Sunday, September 24, 2017

Oil and Gas in debt. Let's try again.


A while ago, I tried to explain why debt and falling oil prices can be so catastrophic. There are a lot of moving parts and there is a lot of technical and economic uncertainty in evaluating the oil and gas reserves that secure the debt. So, below I have created a ‘make-believe’ scenario to better explain (I hope).
Somebody is typically willing to lend you money if you have enough income to pay the interest on your loan and pay back the loan overtime without starving your family. Your house is the security for the loan; that is to say that if you can’t repay the loan, you can sell your house and use the proceeds for repaying the loan.  So if you lose your job and your salary then the bank is likely to tell you that you no longer have the income to repay the loan and thus, you better sell your home or any other assets and repay your debts right away. Now, if you lose your job during a real estate crash then the value of your house may be less than that what you owe and now you are basically bankrupt.

Well, with oil companies, matters are not that different. Your net operating income (NOI) is for interest and principal repayment. Your oil and gas reserves are the security for your debt.  When you get $100 per barrel oil and your operating costs are $40 per oil then you’re making $60 NOI from which you pay the interest on your loans. But… you also must replace the oil reserves that you produced (depleted). So now you have to buy additional mineral rights to own the oil reserves below and you need money to drill a new well and put in place the production facilities to produce that oil and transport it to the consumer.  That money also comes out of your net operating income and is are often referred to as finding and development (F&D) costs.

What remains of the $60 net operating profits after you pay to replenish your depleted oil reserves is your ‘net income’. Although your operating income is $60 per barrel, it may cost you easily another $28 per barrel to find new oil. So your ‘free cash flow ‘ is $32.00 that that may be used for other acquisitions or for paying dividends and so on.  But first you also have to pay corporate income taxes. This is assuming that royalties were included in your operating profits of $60.

As you may have noticed, oil prices are not exactly stable and what would happen to your operating profit if the price dropped from $100 per barrel to $70?  Yes your operating profit falls from $60 to $30 or by 50%. Oops, you still must replace your depleted reserves at a cost of $28 per barrel, eh… so you have only $2 per barrel left in net income and after taxes the money available for paying dividends is virtually zilch!  Be thankful you did not have any debt and interest that needs to be paid!

What?  You took on debt after all?  The stock market demanded that you kept on increasing production and so to pay for all that extra drilling you took out a loan.  With $100-dollar oil what is an extra $10 interest per barrel?  But… every other oil company did the same… how else to keep up with the stock market demands?

Oops, with oil prices at $70, we still have to pay that $10 interest. So now we have a cash deficit; ok we pay it out of the funds for capital program that should have been used to replenish our reserves.  Also, we had to keep up dividend payments and so we borrowed money to get past this short term drop in oil prices. But prices stayed lower longer. Who could have known????  Now we have to cut dividends and nobody wants to invest in us anymore. Our stock is down by 40%.  Well, since we have no money to drill, why keep drilling staff? Layoff the geologists and engineers. Get rid of the drilling rigs. Cut costs!!! Cut costs!!   But now production starts to decline and we can’t pay for waterfloods that are no longer making money. Production falls even more. Now we don’t just make less money on each produced barrel but the number of barrels produced is falling too!  After all, a decline rate of 25% means that our production drops each year by 25% if we don’t drill!   Do you know what the decline is of a low permeable Horizontal Well with multistage fracking?   A lot more!

The banks tell us that we should sell some of our oil and gas reserves to pay back the loans they secured. Eh… oops. You know those reserves that we could produce at a profit at $100 per barrel? Now we’re losing money on them at $60. And the reserves we are no longer worth anything. But the banks want their money back. NOW!  So, what are they worth now, our reserves?   Well we laid off the geologists and engineers. Nobody really knows. We don’t even know how to recomplete or repair wells because the technical expertise was laid off. Let’s temporarily hire some cheaper geologists. Oops they don’t know our properties; besides the old guys made estimates of reservoir thickness and potential amounts of recoverable oil reserves that the new guys no longer agree with. It is easy to be out 10 to 20% in the reserve numbers just on technical grounds and we have to reduce those reserves because many are no longer economic to be produced at $60 dollar per barrel.

