Oil the industry’s diminishing returns. The law of

Oil prices are nowhere near the $140/barrel
high of 2008, but the low crude oil prices fluctuating between $40 and $60
dollars in recent yeaars have not stopped the shale boom from catching the attention
of investors. Innovative horizontal drilling and hydraulic fracturing
techniques have enabled U.S. oil production to grow to about 9.6 million
barrels a day in comparison to 5 million barrels a decade ago (Wall Street
Journal). Natural gas production has had a similar increase.  However, as many shale gas and tight oil
plays are being forecasted to reach peak production within the next couple of
years, the shale revolution seems to be reaching a halt. Many investors have
become upset with the shale oil industry because they are receiving subpar
returns in a supposedly booming industry. Oil prices have been rising since
June, but the stock prices of shale companies have not followed the same
direction (Wall Street Journal). Due to diminishing returns, increased
competition, and the green movement, the fracking industry is no longer a
promising investment even though it continues to produce huge amounts of oil
and natural gas.

            One
of the biggest obstacles is the industry’s diminishing returns. The law of
diminishing returns “refers to a point at which the level of
profits or benefits gained is less than the amount of money or energy invested”
(Wikipedia). As drilling continues, more money is invested and less shale oil
is extracted. In recent years, the depletion rate at various drilling locations
has increased, leading to growth issues for all shale producers. When observing
the diminishing returns of shale oil, it is important to differentiate between
overall production growth and oil production productivity. In terms of overall
production growth, oil companies are still fairly successful in producing a
high amount of energy for the country. 
On the other hand, various trends have shown that production
productivity, the actual rate of growth, has decreased.

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From 2012 to 2014, oil prices were
increasing and shale oil production per rig grew at a monthly average rate of
2.7%. This rate grew to 3.6% in 2015 and 3.2% in 2016 while oil prices were
decreasing. By December 2016, oil prices and the rig count increased as
productivity per rig declined. (Seeking Alpha)

 

In other words, shale producers started to
drill in deeper layers of acreage to try and capture more cash flow. The
consequence of these high depletion rates are unproductive drilling locations
and higher costs of raw materials to used in fracking and horizontal drilling
operation.  Studies by the U.S. Energy
Information administration show that new well rig productivity has slowed. New
well productivity peaked in 2015 and has declined since. Therefore, to continue
these expensive drilling rates, shale oil companies will need oil prices to
rise substantially or need to alter their capital structure. With oil prices
staying consistently between the 50 and 60 dollar range, the former is not
likely.

            Fracking
just a single well requires equipment, trucks, pipelines, water, waste
management, and a large amount of manpower. When hydraulic fracturing was just
coming into play, only three companies had the majority of the market for
pressure pumping in the U.S: Schlumberger, Haliburton, and BJ Services. Through
the popularity of the industry, many new companies such as Nabors Industries,
Basic Energy Services, and Patterson UTI Energy have expanded their footprint
and market share (Wall Street Journal). The increase in entries to the market
forces shale oil companies to change their drilling strategies. When the
drilling boom was just beginning, energy companies focused mainly on snapping
up acreage in order to produce a large amount of output. In a more mature
industry with more competition, companies must operate more intelligently. Due
to the initial success and popularity of the industry, many companies failed to
focus sufficiently on profit producing drilling techniques.

            The
key in such a competitive market is to limit supplies and boost prices; in
other words, pump less and profit more. Anadarko Petroleum Corporation had $6
billion on their balance sheet earlier this year and their stock price fell
almost 40% (Wall Street Journal). Many shareholders feared that Anadarko would
spend the money on questionable drilling campaigns. After pressure from
shareholders, Anadarko announced a buyback of $2.5 billion in stock rather than
pouring their money back into production (Wall Street Journal).  The company said that  making faster returns is a priority. “The
number of in the money wells is much smaller when costs for land, pipelines,
and other infrastructure and overhead is factored in” (Wall
Street Journal).

            A
number of European countries have put a ban on fracking and as more European
countries go against fracking, more companies lose hope of ever starting an
energy revolution in the continent. The European Energy Centre has completed
many studies comparing fracking to renewables in order to promote its positive
stance on renewable energy. The E.E.C. has continuously highlighted concerns
about environmental, safety, and viability effects. There was an early hype of
fracking in Europe, but not many are keen in establishing a shale gas industry
in the continent.

In 2011,
Poland’s
president Donald Tusk pledged to begin commercial fracking in 2014, but as time
went on, more and more countries banned fracking. U.S. Oil companies went to
France, Germany, Poland, Romania, and Bulgaria to kick start a shale gas
market, but environmentalists stood in their way. Friends of the Earth Europe
grassroots campaigner Antoine Simon expressed “The failure, so far, of shale gas
development in Europe is mostly due to a failure by the fossil fuels industry
to understand the differing context here…” He conveyed that Europe had higher
environmental standards and a higher population density against living in close
proximity of gas production. Environmentalists believe that shale gas produces
less CO2 than natural gas, but “the picture is less clear when it includes
methane emissions, which are 56 times more potent than CO2 over a 20-year
period, and could trigger feedback loops of global warming” (The
Guardian).

