"That Jarring Gong," Part XV
A Reasonable Hypothesis
One of People, Ideas & Objects’ basic hypotheses is that the oil and gas industry has not built value since the late 1970s. Instead, it has been incinerating capital on an unimaginable scale. Without annual share issuances through the ongoing support of the investment community, the capital built in the industry prior to the 1980s was exhausted. This forced producers to source fresh capital to maintain their organizations as going concerns. Our hypothesis is derived from the 1986 oil price crash, which made the situation more difficult and seemed to culturally separate commodity pricing from decision-making. Capital was sourced and spent on whatever was the most attractive catchphrase to Wall Street at the time. Our hypothesis was confirmed through repeated oil and gas commodity price collapses that were highly destructive and largely ignored by the current crop of producer officers and directors. Even without the repeated price collapses due to chronic overproduction, or unprofitable production as we describe it, overproduction continues to erode oil and gas prices. Officers and directors fundamentally believe they are price takers, where commercial operations are obtained by making it up on volume.
We argue that the industry has become a spending machine, learning through specious accounting methods that spending money is profitable. Performance, therefore, is measured by the capacity and capability to spend money, as all money spent is considered profitable according to audited financial statements. Capitalizing almost every cost incurred by the producer creates overcapitalization, which is only equaled by the volume of overreported profitability. Despite what the results or performance of the property may be. This circular relationship is designed to, as officers and directors claim, “build balance sheets” and “put cash in the ground.”
Our hypothesis also suggested that once the accounting magic was discovered for what it was, investors would become wise to the producers’ eventual fate. Producers would and have become hollowed out, poorly performing, and capital dependent. Today, producer firms are leaderless and lost. They lack a basic understanding of business and are unable to function as businesses. Declaring shale uncommercial, they exited the industry, taking oil and gas revenues to fund clean energy investments with them. Meanwhile, they allowed others to maximize profits by developing the significant global LNG marketplace, leaving the domestic market to producers.
Locked out of the global LNG market, producers are now relegated to domestic prices subject to frequent price collapses. They failed to realize they couldn't take oil and gas revenues with them to fund clean energy investments, proving their lack of commitment to oil and gas. Abandoning shale as uncommercial shows they admit failure, and lack the understanding necessary to implement the appropriate remedial efforts. Their complacency allows significant oil & gas business opportunities to be easily missed in a preoccupation with unrelated clean energy technologies and unrelated industries of which they hold no competitive advantage.
Producer financial statements’ reliability and the officers and directors’ business capabilities became issues for investors in 2015, leading to their suspension of further support for producers' capital structures. This situation should have concentrated producers' efforts on remediating investor concerns. A decade later, nothing has been done, leading to chronic cash and working capital shortfalls, an embarrassment to all of them. Media and politicians claim producers are earning record profits and hoarding cash, yet critical analysis shows minimal working capital is unable to support a capital-intensive industry. Producers' capital expenditures budgets are only considered funded by including 100% of their lines of credit.
After decades of believing that spending was profitable, there was no performance or competitive criteria to eliminate weak players. The homogenization of producers’ performance has dropped to about 25% of what commercial enterprises need to attain.
When working capital is an issue in a primary industry whose commodities are price makers, a phenomenon unique to the business world. The damage caused to the trust, faith, and goodwill by the oil and gas producers towards the service industry is significant. Producers conducted operations with accounts payable being paid in 18 months, slashed activity levels, and demanded huge discounts, cutting service industry revenues by 75%. COVID-19 exacerbated these difficulties, forcing the service industry to cut up equipment for scrap and sell horsepower to other industries. Now operating at 30% of prior capacity, the service industry is declining rapidly due to equipment retirements and fleet cannibalization. Producers will need to rebuild capacities and capabilities on a direct, philanthropic basis to regain the service industry's trust and respect.
Winston Churchill
When the situation was manageable it was neglected, and now that it is thoroughly out of hand we apply too late the remedies which then might have effected a cure. There is nothing new in the story. It is as old as the sibylline books. It falls into that long, dismal catalogue of the fruitlessness of experience and the confirmed unteachability of mankind. Want of foresight, unwillingness to act when action would be simple and effective, lack of clear thinking, confusion of counsel until the emergency comes, until self-preservation strikes its jarring gong—these are the features which constitute the endless repetition of history." (Martin Gilbert, Winston S. : The Prophet of Truth, 1922-1939 (Volume V) (Winston S. Churchill))
The last point of our hypothesis aligns perfectly with Churchill's sentiment and is the "Jarring Gong" everyone must wake up to. This is evident in the EIA’s "Monthly U.S. Dry Shale Natural Gas Production by Formation" graph. Notice anything significant?
For the past year, I have speculated about the turning of the natural gas basins, and there is now undeniable evidence that they have indeed turned. How will this be remedied? Clean energy, consolidation, or perhaps a board meeting? Let's not confuse ourselves with the obvious facts that support this.
- Shale is the greatest endowment of riches known to man. We are fortunate to have them and therefore secure, reliable, profitable and affordable energy for all of North America is attainable, at a minimum, for at least the remainder of this century. Of which we’ll need.
- The level of incompetence required to destroy an industry while producing these resources is staggering. Officers and directors are 100% responsible, should have been accountable, and had the resources to address the issues and opportunities they face. However, they did nothing but “muddle through.”
