Desperately Seeking Cash Flow
It’s no great secret that oil producers are hemorrhaging cash with the price of crude still languishing below $50 per barrel, but there is quite a bit of mythology around the economics of the oil industry. It’s important to understand that the oil industry is cyclical, but more important to understand the reason that it is cyclical.
When oil prices are low, oil companies don’t earn as much money, and so they invest less in new exploration and production. This results in slowing production growth, which will ultimately lead to supply failing to keep up with demand. This was the case in the early 2000s, when oil prices were bouncing between $20 and $30/bbl.
In 2002 the price of oil slowly began to rise as demand started to catch up to supply. In 2005, the price of West Texas Intermediate (WTI) averaged $56.64, rising to an average of $66.05/bbl in 2006, $72.34/bbl in 2007, $99.67/bbl in 2008, but then falling back to $61.95/bbl in 2009.
The oil industry generated solid operating cash flow — defined as the cash generated by a company related to core operations — from 2005 through 2008. But then cash flow turned solidly negative in 2009, even though the price of oil was higher than it was in 2005. A recent graphic by Oppenheimer tells the tale:
How is it that this sampling of major oil and gas companies could see operating cash flow decline from $14.7 billion in 2005 with WTI averaging $56.64/bbl to a deficit of $6.4 billion with oil prices averaging $61.95 in 2009?
While oil producers cut their investments in lean times, they tend to go overboard during the good times. As oil prices rose each year from 2005, a couple of things happened. These higher prices ushered in the shale oil boom, which required a combination of hydraulic fracturing, horizontal drilling and higher oil prices. But higher prices also meant that more marginal fields were now economic to produce. And as prices rose year after year, oil producers had ever greater incentive to invest every dollar they could get their hands on. This ultimately led to too much oil production for the growth pace of global demand and an inevitable price crash — the downside of the cycle.
It’s easy to understand why they do it. Imagine you are running a business, and making very hefty margins on the products you are selling. You would likely want to plow your profits back into the business to grow your volume as long as those margins are strong. If you are getting higher prices for your products each year, you are going to continue to plow that money back into growing the business. But this may very well put your business in a negative cash flow position even when prices are high.
As long as margins are good, you can grow your business rapidly. But what happens when margins fall? It depends. If you grew by highly leveraging your business — in other words not only did you plow earnings back into the business but you borrowed lots of money to grow it even faster – then you could be in trouble. If, on the other hand you don’t have a lot of debt to service and are able to slash your capital spending, you may be able to generate profits even though margins have collapsed. Further, you may be in a position to buy out some excessively leveraged rivals.
When oil prices began to fall last year, companies began slashing capital expenditures. But they are slashing from capital expenditures that a year earlier were based on $100/bbl oil. Oil prices have fallen so far, so fast that essentially all oil and gas producers are still in a negative cash flow position despite the cuts they have made (except of course the refiners, who benefit from low oil prices). And they are slashing based on projections of where they think oil prices will be in the future. Different companies will have different ideas of where oil prices are headed and different levels of indebtedness, so they will naturally differ in how aggressively they will prune capital expenditures.
History argues that, even in the unlikely event that oil prices remain near $50/bbl for an extended period of time, plenty of companies will be able to rein in costs enough to generate free cash flow. Of course the counterargument is that it costs more to produce oil in 2015 than it did in 2005, when companies had positive cash flow with WTI at $56.64/bbl. After all, it took higher prices to enable the shale oil boom, and therefore it stands to reason that it will take higher prices to keep it going.
This is partly true, but it completely ignores the cost savings that operators have realized as they have traversed the shale oil learning curve. A 2009 filing by Brigham Exploration — later acquired by Statoil (NYSE: STO) — demonstrates how oil well economics improved as more hydraulic fracturing stages were introduced to horizontal wells:
Source: Brigham Exploration SEC filing
This shows that within four years or so this company was able to reduce the cost of producing a barrel of oil from shale formations by more than $25/barrel of oil equivalent (BOE). (Note that this is only the cost to produce; it doesn’t include exploration costs, overhead, etc.). Thus, one shouldn’t assume that oil prices need to get back to $100/bbl for these companies to generate cash flow surpluses.
The history of the oil industry is one of cycles. In the down cycle that we are currently experiencing, demand rises due to low prices even as oil producers begin to cut capital expenditures. The inevitable result is that low prices are the cure for low prices. For long-term, patient investors this is the time to seek out bargains. The return of higher oil prices will once again bring big profits and higher capital spending on new projects. The cycle repeats.