Libya rebelled against OPEC. The former major oil producer says it won’t join a production freeze until it restores output.
The Philippines moved on more miners. At least 10 firms will likely be suspended next week — and there could be more.
Attorney Generals investigated ExxonMobil. Prosecutors are looking into whether the major cheated in booking reserves value.
The world’s #1 coal miner went shopping. Coal India says it is in talks with Indonesia to buy mines in the country.
A new petroleum contract was born. Lawmakers in Iran finally agreed on a revised model — but it came with compromises.
The Real Reason Energy Companies Are Going Bankrupt
I want to do something a little different this week.
Before I get to that, a few housekeeping notes. First and foremost — thanks once again to good folks at BNN for having me on this week to talk molybdenum, platinum and met coal. Great discussion as always with Andrew Bell, you can see the full segment here:
Between that and everything else going on, it’s been a busy week — including discussions on the emerging City of Gold project I’ve mentioned in Myanmar, as well as a promising new gold project in Africa and a past-producing platinum mine (yes, finally managed to find one!).
And to top it all off, I’m getting ready to fly to Asia today.
One thing I did make time for the last few days was reading an article sent by my friend, Brad Parkes. Bearing the intriguing subject line: “The Real Reason Energy Companies Are Going Bankrupt”.
Brad is a person I love to read, because he’s a rare breed with a foot in two different worlds — having started life as a stockbroker in Calgary’s energy scene, and then returning to school to complete a geology degree. He’s thus one of the few people I know who intimately understands both stocks and rocks, which makes his perspective on resource markets always intriguing.
This week’s piece is a case in point — where he breaks down why valuation of oil and gas reserves has basically turned into a Ponzi scheme in North America. Whether or not you agree with his thesis, this is an issue that’s vaulting to the forefront of the energy world, evidenced by this week’s Attorney General investigation of ExxonMobil mentioned above.
Below is the full-text of the article originally published over at Macro Charts (Brad is also an analyst after my own heart in that his writing is mercifully short and direct, with lots of show-don’t-tell illustrations). I hope you find it as thought-provoking as I did…
The reason oil companies have gone bankrupt over the past few years is not due to “historically low oil and natural gas prices” as stated in this article.
Here is a long term inflation adjusted price chart:
Reserve base lending for unconventional reservoir projects became a ponzi scheme. This is how it works.
Step 1) An oil company borrows money or issues equity to drill a well.
Step 2) The well “discovers” oil. The reason I put discover in quotations is that the resource (not reserve, there is a difference) potential of shale source rocks has been known for decades.
Step 3) Estimate the resource and reserve potential.
NB: Resource is properly defined as uneconomic at the current price. Reserve is properly defined as economic at the current price.
Step 4) Book the reserve as an asset on the balance sheet as per SEC legislation.
Step 5) Borrow money against the reserve.
Step 6) Drill more wells and book more reserves and borrow more money.
Step 7) Repeat until you cannot repeat again.
This process was not always a Ponzi scheme. Before the mantra of peak oil and the fear the world as running out of oil this practice was done conservatively. But when the idea that world was short of crude supply the thinking became that oil was a one way trade. This gave Wall Street the confidence that lending money against high cost reserves to develop more high cost reserves was a sound practice. On the other side of the transaction little thought by producers was given to the scenarios that would cause these reserves revert to resources and be treated differently on their balance sheet.
Furthering the Ponzi scheme was Central Bank policies of zero percent interest rates. This cheap source of funds decreased the discount rates for cash flow streams, increasing the net present value and distorting the time value of money calculation for these type of projects.
Under this strategy developing more reserves meant more debt. When prices reverted to the mean, reserves became resources and these companies became insolvent as resources are not the same quality asset as reserves and are treated differently under SEC legislation.
Exacerbating the problem was now these producers have to maximize cash flow to cover the interest cost which creates more excess supply and more downward pressure on prices turning more reserves back into resources impairing more balance sheets and strengthening the negative feedback loop.
The bankruptcies happening today are the result of historically high oil prices, a this time is different type thinking and central bank distortions, but not low prices.