So, major reserves write down and our assets (reserves) are no longer worth what we owe. Well, we have to declare bankruptcy! If we had been more conservative regarding our debt or if we had no debt at all, we could have waited until oil and gas recovered but now…  The only thing we can do is sell assets that nobody wants and even banks have to be happy getting 10 cents repaid of each dollar owed.
Ten months later, oil prices are back up but our company is gone!. Our shareholders lost all their equity. Good news though, someone is buying oil and gas assets dirt cheap!  Now that are smart guys. Just pray they can keep production growing. Because that is what we shareholders want: more production!

Saturday, September 16, 2017

The Declining Middle Class is because lack of self-accountability

Right now we’re all up in arms about the liberal changes of small corporate taxes. In the meantime, Morneau and his cronies claim this is needed to fight evil tax dodgers which are of course the ‘rich’. This is just another lie in the class warfare between the ‘Deep State’ and the middle class. And of course, being employed is quite different than being self-employed and or running a small business. It is difficult to imagine yourself in the shoes of others and… we think that the grass on the other side of the fence is always greener. It is easy for a divisive government to single out a portion of the population and have the rest of the population believe that they should be taxed even more. If you think that Pierre Trudeau was divisive, just wait until Justin is done with you!
Reality is that when Canada voted for the liberals, it voted for more government and, no matter all the liberal promises, that means higher debt and wasting a lot of money on green and other socially nice utopian dreams. The slogan that liberals tax higher and spend more is absolutely true. It is also true that there are in each society ‘haves’ and don’t haves. The more don’t haves there are the more they vote liberal or even worse, they vote NDP. They vote to tax others and give themselves more money which in the end is self-defeating.  This is further exacerbated by the government system – anyone that makes a living of the government: civil servants, accountants, lawyers, politicians, nurses, teachers and of course, the media and the think tanks and the universities.  These represent the ‘intellectuals’, the opinion makers, and the manipulators that want to use their unearned powers to tell everyone how to live. They are what some refer to as the ‘Deep State’.  Mostley, they are not elected by the population and they are not very democratic. It is all about having power over the masses and to tell them how to live.
Then there is the real economy which we call the private sector: that portion of society that produces things; exports and imports and that provides services.  There is a grey area between the Deep State and the private sector - as usually not everything is black and white. Part of the private sector is  ‘old money’ those people who inherited their wealth and often walk around with a guild complex and a lack of appreciation for the true value of things.  Old money often votes liberal as well.  Then there are the extreme rich like Warren Buffett in many ways self-made, although his farther was a stock broker in the early 1900s, so there was some ‘privilege’ as well.  Bill Gates also came from a privileged background, but still in many ways is self-made.  Then there are other extreme rich, such as movie stars who every day are in shock about how rich they are. Many of these guys do excessive philanthropy and… out of guild vote democrat or liberal as well.
What remains is the self-employed middle class, which is fleeced every day by those liberals and their Deep State. The ‘Middle Class’ make between $50,000 and $150,000 per year. Not many politicians make that little money. Just check the people in city hall!  No wonder the middle class is shrinking. The middle class and the poor are the largest part of the population but it is mostly the small business owners, farmers, doctors, shop keepers and most professionals that are the libertarians of this world. Big Business is not on their side. Senior management and senior government officials are not that different. Big business management is about adhering to political correctness, social consent, corporate policy and ‘culture’ while stuffing their pockets with other people’s money.  No wonder the middle class is shrinking or pushed into poverty.  Especially the employed, though, seem to think that it is the self-employed portion of the middle class that get’s away with murder and it thinks that the corporations that others work for are polluters and evil but that the ones they work for need protection. Hence many vote liberal.
That is the source of the current ‘class warfare’, something liberals are so good at. Libertarians are often the small business owners that want to be their own man; that want to be accountable to themselves and their community not to the faceless bureaucrats and national politicians so far removed from their reality. Libertarians want to be their own man; they want less government and more say over their own life and finances. Through life experience they often know that there are lots of risks in life and they are inherently more conservative.  Strangely enough, their middle class employed cousins are not thinking about he future other than dreaming of a golden retirement where they do nothing but travel and have overseas vacations. This, while the self-employed build their savings and their businesses; they often become the new millionaires. The employed middles class does not build but spend their money and live from paycheck to paycheck; they and most of their children get entrenched in their social position or end up in poverty. Slaves of the banks and envying their entrepreneurial cousins. They are their own worst enemy who want the ‘Deep State’ to take care of them and tax the rest of the middle class. And that is why we have a shrinking middle class.  Is it not easier to have others take care of you and then blame everyone else for your impoverishment? 

