How Important is Free Cash Flow to E&P Companies?

With the EPA and lobbyists on a mission to purify the world, coal has proven to be an outdated and dirty way to power our lives.

Yet oil companies like Exxon (XOM -0.33%) throw money at any glimmer of oil to dig up, leading to higher costs in production and reserves. While the oil prices are still low, it's hard to imagine sustainability with that game plan, but that hasn't stopped their free cash flow numbers from making our analysts do a double take. 

In this week's episode, Sean and Tyler explore three topics on the minds of energy investors: Can coal survive? Will oil companies actually do something about climate change? And why is cash so important to energy investments?

A full transcript follows the video.

 

Sean O'Reilly: Why doesn't free cash flow matter to oil companies? On this energy edition of Industry Focus.

[INTRO]

Greetings, Fools! I'm Sean O'Reilly joining you here from Fool headquarters in Alexandria, Virginia. To my left is Tyler Crowe. How are you today, sir?

Tyler Crowe: Doing pretty good.

O'Reilly: You all teed up?

Crowe: I think so. We'll see how this goes. I mean, I am solo without -- we're without Taylor this week. He's doing a Motley Fool Canada member engagement thing. Doing a little bit of cross company marketing there.

O'Reilly: We will miss you Taylor, if you're listening.

Crowe: We'll pour out some coffee.

O'Reilly: Yes. On the floor for you. So, before we get into -- I really want to get into free cash flow because I was messing around on S&P CapitalIQ and it's not pretty. Before that...

Crowe: Nerd alert.

O'Reilly: Nerd alert. Obama's climate plan just came out this morning. A really cool article on Bloomberg, and it really is that bad for coal companies. Coal has not exactly been a 'boom' industry in recent years. That's being generous, I assume.

Crowe: That's -- very. Yeah. A very generous statement.

O'Reilly: Apparently these government analysts came out last month and said "Oh, yeah. Production from coal for our electricity generation is going to drop about 45 gigawatts. This new report comes out today under Obama's plan and it's going to actually be 90. So, twice as bad. We're not really here to debate the merits of fighting. We're not fighting climate change, but we are investors looking at the coal industry.

So, what's going on here, Tyler?

Crowe: The basic idea behind this is looking at it from an emissions standpoint. With the inclusion of emissions abating technologies, things that you can do at a coal generating plant -- or any fossil fuel generating power plant -- you can add components to it to actually reduce the pollutants that you put into the air.

They're normally called 'scrubbers'.

O'Reilly: That was the buzz word a couple years ago, was 'clean coal'. What happened with that?

Crowe: Clean coal. Well, the idea is that you can actually build systems that can scrub the pollutants out of the air. There's a lot of various technologies and ways to do this. You can use...

O'Reilly: Are these giant air filters like the ones I have on my air conditioning?

Crowe: Think of it like the catalytic converter in your car. Basically it is there to remove certain components using either chemical, or physical properties that can clean out what is coming out of a smoke stack. The problem, or the -- while it does work -- it has shown the technology can be applied and be practical. The problem is: is it economical?

That's one of the really hard parts when it comes to these sort of processes. I went to engineering school so I'm going to really nerd out here for a second. We can do anything.

O'Reilly: Plug your ears, folks.

Crowe: We can build, we can do anything. It's always about the cost and how much we're willing to pay to do it. If we look at some of these pollution abatement technologies for coal plants, they're just too expensive to compete, versus something like a natural gas, or versus an alternative energy. Where, say if I am a power producer utility. Let's take a southern company, for example. If I'm looking at a coal plant that is 40 years old -- which a lot of them in the United States are today -- and were to say "Do I want to reinvest money into this coal plant to bring it up to snuff on these emissions, which is going to cost a lot of money."

Not just for that, but also for the retrograde of the entire system itself. I can do that, or I can invest in a new natural gas plant.

O'Reilly: That will last another...

Crowe: It will be cheaper, it will be more efficient, my fuel costs will go down. It's not the only factor, but it can be a very large factor in doing it. When you look at the cost of alternatives today -- natural gas, solar, emergent, wind -- these things are making it so much harder from a cost competitive standpoint; that is why these things are getting written down.

It's not like we're saying "You can't use this coal plant." We're saying "You have to do this to this coal plant to make it up to snuff."

O'Reilly: And that makes it non-economical.

Crowe: It makes it non-economical.

O'Reilly: I realize we're in the studio and not on the Internet with tons of reports and everything, but is clean coal eve worse than solar right now?

