Notes From Saudi America

Saudi America
by Bethany McClean

On Aubrey McClendon, founder of Chesapeake

• McClendon went all-in on shale buying land in Austin Chalk region when he saw Devon energy’s success drilling horizontally.
• McClendon would overpay for land. His world-class salesmanship would allow him to raise capital more effectively than competitors.
• He would be bailed out in 2000s when oil and gas prices rise and shale lands were in high demand.
• By 2012, Chesapeake was trying to rebuild after the crash of 2008 and gas prices depressed. They would raise capital globally and make deals with pipelines that would require them to produce large quantities of gas regardless if price. They were basically funding themselves by selling the equivalent of naked puts on gas.
• The board was replaced and McClendon stripped of chairmanship. Icahn even took a seat. But the company and governance were a disaster.
• McClendon left and started AEP which would create a portfolio of companies with an interest in specific drilling operations.

• Known as the “Apple” of oil
• In 1999 Enron spun off EOG (“Enron oil and gas”) when Jeff Skilling became dismissive of businesses requiring hard assets.
• EOG and Continental (Harold Hamm’s co) were first in the Bakken where production would increase 10x in the first decade of 2000s.
• Encouraged that the fracking technology worked although unspectacularly (the industry and academics were still skeptical) they started acquiring land in Eagle Ford for under $500 an acre. Then in 2010, at the 4 Seasons Houston they announced there was 900mm barrels contained in Eagle Ford.
• A look at EOG which has positive returns.
  • Only wells with at least 30% irr since about half of that is required to cover overhead including land and infrastructure.
  • Requires profitability at $40 oil so that it can survive full price cycles.
  • Means that there is limited capacity to invest since land prospects can be much worse (“better rock is exponentially better”)

Fracking is 2 technologies

• Horizontal drilling and high pressure water to crack open rocks. A proppant (ie a sand usually from Wisconsin) is used to keep the crack open to let the oil or gas flow.

Shale depends on unsustainable economics

• In 2015, Einhorn at the Sohn conference showed that even with oil at $100 the shale industry was incinerating cash. He called out Pioneer in particular (a descendant of a merger with Pickens Mesa Energy). Shale Wells have too steep a decline rate. A Bakken well declines 69% in year 1 and 85% in 3 years vs 10% pa for conventional). Einhorn argued that frackers’ pitches don’t account for cap-ex and cost to acquire leases. He showed that they embellish their estimates of reserves to investors (vs what they report to SEC standards). He and SailingStone of SF showed how comp was tied to production, not profitability. They both agreed that has was much better biz than oil.
• Pension backed PE firms are financing shale 2.0 which is marked by better technology and more precise operations. 35% of horizontal drilling is done by private PE-backed companies. Rates of return remain unsustainable for all but the most efficient operators who are generating positive albeit still uninspiring returns.
• Decline rates always mean you need to spend more to stay in place. The shale transformation was a Lollapalooza effect of Bakken, Eagle, and Permian hitting all at once. It may very well be a one-time price effect. And the more efficient we become on drilling the faster we deplete the wells.

The crude oil export ban

• The crude oil export ban had been in place since the 1970s.
• But there was now a growing movement to overturn the ban backed by oil producers while refiners and environmentalists opposed it.
  • Many saw it as a counterweight to the political leverage of unfriendly powers such as Russia and the Middle East. Europeans were already grateful for the US agreeing to export LNG, keeping Russia from having a near monopoly on gas sales in Europe esp in Germany.
  • Many argued that the decline in global prices would more than makeup for the reduction of domestic supplies and that in boosting global supplies the political premium baked into oil prices would ease.
• The collapse of oil prices in 2015, the “condensates” exemption, and being part of a larger spending bill provided cover from detractors as the bill was passed in Dec 2015. Environmentalists would gain an extension to solar and renewable subsidies.

My takes plus a Munger insight

• The byproduct of commodity businesses is really an investment product.

A levered slice of volatile returns. The companies are closer to derivatives than they are businesses. The derivative is on the price of the commodity. The leverage is operational (call option struck on breakeven cost structure) and financial (companies have debt financing). The derivative is economically tied to the commodity via land rights which collateralize additional debt financing.

• Sloppiness can occur when policies are seen as good for the public.

Greenspan saw rising energy prices as a threat to the economy and he suggested we invest in LNG import terminals. The fear of risings prices hastened the 2005 Energy Policy Act which exempted drillers from disclosing the chemicals used in fracturing.

• Is Saudi’s timing of their portfolio rebalance performance-chasing?

• While increasing the security of US energy supplies seems like a net positive it’s unclear what the ramifications are longer term.

Shale for example has reduced our reliance in unstable regimes. But many of those regimes such as Nigeria were not major threats. If an insecure bully has some moderate economic leverage against you it may be better to pay them to control them. If you remove the leverage you also destabilize the equilibrium. An equilibrium you were ultimately in control of. You may find yourself now facing a desperate, rabid adversary who despite a smaller stature now has its back to the wall. You have exchanged a stable, modestly negative state for a wildly uncertain modestly incrementally positive (perhaps fleeting) state. This is especially true when the dog whose bark is louder than its bite is in a region concerned with terrorism and nuclear proliferation.

• Munger: we should be conserving oil and delaying gratification until we are certain about the extent of its future needs.

This is because fertilizer, pesticides and other ag products are made with hydrocarbons and there is no technology that has replaced that. “Like the topsoil in Iowa, you wouldn’t want to use it as fast as possible” he believes the shale boom was lucky and we shouldn’t just consume the gift. He recommends we commit to production enough to remain competitive in its technology while maintaining reliance on foreign oil. Let them deplete their reserves until we have a better understanding of what the future barrel is worth. Remember that the US being the first to switch to unconventional oil and gas required it to be the first to run out of conventional oil and gas.

Shale has been a subsidy to the economy and it’s very unclear to what extent we should drill aggressively or more thoughtfully since the future demand for oil is devilishly uncertain (there is more certainty around gas supplies). Is this another example of being short-sighted and drilling at all costs while oil execs and consumers win or if we’d be better off with higher near term prices and renewables even more competitive?