So, if you want to have a prosperous growing middle class; start with yourself and be accountable to yourself; refuse to become a slave of the bank and your government. Yes, we all are in someone’s employ at one point in time but really, the goal is to be your own man (or woman) and don’t let others tell you how to live. Build your own resources and use them as you want. It is not for nothing that the middle-class entrepreneur provides most jobs in this society: not big business nor government. 

Monday, August 7, 2017

Why is too much debt so dangerous for oil companies?


An oil company is very sensitive to debt because it is a ‘capital intensive’ enterprise.  It spends relative little on wages and equipment but it needs lots of capital to find hydrocarbon reserves and to grow those reserves.  Reserves are strange things. They fluctuate not only because of the technical uncertainties they pose. A change in technology may result in higher recovery factors from a reservoir, say it increases from 6 to 7% that means your recoverable reserves increase by 15%. Say the oil price drops from $70 to $50 and now a reservoir may no longer be economic to be produced and the whole thing gets written off or a significant proportion thereof.  When geologists ‘calculate’ or better estimate the proportion of water in a hydrocarbon reservoir (officially referred to as water saturation (SW) it can easily be out by 10%. Say we calculate an average SW of 60% but then we redo the calculation and find it 'is' 54%, that means the corporate hydrocarbon reserves incease by 10%.  
The reserves are a corporation’s assets and if you valued them at $600 million and you lose because of any reason 10% of its value, your assets lost $60 million in value. What if those assets secured the corporate debt; how would a creditor look at that?  That is why often oil and gas companies are sold based on actual production, a bird in the hand being better than 10 in the air. You may hear that a company sold assets for $40,000 per producing barrel of oil. Yet the quality of that production (how long and how much is the decline of that production?) is often just as uncertain as reserves numbers and would you value the reserves as zero?  Tell that to oil sands mines; they see you coming.  What about the facilities; pump jacks, gathering systems and pipelines?  Are they 30 years old or only 5 years?  How are they maintained and what are the environmental liabilities? Buying and selling oil or gas assets is a risky game and so is financing them.

Many companies are reporting EBITDA (earnings before interest, taxes, depreciation and amortizations) or operating income. So do oil companies. Have you ever seen the price of Kraft macaroni fall by 50% over a longer period of time, apart from the occasional sale?  Well, oil and gas take prices are set by the market and it is a real circus. If your oil price falls by 50% during a down turn so does your revenue and your EBITDA may fall by a lot more because your operating costs do not change right away and to a much lesser degree.
Operating income is not net earnings because when you produce oil and gas your reserves deplete and knowing the uncertainties of reserves determination, how much capital do you need to invest to replenish those reserves and how much more do you need to grow the company? Every year, oil and gas companies set their capital budget and you can see how much uncertainty one has to deal with.  Where is the capital coming from?  Out of operating earnings or EBITDA! 

Now EBITDA are not net income! Because, just like real estate, many oil and gas producers use leverage to increase their net income or better their net income per share and their return on equity. Interest and income taxes are paid out EBITDA.  What’s left, Net Income, is used for capital expenditures and dividends and debt repayment.  If oil prices fall, interest payments typically don’t. In fact, the market including lenders may no longer wish to provide financing as reserves that back loans are suddenly worth a lot less and lenders may demand much higher interest rates. If rates increase from 3 to 4%, interest payments increase by 25%.  Lenders may demand repayment of their loans.  With reduced EBITDA how does one pay for the suddenly much higher interest rates, the capital expenditures to replace reserves, taxes from the good times and debt repayment demands?  Well the first thing that goes are capital spending and dividends. That is the beginning of a downwards spiral. Because if you cut dividends how can you raise new capital through IPOs unless you do it at fire sale prices?  But how can you repay your debt if EBITDA is barely sufficient to pay for the interest?  Raise money by selling oil and gas assets that nobody suddenly wants?

