False Profits: A Prodigal Value Investor Returns from the Oil Patch


  • There are two ways to create value in the upstream business: find and produce extremely low cost-of-supply resources; and, integrate along a value chain in order to sell at relatively higher prices.
  • Of these two options, rational integration is far more scalable and repeatable.
  • Data of historical free cash flows overwhelmingly supports the notion that integration is the strategy most conducive to value creation.
  • However, omens of an oil and gas upstream and midstream investment bubble have not been conducive to identifying investment opportunities.

I watched There Will Be Blood a few years back, right after oil prices tanked in late 2014. A scene stood out in my brain, though I never really figured out why until now.

2007_there_will_be_blood_001Source: Critical Analysis: There Will be Blood (Paul Thomas Anderson, 2007). The Film Emporium Blog. 9 October 2010

It goes like this:

Our protagonist, Daniel Plainview is “hunting quail” — a cover for prospecting for oil — on private property with his adopted son HW. HW runs off to retrieve a downed quail and returns to his father with a tarry black substance covering the bottom of his shoes. They soon realize that they have found their “pay sand”.

Then, as they both gaze over the horizon, we learn about Daniel’s vision; one which foresaw the crux of petroleum economics through the century and beyond.

so-so. if there’s anything here…we take it to the sea — we can go into town and see a map – but what we do — we take a pipeline from here to Port Hueneme or Santa Paula and we make a deal with Union Oil — this is what we do and we don’t need the railroads and the shipping costs anymore, you see? …and then we’re making money. we make the real money that we should be making and we’re not throwing it away — otherwise it’s just mud.

Daniel’s revelation is simply that the lion’s share of profits in a commodity driven business come from connecting raw goods to those who demand them, otherwise on the open market these raw goods are equal to “mud”. In other terms, rational integration along a value chain is the premier means by which to realize economic value.

To me, this is somewhat groundbreaking because I formerly came to a different conclusion: maintaining a sufficiently low cost of supply resource was the key to value creation in a commodity driven business. Although having access to a very low cost resource is one means of realizing value (and one which is relatively resilient to commodity price swings), I have learned that this is extremely difficult to do and even harder to repeat — even among those who possess very specialized skill sets. E.g., were managements of companies that focused on the Permian Basin (before you had pay > $45,000/acre for prime acreage) good or lucky? As in a national coin flipping contest (a-la Warren Buffett’s Superinvestors essay), it is extremely difficult — nay, impossible! — to distinguish skillful coin flippers from lucky ones.

My point: you don’t have to have the lowest costs in order to profit. Rather, it is much easier (and less risky) to embed yourself into a value chain where you can buy relatively low, and sell relatively high.

Figure 1: Illustrative Petrochemical Value Chain
Source: Author

Anticipation of Opportunity
Anyway, while oil prices were tanking, I thought that mass hysteria would lead to some easy pickings in the market, especially for upstream companies. The idea was simple enough. Yet, nearly every time I attempted a bottom-up valuation (i.e., discounted cash flow analysis) of an upstream petroleum company, I got an equity fair value that was much less than the market capitalization — often times, it was zero.

The underlying assets always had some value, so there was definitely something to be said of owning the bonds. However, I was forward deployed at the time, and didn’t have time to embed myself in a new type of market.

And actually, a lot of equity valuations did make sense if I thought energy prices were recovering. But if that was the case, then why not buy the commodity itself?

Though frustrated by repeated failure, I maintained my value investment mindset (i.e, price seeks value — if you pay a low enough price, time is the only catalyst needed — et cetera) and never paid what I thought was a high price. Moreover, I was goaded on by a suspicion that there was an important piece of information I had missed or was not fully appreciating. E.g.: what happens when I assume prices grow by the rate inflation? What if efficiency gains are sustainable and costs stay low even if/when prices rise? What if I treat the potential resource base as a no cost real option? What if corporate decline rates improve? What if secondary and enhanced recovery methods add significant upside to ultimate recovery?

Usually, even after stretching reality to the limits of imagination, prices still exceeded my notion of fair value.

The word “bubble” lingered in the back of my mind, but I digress.

The crux of my problem is this: I have scoured across the North America upstream industry and found that money is being poured into the ground and that less is coming back out. All the while, production has soared and accounting profits are being declared. So, no problem. Right?

The Meaning of Profit
To traditional value investors, statements of cash flows offer essential information regarding companies’ underlying profitability. GAAP earnings, which are based on the accrual method of matching expenses to the time period in which corresponding revenues are recognized, allow for significant managerial discretion as to what costs are capitalized (i.e., added to the balance sheet as an asset). For example, in the United States, FASB classifies upstream business as extractive enterprise — as such, these companies may choose between employing full cost (FC), successful efforts (SE), or hybrid accounting methods when classifying costs as investments or expenses. Upstream companies can practically engineer GAAP profitability by taking impairment charges, and playing them down as “one bad quarter — not too be expected going forward”.

