It remains to be seen if the U.S. is in the midst of a popping bubble in shale oil and gas exploration, or if a temporarily supply glut will merely be a bump in the road, but the last couple of years have served to shine a light on what should be alarming for those who continue to be bullish on the equities of fracking companies.
The biggest crack in the long fracking investment thesis has to be the amazing lack of free cash flow generated by these companies. When oil prices were hovering around $100 per barrel investors were content with capital expenditures that far exceeded operating cash flow in the name of “growth.” Leading frackers like Continental Resources (CLR), Pioneer Natural Resources (PXD), and Range Resources (RRC), among others, borrowed billions of dollars in order to continue acquiring land and drilling for oil and gas. As long as in-ground reserves increased, investors did not worry much about negative free cash flow or the lack of material dividend payments or debt repayment. They simply valued the companies based on the value of their millions of barrel of reserves.
Such events are not that surprising during a boom, but the strangest thing is what happened after oil prices cratered. At current prices, the fracking companies are rushing to slash operating costs and focus only on their lowest cost wells in order to bring cash operating costs per barrel down as low as possible. Doing so allows them to continue to service their debt and wait for commodity prices to turn around (at least for those companies with above-average acreage and manageable leverage).
What I find so disturbing is what has happened to the cash flow statements of these fracking companies during this transition away from rapid growth and towards operational efficiency; most of them are only able to operate at free cash flow breakeven, at best. The economics of fracking are so poor that even when you are supremely focused on minimizing operating costs and extracting from only your most productive wells, you still cannot generate free cash flow. And yet, these circumstances are exactly when you would expect profits to be highest (again, your best wells operating at the lowest possible cost). Simply put, the economics of fracking for low-cost producers should be very strong right now, but they are not.
What does this say about the fracking business model? Why should investors be putting their money into these stocks? If you care at all about the quality the businesses you invest in, and you judge quality at least to some degree by how profitable the model is, this energy cycle should be very illuminating. If the best companies in the industry cannot generate material free cash flow today, then when?
The pipeline stocks look better and better to me every day.
Full Disclosure: No positions in CLR, PXD, and RRC at the time of writing, but positions may change at any time