Energy Prospectus

I agree with most of what Arthur says in this article: http://www.investorvillage.com/groups.a ... d=14526650

Arthur is a very smart guy and I agree with almost everything in the article. I definitely agree that today's low oil price is unstainable and will lead to a drop in global oil production and much higher prices in 2016.

Here is the confusion with the "break-even" concept: Many people seem to not understand the difference between "capital expenditures" and "operating expenses".
> The cost of drilling & completing new wells are capital expenditures (add to fixed assets on the balance sheet). By definition, capital expenditures create long-term assets that generate revenues in future periods.
> Once a well is placed on-line the cost to operate that well's ("Lease Operating Expenses") and production taxes are the primary operating expenses. Operating expenses by definition do not benefit future periods and therefore offset current revenues to arrive at Net Income.
> Even if you include gathering, processing and marketing costs, the current "cash expenses" for most upstream companies are under $15/boe of production. So, on existing production the companies in our Sweet 16 are netting $35/bbl cash flow from operations if they sell the oil for $50/bbl.
> D&C costs are "expensed" in future periods as depreciation & depletion ("DD&A"). [The are non-cash add backs to arrive a Cash Flow From Operations.]

An E&P company can survive for a very long time with $35/boe netbacks. When I worked for Hess (18 years) we NEVER had netbacks that high.

Let's compare it to a growing real estate developer. The land cost and construction cost of new buildings are not expensed in the current period. They are "capitalized" on the balance sheet. Those costs are "recovered" in future periods as Depreciation Expense against the revenues generated by the new buildings.

I see analysts all the time talk about E&P capital costs as if they are current expenses. Arthur seems to imply that because Continental Resources (CLR) is spending more on capital costs than its operating cash flows, it is losing money. Based on CLR's annual reports for the last few years they are making a lot of money. Keep in mind that GAAP accounting rules for E&P companies are very conservative, so these are "real earnings".
2012A = $2.01 EPS
2013A = $2.07 EPS
2014E = $2.94 EPS < This will be the best year in company history

Back to the real estate example. Saying CLR is losing money is the same as saying a rapidly growing RE company that is outspending its operating cash flows by adding more office buildings each year is losing money even though annual rents are going up by 50% each year and exceed (by a wide margin) the current operating expenses of the buildings.
Think of it this way: Each time an E&P company completes a new well, it is adding a new source of future revenues. The cost of that well will be "expensed" against that revenue stream as DD&A (Depletion, Depreciation and Amortization). We will only know if that well was a wise use of capital when it is depleted (actually we will know on a typical shale well in about two years), just like the real estate company will only know if it was wise to build a new office building after it is occupied for a few years. If oil prices run back to $100/bbl in 2016, everyone will say how smart CLR was to drill wells in 2015.

What's true is that at today's oil & gas prices it makes no sense to drill "average" shale wells. Only wells in the Sweet Spots make sense and if I were advising an E&P company, I would advise them to cut as much drilling as they can until prices come up. The big horizontal shale wells produce 60% to 70% of their reserves in the first two years. I think even the companies with rigs under long-term contracts should push back well completions as long as they can.

Dan

excellent post, dan. there are so many of these articles that really can confuse the issues. your post was much needed. you have said these things at some of the lunches--now we have it in writing and can refer back to it.

dan, just how long can the capitalization of a well be. i think it varies from industry to industry. in the business i was in we tried to capitalize over as short a period as possible.

also, can a well rework such as re fracking or acid treatments be capitalized?

Workover that just clean up a well are expensed in the current period. A workover that deepens a well or opens a new zone are capitalized, because they extend the wells life and add new proven reserves. Full Cost companies put capitalized workovers in the Full Cost Pool.

DD&A rates for book purposes and tax purposes are two totally different things.
> For tax purposes you want to depreciate well equipment as fast as you can. Most oilfield equipment is depreciated for tax purposes over 5 years using double declining balance. For tax purposes all intangible drilling costs (IDC) are expenses as incurred.
> For book or GAAP purposes all well costs (leasehold, IDC and equipment) are capitalized and eventually expensed as DD&A using the unit of production method (UOP). How that's done depends on if the company uses the Full Cost Method or the Successful Efforts Method of accounting. Most of our portfolio companies have elected to be Full Cost.

Full cost companies put all capital costs (including dry holes) into the "Full Cost Pool" (there is a "pool" for each company). Most of our companies only have one pool (the U.S.). Each quarter: (Current production / proven reserves) X the Full Cost Pool = DD&A expense for the quarter.

Successful Efforts companies do about the same thing on a property by property basis.

The HUGE difference between how capital costs are handle for book and tax purposes explains the big split between current and deferred income taxes.