Chesapeake and SandRidge Alum Tom Ward Just Admitted How Bad The Energy Exploration Business Model Really Is

Those of you who follow the energy exploration and production industry probably know Tom Ward very well. He co-founded Chesapeake Energy with the late Aubrey McClendon in 1989 and later left to start SandRidge Energy in 2006. With Chesapeake struggling mightily these days (there were whispers of a bankruptcy filing earlier this year and shares trade below $4, down from an all-time high of $74 back in 2008) and SandRidge having filed bankruptcy just this month (Ward was fired as CEO in 2013), Ward’s two companies are wonderful examples of how the need to grow via debt financing can cripple energy exploration firms. Undeterred, Ward founded Tapstone Energy in 2013 as act number three.  Tapstone’s web site reads “Tapstone Energy: A Tom Ward Company.” I’m sorry, but given Ward’s track record that’s quite humorous.

I just saw Tom on CNBC discussing the current state of the domestic energy market and one of his comments was very instructive for energy investors. He said the industry’s “dirty little secret is that you cannot spend within cash flow and grow production.”  This comment was following his assertion that lack of access to capital was the real hindrance to the industry right now because banks “want you to spend within cash flow.”

I guess banks only want to lend money to energy companies that can operate at free cash flow break-even at a minimum. This is very logical of course, as it means that the profits from the oil and gas sold can cover the interest payments due to the banks. I find it amusing that Ward is in a way criticizing the banks for being so strict so as to want to ensure they can be repaid.

But the “dirty little secret” comment is most important in my view. What Ward is saying is that energy exploration companies cannot grow their production without borrowing money to do so. Put another way, this means that drilling for oil and gas does not generate any free cash flow (after all, if it did there would be excess cash to drill more wells and thus grow production). In financial speak, maintenance capex (the amount of reinvestment requires to maintain a steady level of output) eats up every dollar of operating profit.

This is crucial for investors because stock values reflect the present value of future free cash flow. If free cash flow is never above zero, there is no profit left for equity holders after creditors are repaid. From a strictly textbook definition, that would mean that all of the common stocks are worth zero.

I wish I had heard this comment many years ago, as it might have allowed me to realize a lot sooner just how bad of a business model most independent energy producers are employing. What is amazing is how many people continue to want to invest aggressively in the sector.

Oil Slump Shines Light on Weakness of Fracking Business Model

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

The Oil Shale Revolution Is A Double-Edged Sword

Back in the old days falling energy prices were a clear incremental tailwind for the U.S. economy. Some economists even went as far as to argue that low gasoline prices were the equivalent of a tax cut for consumers, but that line of thinking never made sense to me. After all, a tax cut implies that you have more money in your pocket, but when gas prices go down you have the same amount of money. You are simply able to reallocate some of it away from gas and into other things, as your total spending stayed the same.

Then the shale revolution came to the U.S. and technological advances resulted in states like Colorado, Ohio, Pennsylvania, and North Dakota having large slices of their regional economies linked to oil production. The tide shifted and the U.S. economy now was tied to oil production as opposed to simply consuming oil imports from Canada and the Mideast. When oil prices were high that was a good thing, but now that oil has cratered from $100 per barrel to below $30 we can clearly see the other side of the double-edged sword.

To understand why the stock market is reacting so much lately to falling oil prices, we simply have to think about the ripple effects now that we have so many more domestic oil producers. Most of these shale firms are relatively new companies that borrowed billions of dollars to acquire land and start drilling. Their business models were predicated, in most cases, on oil prices of $75-$100 per barrel. Once prices dropped below $50 certain companies no longer could produce oil profitably. As prices have continued to fall, more and more companies fall into that category. Very, very few can make money sub-$30 per barrel.

So what happens in this scenario? Frankly, many smaller oil companies will not survive. Without profits they will not be able to pay the interest on their debt (let alone the principal), which causes multiple problems. Most importantly for investors and financial markets, as debts go unpaid lenders will lose a lot of money. The energy sector owes tens of billions to banks and investors who hold their corporate bonds. Much of that debt is held in mutual and exchange traded funds, so the losses will accrue from the biggest banks all the way down to small investors. And without knowing how low oil prices will fall, and for how long it will stay there, there is no way to know exactly how many companies will survive and how much debt will go into default. That uncertainty is impacting financial markets today, this month especially.

