Our Value Proposition, Capital Component
Capital management is a critical component of People, Ideas & Objects' value proposition. Over the next 25 years, the demands on capital are substantial, including achieving profitableƒ energy independence and upgrading infrastructure. Historical reliance on investors for funding consumer energy consumption, a result of past producer policies, anticipates a need for $20 - $40 trillion. This figure exceeds the financial community's capacity and, like past policies, may be unnecessary.
Capital Management Challenges
Capital costs, retired to the income statement over decades, are a luxury few industries could imagine in the 21st century. Turning capital over in a much more efficient way is the method we use in the Preliminary Specification. Capital sitting on today's balance sheets represents cash that has been invested. With the Preliminary Specification, this capital will be priced into the commodity costs and passed to the consumer. We attempt to more accurately match the costs of exploration and production to the reality of the markets. Returning the previously invested cash to be reused, repeatedly, for dividends, future capital expenditures, and bank debt repayments.
The demands of $20 - $40 trillion in capital expenditures over the next 25 years can therefore be sourced through the $1 to $2 trillion sitting on producers' balance sheets today. Iteratively, and repeatedly using the same cash to approach these otherwise impossible capital demands. The remaining $5.7 trillion of our value proposition is attributable to our decentralized production models, price maker strategies, increased revenues, and profits realized by the producers. Establishing the much needed market or production discipline. Our recent publication of the greater than $4 trillion in natural gas revenue losses since 2007 is evident of the issue. Reuters recently stated that an additional $2.6 trillion was available to producers in the next two years. Supporting our value proposition of $25.7 to $45.7 trillion over the course of the next 25 years.
Our calculations support the issues and justification of oil & gas investors suspending their support in 2015. There is no greater message of urgent management attention required than a firm's abandonment by their investors. These signal to management that there are serious issues of concern. And issues in which the officers and directors have done nothing about since the 2015 investors' action. It is these enhanced revenues and profits from the Preliminary Specification that will be the only source of producers' future capital needs.
SEC Regulations and Misinterpretations
People, Ideas & Objects hypothesize that the late 1970s SEC’s Full Cost accounting methodology has caused an overcapitalization in oil & gas. Producer misinterpretation of SEC regulations is evident through the ceiling test, which reads that the Capital Assets of the producer cannot exceed the value of the independently evaluated reserves. This has shifted accounting in the industry from a measurement of performance to a measurement of value and fostered misguided ambitions such as “building balance sheets.” Turning the ceiling test, or maximum limit, into a target for each and every producer to achieve each year.
This leads to the following consequences:
1. Overcapitalization leads to a proportionate amount of overreported profitability.
2. Attracting undue attention from investors who overinvest in an attempt to capture those profits.
3. Leading to an overinvestment in productive capabilities, or unprofitable production as we describe it.
4. Which leads to a subsequent overproduction of commodities which follow the economic principles of price makers.
5. Commodity prices have been chronically depressed during the past four decades.
6. Leading to a number of catastrophic price collapses in both commodities.
The Preliminary Specification decentralized production models' price maker strategy is the only reasonable and fair method in which producers can attain production discipline. Remedying these chronically depressed commodity prices by instituting a means of production discipline across the industry. Unaware that it would be the most competitive producer that carried the lowest capital cost in the form of property, plant, and equipment. Having a reduced carrying amount due to operational efficiency or enhanced profitability by reducing property, plant, and equipment on the balance sheet. Ensuring 100% of their production profile was eligible for profitable production.
There is no requirement in the SEC regulations for a producer to attain the limit of the ceiling test. Just as there is no minimum requirement of what the balance sheet value of property, plant, and equipment needs to be. These bloated balance sheets, once again, lead to an equal amount of overstated profitability on the income statement. The disproportionate nature of capital, in a capital-intensive industry, and its vastly overstated profitability are not lost on the current officers and directors. They have created a perception of performance that is false. One in which accountability through poor ERP systems, where little to no software development was undertaken for three decades. (People, Ideas & Objects' competitors have done stellar work in the face of impossible budgets and working conditions.)
The question then became throughout the 1980s of the philosophical question of what is capital? And therefore large percentages of overhead and interest were then capitalized to property, plant, and equipment. These have continued although as a response to People, Ideas & Objects we have seen a reduction in the percentage amount of interest being capitalized with enhanced reporting regarding its makeup. This however has not been the case with overhead. Which has seen the exact opposite in terms of enhanced accountability. Less is known about the nature of capitalized overhead today than at any time in the past four decades. What we know through experience is that upwards of 85% of all overhead in the industry is capitalized.
The issue with the capitalization of overhead and interest is that these costs are incurred on a monthly basis and are part of the organization. They are a cost of the business and therefore need to be priced into the commodity being passed to the consumer each month. The fact that they’re not eliminates the producers' “cash float.” The cash consumed in these costs is not replenished in the following month when they’re capitalized for 20 years and depleted with other capital over that time. Leaving producers so heavily dependent on outside sources of capital and searching for new cash to cover overhead each month.