- A solution in the form of the People, Ideas & Objects Preliminary Specification has been available since August 2012 to tackle these specific issues.
- Chronic and systemic overproduction of natural gas continues and will continue.
- Natural gas prices are producing unprofitable production, therefore it is overproduction.
- Shutting in of any natural gas production announced by producers in March 2024 was effective however temporary. Prices have resumed their declines.
- Of the 12 shale basins, 6 have turned.
- Marcellus on 12/2021, Down 5.7% as of 5/2024
- Utica on 12/2019, Down 53% as of 5/2024
- Barnett on 11/2011, Down 66% as of 5/2024
- Fayetteville 11/2012, Down 84% as of 5/2024
- Mississippi 10/2022, Down 16% as of 5/2024
- Rest of U.S. 10/2012, Down 57% as of 5/2024
- Reversing this trend to previous growth levels will not be achieved by merely returning to 100% field-level capacities and capabilities. It may require over 200% of the prior capacity to grow production deliverability and overcome these basin's decline.
- Where will these resources be sourced for these capacities?
- Who will be motivated to sacrifice their capital in the manner expected by current officers and directors past actions.
- How will those field hands who’ve now moved on to other careers in other industries be motivated to return. It may require more than one big paycheck.
The Producers Logistics
I estimate it takes a minimum of seven years to transform a concept to a producing oil and gas property. Investopedia quotes a study indicating that the period from discovery to production is 5.5 years, which aligns closely with my estimate. Since investors stopped supporting producers in 2015, capital, working capital, and cash have significantly diminished. Alternative sources were found to meet their needs, but these have now dwindled. Despite my attempts to convince producers that the Preliminary Specification would generate substantial profits and provide all the cash they need, they resist due to concerns about their personal career security. Nonetheless, in times like these, focusing on internal cost-cutting is the obvious strategy.
The oil and gas industry, being capital-intensive and reliant on external capital for all its costs, has been performing at just 25% of a commercial operation threshold. Having lost investor support they’ve now exhausted their seven years of work in progress, producers now lack the field capacities and capabilities to drill more than 30% of prior growth levels. It's as if old Mother Hubbard went to the cupboard to feed her children and found that the kitchen had been taken in last night's tornado.
Given the seven-year timeline for this process and their limited understanding of business, cutting costs in the initial stages would be prudent. Starting in the first year of difficulties, it would be most effective to cut costs incurred in the first year, hoping to reclaim resources once business returns to normal. If this proves insufficient, cut costs in the second year, and so on. This approach allows the process to continue for another seven years from the onset of difficulties, with the expectation that normal business operations will eventually resume, preventing permanent loss.
Prior growth level capabilities may be woefully inadequate. The shale characteristic of steep decline curves becomes critical when a basin cannot maintain the necessary level of activity to sustain and grow deliverability. Shale offers immense wealth, but with conditions, and the steep decline curve has always been known. Officers and directors may not have understood the business principles behind managing a diminishing resource. If they did, they would not have ignored their investors' concerns for nearly a decade. It's as they say, math is hard. During this period, officers and directors were proudly parading their "biggest, most beautiful, and well-built balance sheets" down main street.
Conclusion
The actions and behaviors of the past few decades suggest that officers and directors will only make a sustained effort to turn the industry around once they fully understand the consequences of their actions. While some may cynically believe their commitment would last mere days, I would wager it might extend to a few weeks. Their best opportunities will lie in finding new sources of cash from areas unfamiliar with their past antics. The media and governments, which the latter have significant financial resources, could be prime targets.
Producers have signaled to their investors that profits are not a priority. Their inaction implies a lack of concern for both the oil and gas business and investor interests. Allowing the industry to be destroyed to prove their point. This attitude suggests that they are uninterested in the future, which holds unlimited potential for everyone except the officers and directors. Their lack of motivation I would suggest is due to the fact they control the oil and gas revenues. It will become increasingly difficult for them to explain to their investors why this limitless future is of no interest to them.
Blaming the declining productivity issue on the government might be a strategic move, especially with the media support producers currently enjoy. However, this strategy could backfire if the truth about these outcomes from producers' past actions becomes public knowledge. A more hostile environment could emerge if it is revealed that producers have been misleading the American people. I would not want to be around when the public turns against these officers and directors.
What we’ve heard before is a long litany of excuses, blaming, and viable scapegoats as to why producers could not do this or that. Most of these excuses did not pass for basic common sense, such as “waiting for a cold winter,” or were outright mistruths, like “shutting in production will damage the formation.” The creativity in generating these excuses has been impressive, and there seems to be no diminished capacity in this regard. The expectation might now be to "drill baby drill," which contradicts the arguments that have stymied them in the past. Who will they blame then? The service industry, investors, or anyone else they desperately need to depend upon?
As a former auditor, I have a propensity to want to kick dead horses to see if they are, in fact, dead. Therefore, let’s review: Producer officers and directors will need to undertake a significant effort with no capital or support, no ability to earn money and no money on hand, no internal capabilities to conduct operations, and a reputation in the recruiting industry where no one is generally interested in them when exciting opportunities abound elsewhere. They lack field-level capabilities to conduct any operations from operators that would trust, believe, have faith, or goodwill even if the check was certified. Lastly, they have no organizational capability to do things in a way that doesn’t just cause more damage and destruction. Yea, this horse is dead.