It has been a poorly kept secret that I am among the biggest skeptics on the planet as it relates to this whole US “energy independence” fantasy. As a credit investor, I have been “no bid” on the entire US E&P business. This was not an easy thing to sidestep as “energy” as a sub-set is by far the largest component of the various high yield indexes representing around 18%1. Interestingly, we have been severely punished for our exposures to “energy,” however, we continue to have confidence in certain sub-segments of the energy space, as we expect that oil will ultimately move dramatically higher, likely leading many industry players to not only come back but prosper in the coming years.
We have written chapter and verse on what we want to be long in the oil space: long lived production and reserves, reasonable decline rates, moderate leverage and exposure primarily to heavy oil. We have found this in many companies in the Western Canadian basin and will continue to focus our attention there. The Gulf Coast (and the rest of the world) needs heavy oil and Venezuela and Mexico, the traditional providers of this crude, are declining rapidly. This has already created increased demand for the heavy oil from Canada (versus the light oil largely produced domestically). The plunging Canadian dollar and tightening heavy/light differentials have offset some of the price decline realized by many Canadian producers.
We see the US shale basins as almost the mirror opposite of what we are looking for. We are watching bond prices of these E&P (exploration and production) companies plunge over the past few days but remain completely and totally disinterested in what we would view as falling knives. But our disinterest has nothing to do with the price of oil. Our issue with all of it has to do with the confusion of a single word. And that word is “of” vs “on.” Stated more completely investors are going to be given a lesson on the difference between return “of” capital versus return “on” capital. How many times must we listen to the word “breakeven” as it relates to these producers? Candidly, I have no idea what is meant by breakeven.
My take is straightforward. There is no free cash flow generation in any of these shale E&P “companies” that I have reviewed. Let’s use the simplest definition of free cash flow we can: EBITDA less interest less capital expenditures. If you run those numbers they will frighten you. We believe that the business models were broken from the start because capital expenditures dwarf EBITDA generation. This is because tight oil/shale wells have decline curves that are around two years. This means that production declines by 90-95% every two years2. We don’t see them as businesses, they are projects. We believe that financing these so called companies using long term debt (5-7 years) will end badly. These companies were bleeding cash with oil at $100 but nobody was looking at the numbers; there was just an assumption that everyone makes money at high oil prices. But oil’s price collapse has woken up the herd and they are beginning to look under the hood.
Now let’s deal with some realities. If you are an income investor you are most likely invested in the energy game whether you know it or not. This includes high yield bonds and loans along with the very popular MLPs (master limited partnerships). It is imperative that you know what you own and why you own it. Most importantly, businesses need to generate a return on capital not a return of capital. When financing markets close, the return of capital game ends. And my take is that it has ended.
While we love to buy value created by some stress, I have no interest in putting on positions in “companies” that aren’t companies. We see no safety in numbers here: owning a whole bunch of names in the same space gets you to the same place. And to us that place is default. But more concerning should be recovery values. If these “companies” limp along for another few years (likely) and continue to drill out the inventory (sweet spots aren’t that large), what is left at the end of the day? Rocks in Fargo I guess. Perhaps it unravels sooner. If you ratchet back capital expenditures to preserve liquidity your production collapses along with cash flows. You can see the endless treadmill that many of these guys are on because two year declines won’t allow you to build a business.