The other issue worth mentioning is why exactly oil prices have not been able to stabilize after so many months of decline. The problem of excess supply is not self-correcting as quickly as many might have thought (the cycle looks like this: high prices result in too much drilling, prices fall due to oversupply, production is curtailed due to unprofitable prices, supply comes down to balance the market, low prices spur demand, prices stabilize and rebound).

For these shale companies want to hang on as long as they can, they simply need to keep paying the interest on their debt. If their debt does not come due for another 2-3 years, the companies can continue to sell oil at prices above their cost, so long as they have a little runway left on their bank credit lines and they can generate enough cash to cover interest payments. The reason we have not seen many oil-related bankruptcies yet is simply because very little of the debt has come due. But that time will come, and as long as oil prices remain low the banks and other lenders will not shell out any more money. Only then will companies stop producing, which will start to bring the supply/demand picture back into balance.

Coming back the stock market specifically, it is important to note that the non-energy sector is doing just fine (S&P 500 companies actually grew earnings in 2015 if you exclude the energy sector). Lenders will take some losses on their energy loans, but the size of that market is small relative to the rest of the economy. For that reason, it is fair to say that the current stock market correction is sector-specific and not indicative of a widespread, systemic problem (unlike in 2008 when banks were in danger of closing, this time they will simply take losses on a part of their loan book).

For comparison purposes, today’s situation reminds me very much of the dot-com bubble that peaked in early 2000. As was the case with oil in recent years, back then there was a bubble in one sector of the domestic economy (tech and telecommunications). While it caused a recession in the U.S. the problem was contained to that one area, which allowed for a relatively swift recovery. In fact, S&P 500 corporate profits peaked in 2000 at $56 before falling by 30% to $39 in 2001. Earnings began to rebound in 2002, got back to even in 2003, and hit a new all-time record of $67 in 2004.

The goods news is that this time around things should turn out considerably better because the energy sector peaked at 15% of the S&P 500 index in 2014, whereas the tech and telecom sectors comprised 30% of the S&P 500 in 1999. Therefore, energy should have only about half of the impact compared with the technology sector 15 years ago. Even as oil prices collapsed in 2015, S&P 500 profits only fell by 6% from their peak. While that number could certainly get a bit worse if oil stays at current prices for the duration of 2016, there is a floor in sight; in terms of market value the energy sector today only represents 6% of the S&P 500.

Contrarian Opportunity of the Moment: Oil Stocks

You may remember back in 2008 there was a debate about whether financial market participants (“speculators”) and the billions of dollars they moved around every day were impacting prices to such an extent that it severely widened the gap between what was “real” in the world and what the markets were supposedly telling us. Efficient market believers want us to think that the market always reflects reality and things rarely get off track. As we saw in 2008, however, market prices often did not accurately gauge the underlying fundamentals of the financial industry. Many companies were in trouble, no doubt, but when pretty much every single asset is mis-priced at the same time, there are clearly instances where the short-term traders have overcome the system regardless of what the underlying fundamentals truly are.

I am not saying that today’s oil market is anywhere near as mis-priced today, but when the price of a barrel of oil fetches $100 in late July and then in December drops to $58, when very little in the world has changed during the interim, investors need to ask themselves if the daily ebb and flow of the capital markets, and the computers that largely control that flow these days, is materially impacting the price action we are seeing in the oil market.

Is the U.S. energy production boom helping contribute to a temporary glut of oil? Yes. Has the supply-demand picture shifted so much that $58 oil reflects the true balance between supply and demand in the end markets for crude oil? I suspect probably not. Now, if $100 per barrel was the “wrong” price based on supply and demand then you can certainly argue that prices should have come down quite a bit. But when prices drop so quickly and then the fall accelerates lately as it has, I have to think financial “speculators” and short-term hedge fund traders are controlling the near-term price quotes.

CRUDE OIL PRICES HAVE DROPPED BY 43% IN LESS THAN 6 MONTHS

oil-july-dec

If you think we will look back a year or two from now and think $58 oil was a bargain, as I do, then now is the time to think about increasing exposure to the sector. Below are some of the names I like along with their current quotes (long all except EOG as of this writing).