The commonplace practice of impairing assets, which is relatively more common among companies which use FC accounting, causes GAAP costs to greatly understate full-cycle economic costs and leads to significant distortions between GAAP profits and economic profits.

Interpretation of the statement of cash flows, on the other hand, is far less ambiguous. There are only three categories of cash flows — cash flow from operations (CFO), cash flow from investing (CFI) and cash flow from financing (CFF) — that when summed together equal the change in cash balance. Unlike earnings, cash balances are concrete numbers, easily verified in an audit. So, for an oil and gas company, if CFO exceeded CFI, then one can safely assume that more money came out of the ground than was put in. In practice, CFO plus CFI is a common measure of free cash flow (FCF). In effect, it is pretty darn close to a working definition of economic profit.

Charlie Munger agrees:

There are two kinds of businesses: The first earns 12 percent, and you can take it out at the end of the year. The second earns 12 percent, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.
Charlie Munger, Berkshire Hathaway 2013 Annual Meeting

Of course, the shortcomings of using cash flows as a proxy for economic profits are manifold. For example, asset sales of oil and gas properties are ubiquitous in the oil and gas industry. Large upstream companies frequently utilize asset sales during downturns to generate liquidity and preserve dividends. Considering cash received without also considering cost basis leads to a poor understanding of profit. In spite of the limitations, aggregating cash flows over multiple companies and/or time frames should mitigate the noise.

The Experiment
So, after more than two years of research, I have come up with three key observations:

  1. Upstream economics stink.
  2. Upstream company stock valuations discount much higher energy prices.
  3. “Profits” have for years failed to result in free cash flow.

In order to determine just how much cash had been sunk into the ground and has yet to be recovered, I designed an experiment using Portfolio123 which was conducted as follows:

  1. Set the “universe” to all companies in the oil and gas industry, according to the Global Industry Classification Code System (GICS).
    Table 1: The Sample

    GICS Sub-Industry Code GICS Sub-Industry Name GICS Sub-Industry Short Name Number of Companies in Sample Total Market Capitalization (MM USD)
    10101010 Oil & Gas Drilling OILGASDRILL 24 $40,619
    10101020 Oil & Gas Equipment & Services OILGASEQUIP 86 $302,106
    10102010 Integrated Oil & Gas OILGASINT 23 $1,699,022
    10102020 Oil & Gas Exploration & Production OILGASEXP 208 $695,639
    10102030 Oil & Gas Refining & Marketing OILGASREF 37 $152,106
    10102040 Oil & Gas Storage & Transportation OILGASTRANS 108 $585,711
    All Oil and Gas 486 $3,475,204

    Source: Portfolio123; author’s calculations

  2. Calculate FCF, defined as CFO plus CFI, for each company over the past 10 years.
  3. Aggregate free cash flows by GICS Sub-Industry.

The results of this study are as follows:

Table 2: Cumulative Free Cash Flow of Oil and Gas Companies, 2006 to 2015

GICS Total Market Capitalization (MM USD) Cumulative FCF – 2006 to 2015 (MM USD)
OILGASDRILL $40,619 $394.00
OILGASEQUIP $302,106 $37,018.75
OILGASINT $1,699,022 $730,211.47
OILGASEXP $695,639 -$120,071.80
OILGASREF $152,106 $36,260.77
OILGASTRANS $585,711 -$242,766.43
All Oil and Gas $3,475,204 $441,046.76

Source: Portfolio123; author’s calculations

Or, graphically…

Figure 2: Discrete Free Cash Flows of Oil and Gas Companies, 2006 to 2015
Discrete Free Cash Flows of Oil and Gas Companies - 2006 to 2015
Source: Portfolio123; author’s calculations

Figure 3: Cumulative Free Cash Flows of Oil and Gas Companies, 2006 to 2015
Cumulative Free Cash Flows of Oil and Gas Companies - 2006 to 2015
Source: Portfolio123; author’s calculations

The result of this simple experiment overwhelmingly supports Daniel Plainview’s assessment regarding petroleum economics. Out of 486 companies which over the past 10 years have produced $441 billion in FCF, 23 of the companies (which make up about 50% of the group’s total capitalization) produced $730 billion (165%) of the group’s total FCF. Of this $730 billion, Exxon Mobil (XOM) produced 34% and the next four biggest FCF producers — Royal Dutch Shell (RDS.A) (RDS.B), BP (BP), Chevron (CVX), and Total (TOT) — produced an additional 46% of the group’s $7.3 billion, leaving the balance of 18 remaining competitors to scrap over the remaining 20%.

