The Real Reason Oil & Gas Companies are Going Bankrupt: Financing Fracking Projects Became a Ponzi Scheme

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Repeat until you cannot repeat again.

By Dave Forest,

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:

Does the current price look historically low on an inflation adjusted basis?

Here is the chart not adjusted for inflation.

Natural Gas prices are closer to the lower end of the price range. Below is the inflation adjusted long term natural gas price.

However, for as far back as the above data goes the price of natural gas is regularly between $2-4/mcf. This is the natural range. The higher prices have all been “spikes” due to hurricanes, La Nina events or other short term phenomenon.

Here is the non-adjusted price chart. As you can see these are not historically low prices.

It appears the 2006-2011 period for oil and natural gas were HISTORICALLY HIGH prices. The opposite of what the article states.

The real reason energy companies are going bankrupt is more technical.

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, and this time it is a different type of thinking and central bank distortions, but not low prices. By Dave Forest,

Teetering on the brink of utter economic collapse, Venezuela makes one more effort. Read… As Default Looms, Venezuela Pushes Highly Dubious Oil Deals

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  21 comments for “The Real Reason Oil & Gas Companies are Going Bankrupt: Financing Fracking Projects Became a Ponzi Scheme

  1. nick kelly
    September 26, 2016 at 8:59 pm

    A very interesting piece/theory that I have in primitive terms been stating for a while- not always to a pleasant reception.
    For some folks fracking is the equivalent of cold fusion- the answer to all out problems. There is also a patriotic theme- ‘frackers take on Saudi Arabia’.
    Now we have to ask which banks are most exposed to this Ponzi scheme.

    • Chicken
      September 26, 2016 at 10:43 pm

      Exactly, which banks and are they hedged? This problem for banks might be woefully understated.

      • nick kelly
        September 27, 2016 at 1:28 pm

        And who is on the other side of the hedge? In the Big Short the duo making the short bet were very concerned that the crash would take down their counter party.
        I forget who they picked but that party was mighty surprised when the shorts presented their bill.
        And although the duo had to settle immediately if the trade went against them, the giant counter party only had to settle at the end of a period.

  2. Northwest Resident
    September 27, 2016 at 1:25 am

    Shale/fracking was known to be an unprofitable enterprise from the very beginning. NY Times published a trove of oil insider emails and written communications which included top engineers and financial specialists questioning the viability of shale oil and NG. In one email, the insider compared the whole “shale phenomenon” as “another Enron”. Another referred to it as a Ponzi scheme. Many similar points of view.

    I have long known that shale oil production was only enabled by ZIRP, but not only ZIRP. Also crucial to the entire Ponzi development was QE and assorted central bank/FED liquidity floods, much of went straight into the shale oil Ponzi. And there was one final vital component to the massive Ponzi — propaganda, 24/7/365, pumped across all communication channels nonstop to lure the muppets in, and they came in droves especially with their “safe” investment returns suddenly flat-lining on them courtesy of ZIRP.

    The whole shale Ponzi was in fact one massive JOBS program. By pumping the oil industry with trillion$ in newly minted fiat, the good times rolled, and it was one hell of a retirement party for the oil industry — one last fabulous BOOM.

    Now it is bust time. And this time, it is hard to see where the next boom is going to come from. A lot of people who pay close attention to oil-related news and information tend to think that the oil industry has seen its last boom, and that it is all downhill from here on out. And it goes without saying, that if that turns out to be true, that our modern high-tech and highly mobile civilization is in for some dramatic and painfully abrupt changes.

    But hey, it really was one hell of a going away extravaganza. Now there is hell to pay.

    • September 27, 2016 at 8:47 am

      Yes! Well said.

      I’ve lambasted the financial end of fracking since 2012 (“where money goes to die,” I called it routinely). For example, in June 2014, with WTI still over $100 a barrel, I wrote an article titled, “Where Money Goes to Die: How Fracking Blows Up Balance Sheets of Oil and Gas Companies.”

      It wasn’t just me. There were many critics of the financial end of the fracking industry. But industry hype and the search for yield in a ZIRP environment overcame all obstacles.

    • CrazyCooter
      September 27, 2016 at 9:21 am

      Spot on. Both my father and grand father had ties to the oil industry, and I just giggled when I read “… this practice was done conservatively”. There are several axioms which have applied since the first oil boom and one of them is “always drill with other peoples money”.

      So, the notion of conservatism in drilling, when by definition the very act of investment is high risk, is just BS. This improved with time, folks have a better idea of what they are going to get these days, but even now there are sweet spots in the shale that greatly outperform neighboring wells. Folks who were in the business of wild catting and what have you would drill, drill, and drill some more – as long as they had access to OPM. This is probably baked into the DNA of anyone who survives in this space over time – because if you don’t do that, how do you compete with those who do? And, there is always the fact that when your own money is gone – you are out of businesses.

      Now, on the other end of the spectrum, you have folks like Exxon and you have a different world view with regards to spending THEIR capital. In more modern times they are gambling huge piles of money on very large development projects – but it isn’t the same thing.

      The entire fracking oil boom was simply newly minted cash looking for an investment (as Wolf points out) – and frack oil was in the right place at the right time. I have no doubt that these frack oil companies expanded rapidly, simply because they could. As my old man likes to say regarding royalties for drilling rights “always take a piece of the revenue, never share in the profit – i don’t high roll on my money and that son of a bitch sure is hell isn’t either.” So these companies simply duped investors, lived the high life expensing steak dinners and business meetings in Vegas, looked really busy for as long as possible – and I am certain the folks in the know will walk away with huge nest eggs harvested during the boom.