Mega-cap integrated dividend payer: BP PLC (BP) $36

Large cap E&P growth: EOG Resources (EOG) $86

Small cap E&P growth: Halcon Resources (HK) $1.95

Pipeline infrastructure: Enlink Midstream (ENLC/ENLK) $29/$25

 

Gold: It’s Just Yellow Metal

Henry Blodget said it perfectly in an article published on Thursday (“Gold Prices Collapse As Everyone Remembers It’s Just Yellow Metal”). Now that the financial crisis is over and the U.S. economy is normalizing (albeit slowly), gold is no longer an asset class that makes much sense to many who have loved it in the recent past. Gold has no inherent intrinsic value, so buyers are merely hoping that others will buy it from them at a later date for more than they initially paid. There is no claim on any assets, which could increase in value over time (unlike a share of stock which represents a piece of ownership in a money-making corporation). Some people say gold is a currency, and yet you cannot deposit it into your checking account or use it to buy goods at your local store.

In fact, the recent strength in the U.S. stock market, coupled with severe weakness in gold prices, has resulted in stocks now having beaten gold since 2009. It took some time, but fundamentals do matter again. See the chart below:

gld-vs-spx

Netflix and Tesla: Early Signs of Froth in a Bull Market

It is quite common for a bull market to last far longer than many would have thought, and even more so after the brutal economic downturn we had in 2008-2009. Only just recently did U.S. stocks surpass the previous market top reached in 2007. Although it does not mean that a correction is definitely imminent, the current stock market rally is the longest the U.S. has ever seen without a 5% correction. Ever. Dig deeper and we can begin to see some froth in many high-flying market darlings. Fortunately, we are not anywhere near the bubble conditions of the late 1990’s, when companies would see their share prices double within days just by announcing that they were launching an e-commerce web site. However, some of these charts have really taken off in recent weeks and I think it is worth mentioning, as U.S. stocks are getting quite overbought. Here are some examples:

TESLA MOTORS – TSLA – $30 to $90 in 4 months:

tsla

NETFLIX – NFLX – $50 to $250 in 8 months:

nflx

GOOGLE – GOOG – $550 to $920 in 10 months:

goog

 

You can even find some overly bullish trading activity in slow-growing, boring companies that do not have “new economy” secular trends at their backs, or those that were left for dead not too long ago:

BEST BUY – BBY – $12 to $27 in 4 months:

clx

CLOROX – CLX – $67 to $90 in 1 year:

clx
WALGREEN – WAG – $32 to $50 in 6 months:

wag

 

Ladies and gentlemen, we have bull market lift-off. My advice would be to pay extra-close attention to valuation in stocks you are buying and/or holding at this point in the cycle. While the P/E ratio for the broad market (16x) is not excessive (it peaked at 18x at the top of the housing/credit bubble in 2007), we are only 15-20% away from those kinds of levels. Food for thought. I remain unalarmed, but definitely cautious to some degree nonetheless, and a few more months of continued market action like this may change my mind.

Full Disclosure: No positions in any of the stocks shown in the charts above, but positions may change at any time

First Carl Icahn, Now Former Warren Buffett Co-Manager Lou Simpson Invests in Chesapeake Energy

Corporate activist investor Carl Icahn timed his 6% investment in natural gas driller Chesapeake Energy (CHK) almost perfectly earlier in 2011, buying in the low 20’s and selling in the mid 30’s a few months later after extracting a publicly announced debt reduction plan out of management. Now, with the stock back down to prices even lower than where Icahn originally bought, Lou Simpson (former GEICO executive and Warren Buffett number two investment manager at Berkshire Hathaway (BRK)) has bought 200,000 shares in the energy producer.

Simpson, long considered to be a possible Buffett successor despite only a small age difference, retired from Berkshire in 2010 but remains active as a director on three public company boards of directors. Chesapeake is one of the three and the latest. Interestingly, in recent months Simpson has sunk more than $5 million of his own money into Chesapeake stock, at prices in the high 20’s. This is a rare move for Simpson, who typically does not make moves in the public eye like this. As a director though, he must update his holdings in Chesapeake whenever changes are made. I find this move especially telling because in the case of the other two public companies he is involved with, he has largely been given stock options in return for his service, whereas direct open market purchases are rare for him. Often times new directors make small investments (say, a few thousand shares) to show public support, but Simpson has made two separate purchases of 100,000 shares each, for more than $5 million in total.