If that is not a vindication for integration, then I am not sure what is.

On the opposite end of the spectrum, exploration and production companies and trans-logistics companies have literally been money pits. Since 2006, US publicly traded oil and gas upstream and midstream companies have outspent a combined $363 billion. It may be that this negative cash flow will someday be recuperated and then pay returns, but from what I’ve seen in the upstream business, many assets will not ever pay out.

Midstream assets, generally regarded as stable and safe investments, have incurred huge capital investments. The investment thesis has been that these are long-lived assets with a long-tail of cash flows to cover the upfront costs. However, the economic viability of these greatly depends on where they are and what they do. For example, gathering pipeline infrastructure in a rapidly depleting field is basically worthless. On the opposite end, transcontinental pipelines and key transportation infrastructure to refineries and utilities basically own a perpetual growing annuity.

The refining business has done relatively well, generating more than its fair share of the industry’s FCF. Refineries straddle an economic “sweet spot” in the petrochemical value chain. In a relatively short amount of time, over a relatively short distance, Daniel Plainview’s “mud” is magically-mystically transformed into stuff with real economic value. Additionally, some refineries are capable of producing specialized petrochemicals which can then be very profitably sold to specialty chemical manufactures or directly to consumers. Moreover, a massive wave of consolidation since the 1970s has concentrated refineries among relatively few management teams, leading to efficiencies of scale.

Even though refiners operate in an extremely tough regulatory environment, most regulatory costs (e.g., Tier III gasoline and emissions standards; recent fenceline emissions monitoring requirements; local regulations; et cetera) are offset by higher prices at the pump (i.e., the consumer pays). However, the current implementation of the EPA’s Renewable Fuel Standard (RFS2) threatens to erode merchant refiners’ competitive advantages completely. Seeking Alpha contributor, Tristan R. Brown, has written on this topic extensively, especially throughout the 2016 election cycle.

Oil and gas equipment companies earned significant free cash, commensurate with the segment’s relative capitalization. The “picks and shovels” business model certainly has economic viability when and where companies can differentiate themselves from competitors.

For the remaining balance, oil and gas drilling companies basically broke even. Drilling is an extremely commoditized and competitive business. No surprises here.

What’s Missing
While this experiment was intended to provide economic insight into a large and representative cross-section of the greater oil and gas industry, the analysis has its limitations. It only includes companies publicly traded on US exchanges. Private companies and companies for which no fundamental data is available in Portfolio123’s (i.e., S&P Capital IQ’s / CompuStat’s) database are disregarded. In addition, it fails to explain stock market returns.

Figure 4: Oil and Gas Industry Total Return Indices versus WTI
Oil Gas Industry Total Return Indices - 2006 through 5 Dec 2016
Source: Portfolio123; author’s calculations

Note to Figures 4: Custom Total Return Indices are constructed according to a modified capitalization weighted indexing methodology which adjusts previous close prices for the effects of dividend, splits, and other corporate actions. Industry Total Return Indices aggregate returns according to a company’s primary GICS code. Calculations included all U.S. publicly traded companies in the Portfolio123 database for which prices and share information were available point-in-time.

Follow on analysis failed to demonstrate any meaningful correlations between an oil and gas market segment’s FCF (or GAAP earnings) and equity market returns. On first glance, this observation — that valuation matters not — seems contrary to a key tenet of value investing: price seeks value.

The midstream business segment provides the most obvious example of the apparent dislocation between FCF generating ability and equity returns. While the sampling of oil and gas transportation and logistics companies have outspend by nearly $243 billion since 2006, the sector’s stock equity has appreciated by 156.5% (or by about $357 billion) over this time.

However, I never expected to find systemic mispricings. Instead, the purpose of this analysis was to test inclinations regarding the overall economic viabilities of various business models within the industry.

Still, I wonder if the lack of correlation between operating and market returns is related to this earlier ideation of a bubble. Is not one sign of a bubble when markets fail to respond to contradictory data?

When the Bough Breaks
OPEC’s actions are not inconsistent with this idea. If indeed we are in the midst of an oil and gas investment bubble, OPEC’s relative inaction through the downturn could be interpreted as evidence that it had been willing to let its member states suffer while market forces let some of the air out — I am not the first to think of the Sheikhs versus Shale motif. However, OPEC’s 30 November production cut — its first since 2008 — in the face of robust worldwide production supports the idea that this bubble is far more resilient than its economists had originally believed.