As the
green movement continues to gain momentum in Europe, the consumption of energy
from renewable sources has spread across the continent. The European Union
seeks to have a 20% share of its gross final energy consumption from renewable
sources by 2020. The EU has also set a target of 10% for the share of renewable
energy in the transport sector by 2020. 
With efforts to have renewables conquer the European market in sectors
such as transport and electricity, the potential for new tight oil and shale
oil plays outside of the U.S. and for exports of U.S. oil decreases. This puts
shale oil companies in a tough position; if companies do not start becoming
more strategically profitable, then it will be more difficult for them to
overcome the green movement and find more acreage outside the U.S.

The Tale of Two Fracking Companies: Anadarko
& Schlumberger

In the
previous section, the biggest obstacles of the fracking industry were explained
in detail. Oil productivity per rig seems to be a growth issue for companies
such as Anadarko, EOG Resources, Exxon Mobil, Chevron, ConocoPhillips,
Continental Resources, Schlumberger, and Hess. This section will focus on
Anadarko (APC) and Schlumberger (SLB).

Schlumberger
is one of the world’s largest oilfield services providers –
leading in technology, project management, and information solutions to the oil
and natural gas industries. Once upon a time, Schlumberger was one of three
companies that did almost all of the fracking for the U.S. However, over the
past year their stock price has been falling over the combination of lower oil
prices and the failure of management to slim down operations to be profitable.
Between January and March of 2017, Schlumberger posted adjusted diluted
earnings per share which fell 37.5% from the previous year. Even though their
revenue rose for the first time in two years, it still fell short of investors’
estimates. Schlumberger has had a history of creating value for shareholders,
but over the past year, that has not been the case.

Schlumberger’s service
business has been negatively affected by the sapping profitability of fracking,
just like other companies they have paid to lease land for drilling in places
such as the Permian Basin in Texas and New Mexico. The issue is that many
operators drop out of their leases before breaking even. Even though
Schlumberger has well locations all over the world, the number of in the money
wells is far smaller when considering the costs for land, pipelines, manpower,
and overhead.

           

            Over
the past year, Anadarko has been struggling with production cost losses and
negative free cash flows. This is due to weak production volumes and high
spending levels. Their stray from focusing on profitable drilling has led them
to fall deep into the trap of diminishing returns. Through its past focus on
expanding production, Anadarko has just been gaining more acreage and spending
more to gain less value of shale oil.

            In
the first nine months of 2017, Anadarko faced a cash flow deficit of $516
million. In the third quarter of 2017, the company lost $699 million and now
their loss is $2.14 per share through the third quarter. They generated $2.62
billion of cash flow from operations during the first three quarters of the
year, but spent much more on capital expenditures. Therefore, their cost to
produce oil is more than the value of the oil they drill. Anadarko’s fourth
quarter results are still struggling due to their weak production and high
levels of expenditure throughout the rest of the year. (Seeking Alpha) On the
bright side, Anadarko has very strong liquidity of more than $10 billion
consisting of $5.25 billions of cash reserves and $5 billion under revolving
credit facilities. Therefore, the company definitely has potential to recover
from its deficit and become more profit oriented. However, this will all depend
on how they strategize with the diminishing amount of available reserves and
low oil prices. (Seeking Alpha)

            As
a result of Anadarko’s struggle with losses and declining
production, the company’s shares have heavily declined throughout
the year. Even though underperformance could mean a potential buying
opportunity, it is not likely that they can successfully recuperate from the
end of the fracking bubble without significantly adjusting their capital
expenditures. Because of depletion and increased competition, Anadarko is a
shorting opportunity. 

 

 

 

 

 

Conclusion

Fracking
is now a relatively maturing industry and as always, Investors want good
returns. Based on the poor performance of companies such as Schlumberger and
Anadarko, Investors are not going to be willing to put in money to these
companies.  Investors will be very
careful and will focus on actual earnings instead of taking a chance (something
appropriate for the beginning of a boom). Investors realize that the stock
price needs to reflect real returns and many shale oil companies’ stocks
are not doing that.  The recommendation
would be to invest in any company in the fracking industry that has good
earnings prospects. Schlumberger and Anadarko both have strong liquidity but
lousy returns. Various factors play into the subpar returns shale oil companies
are giving their investors: diminishing returns, increased competition, and the
green movement. Throughout the past year, oil prices have been fluctuating
between 50-60 and have been as low as 30. If you have low production costs and
good reserves, you can make good money on low oil prices. However, in a
maturing industry, one cannot assume either higher prices of oil or higher
production productivity down the road. The best recommendation is to begin to
short shale oil stock because many tight oil and shale oil plays are beginning
to peak.