Now, some may point out that Simpson is worth a heck of a lot of money, so $5 million to him may be peanuts relatively speaking. And I can’t argue that point, but given Simpson’s investment savvy, coupled with the fact that he has not done this with the other companies he serves, I think it is worth noting and is likely due to his belief that the stock is actually quite attractive.

CHK shares, as mentioned previously, are down a lot in recent weeks, as natural gas prices have sunk to $3 and the company continues to spend more on exploration and production than it brings in (to the detriment of equity holders), but it is now even cheaper than it has been previously. And given that Icahn was very successful with his first investment in CHK, I would not be surprised if he got back in, now that the stock price has given back all of the gains he booked, and more. Chesapeake investors, myself included, have been frustrated a lot in recent years, but these recent buys by Lou Simpson strengthen the case that giving up now might be a mistake.

Full Disclosure: Long shares of CHK at the time of writing, but positions may change at any time

Did David Sokol Lie About His Lubrizol Trades on CNBC?

It appears David Sokol picked a bad time to resign from Berkshire Hathaway (BRKA) to start his own “mini Berkshire” investment firm. After appearing on CNBC this morning to try and get out in front of the media blitz regarding his trading in Lubrizol (LZ), Sokol didn’t do himself any favors on national television. Oddly, perhaps the most least talked about detail in press reports today was the explanation Sokol gave on CNBC when he was asked why he bought 2,300 shares of Lubrizol on December 14th, sold them a week later, and then bought them again two weeks after that (in early January). On the air Sokol claimed the sale was for “tax planning purposes” and nobody seemed to question that.

Of course, the problem with that explanation is that when you sell a stock at a loss and want to use that loss to cancel out other gains for the year (which is what Sokol was referring to when he said “tax planning”), you must wait 30 days before buying the stock back again. This is a very well known law called the “wash sale rule” and there is no way Sokol (or his tax advisor if he uses one) is unfamiliar with it. It appears that Sokol may been hiding the truth when he used the “tax planning purposes” defense. Either he is lying about his reasons for selling the stock, or he is unaware of the tax rules and routinely deducts losses even when he violates the wash sale rule.

And to think Sokol was considered a leading candidate to take Warren Buffett’s place. Berkshire Hathaway shareholders really caught a break there…

Update (6:30pm)

The first commenter below has pointed out that Sokol appears to have earned a profit of about $5 per share from his initial LZ sale. In such a case, wash sale rules would not have applied. It is a shame that Sokol did not provide a crystal clear and more detailed explanation for his actions, as opposed to having others speculate. But in terms of this particular speculation on my part, it does appear that Sokol sold the 2,300 share lot of LZ in order to avoid paying taxes on the gain, as opposed to offsetting gains elsewhere with a loss on the LZ position. Thanks to Michael Kelly for the insight. -CB

Sokol’s Lubrizol Trades Sure Look Illegal, And Buffett Needs To Change Berkshire Hathaway’s Internal Trading Policies Immediately

I would not go as far as some people have and suggest that Warren Buffett’s Berkshire Hathaway has lost its way, but there have certainly been some developments in recent months that should give people pause. First, a young, unknown investor is named as one of Buffett’s likely successors, and now we learn that one of the firm’s most highly regarded internal candidates has resigned from the company over what appears to possibly be insider trading accusations.

After looking at the timeline of events surrounding Berkshire’s discussion to acquire Lubrizol (announced March 14th) and Sokol’s trading in the stock while he was serving as the point person for those talks, it is hard to argue that Sokol’s trades are not illegal. Not only that, it appears that Berkshire Hathaway has no internal controls regarding how managers trade stocks they may have inside information about, which is also troubling. Although it is reasonable to assume that high level people at the company should know what would fall under insider trading and what would not, given the fact that Berkshire’s main source of growth is through acquisitions, the firm should have a specific personal trading policy in place for all of its employees. If anything, to avoid situations like this, where it appears that Sokol made a big mistake and Buffett is pretty much defending him by saying he didn’t see anything wrong with the trades.