Cheap capital — a result of artificially low interest rates — resulted in mobs of eager money managers with gobs of cash who are all still chasing yield. This potential for malinvestment combined with the animal spirits of the “North American Shale Boom” or “US energy Renaissance” led to conditions conducive to an upstream and midstream investment bubble. If such an alleged investment bubble is simply the result of investor overoptimism (i.e., over-capitalization), economic woes will be relatively isolated to banks and investors with concentrated holdings in energy. However, if the bubble turns out to be an operating concern — and the boom itself is unsustainable, as the Post Carbon Institute purports — then the specter of peak oil will reemerge, much higher energy prices will almost unquestionably follow, and the preponderance of industry pundits and cheerleaders will have been rightfully embarrassed.

Though one might think that the scores of analysts following this market would cry wolf if a bubble were imminent, the failures of mortgage derivatives analysts to do the same in the 2007 financial crisis tell us otherwise. Garbage in — garbage out.

Coming full circle, the point is this: if/when, for whatever reason, the alleged investment bubble deflates and investors stop pouring money down the gullets of oil and gas companies, companies must survive off their own internally generated free cash flow. Assuming that future demand for petroleum is not significantly disrupted, we should all be able to use the data to see how past becomes prelude.

Although there will be a period of great suffering in the upstream and midstream industries, rationally integrated companies will continue to exploit the basic economic viability of shipping transformed mud to those in need of it. Moreover, increasing technical complexity in locating, extracting, and transporting future supply should eventually translate into higher prices. In this case as well, rationally integrated companies are poised to benefit.

But this is the same strategy that has worked through multiple commodities cycles…

Where Now?
Now, knowing what we now know about petroleum economics, we are hopefully better informed to make good investment decisions.

I hope most readers come away with the understanding that, for most classes of investors, there is absolutely no reason to sink money in the commoditized end of the oil and gas business unless its in a well-rationalized integrated company which turns relatively worthless mud into a substance with tangible benefits to society. Also, since deep value investing is unusually difficult in this industry, I believe that Warren Buffett’s late-period investment advise, that “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”, holds unique salience.

Along those lines, there do appear to be certain oil and gas service companies which are uniquely economic. Service companies like Schlumberger (SLB) and Core Labs (CLB) offer specialized services which result in efficiencies that only grow in importance during downturns. Also, companies with deep technological and intangible asset portfolios are relatively better insulated from inflationary pressures than capitally intensive companies that must replace fixed assets at ever higher prices. While I haven’t specialized in analyzing these companies, I would think that one purchased at a fair price offers a good margin of safety through future growth potential.

The alternative — to identify a good investment thesis in one of the commodity driven oil and gas segments — requires specialized skills and a keen eye for value.

Before going any further, I must admonish the readership: “abandon hope all ye who enter here”. But for those brave souls who insist on venturing through the gates of commodity hell, I offer hope that mis-pricings still do exist.

Even if energy prices recover slowly, at the rate of inflation, there is value to be had in identifying boring, low cost producers. Two such companies in which I believe one can receive more than one pays are Granite Oil (GXOCF) and Evolution Petroleum (EPM). Both specialize in enhanced recovery (ER) — an old technology that has in certain cases remarkably prolonged reservoir productivity. However, ER lacks the sex appeal of fracking’s huge IP rates. Low capital intensity – check. Acquired acreage cheaply – check. Nearby infrastructure – check. Upside potential – check. Cheap valuation – check.

There is also significant upside from identifying emerging plays. This is very difficult to do. There are droves of Ph.D. petroleum geologists with access to immense proprietary data, specialized software, and a cadre of assistants that spend their days trying to crack that nut. If you or I believed we had any edge in this arena, we would almost certainly be nuts.

Yet, there are certain instances early in an emerging resource play’s life where valuations have not yet caught up with potential. One such instance might involve the Montney Basin which straddles British Columbia and Alberta, Canada. A recent Oil & Gas 360 Article points out that although the Montney offers similar stacked pay potential as the Permian Basin, leases are still relatively affordable. Also, the Duvernay Shale, which underlies the extensively drilled Cardium formation, is thought to be “much thicker and richer in hydrocarbons per section than the Cardium“. However, it is still far too early to know about its true potential.

Aside from those two types of opportunities, I am currently not aware of any enticing business or investment propositions in the upstream business. Although there are assuredly companies and management teams which have created and will go on to create a lot of value, I can only remind the readership that it is difficult — nay, impossible — to distinguish skill from luck. And to echo Mr. Plainview’s wisdom:

Now, you have a great chance here, but bear in mind, you can lose it all if you’re not careful. Out of all men that beg for a chance to drill your lots, maybe one in twenty will be oilmen; the rest will be speculators – that’s men trying to get between you and the oilmen.