      And it was the endless supply of free money that made it all possible. Thanks Fed!

      At present, I am of the opinion that demand is cratering – lots of indicators are looking recessionary, so prices are low and staying low. This is compounded by the fact that the Fed enabled a massive investment in over capacity (business 101 – always invest in overcapacity, right?) which will have to clear for prices to stabilize. And that is going to be a slow process with new money chasing old dead money.

      And I live in Alaska, where 90% of the states general revenue come from oil revenues – so I am along for the ride like it or not.



      • night-train
        September 28, 2016 at 1:00 am

        Cooter: As a young geologist, one of the first pieces of wisdom passed on to me from a veteran was “always take an over-riding royalty, never a working interest”. Even with a good well, the operator can “operate” you into the red. If you ever get a chance to look at a working interest’s well operations financial statement, treat yourself and read it. I have seen them charge for the toilet paper in their bathrooms and coffee for the break room. And that is for the more reputable operators. You can imagine what the less reputable will charge you for, not that it would actually be an item on the statement.

    • Kevin
      September 30, 2016 at 9:38 pm


      Another big problem with shale and fracking is depletion. Wells run dry more than twice as fast in shale formations, and require large capital injections much earlier in the field’s life cycle to keep the oil flowing. Horizontal drilling helps, but soon enough the rigs needs to be moved. And that is very expensive.

  3. RobvC
    September 27, 2016 at 7:28 am

    Thanks Dave and contributors.
    I’m new to the subject but highly interested.

    Can anyone enlighten the narrative with (estimating) numbers on how much debt is incorporated in the Ponzi scheme and/or give a lead to where I can do a little further reading on the subject?

    • September 27, 2016 at 8:29 am

      I don’t remember the estimates of bank debt and bonds outstanding by oil & gas companies in the shale space, and it’s a very large amount. Maybe one of the readers remembers or can dig up the number.

      But here is a new figure that will shed some light on your question: The 102 US and Canadian oil and gas companies that have gone bankrupt so far in this oil bust (per Hayes and Boone) listed $68 billion in debts. Those are mostly relatively small players. None of the big ones have gone bankrupt.

      • Peter
        October 6, 2016 at 3:36 am

        This is just Penn Square Bank all over again. Read the book.

  4. Nicko
    September 27, 2016 at 7:32 am

    I’m not seeing the downside here, consolidation always happens with over leveraging and cheap credit. There’s 200 years worth of fracking reserves across the continent, not including new offshore discoveries yet to be made. The oil and gas will flow.

    On the other hand, the US is quickly becoming a renewable energy and emission free vehicle superpower.

    • economicminor
      September 27, 2016 at 8:58 am

      Nicko, the downside will be the defaulted debts left by all this. The Banksters have historically figured out how to pass the consequences of their ponzi crony transfer of wealth schemes onto the public. Decades of doing this has left the US consumer weak along with their pension funds. At some point the Monopoly game ends and then either everyone goes to sleep or you start over. Many of us have thought that we were near game end in 2007/8 but the Banksters found a new rabbit to pull from their old felt hat.. Can they do it again? Time will tell but at some point the deflationary cycle will begin. It won’t matter until it matters and when it matters it will matter a lot!

  5. Ed
    September 27, 2016 at 8:03 am

    Hot money looking for yield for a long, long time. Many small investors were taken for a ride in the Ponzi scheme as well. Brokers sold those oil and gas limited partnerships like candy.

  6. Tim
    September 27, 2016 at 11:12 am

    High cost production = margin squeeze. High cost production = zombies.

    Low cost production always winds up driving a stake thru the heart of the zombies.

    • Tim
      September 27, 2016 at 11:15 am

      exceptions are tariff or subsidy protected, or state interest industries.

  7. Bobo
    September 27, 2016 at 1:39 pm

    Some fracked wells do make money, but mostly the bigger ones, those that pump over 300-500 BPD for a while. In some states daily production is limited by the state oil regulators, in TX daily production per well is limited to something like 121 BPD, unless you can get a variance. Shale oil wells usually deplete very fast, production drops off a cliff after 1-3 years in many cases. You can however frack the same well repeatedly. There are a lot of technical details involved and a lot of very marginal wells were drilled based on hype and poor understanding of the economics.

    • night-train
      September 28, 2016 at 12:49 am

      Some plays are better than others and some parts of a play can be better than other areas of the same play. States dictate production quotas to maintain the drive energy of the reservoir as a conservation measure. This is true of conventional reservoirs with gas or water drives. I haven’t checked to see what is done with shale plays. Since they start out on the pump, I don’t know if there is much drive energy in the reservoir to begin with.

  8. night-train
    September 28, 2016 at 12:41 am

    Having retired from the industry as a petroleum geologist in 2010, I called the gas bubble in 2008 and the shale play a scam in 2010. The article is a good presentation of the financial side of the industry. In my hay-day, we called wells that didn’t pay out “geological successes and economic failures”. Then the shale players turned that phrase into a business model.

    It is all very technical, with a lot of geological and engineering concepts required to fully understand these plays. But, I think I can simplify it for the laymen here. Drilling one uneconomical well is a failure. But, drilling thousands is “play”. Some call it a Ponzi.

    • Sadasivan
      September 28, 2016 at 8:34 am

      1.Improper Accounting And regulation
      2.High Leverage.

  9. wratfink
    September 28, 2016 at 2:42 pm

    An important point is that when these producers go to roll over their debt or extend a credit line their “reserves” are re-calculated. With a huge drop in the price of a barrel of oil, much of their former banked reserves become resources at the lower price. As in not economically recoverable at the current price. This means they are not generally eligible for financing and this causes bankruptcy in some cases.

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