So why is it most likely insider trading? According to a timeline of the Lubrizol deal compiled by the Wall Street Journal, Sokol met on behalf of Berkshire Hathaway, with their investment bankers (Citigroup), on December 13th. At this meeting the two parties discussed a list of 18 companies that the bankers had put together as a possible deal targets for Berkshire and Sokol told Citigroup that Lubrizol was the only company on the list that he found interesting.  Sokol also told them to contact Lubrizol’s management to inform them of Berkshire’s interest in exploring a possible deal.

At that point it should be obvious to anyone, including Sokol, that he and the bankers are in possession of material, non-public information. Sokol has decided that Berkshire Hathaway would like to explore the possibility of buying Lubrizol and he has instructed his bankers to inform Lubrizol of their interest. It is painfully clear that a deal could result from these discussions, and only a few people are aware of these private plans. Now remember, this meeting occurred on December 13th.

So when did Sokol first buy Lubrizol stock for his personal account? On December 14th. Seriously? Seriously. Sokol bought 2,300 shares of the stock the day after telling Citigroup to call them and express interest in a deal. Interestingly, Sokol sold those shares on December 21st. He didn’t wait very long to buy them back though. During the first week of January Sokol bought 96,060 shares of Lubrizol. Lubrizol’s board met to discuss the interest from Berkshire Hathaway on January 6th and Sokol met with Lubrizol’s CEO face-to-face on January 25. The deal was approved on March 13th and announced March 14th. The purchase price was 30% above where Sokol bought the stock for his own account.

Not only is Sokol going to have trouble on his hands here, but Buffett’s reputation is also on the line. Even though Warren didn’t know about these trades as they were happening, the very fact that Sokol is allowed to trade in the same companies that he is looking at as possible acquisition targets for Berkshire Hathaway (and at the same time!) screams of lax oversight.

GM Buys Subprime Lender for $3.5B (Some Companies Just Never Learn)

Just when I thought General Motors was on solid footing and heading in the right direction after shedding a large portion of its liabilities in bankruptcy, they seem to have forgotten what has happened over the last several years in the world of credit. One of the big reasons GM’s losses were compounded during the recession was because they funded a lot of subprime loans for their vehicles through GMAC. When those loans went sour, the losses not only negated the razor thin margins they had on the vehicle sales themselves, but resulted in a company that lost money on most of their cars. Hence, SUVs (with their fat profit margins) became a focus for the company, even in the face of rising gas prices, which aided their competitors in stealing market share.

Since GM has exited bankruptcy and the economy has stabilized management has stated publicly a desire to once again expand into the subprime auto finance market, but this time GMAC was hesitant (and understandably so). Undoubtedly, the result has been that GM could be selling more vehicles if they were willing to finance customers with bad credit who could not get loans elsewhere. This morning we learn that for $3.5 billion in cash GM is buying AmeriCredit (ACF), one of the larger subprime lenders in the country. They will use this new financing arm to get more cars into the hands of more people, many of whom could not get loans from third party lenders due to bad credit, no job, etc.

While I am sure those in the industry will praise this deal as a way for GM to maximize unit sales, we need not completely forget how cyclical economies work. Subprime lending pays off when the economy is improving but when the business cycle inevitably turns (as every economy does), the loans turn sour, the losses are crushing, and the cycle starts all over again. To me this highlights one of the core problems our domestic economy has developed over the last 10 or 20 years. We continue to follow the path of loose credit when things are going great and at the first sign of a downturn, credit standards increase dramatically. Once things stabilize, we hear that banks are slowly reducing their standards and loan volumes increase again.

For the life of me I cannot figure out why banks and specialty lenders refuse to maintain the same lending standards throughout the entire business cycle. The idea that lending money to people who are likely to default is good business sometimes and bad business other times baffles me. Sure, the few banks that always make smart loans, despite the economic backdrop, make a little less profit during boom times, but they also weather the recessions quite well in return for such prudence.

This kind of cyclical lending activity from the likes of GM (and most others) only contributes to the boom and bust economy the United States has seen become even more pronounced over the last decade. Fortunately, GM is set to go public via an IPO sometime in the next 12 months, at which time the U.S. taxpayer can shed its majority ownership in GM and therefore no longer be in the subprime lending business.

Update (9:15am)

Here is a 15-year chart of AmeriCredit’s stock price which puts into graphical form the cyclicality I mentioned above.


Full Disclosure: No position in AmeriCredit at the time of writing, but positions may change at any time.