You may now have an idea how dangerous debt is. Typically, an oil and gas company should have not more than 30% of its holders’ equity as debt. But during booms many ambitious managements and greedy demanding investors go for much higher ratios and that spells often the end of a company during the unavoidable downturns. You see, 30% debt/equity may not seem much for say real estate, but how often do you see rents fall by 50% or more?  Well, in oil and gas, that happens every 3 to 8 years and investors as well as poor managers often forget that after ups there are downs.   And it is often the shareholders and employees that pay the price.
Oil and gas companies, as well as many other resource industries are price takers; they often face high price volatility from a manic market . The  only way you make money in oil and gas investments is to buy them when they are in the dog house and sell when everybody loves them. They are under no circumstances buy and hold unless you are the insider and you control the debt.

Sunday, August 6, 2017

How vision of life and investing are the same (for me).

I hope this is not too personal, but what better example can I give?

Sitting on my patio on a warm early summer evening I am contemplating life and how investing is such an important part of it.  I am not overly religious but if there is a God, a maker of the universe than it must be a being of such different thinking in time and scale that it doesn’t care about me and neither can I care to learn about it. Men is driven mostly by fear and one of the biggest questions is whether we will retain our individuality after death or not. Let me answer that for you. If you don’t retain your individuality then you will never know it. If you do, it is completely irrelevant for the now.

We are all without question dust parts of the universe and as such we are the universe and so is God. Because if it exists then it is part of all and we are part of all so in the end we are all part of the whole. To be honest, there is so much universe and there are so many objects in this universe – large, small and everything in between. What is the chance that one becomes human out of all those dust particles? It is truly rare and precious to be alive and  human. We should be grateful for our existence. We’re not having an opportunity that is once in a lifetime of a universal dust particle  to do something great but probably a chance of one in a billion or even trillions to do something worthwhile with our human live. Our life is full of choices and if we want to know what hell is about, just make a couple of really bad decisions or have a group of people make wrong decisions and see how that works out. It is in our individual and common interest to live a life of integrity and care for those around us. When we strive to make the best of our lives and for those around us, we are likely to build a heaven on earth. If we live poorly the opposite will happen. Many of the old religions noted this and made all kind of positives part of its value system but often written in terms that people during various periods and in various cultures could understand. Rules and laws and morals change over time as we evolve. Mankind learns, although not always at the same pace and often there are large differences between individuals and groups of individuals. But looking back, we have come a long way and the path forward is likely to be even longer.

We’re living longer and this has major implications as how to view our live. A person of 60 has quite a different perspective on live than a 20-year-old. A male sees things often different than a female. So does a rich versus a poor person, or a Canadian versus a person grown up in India or in Russia.  You probably see things even different than your next-door neighbor does or your spouse. Over time we think different from when we were younger. So we likely value things now differently than 10 or 20 years ago and going forward we will again see things in a different light. The only thing that doesn’t change is the fact that things change. If we don’t want to get lost and avoid ending up in a rut, we have to map out a travel plan but with the expectation that when we are getting closer to a particular milestone, things will change. But one thing is relatively certain: we want to stay healthy as long as we can; we want the means to live the way we want and we want to do things we consider worthwhile. It doesn’t matter how old we are, our life is too precious to do things we don’t consider worthwhile and live in a rut and in a fog of indirection.

Regardless of goal and perspective, we all will need the means to do in live what we want. This is something we can all plan; but so few achieve it. In the past, we may have thought that by sixty we need to have enough money to live until we die – probably in our early eighties.  But now we’re learning that you may live to a much older age and that it could be quite uncomfortable to run out of money with many years to go. Another way of thinking is required. To lead the life that we want until the end of our days, whenever that may be, we need the assets to generate cashflow sufficiently to achieve the things we consider worthwhile doing at the various stages of our live no matter what they may be. To do so, we need to become long-term thinkers while staying nimble to adjust with the times. Rather than expecting that our needs will decrease over time as our lifeforce ebbs, what about thinking about growing into doing ever bigger things?  Fulfilling larger and more exciting projects. In fact, more exciting to us may be more important than just ‘larger’.  But why should our ambition decrease with age?  Life is about growing not about declining. Yes, ultimately our life energy may disappear, but maybe by aiming for the opposite we may use our physical potential more active and longer; we will use our brains more active and longer and feeding on our successes our life energy will stay or even increase over time!
To do what we want in our longer lives we will need the financial means and the energy (health and motivation) to do so. We owe it to ourselves and the universe that provided us the opportunity to live as a human to do so. How do we build this financial wealth?  Simple: live below our means and grow our savings using the laws of compound interest over time.

