The Big Australian — BHP Billiton [ASX:BHP] — came out with a pretty good result yesterday. Underlying earnings (EBIT, or earnings before interest and tax) jumped 257% to US$12.4 billion.
Most of the increase in profit was due to higher commodity prices — specifically iron ore — and good cost control.
For example, the dominant iron ore division increased earnings (as measured by EBITDA, earnings before interest, tax, depreciation and amortisation) by 62%!
The big increase in metallurgical coal prices also saw a huge rise in that division’s earnings. EBITDA was up 500% to US$3.8 billion!
The cycle has clearly turned for resources, and for BHP. Clear evidence of that lies in the amount of cash the company generated. Free cash flow (cash available for reinvestment back in the business, dividends, buybacks etc) grew to US$12.4 billion, up from just under US$4 billion last year.
The question for investors now is what point of the commodity cycle we are in. There’s no question that BHP has (mostly) world class assets. When commodity prices are healthy, BHP can’t help but make money. So if prices stay healthy, BHP will continue to churn out plenty of cash.
But there is one problem area for the company. This ties in with what I’ve been talking about for the past few days.
Shale Oil Performance
One notable disappointment was the performance of the US onshore oil operations. Also known as ‘shale oil’.
BHP’s attempts to get into this area have been a disaster. Their strategy was akin to buying the NASDAQ in early 2000, or the S&P 500 in 2007.
They invested nearly US$20 billion around the top of the market in 2011, buying acreage in various US shale fields. Since that time, they have invested another US$20 billion to work these fields.
Yet, according to BHP’s results presentation, the division generated a NEGATIVE return on capital employed of 3.3%.
You might recall I recently wrote that the hype around US shale oil is overdone. Many proclaim that the shale oil fields will reduce US reliance on Middle Eastern oil, and could even support US energy independence.
At current oil prices, I can’t see that happening.
At these oil prices, BHP can’t make its multi-billion dollar investment work. I’m sure there are shale players who are generating good returns right now, but they would be the exception, not the rule.
BHP wants to get out of US shale because the returns are simply not good enough. They don’t fit into its ‘world class suite of assets’ profile.
One of the biggest claims about US shale is that advancements in hydraulic fracturing technology is constantly reducing costs and allowing US shale to compete with conventional oil.
But the reason for the current onshore oil production surge in the US may be much simpler. That is, the producers are simply targeting well ‘sweet spots’.
Shale Oil Hype
According to a December 2016 study conducted by scientist David Hughes, who drew on 40 years of experience studying Canada’s energy resources, you should question the hype around shale oil production.
When oil prices dropped in 2014, he wrote (with my emphasis),
‘…companies adopted three strategies to lower break-even prices: apply better technology (longer horizontal laterals, higher volume injections of water and proppants, and more fracking stages); focus on drilling sweet spots; and pressure service companies to lower rates. This resulted in lower break-even costs for production and considerable growth in average well productivity.
‘The focus on better technology, however, will not necessarily increase overall recovery. Drilling sweet spots is thought to be nearly twice as important as better technology in reducing well costs according to IHS Markit.
‘Longer horizontal laterals with higher volume treatments drain more area and reduce the ultimate number of wells that can be drilled without interference. Hence better technology produces the resource sooner—and at potentially greater profit—but does not imply greater ultimate recovery.
‘The consumption of the highest quality drilling locations during this period of low prices means that progressively higher prices will be needed, along with much higher drilling rates, to access the poorer quality portions of shale plays and maintain production. Typically, sweet spots comprise less than 20% of total play area.’
There is a reason BHP is getting out of shale oil production. The returns are value destroying at these prices. And whatever cash companies generate, they have to plough straight back in to maintain production.
In March, The Economist ran an article highlighting the complete lack of profitability of the sector as a whole:
‘The business has burned up cash for 34 of the last 40 quarters, according to figures on the top 60 listed E&P [exploration & production] firms collected by Bloomberg, a data provider. With the exception of airlines, Chinese state enterprises and Silicon Valley unicorns—private firms valued at more than $1bn—shale firms are on an unparalleled money-losing streak. About $11bn was torched in the latest quarter, as capital expenditures exceeded cashflows. The cash-burn rate may well rise again this year.’
That begs the question of why so many companies are having a crack at US shale oil. The answer is either that I am completely wrong — which wouldn’t be the first time — or that something as simple as ultra-cheap financing is keeping these companies going.
What I mean is that a huge amount of capital went into the sector from 2011 to 2014, fuelled by high oil prices and quantitative easing by the Federal Reserve.
Instead of packing it in and defaulting on their debt, these firms are running as fast as they can just to stand still.
This is why I state in my just released report on the brewing bull market in oil that the Saudis are sitting pretty. There’s a reason they’ve scheduled the biggest IPO in history for 2018. That’s because by then, they know the bull market will be back.
If you want to get ahead of the pack, I urge you to read this report right now.
Editor, Crisis & Opportunity