Fracking: A Ponzi scheme?

While most of the debate regarding Fracking for oil and gas is about environmental issues, there is something else about it that caught my eye as was I researching various topics. Despite all the talk about job creation and energy independence it turns out that things are not as rosy as they look on the surface. The first point is that oil and gas wells made by fracking lose at least 50% of their capacity in the first year and can be as much as 78%. The second is the breakeven cost of production and transport of the oil and gas produced by fracking compared to current energy prices and finally the amount of debt being taken on by the energy companies involved in fracking to fund their operations.

While energy companies are improving fracking technology and working more closely with geologists to improve the fall-off rate of extraction from wells, it is something they admit will always be a problems as is written about in this Bloomberg article. At the end of the article chief executive officer Dave Dunlap of Superior Energy Services inc said of fracking in general “We’ve drilled all the good stuff,” “These are very poor quality formations that I don’t believe God intended for us to produce from the source rock.” As a result, energy companies have to constantly drill new wells, with all the associated costs, to compensate for wells losing capacity so quickly.

Add to this the second point, which is the price at which energy companies can breakeven on the cost of production and transport of the oil and gas. The current WTI crude oil price against which shale oil is benchmarked is in the $97 – $98 per barrel region. Shale oil production and transport costs stands on average at about $90 per barrel.The ironic thing is that as more oil is produced from fracking it is causing the price to fall due to a glut. When you look at the futures market for crude oil the trend is for it to get cheaper. This will result in a reduced margin between breakeven costs and the market price. The pressure is on. Certainly, production could be reduced to force the price of oil higher but the energy companies can’t afford to cut production as they need to get a return on the huge investments they have made.

The problem is that with this slim gross profit margin, they have to service their debts as well as invest in new drilling activities. The US Energy Department came out with some research recently and said “Based on data compiled from quarterly reports, for the year ending March 31, 2014, cash from operations for 127 major oil and natural gas companies totaled $568 billion, and major uses of cash totaled $677 billion, a difference of almost $110 billion.”

US-oil-gas-drillers-cashflows_2010-2014

US-oil-gas-drillers-cashflows_2010-2014

To make up for this huge cash shortfall, energy companies have gone out and borrowed $106 billion in one year alone as well as selling $73 billion in assets, that is mostly land where they have drilling rights, therefore cutting their potential for future production. According to a Bloomberg analysis “Shale debt has almost doubled over the last four years while revenue has gained just 5.6 percent, according to a Bloomberg News analysis of 61 shale drillers.” Even without the debt, converging production costs with the market price are going to stress even the biggest players in the market.

I’m not saying the shale fracking business is a Ponzi scheme in the Bernie Madoff sense of things but rather the fact that all these energy companies are having to run increasingly faster just to stand still. Oil and gas wells are drying up quickly so they have to constantly drill new ones to keep the cash flowing, but to do that they have to borrow more money and sell more assets. Profit margins are getting slimmer and it is getting harder to pay back the debt they owe. Fracking is where money goes to die, all that will be left in the end are empty oil and gas wells and a pile debt. Those who lend money to or invest in the fracking industry are running a high risk. Sooner or later things will reach a critical point and all those billions of dollars of debt will be crystalized. When that happens there are sure to be many knock on effects. If I were in a position to do so I would be seriously considering short selling the stocks of most of the fracking companies.

I know this isn’t the one of my usual topics but my interests and studies are wide and varied. Part of the reason I wrote about this is because all my instincts are telling me there is going to soon be a serious jolt to the financial system, probably before the end of the year and most likely from an unexpected quarter. There are many candidates for what will be the cause, including the current global geo-political situation. Watch this space.

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