John Mauldin defends the faith of what he calls the “fracking gospel” but fails Economics 101.

In his recent post “Riding the Energy Wave to the Future”, he claims that oil prices are falling because the cost of producing tight oil is cheaper than most conventional oil.

But oil is $40 per barrel and falling because it is being devalued by global market forces that have little to do with tight oil at this point.

Mauldin’s evidence that producers are making money at $40 oil?

“I have friends,” he says, “here in Dallas who are raising money for wells that can do better than break even at $40 per barrel.”

I have friends at oil companies here in Houston who assure me that they are losing their shirts at $40 per barrel.

Do my friends in Houston live in a different galaxy than Mauldin’s friends in Dallas?

No, Mauldin’s friends are investment bankers and private-equity providers who are still able to raise money for lost causes in the tight oil patch. My friends are working stiffs in the business who are losing their jobs as companies struggle to adjust to price deflation.

Mauldin goes on to say, “How are these new economies possible? Answer: they bent the cost curve downward. It has fallen fast and – more importantly – it will keep falling.”

These sorts of claims can be tested by looking at tight oil companies’ first half (H1) 2015 cash flow and income statements. The first chart on the left in Figure 1 below shows that, on average, tight oil companies outspent cash flow from operations in H1 2015 by a dollar more than they did in H1 2014.



Figure 1. Tight oil companies spending vs. earning, H1 2015 vs. H1 2014, and H1 2015 debt-t0-cash flow for tight oil companies. Source: Company SEC filings and Labyrinth Consulting Services, Inc.

(click image to enlarge)



That means that these companies are losing more money than they were a year ago regardless of which way the cost curve is bending. Mauldin’s claim fails the test. F.

Debt-to-cash flow from operations is a standard measure used by banks to determine an oil company’s credit risk. The E&P industry’s average ratio from 1992 to 2012 was 1.58. A ratio of more than 2.0 is a red flag that a company may become a credit risk, probably has exceeded loan covenant agreements, and may have its loans called by the banks.

The second chart on the right in Figure 1 shows that the tight oil companies that I cover have, on average, a 3.3 debt-to-cash flow ratio, way above the red flag threshold. That contradicts Mr. Mauldin’s claim that these companies are making money at $40/barrel — companies are deep in debt and could not pay off the debt if they used all the cash they generated in less than 3 years. In fact, tight oil companies will probably have their credit ratings greatly reduced at the end of this quarter because their income statements and balance sheets are such a mess.

Another F for Mr. Mauldin.

Mauldin states, “At $65, they [tight oil companies] can make higher returns than they did three years ago with oil at $95.” I am fairly certain that claim comes from EOG’s latest investor presentation. I know that because I own EOG stock and pay attention to the information they provide. Figure 2 shows the source of the claim that Mauldin references.



Figure 2. EOG Resources current returns versus 2012. Source: EOG Investor Presentation May 2015.

(click image to enlarge)



This is an example of “cherry picking.”

EOG bases their claim on two plays and not tight oil in general. Plus, the value on the y-axis “ATROR” only includes the cost of drilling, completion and equipping a well. It excludes basic costs of doing business like G&A (overhead), interest expense, gathering, processing and midstream costs, land, seismic, geological and geophysical expenses (these exclusions are stated in Slide 6 of the same investor presentation).

EOG is not breaking any rules here because they tell us why their claim is misleading.

I am surprised that an expert like Mauldin is willing to accept a statement that is, on the face of it, unbelievable. Seriously, is there a business in the world that can experience a one-third drop in the price of its product–from $95 to $65 oil price, in this case–and make more money after the fall in price than before?

Figure 3 shows that EOG is, in fact, among the more disciplined tight oil producers with a spending-to-earning ratio (capex-to-cash from operations) of 1.5 for H1 2015. They are, however, spending 50% more now than they were a year ago when they were able to fund their capex out of cash flow. That means they are making less money as a company at $65 oil than they were a year or a few years ago at $95 oil. Period.



Figure 3. Tight oil companies’ spending vs. earning, H1 2015-H1 2014 comparison with EOG highlighted. Source: Company SEC filings and Labyrinth Consulting Services, Inc.

(click image to enlarge)

F number 3 for Mr. Mauldin.

Mauldin accepts that increased rig productivity “with costs per rig stable or declining” is proof that tight oil companies are making a profit at low oil prices. Rig productivity gains are real but this does not mean that anyone is making money. It means that companies are losing money on more barrels of oil than they used to produce per rig.

“We’re losing money but making it up on volume.”

Another F.

I could go on but I believe that I have adequately shown that “Riding the Energy Wave to the Future” is not among John Mauldin’s better researched or well-reasoned posts.

I will not speculate about why Mauldin adds his influential voice to the dangerously incorrect notion that that tight oil is commercial at low oil prices or that U.S. energy independence is possible. It is a dangerous argument because investors and policy-makers are not knowledgeable enough about the oil business to understand that Maudlin’s and similar views are pure fantasy that cannot be supported by data.

Politicians will base important decisions about domestic energy supply and export on influential but bogus arguments. Investors will spend money on projects that may never return their principal.

This kind of mis-information gives people the false sense that our energy future is secure and inexpensive and that they can go on using as much energy as they like without any consequences. It allows them to ignore or deny the very perilous state of the world economy in which oil price is but the vanguard of a series of cascading and troubling trends.

Energy is the economy.

Figure 4 shows that after every period that oil prices exceeded $90 per barrel in real 2015 dollars — 1979-1981, 2007-2008 and 2010-2014 — the global economy went through a period of adjustment that included devaluation of commodity and currency prices, otherwise known as a recession.



Figure 4. Oil price in CPI-adjusted 2015 U.S. dollars and key events. Source: EIA, Federal Reserve Board and Labyrinth Consulting Services, Inc.

(Click image to enlarge)

We have been in the midst of one of these adjustment periods since at least September 2014 when global oil prices began to fall in earnest.

After the 1979-1981 period of high oil prices, there was an 18-year adjustment period before the global economy began to recover. After the 2008-2009 period of high oil prices, the economy seemingly recovered in about a year thanks to central bank intervention and an OPEC oil-production cut. Bank intervention included massive creation of liquidity and credit through artificially low interest rates, a situation that continues today.

We are currently at least 9 months into another adjustment period following the 2010-2014 period of oil prices above $90 per barrel. Major adjustments to stock and currency markets are occurring as I write, with the Dow-Jones Industrial Average down more than 1500 points since last week. WTI is near $38 per barrel and Brent is below $43 per barrel, down from $106 and $112, respectively, in June 2014.

But no problem for John Mauldin because he claims that “some US shale operators can break even at $10/barrel.” Really? He sees no requirement to back up such a blatantly preposterous statement with a shred of supporting data.

He thinks that the low cost of producing tight oil is driving down the price of oil. I think it is a colossal market correction that cares nothing about anyone’s marginal cost of production at this point.

You decide who is closer to the truth.