Shale Production Economics
People, Ideas & Objects believe a number of unique characteristics of Shale need to be taken into consideration. These include:
1. Higher drilling and completion costs.
2. Shale exposes substantial reserves.
3. Prolific initial production volumes.
4. Steep decline curves within the first 2 years.
5. High rework costs to run additional laterals and/or frac.
The SEC’s theory allocates an equal amount of capital cost to each molecule of proven hydrocarbons. Shale exposes a large reserve base for producers to allocate their costs to. Production from the lateral that extends up to 10 miles can be exhausted in as little as 18 months. Leading to the need for costly reworks to re-frac the original lateral or drill another lateral and frac it. Meanwhile, the 18 months' production only recovered 5% of the recoverable reserves (and capital costs). Up to 50% more costs for the second lateral will be added to the costs of each remaining molecule. Within ten years, what appears to be a commercial, viable technology, will become an expensive and costly endeavor due to the method of collecting capital costs on the property and not recognizing them quickly enough.
People, Ideas & Objects resolves this in two ways. First, by recognizing the high Shale costs of capital over the course of its initial production. Second, by recording any secondary, service work, or rework as an operating cost. In this way, the unnecessary asset bloating will cease. And there will be a return of the cash consumed in the high-cost Shale operation on a much quicker basis. Subsequently, oil & gas will be priced at its actual cost. If it attains profitability it will produce, if not it will be shut-in. Producers and consumers will choose to sell or buy on the price of the commodity that is offered. Its marginal replacement value.
Shale is the key to long-term, profitable, energy independence on the continent. There is an abundance that may last for 50 years or more. Prudent use of these resources would dictate that they be produced and consumed based on the market price so that effective decisions can be made as to their cost and use. There is no more costly oil & gas available than Shale, and as such, Shale will dictate what the price of all oil & gas will be. Industry needs to ask “what is that cost?” Are we to deceive ourselves continuously on the basis of “building balance sheets?” Where any production qualifies as profitable due to the fact it consists of operating costs, royalties, a sliver of overhead, and a small portion of the actual capital consumed in the exploration and production process? Or should we attempt to more accurately match these costs to find a more accurate accounting of what the actual costs are and consider more than just the SEC’s ceiling test?
Today we have the obscene, bloated, and out-of-context capital asset balances of the producer firms. Supported by debt and in many cases negative retained earnings and in some cases negative shareholder equity. These are part of the cookie-cutter financial statements that each producer issues with the only differentiating quality being the size of the production profile. To ascertain which producer is the hero and which is the zero, a reader is unable to come to any conclusion. Homogenized financial statements are the opaque method in which performance and accountability are avoided.
Conclusion
As a consequence of these financial statements and their long-term acceptance, a culture has developed around this method of operation, which is oblivious to any alternative and believes in its own processes. In reality, indiscriminate spending, which is assumed to generate profits, has led to a lack of commercial or competitive differentiation or understanding within the industry. Over four decades, the costs of assets involved in oil & gas have inflated, mirroring the rise in prices. The industry's competitiveness has gradually eroded, leading officers and directors to mistakenly believe in their competitiveness. However, by any standard, the assets are bloated and represent a non-performing cash drain on shareholders and banks. Without the annual infusion of capital from investors, the industry would not be sustainable.
Regarding the secondary service industries, they too have experienced abuse at the hands of producers. Confronted with the boom/bust cycle of an unmanaged industry, producers have cut up to 50% of their field-level activity. Observing the desperation in the service industry, they exploit it by offering work at half their previous prices, thus slashing the service industry's revenues by 75% - a situation that has occurred numerous times in the past.
Recently, producers have sourced cash through the service industry by delaying payments for over 18 months, eroding the faith, trust, and goodwill in producers. Service industry investors, who have seen their equipment scrapped and sold off to unrelated industries to stay afloat, have learned harsh lessons about their role in oil & gas that will take a generation or more to unlearn. Sudden shifts in producers' business models towards clean energy have left them feeling that their interests might lie elsewhere. If producers are committed to clean energy why would they continue investing in oil & gas. I argue that rebuilding the service industry is essential from the producers' perspective. If they were more invested, perhaps they would show more respect for the industry. Therefore, it is believed that any rebuilding of the service industry's capacity and capabilities must be initiated by the producers' philanthropic goodwill. They broke it; hence, they should fix it. Additional capital will need to be generated by producers to provide for these sources of capital.
There are few options for the industry to actively commence the rebuilding of the greater oil & gas economy. Profitability and prosperity were never genuinely earned but rather surreptitiously acquired through inappropriate means. We have argued this point since 2012 and have not seen any change in producer behavior. Change will not occur with the current producer officers and directors, whose culture will resist every step and ultimately prevail. Producers must rely on profitability to source their capital needs. In a capital-intensive industry, the majority of costs passed to the consumer would typically be capital in nature, but this has not been the case either today or at any time in the past four decades. The trust, faith, and goodwill in the producers by the investment community have been destroyed. Only the People, Ideas & Objects Preliminary Specification is structured to rebuild a dynamic, innovative, accountable, and profitable oil & gas producer. Without profitability and a rapid cycle of capital management, the future of the industry remains uncertain. The fact of the matter remains, if officers and directors made the industry profitable, they would have had unlimited resources to do what was necessary.
