The Arduous Road To Limited Oil-Company Profits
Among certain elements there is much vilification of the oil and gas industry. Profits are too high, tax breaks are excessive and fossil fuels pollute too much. Such are the constant refrains from the cabals of environmental groups which echoes onto the doorstep of the White House. Let's focus on that cacophony of drivel that endlessly drones on over excessive earnings.
For full year 2013 Exxon (XOM) reported net income of $33.45 billion. Their operating cash flow was an even more monstrous $44.9 billion. However, when you factor in that capital expenditures on exploration amounted to $34.7 billion, then free cash flow was $11.2 billion or about a third of stated net income. Free cash flow is what remains after all capital expenditures and other investments have been made to sustain and grow the underlying business. After Exxon paid its dividend to shareholders of just under $11.2 billion, it was basically flat for the year based on the metric of just measuring cash. Apple (AAPL), in contrast, reported fiscal 2013 earnings of $37 billion, operating cash flow of $53.7 billion and free cash flow of a whopping $44.6 billion. Yet there is nary a pejorative peep suggesting anything extraordinary about those numbers.
After randomly surveying over a dozen public companies, large and small, engaged in exploration and production, (the "upstream" end of the business), being cash-flow positive after capital expenditures on a consistent basis is not an easy task.
Carrizo Oil & Gas (CRZO), Chesapeake Energy (CHK), Devon Energy (DVN), Sandridge Energy (SD), Southwestern Energy (SWN), and Talisman Energy (TLM), six of the fifteen companies I examined, had negative free cash flow for each of the past five years. This is not a long term sustainable business model. Hess Corp. (HES) reported $5.2 billion in net income for 2013 yet reported negative free cash flow of $970 million, and has been in the red measured by free cash in four of the last five years. Apache Corp. reported an aggregate of over $11 billion in net income for the past five years but had net negative free cash flow for the period.
Of my sample only Exxon (XOM) and Occidental Petroleum (OXY) were free cash flow positive every year for the entire five year period. Even juggernauts like Chevron (CVX), Royal Dutch Shell (RDS.A), and Anadarko Petroleum (APC) had a year or two of negative free cash flow.
While it is not easy to make consistent returns in the exploration business, it is even more difficult to continue to grow both resource reserves and production at any more than low-to-mid- single digit rates. Many of the high profile American fields such as the Eagleford in Texas have very high decline curves compared to their initial productions rates. An oil well that starts out with good pumping pressure making 800 barrels per day, may only be producing 100 bbl./d. or less at the end of the first full year.
These very rapid depletion rates imply companies must drill, drill, drill just to keep production rates steady. As the low hanging fruit from the fracking boom has long since been picked, to find a big discovery to increase a reserve base is challenging. International resource exploitation opportunities are equally limited, since over the past couple of decades political risks have increased exponentially as more dictatorship kleptocracies (think Venezuela, Ecuador, and Russia) either expropriate mineral interests or limit United States and other western democracy participation.
Inconsistent results coming from even the most well run companies are axiomatic given the drastic fluctuation in underlying commodity prices. In late 2008 West Texas Intermediate (WTI) crude reached a bubble price point of over $140 per barrel only to crash to near $40 by early 2009.
Natural gas prices have experienced an even more dramatic roller coaster. After peaking at over $12 per thousand cubic feet (mcf) in July of 2008, prices declined over 80 percent to $1.95 per mcf in April of 2012. This year alone the spot prices have fluctuated between $3.50 and over $6.00. Unless it has underlying gas reserves of perhaps 8 to 10 billion cubic feet, at current spot prices of $4.50 per mcf, most gas wells still remain unprofitable to drill on a net present value basis.
One of the few fields with wells that prolific is the Marcellus Shale in Pennsylvania and West Virginia. To drill a ten thousand foot multi-stage horizontal frac job can cost $8 to $10 million or more to complete. After a 20 to 25 percent landowner royalty right off the top, 7.5 percent production taxes, 2 percent ad valorem taxes, plus other operating expenses, the returns become very sensitive to commodity prices.
Yet many companies continue to knowingly drill many wells with a decent probability that they may be only marginally profitable, if at all. Wall Street warns: grow your production and reserves or your stock will be punished unmercifully. The consequence is that irrational capital allocation decisions get made, especially by small and midcap exploration companies.
For many like Chesapeake Energy (CHK) and Sandridge Energy (SD) the game finally caught up with them. When a company is consistently free-cash-flow negative, there are only a few options; issue more debt, issue common or preferred stock, or sell assets to raise cash. Sandridge (SD) has more than double the common shares it had outstanding five years ago, and after a high profile sacking of CEO Aubrey McClendon at Chesapeake, new management was forced to sell assets to close a multi-billion dollar funding gap.
Recently there was a report by a left wing think tank, Center for American Progress, carping on all things pernicious about "big oil." A chart was displayed announcing the sin that Exxon Mobile (XOM), Royal Dutch Shell (RDS.A), British Petroleum (BP), Chevron (CVX), and Conoco Phillips (COP) had amassed at 2014 first quarter end, combined cash reserves of $68 billion. For some perspective this is but 4 percent of trailing twelve months revenues of nearly $1.7 trillion; for some real perspective consider that Microsoft alone has a cash reserve of over $88 billion, or almost 110 percent of latest twelve months revenues. I guess software and tech are exempt from the progressive ire.
Apple (AAPL) spent a little over $13 billion in research and development over the past 5 years. Exxon alone spent $149 billion during the same period. Just the above five evildoers singled out for humiliation amassed more than $500 billion or $1.5 trillion in capital expenditures looking for oil and gas around the world. According to a 2011 study promulgated by the American Petroleum Institute (API) the oil and gas industry supports some 9.8 million ancillary jobs as a result of the staggering amounts spent in their efforts to keep our tanks filled with gas. Imagine the amounts of potential new jobs if the Obama administration were neutral, or just marginally friendly to this industry. Keystone Pipeline project would be a great start.
It doesn't require too much spade work to realize that making money in the oil business is not as simple as sticking a straw in the ground to suck out the liquid gold. The United States oil and industry is a world leader in innovation to overcome what otherwise would be a declining industry. These companies work hard for their money.
