These Are Not the Leaders We're Looking For, Part VI
Bloomberg’s Javier Blas wrote in an article on Thursday March 7, 2024, entitled “When the Fix for Lower Commodity Prices Isn't Low Prices.” He discusses how low nickel and natural gas prices are no longer affected by this principle, due to some fundamental changes in the costs' makeup in those markets. It’s an interesting read for the changes that have occurred in the nickel market. I would argue that the assumptions he’s operating under in natural gas are skewed by producers' specious financial statements, financial statements that appear accurate on the surface but are misleading or deceptive upon closer inspection, and their propensity to say whatever comes to mind in their press releases.
Shale has brought about a new era in oil & gas. An era of abundance that is the polar opposite of the scarcity era that preceded it. Although producers had developed behaviors of overbuilding capacities and capabilities in the scarcity era, and did not make any changes to their underlying business if prices of oil & gas were too low to command a profit. Doing so by continuing to produce at 100% of their production profile. Shale gas has worsened the situation, distorting the pricing structure significantly. Years of deliberate action will be required to rehabilitate the oil & gas commodity markets.
First, a quick 101 in commodity economics. The theory says that low prices force producers to reduce investment, curbing supply; they also incentive consumers to use more stuff, perhaps in new applications, lifting demand. Over time, both forces rebalance the market bringing prices to their so called mean reversion, aka, the average. But that stylized supply and supply-and-demand model assumes a fixed environment that doesn’t consider technological changes.
Javier Blas' argument is the one that producers have argued for decades. It is a product of “muddle through” and their belief that cutting capital expenditures will ultimately remedy low prices. People, Ideas & Objects has repeatedly put across its point of view regarding 'muddle through.' The cutting of industry capabilities and capacities does nothing but:
- Aggravate and accentuate the boom / bust cycle within the industry.
- It destroys the field service industry, forcing it to bear the consequences of producer capital cuts.
- Willingly destroys producers reserves while years pass for the productive capacity to either recede or market demand to increase.
- Is a dull, blunt instrument that commands no effort or work on the behalf of officers and directors outside of issuing a press release or two.
- Officers and directors continue to be rewarded with the revenues from a primary industry.
People, Ideas & Objects Preliminary Specification enables producers to shut-in any unprofitable production within the current month. Immediately dealing with the oversupply of the commodity. These specialized financial statements, designed by People, Ideas & Objects, offer a detailed and factual account of each oil & gas property's profitability, unlike traditional ERP systems. Determining the actual profitability of the property based on actual, factual, objective and standard accounting information. The ability of a producer to determine where and how they earn their profits is unknown and unknowable in any current ERP system in the oil & gas marketplace. What they shut-in would be hit and miss as to be a losing property or one that was contributing to the bottom line. From Bloomberg.
Second, on March 4, EQT Corp., the largest US natural gas producer, said it was cutting its output by about 6% this quarter after US gas prices fell close to a 25 year low.
And please note how common place shutting in natural gas production has suddenly become.
Therefore, we are concerned that the desire of producers to finally shut-in production misses the point. They will continue to lose money on the basis their overheads are fixed, not variable as we’ve proposed in the Preliminary Specification. Although we appreciate oil & gas officers and directors' acceptance of our argument of the need to shut-in overproduction. What they're doing is inadequate without the Preliminary Specification to provide the data and information, but more importantly, to guide them to where they make their money and how. How to deal with any loss and to tune their organizations. For an industry that has a culture that has developed on the basis of “making money,” “building balance sheets” and “putting cash in the ground” by spending other people’s money. A transition to a much more sophisticated understanding of their operation must be undertaken. Merely spending money does not equate to profitability.
In discussing the recent history regarding shale’s build out. Javier Blas emphasizes the industry talking points about the costs of natural gas production dropping from shale’s discovery and development.
The result was a staggering increase in production, making the US the biggest exporter of liquified natural gas last year. Over time, the process has become cheaper and cheaper, lowering overall costs. Despite years of low prices, US gas output has nearly doubled since 2010.
I believe he’s implying that even with low prices, money was made to expand the throughput through shale gas development. He, like the producers investors, may have been deceived by producers' specious financial statements reflecting profitability during this period. Spending money is not profitable.
Shale gas has four characteristics that make it unique and support the abundance era. It is substantially more costly to drill and complete, exposes prolific petroleum reserves, it achieves high deliverability and incurs early and steep decline curves. Some of these are considered in the prior quote. However, the need to spend substantial amounts of money within a few years is necessary in order to maintain the high deliverability. This can involve incremental fracing on the initial leg, drilling a second leg and fracing or other work. Higher expenses of shale compared to conventional wells generate these costs.