When you come on your own and start your working live, you can choose to spend all your money on your lifestyle and live for the moment. You, may instead, decide to live like Scrooge and scrape every penny towards savings, i.e. building assets.  Often there is a middle road, and for each person the amount of wealth desired is a personal choice. But the law of compound interest is not only simple but also extremely powerful. You save every month $100 starting from age 25 and invest it at a compound rate of 10% and you will be a millionaire by age 60. Ho, ho! I am not saying invest in GICs or an RBC savings account!  No it is about assets and liabilities!
Assets grow in value and often create cashflow. Liabilities is about your cost of living and the consumption of whatever toy you fancy. Your career is an asset and the cash flow it generates can be put in liabilities or in assets in whatever proportion you desire. ‘Living below your means’ is a way of saying that not all your income is spent on liabilities but also, in a significant proportion on assets which will ultimately constitute the bulk of your net worth. Your assets when grown in sufficient size, will at one point in your life, provide more cash flow than you can earn with a salary. The moment that your assets provide cash flow greater than you need to live from, you are independent of proceeds from your career and you have reached ‘financial adulthood’.  When reaching financial adulthood, you have the means to live the remainder of your live in comfort as a vegetable. But I can tell you from experience, living the life of a vegetable can be extremely boring, kills off your brain cells and reduces your life energy. A deadly state of life! For a human to be truly be happy and fulfilled you need to be willing to push your limits and take on challenging projects that you feel worthwhile. You may also experience that the satisfaction you derive from such challenges depends on going out on a limb and to be willing to work outside your comfort zone often working on increasingly larger or more complex projects. The costs of these projects may increase over time; but so will likely the rewards – both spiritual and financial.

When I say ‘growing your assets according to the laws of compound interest’, I mean that with your net worth, your projects will increase in size and return. Yes, you will have to allocate your capital in a responsible way; but especially when you can invest in your own projects or in those run by people or with people close to you, the rewards could be enormous in many ways and your net worth will grow along with it.


Monday, July 3, 2017

Market Timing no Good

We have on this blog, on and off, discussed market timing. In fact we tend a little bit towards building cash when approaching market peaks to be ready for buying opportunities in the following down turn. Some months ago, I did a spreadsheet simulation showing that apart from unreal perfect market timing, building low and high cash positions did not add much to your portfolio performance and that panic selling during the downturn is the worst thing an investor can do.

Here is a link to an Globe and Mail article on market timing that confirms the above. In fact it claims that being always fully invested in the bond and stock market with a 40%-60% distribution gives you the best performance. Have a look.

Friday, June 23, 2017

Buying good assets at a good price – aim for 6% plus inflation returns – tax efficiently

