In our previous post, we discussed how the capital component of producers' break-even calculations has been stretched far beyond what is commercially viable. The industry's cultural acceptance of selling oil and gas at a loss, which was initially perceived as inconsequential, has been exacerbated by a prolonged failure to address chronic losses. This inaction has effectively turned many of these businesses into failed enterprises, with decades of operating at a loss pushing industry break-even costs into triple-digit territory.
Despite the period of producer consolidation, we have not seen the asset rationalization that would typically follow such a large-scale event. This may be due to "indigestion" among large producers, a lack of available capital, or a general disinterest in oil and gas and alternative investment industries. The poor reputation and track record of officers and directors—who are known to be unresponsive and unprofitable—have compounded the problem, pushing these firms past the point of easy remediation.
We begin by reviewing a graph from @SoberLook, which shows the general industry consensus on break-even costs (though six years old, the chart remains relevant). The conventional, yet flawed, assumption is that a well will break even at any price. The point at which a well would theoretically be shut in is only when operating costs are no longer covered. The critical oversight is this: selling below the actual break-even price leaves unrecovered capital costs, or property losses, that must be added back to the reserves' cost, which, in turn, recalculates and raises the true break-even price.
We must address two core issues: the overproduction process and the systemic impact of chronic overproduction on industry-wide value destruction.- When producers over-report asset values, they equally overstate profits. This excess profitability attracts unwarranted investor interest, leading to over-investment in production capacity. As the overproduction of a commodity subject to the economics of a price maker occurs, the commodity's price inevitably decreases.
- Price Maker Characteristics:
- No suitable substitutes exist.
- Small changes in supply or demand disproportionately impact the price.
- Producers only increase production when it is profitable.
The consequences of this cycle are clear:- Short-term overproduction by a single producer drops the price below the break-even point.
- Decades of industry-wide overproduction summarily consumes the comprehensive value of the entire sector.
Ignoring these issues only worsens the outlook for producers. Incorporating past losses into break-even calculations increases the required price to recoup what was invested or lost, which is not a viable business model. For example, if a producer operated for a decade at $50 when the required break-even was $55, their current break-even price could be $125. Going forward, each barrel produced has a negative contribution margin of $75, adding an incremental $75 loss to the cost of those reserves. Simultaneously increasing the cost of those reserves and reducing the number of production volumes available to retire them. This is an untenable downward spiral that explains the crisis facing "consolidated" producers.
Producers will argue they can deal with this by increasing the proven reserves by drilling a second lateral. Which is true. However, that will also put up to $10 million more for the property to recover. Here we invoke the hamster wheel analogy. Otherwise producers current strategy for managing this appears to be twofold: consistent denial of any financial difficulty and attacking the messenger. Both are tried and tested but have likely lost their effectiveness. The most prudent step is to cut the loss by disposing of the property. The question then becomes: what price is the market willing to bear?
While this may seem like an accounting issue, it is primarily an economic one. The reality is that the industry's performance is well below what a commercial operation requires. The producer will never recover the "cash they put in the ground" and is merely contributing more value to a losing cause. Activity for the sake of activity is not a valid business model, and these producers' competitive performance is only at 30%–40% of a commercially viable threshold.
The "smart money" is aware of the situation. Waiting for investors to return after observing the producers' failed strategies has proven fruitless. In fact, provoking investors to leave, and then leaving the situation unaddressed for a decade, is a serious tragedy that proved officers and directors were the root cause of the problem.
Reset the Break-Even Calculation
Traditionally, oil and gas properties are valued based on futures market commodity prices multiplied by reserves estimates at that price. Estimated operating costs are provided by an engineering firm, and the discounted present value is risked. This method, however, assumes an altruistic perspective on property valuation.
The performance-related question is what the true break-even number is for both the buyer and the seller. People, Ideas & Objects suggests this is the better way to evaluate today's oil and gas property. Would an appropriate offer to balance these differences be 30%–40% or lower of the traditional assessment? When can profitability, from a "real" financial point of view, actually be achieved? How can a purchaser compete on North American capital markets if 100% of the property's capital costs are realized in just 30 months?
The seller is financially crippled by their property. Their break-even price continues to expand, meaning they cannot and will not ever make money from it, eventually extinguishing all the value invested and generated in finding and developing the reserves and eventually leaching over to other property break even calculations. A sale stops the financial hemorrhaging; the incurred loss is relieved, which is as good as a profit in reality. It assures the seller of receiving up to 30% of the value that would otherwise be consumed by ongoing operations. The key is determining the value they are willing to accept.
Other working interest owners in the Joint Operating Committee may have the right to intervene and purchase the property, or they may face the same cost behavior and also want to sell. The outcome is uncertain. The costs to own the property can no longer be supported by any economic model at the current values held by the original owners. They often claim, as is common in oil and gas, that capital is a sunk cost. It is precisely this flawed thinking that created their current predicament.
For the purchaser, taking on the financial loss relieves the seller of their pain. The offer, which makes the seller free and clear, must also provide the purchaser with an opportunity for profitability. Oil and gas producers must establish a culture that is dynamic, innovative, accountable, and profitable. Adoption of the Preliminary Specification is assumed, and a plan for establishing those profitable operations should be in place. Working with the Joint Operating Committee may be an impediment, so approach those firms and make an offer to them as well. If the plan is not accepted, adjust the purchase price or walk away. Overpaying for assets is the most direct path to failure, and while it may take longer, those large balance sheets do eventually face tragic consequences.
