Oil Free Cash Flow: California and Canada vs Texas; Charlie Munger's Investment Mistake; A Producer at Half of Liquidation Value
Why California & Canadian oil production has better ROIC and more FCF than Texas; a look at one of Charlie's biggest investment mistakes (his own words); a discounted producer buying back shares
A great book to read about the origin of fracking and the Texas shale oil market is Frackers, by Greg Zuckerman. The book discusses the invention of the technology1 that unlocked massive amounts of oil.
The book makes a great story with all of the very interesting and colorful players involved in that industry. And it also goes into detail on the economics of the shale oil business (the economics were not good; more on this later). But to be clear, this was a booming industry with massive growth. The growth was unfortunately not growth in free cash flow unfortunately but growth in production volume, capital investment and debt. The burgeoning shale industry was fueled by Wall Street which funneled billions of dollars of equity and debt capital to the Permian Basin in Texas and the Bakken Formation in the Williston Basin of North Dakota. The oil producers gobbled up this capital as fast as they were allowed to, leading to a production boom in oil that the United States had not seen in decades… perhaps a boom not seen since Rockefeller himself sat atop the industry.
What many might not realize is that modern fracking is a relatively new technology, perfected by George Mitchell who worked on it for years but only successfully commercialized it in the late 1990’s. Fracking literally means breaking apart (fracturing) rock. Water and sand are pumped under high pressure into very thick (“tight”) rock to break it apart and create a pathway for oil and gas to flow.
A critical part of this fracking process is drilling a well horizontally, which allows a single well to cover much more ground (in some cases 1-2 miles or more) vs a “conventional” (vertical) well that was the standard prior to this new method.
I remember the presidential campaign of 2004 when John Kerry was badgering George W. Bush to press OPEC to release more oil, and Bush talking about domestic oil production as a key aspect of national security (remember the big Alaska ANWR (“Anwar”) hot button issue?). Oil was a central feature of every presidential campaign since the Middle Eastern nations put a painful oil embargo in place in the 1970’s. But the 2004 campaign would really be the last that would feature the United States being beholden to foreign faraway lands whose energy resources were more plentiful. We’re still somewhat beholden to a friendly nearby land (more on this below as well), but we’ve effectively become self sufficient when it comes to oil. This is an incredible thing to say, considering just 20 years ago it would have been absurd to predict that the US would be the largest oil producer in the world.
When Bush and Kerry were debating on whether to drill in parts of the Alaskan wilderness, the US was producing about 5 million barrels per day. This number is now 14 million, and it is nearly all thanks to the frackers. Unbeknownst to the politicians and most of the rest of us, an explosion was about to take place, rendering the Alaska wilderness oil reserves to a mere footnote in the oil industry (figuratively, but there is a literal footnote here too2).
Like any great spending boom (railroads, electricity, autos, air travel, computers, telecom/internet, maybe now AI?), this spending boom ended in a bust in 2015-2016. Also like other great spending booms, it didn’t create much aggregate wealth for the stockholders who funded it, but it did leave society and the country with large, permanent benefits.
While the history of fracking is fascinating, there was one giant takeaway for me after reading the book a decade ago: I don’t myself to avoid investing in shale oil. The economics of the business were poor. Fracking is capital intensive and the returns on capital are lousy. The issue isn’t that the business required a lot of capital up front. The issue was that fracking required huge amounts of capital each and every year.
The reason could be summed up in an industry term that is just three words: “high decline rate”.
When you frack a shale oil well, you get an explosion of hydrocarbons rushing to the surface (at least in the successful wells). This sounds terrific, but the problem is the production decline after 1 year might be 70% or more: a shale well with an initial production rate of 1,000 barrels of oil per day might only be producing 300 a year later. Buffett described the shale business in a recent annual meeting (see the 3 hour, 20 min mark).
This rapid decline rate means a shale oil producer constantly has to be drilling new wells to keep current production flat. It’s a hamster wheel, and a very expensive one at that.