What is investing?  At its core, investing is allocating money to things that make money in terms of appreciation or income or… both. A liability is something that costs money. A person is a liability in terms of living expenses but it can be an asset in terms of its ability to earn money or create value. Typically a car is a liability unless it is required for earning money then there is a trade-off.
Children in developing countries, after the initial costs of bringing them up, provide the parents with care and even income once the kids are adults. Overall they are a financial benefit. Children are assets.  In the West, children often are expensive to bring up and apart from the joy they often bring in a parents life, the money they earn typically remains in the child’s pockets. As such, in the West, children are a financial liability (everything is relative). Best form of birth control!
But investing is about allocating money to assets and hopefully increase the investor’s net worth and financial means to a level that makes him/her independent of employment. In this blog we call this latter stage: Financial Adulthood. If you love your career nothing stops you to pursue it until the end of times (financially) and if you have a nasty boss or client, you can tell him to take a hike.  In my consulting business, being financially adult, I have the option to price my services based on the ‘pain factor’ a client may pose. This is a subtle way of telling a client who poses too much of a pain factor, to take a hike. To some degree we have the option to set the terms of our ‘employment’ and I can tell you that that is quite a luxury in the current state of the oil patch. We love to work and provide good quality services for our clients and we do so taking their best interests into account. But we won’t work under abusive circumstances and we don’t get taken for a ride by ‘nickel and dimers’. This makes life very pleasant. Today I took time off, writing this blog on my condo’s terrace in a nice shaded area with nothing but green around me. Oh, that reminds me: I badly need another cappuccino. 😊
So what is a good investment?
For me, it is an asset that every month throws of a bit of cash flow and that appreciates over time. If the average annual return of my portfolio is between the 5 to 7% plus inflation then I am happy. Using the rule of 72 and estimating average inflation of 2%, it should take 72/(6+2%) = 72/8=9 years to double my net worth.  So If at age of 40 I own $ 1 million dollars then at 49 years I own $ 2 million and at 58 I own $ 4 million and by age 67 I own $ 8 million plus my Canada Pension. Not bad.  Of course, this also requires that you don’t pay a lot of taxes.
Hmmm….  So how does one minimize taxes?  Not by applying illegal tax avoidance tricks or putting your money in shady overseas tax havens. Buy a ‘good asset’ and never sell it!  The result is no capital gains taxes over your life time.  Fill up your TSFA to the max. You may say TSFA that’s only a measly $5500 per year.  No that is wrong thinking.  Since inception of the TSFA, with ok returns, that TSFA is now reaching $70,000 to $80,000 in value.  If you’re 25 years old and you make nominal 8% returns, at age 67 you have accumulated tax free $1.7 million. Ooops!  Yes, Oooooooops!
An RRSP is a lot riskier. This depends on the tax rate at which you make a contribution and the tax rate at which you withdraw from your RRSP.  So if your investment income at time of RRSP withdrawal places you in the top tax bracket you likely lose.  Especially considering that you don’t get dividend tax credits and that you cannot recoup your capital losses. From my point of view, RRSPs are evil instruments of the government to suck even more money out of the unsuspecting investor.  No wonder, Justin Trudeau stopped Steven Harper’s increased TSFA contribution. He wants people to stay dependent on the government and force them to work longer as wage slaves.  Really, the liberals are not the friend of the savers and of the middle class. (Ooops was that a bit of ideology on my side?)
A good business throws off cash flow and appreciates year in and year out. You make a product or provide services at a return on equity rate of 8% per year. Now a lot of public companies don’t make those returns without a bit of financial engineering. Neither does real estate. Since real estate is one of the simplest business models let’s use that as an example.  Real Estate typically appreciates just a tiny bit better than inflation. Say at 3% per year. It also provides cashflow – my target is a cap rate of 3%.  That means, its net annual cashflow should be 3% of the property's market value. Say, a building is worth $100,000 than after all costs, it should net you 3% or $3,000 cash every year. There are some tax advantages that you can use to make this 3% virtually tax free. BTW cap rate is kind of similar to EBITDA for corporate financials. 
In our example net rental income is typically tax free (better: deferred) for around 20 years. Of course your appreciation is also tax free as long as you don’t sell. So you’re making 6% tax free returns annually.  Now, how can you increase (financially engineer) your return to say 8%?  Simple, use leverage and take out a small mortgage. The interest on the mortgage if used for investment purposes is tax deductible.  If you are in the top tax bracket that means the government pays half your interest.  Isn’t that nice!  So we’re making (3 + 3% =) 6% or $6,000 per annum on a $100,000 investment.  To make 8% we need to make that $6,000 on how much equity? Right $6,000/8% = $75,000.  How do we get our property for $75,000 instead of $100,000?   By taking out a $25,000 mortgage say for 5 years at 2.4% or 1.2% after tax interest. 1.2% interest on 25,000 reduces our net cash flow by $275 per year that is virtually zero costs especially if you take into account that the $25,000 in terms of purchasing power decreases every year at the rate of inflation by another 2%. So really, you get that $25,000 basically for free. That is the world of negative interest rates today.
Of course leverage has its dangers. Never over-leverage because if you get trapped into too much debt in a falling market, your financial life may come quickly to an end (Think Peter Pocklington, Campeau, Olympia & York, etc.). 
Look no further than the stock market where senior management pumps often up their debt to increase the company's net income to the max until the day things turn sour. But management, by then, has driven up the stock value to the max, cashed in their options like bandits and then run while shareholders are holding the empty bag. Of course, those shareholders demanded maximized net income as well and didn’t care how management achieved this. Well investors in over-leveraged oil and gas companies have found out how debilitating too high debt can be. Their shares are our now worthless and all the senior management departed. To ad insult to injury, with golden handshakes to top off their cash haul.  Yes, expertise is soooo hard to find!
Good business are like good real estate. But often real estate cycles and stock market cycles are a bit out of sync. So are precious metals and other commodity cycles. When one market does do well, another may be in the doldrums or worse. This, of course, provides buying opportunities for investors with strong stomachs and cash-on-hand. This is also why a good investor has a ‘diversified’ portfolio – something that doesn’t makes you ‘seasick’ of the roller-coaster markets and that is good when you have to buy with knots in your stomach at the bottom of an asset market.