With the SEC’s Full Cost accounting treatment these costs are allocated equally to each molecule of proven reserves discovered. Shale is prolific for the reasonable size of its pay, however it also extends from Pennsylvania to Ohio through to New York for the Marcellus formation. The aerial extent of these reserves formations are defined by the number of states that access them. Allocating the extensive costs of drilling and completion to this level of reserves makes the capital costs appear miniscule in comparison to conventional drilling. However, the steep decline curve reflects that those reserves will not be accessible without incremental, costly and repeated reworks. These costs will be added to the initial costs on each of the remaining reserves molecules. This skews the producers capital cost per barrel of oil equivalent to the largely irrelevant stage of commercial operations. Over time what we see is that the property eventually becomes too expensive to produce as the reserves decline and the remaining capital costs are too large to produce commercially. Therefore it is abandoned and the reserves and their costs are left stranded, leaving officers and directors shrugging their shoulders. There may even be times when they realize that shale will never be commercially viable and move on to greener pastures!
Producers claiming to be 'innovative' and 'profitable' quote these capital costs. We’ve seen two phenomena regarding the cost characteristics of producer firms that we’ve never thought would happen, and have not seen in any other industry. When commodity prices were declining producer press releases were stating the firm could then produce at ten dollars less cost than previously quoted. This went through several increments from $70 / bbl to almost $30 / bbl and supported their claim of profitability first and foremost, but also their innovativeness. How does a firm whose capital costs were incurred in prior periods suddenly reduce the capital costs by such substantial margins? Are there innovations in historical accounting that I am unfamiliar with? Simply these are what are called in the industry recycle costs. Capital costs refer to the initial expenses to drill and complete wells, while recycle costs represent the hypothetical current costs to drill anew, often used by companies to suggest lower capital expenditures during periods of reduced service industry prices. When a large producer doesn’t increase their well count by much more than 5% per year, that 5% is not going to have a material impact on the historical accounting costs of the past 95%. Producers are stating that if they wanted to they can drill and complete a shale well for less than before.
I personally gripe about how an industry can claim to be innovative when it has done nothing but seek and destroy. It's the service industry that conducts the innovation in oil & gas. Those with their hands on the problem. And to argue after 33 years of doing nothing about their poor accountability and systems. I can suggest that their only innovation was of the type that Bernie Madoff was envious of.
In most cases where companies are announcing they’re shutting-in production. I’d be concerned they would see their choice is to shut-in their conventional production and keep the shale producing. The exact opposite of what an analysis of profitable properties would be telling them to do. Conventional, it would be assumed, are older with much lower capital costs and the time passed in which to have depleted those capital costs, and therefore would have no remaining capital cost balances to deplete. Therefore being amongst the highest in terms of the profitability for the firm. The difficulty for the producer is conventional oil & gas poses less interesting scientific and engineering issues.
New entrants into the oil & gas industry will be unable to compete at anything other than the highest of costs. Figuring out new and innovative ways to bring their production on line profitably is the challenge. Therefore the fallacy of high prices cures high prices is incorrect as the assumption that low cost production will be brought on to the market is false. All the low cost production in the Preliminary Specifications price maker strategy produces 100% of the time. All the affordable reserves were produced long ago.
From the consumer point of view, the consumption of energy may decline however that has not been proven the case. The inherent cost of oil & gas production has less and less to do with the cost of oil & gas production and much more to do with the utilities “costs” and government taxes that are conveniently attached. When the consumers value proposition from oil & gas is 10 to 25 thousand man hours of mechanical labor, consumers may begin to believe that it is their most precious resource and have some appreciation for it. When it's cheaper than bottled water, no wonder they think it's of little value.
Officers and directors have had ample opportunity to address the pressing issues within the oil and gas industry. Yet, despite the innovative solution proposed by People, Ideas & Objects — one tailored to the industry's unique challenges and fully fleshed out conceptually — they have failed to act. They have failed to meet the most basic expectations of them. Investors have withheld further support for nearly a decade, underscoring the lack of progress. The staggering loss of $4 trillion in natural gas revenues from 2007 to the end of 2023 starkly illustrates the consequences of this inaction. Such a profound failure not only underscores the inefficacy of the current leadership but also disqualifies these officers and directors from continuing their roles. The time for change is now. These leaders have overstayed their welcome, proving that the cost of their continued tenure is too great a burden for the industry to bear. For the sake of the industry's future, it is imperative that we usher in a new era of leadership, one that is willing to embrace innovative solutions and drive meaningful progress.