How long can the frack­ing spend­ing spree last?

Houston Chronicle Sunday - - BUSINESS - By James Os­borne STAFF WRITER

WASH­ING­TON — For the past decade Wall Street has lav­ished cash on U.S. oil com­pa­nies, ea­ger to get a piece of the frack­ing boom that turned what were thought to be un­drill­able shale fields in West Texas and North Dakota into the hottest oil prospects in the world.

If com­pa­nies spent bil­lions more than they were tak­ing in to buy up more acreage and their com­peti­tors, not a prob­lem — the money was fund­ing a once in a gen­er­a­tion op­por­tu­nity.

But af­ter a decade of U.S. oil and gas com­pa­nies spend­ing be­yond their means, a de­bate is un­der­way in the en­ergy and in­vest­ment sec­tors on whether to keep pumping money into oil fields to keep the boom go­ing full speed. Or with in­ter­est rates ris­ing and in­vestors de­mand­ing bet­ter re­turns, are frack­ing firms go­ing to have to live within their cash flows?

“The his­tory of the in­dus­try is com­pa­nies spend ev­ery nickel they have and a bunch they didn’t have,” said Nick Cac­chione, owner of Oil and Gas Fi­nan­cial An­a­lyt­ics, a Florida re­search firm. “The ques­tion is, has the in­dus­try changed and have they be­come more con­ser­va­tive, or are they go­ing back to their old ways of do­ing things?”

Signs point to U.S. oil com­pa­nies chang­ing their habits, shrink­ing their cap­i­tal bud­gets even as oil prices im­prove. Af­ter run­ning a cash flow deficit to­tal­ing more than $40 bil­lion in 2015 — mean­ing their op­er­at­ing costs and cap­i­tal ex­pen­di­tures ex­ceeded the money they were paid — the 60 largest U.S. ex­plo­ration and pro­duc­tion com­pa­nies shrunk that deficit to $17.7 bil­lion last year.

That fol­lowed in­tense pres­sure from hedge fund man­agers who ques­tioned the fun­da­men­tal eco­nom­ics of the frack­ing boom. Af­ter the first 12 months, the out­put of shale wells starts de­clin­ing at a fast clip, re­quir­ing com­pa­nies to drill more and more wells if they are go­ing to keep up pro­duc­tion. At an in­vest­ment con­fer­ence in 2015, bil­lion­aire in­vestor David Ein­horn dubbed the oil ex­ec­u­tives in Hous­ton and Ok­la­homa City “frack ad­dicts,” pro­claim­ing “a busi­ness that burns cash and doesn’t grow isn’t

worth any­thing.”

The tip­ping point came around 2017 when oil prices were ris­ing, but the share prices of many U.S. frack­ing com­pa­nies were flat or falling, as in­vestors lost con­fi­dence that com­pa­nies could live within their means.

“This was the first time there was that dis­con­nect,” said Bill Her­bert, a Hous­ton-based man­ag­ing di­rec­tor at the in­vest­ment bank Piper Jaf­fray. “Pub­lic eq­uity in­vestors, they’ve be­come much more de­mand­ing of th­ese man­age­ment teams to live within cash flow and man­age their bal­ance sheets more re­spon­si­bly than five years ago.”

When oil com­pa­nies first dis­cov­ered they could use the same hy­draulic frac­tur­ing and hor­i­zon­tal drilling tech­niques on oil shale fields that they use to drill nat­u­ral gas, they bor­rowed hun­dreds of bil­lions of dol­lars de­vel­op­ing oil fields in Texas and North Dakota. But when that surge in pro­duc­tion caused global crude mar­kets to plum­met in late 2014, many com­pa­nies couldn’t af­ford to pay their cred­i­tors and were forced to de­clare bank­ruptcy, stiff­ing lenders and in­vestors on more than $70 bil­lion in out­stand­ing loans.

Oil ex­ec­u­tives ap­pear to have learned the les­sons from the oil bust, pay­ing much more at­ten­tion to fi­nan­cial dis­ci­pline and fo­cus­ing on pro­vid­ing in­vestors with higher prof­its, div­i­dends and stock prices. But will they keep it up?

With oil prices hov­er­ing around $70 since May — com­pared with less than $30 in early 2016 — the temp­ta­tion is there to in­crease drilling again. Com­pa­nies have re­duced the ex­trav­a­gant debt loads of a few years ago, but with the Fed­eral Re­serve sig­nal­ing it will raise in­ter­est rates two more times in 2018, rais­ing yields on loans and bonds, plenty of in­vestors will be ready to give oil and gas drillers more money, said Kather­ine Spec­tor, a re­search scholar at Columbia Univer­sity’s Cen­ter on Global En­ergy Pol­icy.

“Banks are go­ing to make more money (through higher in­ter­est rates), so they’re go­ing to want to get more money out the door,” she said.

While ris­ing oil prices have fixed much of what ailed the in­dus­try, com­pa­nies must now con­tend with chal­lenges that weren’t much of a fac­tor five years ago.

To start, the his­tor­i­cally low unem­ploy­ment rate is be­gin­ning to drive up wages, par­tic­u­larly in West Texas oil towns near the Per­mian Basin, where unem­ploy­ment rates are far lower than the na­tional av­er­age. The unem­ploy­ment rate in Mid­land, for ex­am­ple, is just over 2 per­cent, com­pared to 3.9 per­cent na­tion­ally.

The rise in in­ter­est rates also means oil com­pa­nies have to pay more to bor­row, putting the days of ex­pand­ing with cheap money be­hind them. In ad­di­tion, the sav­ings oil com­pa­nies squeezed from new tech­nolo­gies, more ef­fi­cient pro­duc­tion and dis­counts from con­trac­tors may have topped out. U.S. oil ex­ec­u­tives claim they can drill new shale wells with oil prices as low as $52 a bar­rel. But, an­a­lysts said, it’s un­clear if they can keep their costs that low for long.

“The com­pa­nies have prob­a­bly reached the depths they can get their op­er­at­ing costs,” Cac­chione said. “Cost in­fla­tion is start­ing to creep into the oil patch.”

How it will all turn out is any­one’s guess, but there is lit­tle doubt that some oil ex­ec­u­tives will be tempted to ex­pand their hold­ings, ea­ger to take ad­van­tage of the rel­a­tively high oil prices.

Af­ter all, even as a sub­set of oil com­pa­nies have fo­cused on rais­ing re­turns for in­vestors, “growth re­mains core to the sec­tor’s busi­ness model and strat­egy,” Eric Otto, man­ag­ing di­rec­tor at Rap­i­dan En­ergy Group, a Mary­land con­sult­ing firm, said.

In the months ahead, oil com­pa­nies will be­gin re­leas­ing cap­i­tal spend­ing plans for 2019, re­veal­ing to in­vestors whether they’re stay­ing con­ser­va­tive or get­ting back to the high drilling ac­tiv­ity of 2015. Cac­chione, who has spent three decades track­ing the in­dus­try, said that with com­pa­nies still re­cov­er­ing from the oil price crash of late 2014, he is not ex­pect­ing dra­matic in­creases in spend­ing — at least not yet.

“The blood bath is still pretty flesh in peo­ple’s minds,” he said. “At least for another year they’ll be re­spon­si­ble with the money and not go crazy.”

Callaghan O'Hare / Bloomberg

A Col­gate En­ergy oil drilling rig stands in Reeves County in West Texas’ Per­mian Basin, the heart of the frack­ing boom.

Callaghan O'Hare / Bloomberg

A con­trac­tor ma­neu­vers drilling pipe at a Col­gate En­ergy oil rig in Reeves County in the Per­mian Basin.

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