This is what investing is all about. Not gambling or speculating. But buying good assets at the lowest possible price and keeping them as long as you can. The example, par excellence, in this game is Warren Buffett and last week’s investment in Home Capital. 
So next time, first ask yourself if what you buy is an asset or a liability; is it helping your portfolio to achieve the desired returns (6% plus inflation) and can you buy it for a truly good price (say at the bottom of a bear market)?

Saturday, June 17, 2017

Responsible share ownership and drill cuttings in oil and gas wells


In the current economic climate, oil and gas operators do everything to cut costs – sometimes to absurd levels. The horizontal well multi-stage fracking revolution has many think that geology is not that important anymore and that statistically drilling will do the job.  So now, a number of operators are drilling wells with no cuttings sample collection and no geological supervision. After all, the reasoning goes, you really don’t need to know your reservoir you just apply a mega-frack and out come the hydrocarbons. This is especially true for the Montney play on the Alberta/BC border.

Statistical drilling works only where it works. What I mean is that if you do have a development play, yes you can drill it out like a factory spacing horizontal wells out every 200 or 400m and drilling them over as long a distance as production remains economic. In the Montney that means that the ‘lateral leg’ may be 2000 to 3000m long. Operators think as long as you meet the ‘type curve’ with your production you’re doing fine. Type curve is the average production forecast of a well in a certain formation and you can drill when the economics of a well that produces like the type curve are satisfactory, i.e. meet corporate profitability criteria.

In the stock market, everything is based on financial ratios and although these ratios differ by industry sector, investors don’t think typically much farther. So many corporate management teams don’t think much farther either (as they are often compensated in shares and options) and since many don’t even understand the technical aspects of their own oil and gas assets except in the broadest terms nearly every decision is based on those corporate ratios. How much production does an asset have and what do we pay per barrel of oil Montney production? It is often not much based on a true technical evaluation of an area’s geological potential. Thus, who cares about collecting data we have a ‘gas or oil’ manufacturing operation!  In other words, other than financial engineering and reducing operation costs management does not have to use its brains and technical staff is encouraged to think less and less in terms of how to properly manage the asset not only for the future but also for understanding the variable production behavior that exists from well to well within an oil and gas asset because ‘as long as we meet type curve’ we’re doing fine and if we don’t produce enough we just make more frequent and bigger fracks.

Apart from what this kind of thinking does to the oil and gas industry's social license this is not how we should manage these valuable assets. We optimize our short term recoveries at maximum profits but at the expense of our overall recoveries and profits from the asset. Today, the target within the asset is often only one small interval in a huge geological column of rock and we don’t even have the data to determine what that target’s real potential is.

Some companies tell their owners (shareholders) oh, in the Montney we have multiple zones of production. We can drill at one location horizontals that access pay at several depth intervals. Yet, they don’t know whether that is true for their asset without a proper evaluation and they have no idea what the final recovery from each zone is.  Yes, they estimate the ultimate recovery from a well after they have some production history (e.g. a year); this is called EUR.  But really, the EUR is determined by many factors including the reservoir properties but also to a significant degree by the drilling, completion and production practices applied to the play. Ironically, the horizontal multistage fracking technology is an obvious example of that. 