So for years, I ignored oil producers because of this capital treadmill that I felt would never leave shareholders with any free cash to take home. But then two things happened:
One, Covid happened and almost overnight, oil producers pivoted from a “drill baby drill” mentality to a capital returns focused strategy that emphasized returns on capital, free cash flow and buybacks. This is about the time that Warren Buffett went into overdrive buying common shares of Occidental Petroleum. OXY telegraphed a major shift in capital allocation from one of growth to one of prudence and buybacks. The problem for OXY (in my humble view) is that it still has the geological headwind I described above: namely, its rapid decline rate and resulting capital intensity. The other problem for OXY is they still seem to be too focused on what Wall St suggests (i.e. selling its chemical business at a low point in the cycle; guess who the buyer was3?; or getting out of California just because everyone suggests it’s too difficult (more below).
The second thing that happened is that I discovered that not all oil fields are created equal. And this is the basis for the next couple posts and some specific investment ideas.
To skip to the punchline: Canada (Alberta) and California. Two oil regions I’ll be talking about in the next couple posts with very different geology than shale oil. Here’s a chart that compares the economics of a sampling of oil companies in Canada vs the US Permian Basin:
The chart loosely compares Texas shale producers to Canadian oil companies I follow (see footnote4), but the economics in California are similar to Canada.
The key point: both California and Canada oil companies have large oil reserves and low decline rates (5-10% vs shale decline rates of 60-70% or more). The lower decline rate means lower depletion costs (the resource lasts much longer). This oil is like a pump that keeps flowing once you drill the well. It takes less capital to keep the oil flowing.
As a result of lower decline rates, the economics of California and Alberta oil production are much, much better: higher returns on capital, lower maintenance capex, and much more free cash flow. And the great part is that the stocks in these areas are cheaper than the better known shale producers.
The main thing I wanted you to take away from this entire post is that low decline rate (Canada/California) oil production is very different business with much better economics than shale (Texas).
Today, I wanted to talk about California. Charlie Munger, at one of the Daily Journal Meetings a decade ago, once said something to the effect of: “there is a huge amount of oil below where we’re sitting right now” (paraphrasing from memory). I never paid much attention to that comment, but I’ve since learned that Charlie has had a history of investing in California oil.
In 1962, Charlie was playing golf with a guy who was bidding on oil royalties. Charlie (an attorney at the time) helped him structure the legal setup. Charlie also invested $1,000 into royalties on this well. This investment was referenced 61 years later at the 2023 Berkshire annual meeting (same clip linked above), in this very interesting exchange between Buffett and Munger on a question on OXY:
Buffett: “It’s really interesting about oil…” (Turning to Charlie) “When did you buy that royalty in Bakersfield?”
Munger estimates he bought it around the time he met Buffett in the late 50’s or early 60’s.
Munger: “That royalty still pays me $70,000 a year.”
Buffett: “How much did you pay for it?”
Munger: “$1,000.”
As of 2023, Munger still collected $70,000 a year from royalties on a Bakersfield, CA oil well that he bought for $1,000 over 60 years ago!
Buffett then goes on to lay out how different the Permian Basin economics are vs California.
Buffett:
“Now that is the opposite of the Permian…
“If you’ve gone to movies and ever watched oil, you never watch the things that are pumping like Charlie’s oil in California (laughter). You see these gushers of oil. Well, in the Permian, this should sink in on you, in the first day when you bring on a well, it may be 12,000 barrels, it might be 15,000 barrels, it’s dangerous. In a year, or a year and a half, it becomes practically nothing. It’s a different business.”
Buffett further hints at (in a subtle way) why he’s bullish on oil long term. It’s very interesting, but we will now move on to discuss a specific company, and this company not only operates in Bakersfield (where Buffett suggested Charlie’s royalty is) but also has another interesting connection to Charlie. In fact, this company now owns the field that was owned by the stock that Charlie once called his greatest investment mistake: