Energy Companies Are Finally Making Money on Fracking

Source: Chesapeake Energy Corporation.

Fracking is finally starting to pay off for America's top independent oil and gas companies. According to an analysis in an article from the Financial Times, North America's top 25 exploration and production companies are expected to spend less money in aggregate on drilling next year than they'll take in as operating profits for the first time since 2008. In fact, energy companies are forecasted to produce $2.4 billion in excess cash flow next year, which will reverse a trend that saw drillers outspend cash flow by as much as $32.2 billion in 2012. Because of this, fracking is finally starting to be the cash flow gusher energy companies had hoped it would be.

Profitable but not making money?
Fracking has always been wildly profitable, and that's actually been the problem. Energy companies can in many cases earn returns in excess of 100% for every well that is horizontally drilled and hydraulically fractured. That return, however, isn't earned all at once, as wells can produce oil and gas for decades. Still, that hasn't stopped energy companies spending more than their current cash flow to drill new wells in an effort to grow as fast as possible.

The poster child for this wild spending was Chesapeake Energy Corporation (CHKA.Q), which piled on debt as it became America's second-largest natural gas producer. Its worst year for outspending its cash flow was in 2012 when the company spent $14.2 billion, or $12 billion more than its operating cash flow as the price of natural gas plunged. This was all part of the company's aggressive plan to drill new wells as it pursued growth at almost any cost, which forced it to sell off other assets in order to drill new wells. Unfortunately for Chesapeake Energy, it was the unexpected plunge in natural gas prices that eventually cratered the company's growth-at-all-costs model. This is why the company, now under new management, has cut back capital spending to $5-$5.4 billion, which is less than its projected operating cash flow of $5.55-$5.75 billion this year.

One of the reasons energy companies like Chesapeake Energy are able to now invest within their cash flow is because they aren't drilling wells to just hold acreage. When the shale boom started, companies like Chesapeake Energy were offering land owners thousands of dollars per acre to lease their land for drilling. However, these leases would expire if Chesapeake Energy didn't drill a well within a 3-5 year period, depending on the lease. Because it didn't want to waste the money it spent signing these leases, Chesapeake Energy had few choices but to drill wells even if the economics were poor. This is why in 2012, for example, 54% of the wells Chesapeake Energy drilled actually had a negative impact on the value of the company, as the following slide points out.

Source: Chesapeake Energy Corporation Investor Presentation. 

Today, Chesapeake Energy is able to drill much more economically profitable wells as drilling costs have come down and wells are now much more optimized to extract the maximum amount of oil and gas. Because of this, 85% of the wells the company drilled in this year's first quarter were drilled with a focus on maximum value. That has really helped the company to now become slightly cash flow positive.

What will energy companies do with their fracking cash flows?
With more energy companies becoming cash flow positive, the coffers of energy companies should start to overflow. As that happens, we can expect them to pursue three strategies. First, many companies can now begin to increase the capital budgets they had been cutting and drill high rate-of-return wells without taking on the added risk of debt. Another option is that companies can start to strengthen their balance sheets by paring down debt that has been piled on over the years. This is actually the option Chesapeake Energy is pursuing, as it has cut 15% of its debt so far this year as cash flow and asset sales are making an impact.

However, the third option that more energy companies will likely undertake is increasing dividends to shareholders or buying back stock. Oil focused driller EOG Resources (EOG 0.01%) is a prime example of a company using its fracking cash flow to reward investors. The company has increased its dividend to investors twice this year by more than 33% each time. Prior to that, the company gave its investors a small, incremental dividend increase each year, so the recent increases have been noticeably higher.

Investor takeaway
We're likely to see other shale drillers follow suit and reward their investors with the surging cash flows they are starting to produce from fracking. Because of this fracking should start to finally pay off for investors as surging dividends, stock buybacks, better balance sheets, and high return growth should create a lot of value in the years ahead.