Your EUR is mostly a function of, economics, technology and reservoir quality. What we are doing today is focusing on our immediate technology and economics while completely ignoring the third factor: reservoir quality. Most companies have a general concept of their reservoir which is often based on extrapolation of concepts from adjacent operators. “Our land lies on trend” or “We are producing from high TOC rock”. The latter is often just assumed because someone published a technical paper 200km away from their holdings; sometimes a paper half a continent away.

My company Eucalyptus Consulting, has recently performed a regional Montney study in Alberta and we found that there are a wide range of play and reservoir types within the Montney. Most are what is euphemistically called ‘Conventional’ oil and gas plays and have little to do with production from source rock which is often considered ‘Unconventional’.

With a better reservoir description, we can often explain why one horizontal produces better than an adjacent one. We can determine where in the reservoir the wellbore was placed and with that we can design the appropriate size and type of a ‘fracking program’.  Reducing frack size and preventing formation damage by the selection of appropriate frack fluids may result in major cost savings but industry has really given up on this and is just interested in larger and ironically, in cheaper fracks using ‘economy of scale’.

With a better reservoir description, we can plan for extending the life of a well and even consider enhanced recovery schemes. This may not appear economic now and, I guess, with the world expecting a switch from fossil fuels to renewable endless energy any moment now, who would care about such future recoveries. This was meant to be sarcastic. Because it is ironic that we are treating our hydrocarbon assets with so little thought in this so-called time of sustainability and environmental concern.

If the economic life of a 4 to 10 million dollar well is not much more than 4 to 7 years than we must have a truly endless supply of oil and gas. After that we shut-in the well and hope to have to pay for its abandonment far into the future when according to our economic standards that money is worthless. I wonder whether the people living in that far-away future would think the same when they end-up paying for these abandonments and when the original owners of the play are long gone?  

With extending the life of a well, companies have another lease on life. That is often overlooked in favor of immediate cash flow – something demanded by the stock market but is that about running a good business or about being ‘robber barons’ or flight-by-night operators.

Reality is that stock market investors want investments that provide fast returns and many of the institutions that manage your legacy funds invest on that basis in our industries. We need fast growth and high returns; once the growths flatten we dump the suckers and move to our next 'investment'. This attitude seems in particular to exist in commodities and ironically in high tech. When the ownership has this attitude how can we expect that our assets are managed other than as ‘Pump and Dump’ schemes. But that is what we’re seeing, loud and clear, in today’s oil and gas industry. Isn’t it ironic that in this era where we all standing on our high environmental horses and point to anyone except ourselves that our investment attitudes promote exactly what our mouths claim we abhor?  Well, fellow investors and fellow oil & gas workers, you will reap what you sow. There is a difference between making a quick buck and owning a good business. If we really want to do what we preach then start with responsible ownership. And you thought this was about collecting cuttings!
This posting is not to blame the oil and gas industry. It is to point out your role and your attitudes when investing and the consequences thereof regarding how your assets are managed. What I describe here about my industry of which I am generally very proud, happens in many other sectors as well.
Ultimately, you the consumer demands the products delivered at the cheapest possible costs and your investment habits have a direct impact how that is done. No wonder industries act the way they do when you dump your holdings at the first quarterly report miss. What I am asking you to do is to better look at what you own and how you manage your assets. I think this may be a topic for multiple postings where I will explore a more responsible way and a better way of investing. I hope you join me in this exploration and develop a better more sustainable investment strategy not by sitting on a high horse but by becoming more aware about what we are doing and how that goes down the chain all the way to the workers in our assets.  Your ideas/input are very welcome.
I am proud of my industry and all the good it is doing to our society and I am grateful for investor funding that enables our industry to find that energy. I also think that oil and gas will be part of our resource mix longer than most of us believe.  Look no further than coal - it is still an important commodity a century after oil and gas became mainstream.   
Oil and gas is and will remain, together with many other resources and other industries key to Canada's well being. We may find ever cleaner and efficient technologies. Even coal can be used in a cleaner way. Think of new scrubbing technologies; generation of hydrogen from coal. 
It is wrong to blame or point to one sector in our economy and use it as scapegoat for our social problems, real or imagined. We should all take responsibility for our lifestyle and investment habits. Maybe a greater awareness about our own attitudes may show the way to a more sustainable life.