloated balances throughout the industry, the tough part begins. The recognition of the past productions capital will be difficult for producers to deal with and account for.
Bureaucrats will claim these are just accounting charges. They do not affect the cash flow of the producer. Ok, we’ve heard that before and they have the accounting mechanics correct. What they’re essentially saying is keep the spending machine going. Let them issue more stock and continue spending that to “build” the organization. What they never want to do at any point in time it seems, is account for that money that they keep spending and recording in property, plant and equipment. It’s a great game until the investors get wise to it. I truly don’t see where the producers go from here. Oil and gas has not been a commercial operation for the past four decades. This spending machine is becoming more obvious to more people every day. As that is what it is, a spending machine, nothing more.
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 America’s energy independence. People, Ideas & Objects Revenue Model specifies the means in which investors can participate in our future Initial Coin Offering (ICO) that will fund these user defined software developments. It is through the process of issuing our ICO that we are leading the way in which creative destruction can be implemented within the oil and gas industry. 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 403-200-2302 or email here.
