Free Cash Flow Says Little About the Future of Shale

The independent companies at the forefront of the U.S. shale boom will finally earn enough from selling oil and gas to cover their capital expenditures next year, for the first time since 2008.

Free cash flow, which measures operating cash flow minus capital spending, for the 25 leading independent oil and gas producers is expected to show a surplus of $2.4 billion in 2015, according to a consensus forecast in the Financial Times.

That compares with a shortfall of around $9 billion in 2013 and $32 billion in 2012. ("Shale oil and gas producers' finances lift growth hopes" FT, Aug 27)

During the years of negative free cash flow, independents relied on equity issues, borrowing and asset sales to sustain their drilling programmes. That led some analysts to conclude the shale boom was unsustainable or even liken it to a Ponzi scheme, which will collapse when fresh capital inflows cease.

"It is not clear that the U.S. independents are profitable," Steven Kopits, managing director of Princeton Energy Advisers, wrote recently for Platts. "An industry can see a boom irrespective of profits or free cash flow if banks and investors are willing to underwrite the promises of future profits. The Internet bubble showed us that" ("Hamilton has it right on oil" July 30).

"What is not clear (is whether) the industry (both large players and independents) can run a cash-flow positive business in both top-quality and in more marginal plays and whether the positive cash flow could be maintained when the industry scales up its operations," Ivan Sandrea wrote in another sceptical piece for the Oxford Institute of Energy Studies. ("U.S. shale gas and tight oil industry performance" March 2014)

Annual capital expenditures associated with shale oil and gas plays surged to $80 billion in 2013 from just $5 billion in 2006, according to Sandrea.

Capex outstripped operating cash flow, resulting in large negative free cash flow, as shown by a chart from hedge fund Astenbeck Capital. (http://blogs.platts.com/wp-content/uploads/2014/07/Cash-Flow.jpg)

For doubters, the forecast of a small surplus in 2015, after deficits more than 20 times that amount between 2009 and 2013, does not dispel concerns about the long-term sustainability of the business model.

Concerns about financial viability merge with older worries about the shale boom's physical sustainability. Sceptics worry the industry will have to drill an ever increasing number of new wells just to offset the declining output from existing holes. The problem has been likened to Lewis Carroll's "Red Queen's Race", where "it takes all the running you can do, to keep in the same place".

It is a problem common to all oil and gas fields. Eminent U.S. geologist Carl Beal worried about it as long ago as 1919. But sceptics claim the problem is especially serious for shale plays given the rapid decline rates on most shale wells.

Misleading Aggregates
The problem with all these analyses is that they conflate shale oil and shale gas production. The conflation is understandable: all wells, whether in conventional or shale plays, produce a mixture of oil, gas and natural gas liquids in varying proportions, which are then marketed. Even an oil company specialising in drilling oil wells will probably be selling some gas, and vice versa.

For regulatory and tax purposes, companies must identify which holes are predominantly gas wells and which ones are oil wells. But the truth is that all wells produce a range of hydrocarbons.

It is impossible accurately to identify free cash flow attributable to gas production from free cash flow attributable to oil.

For this reason, most analysis focuses on aggregate cash flows from all independent oil and gas producers, irrespective of whether they are producing gas, oil or in most cases, a mix of both.

The problem is that the economics of shale gas and shale oil wells have differed sharply since 2011, as oil and gas prices have diverged.

The performance of many shale gas plays has been dire, while the performance of oil plays has been much brighter. Even in the gas industry, loss-making dry-gas operations are being conflated with the healthier performance of wet-gas plays, which produce a mix of methane and more highly valued ethane, propane and butane.

Aggregate statistics about cash flows and capital expenditures provide almost no useful information about the performance or business model associated with individual plays, companies or wells.

Shift from gas to oil
In response to price signals, most independent oil and gas companies have switched focus to producing oil and condensate-rich wet gas, rather than dry gas.

In August 2014, more than 1,500 drilling rigs were targeting oil-rich formations currently across the United States, up from fewer than 400 at the start of 2009.

Over the same period, the number of rigs targeting predominantly gas formations has shrunk from nearly 1,300 to just over 300, according to drilling statistics published by Baker Hughes.

The drilling shift from lower value gas to higher value condensates and crude explains most of the improvement in free cash flow in 2012 and 2013, and the move into an expected surplus in 2015.

Texas illustrates the transition. In the Barnett shale, the birthplace of the fracking revolution, just 15 rigs are now targeting gas formations, down from more than 60 at the start of 2011.

In the meantime, the number of rigs targeting oil in the Eagle Ford has quadrupled from 50 to 200, according to Baker Hughes. (http://link.reuters.com/bem72w)

But the switch to more wet gas and oil takes time, which explains why the aggregate free cash flow statistics looked so terrible between 2009 and 2013.

In most cases, leases for oil and gas are held by drilling. Provisions in the contract require the leaseholder to commence boring one or more wells within a specified period or pay delay rentals to defer the start of drilling.

Independent oil and gas producers had already paid bonuses to lease acreage, and their contracts also forced them to either start drilling, pay delay rentals, or abandon the lease. Many producers simply could not afford to shut down all their gas-focused operations immediately.

Independent producers faced several years of negative free cash flow and write-offs while the old leases were developed, not renewed, abandoned or sold. But with the subsequent slowdown in gas leasing and drilling and the turn to more profitable oil and condensates, the industry is poised to return to a free cash flow surplus.

Positive free cash flow will make the shale industry look healthier than it has done in recent years, but in reality it says little about the long-term sustainability of the business model, any more than the losses did between 2009 and 2013.

(By John Kemp,editing by Jane Baird)