Crowe: What do you mean 'worse'?

O'Reilly: More expensive. Just ballpark it.

Crowe: Basically, yes.

O'Reilly: Wow. Not even 'bad'.

Crowe: Yeah. Not even in the wheelhouse -- the two companies that are working on clean coal, which is called clean coal because it's a nice buzzword. The technical is...

O'Reilly: You can sell it. Go.

Crowe: Here we go. More nerdy engineering stuff. People are just going to turn this thing off in about 30 seconds here. It's called coal gasification. Basically, we're extracting hydrogen gas from coal and then burning the hydrogen gas rather than...

O'Reilly: That sounds complicated.

Crowe: Burning coal. Yeah, it's a little complicated. The thing is, when you do that, it's expensive, and based on the cost per kilowatt constructed today for a coal gasification plant -- Duke Energy (DUK -0.29%) and Southern Company (SO -0.30%) are building them right now -- the cost per kilowatt produced is equivalent to a new nuclear facility, which is basically the most expensive.

O'Reilly: Yeah. I keep hearing about how we have unlimited natural gas here in the United States. So, I'm sitting here like "We have a lot of coal, but why are we going to use it?"

Crowe: It's the tough, tough thing. It's the construction on those things. It's one of those things where it could get less expensive if more people were willing to spend the money to bring down the technology costs. However, they are so prohibitively high right now in comparison to other options that it's really, really hard for people to cross that bridge.

O'Reilly: Right. So, real quick, before we move on because we're obviously short on time because we want to get to the good stuff. But, they're obviously a footnote of the entire industry, but how bad is the future for metallurgical coal? Because we still need to make steel.

Crowe: Ooh. That's a tough one.

O'Reilly: This is a debate for another day?

Crowe: Can we try that one next week?

O'Reilly: That is more than fine. Yeah.

Crowe: Let's try that next week.

O'Reilly: This actually does have a really good lead into how the climate debate is affecting the oil majors. Because for years Exxon, BP (BP -0.36%), Shell (RDS.A) (RDS.B), even Total (TTE -0.47%); they were just "We'll just ignore it. Maybe it will go away." Now they actually want a voice at the table because they're realizing the alternative is that decisions will be made without them. So, what's going on with that today? Total -- basically all the European majors are getting together and actually doing something here.

Crowe: Right. All European majors are getting together and building a think tank on how they can build their -- not necessarily on shaping policy -- but how can they build their business in a way that is a little bit more adaptive to what's going to happen in climate change policy. What I saw from the report -- it was another Bloomberg report that we're talking about on this one -- what I saw was, it seemed a lot of talk for now, but not a whole lot of action.

We'll see what happens when it actually -- we start to get some results on this. The biggest thing, more than anything sells that these guys are looking to do is show the economic and environmental benefit of switching from coal to natural gas. More than anything else.

O'Reilly: Because it is a lot cleaner. There's not debate about that.

Crowe: Yeah. When it comes to oil, they don't really have a leg to stand on in terms of the climate argument. There are other arguments they could make on terms of industrialization of the developing world -- which...

O'Reilly: Oil has more energy per BTU...

Crowe: Right. And it's cheap.

O'Reilly: You can't get around that. Yeah.

Crowe: It's cheap. You can use it in that way, and there are those social impacts of improving the developing world through industrialization that fossil fuels make possible. But from and environmental standpoint, oil's a tough leg to stand on right now. Natural gas, you have an option. You can show that natural gas is less harmful to the environment than coal. I'm not saying that it's completely clean.

O'Reilly: You mean oil?

Crowe: I'm sorry. No, natural gas is better than coal.

O'Reilly: Yeah, OK. Sorry.

Crowe: And that's -- because coal is still the largest fossil fuel, or largest energy source in the world. By far. As long as that takes the lead, natural gas can cut some of that out. That is their option, and that is a way that they can move forward because it provides them some sort of future that doesn't' involve just fighting it with oil all the time.

O'Reilly: Got it. Okay. So, moving on to the crux of what I want to talk about today. We've got 6 minutes left. Very deep, philosophical question. You can only pick two of these. I was looking at random oil companies in S&P CapitalIQ, looking at their free cash flow, and for our listeners that are curious I literally just took cash flow operations minus capital expenditures --because that's what they're spending every year to find oil and get it out of the ground.

You have to pick two between free cash flow generation, production growth, or reserve replacement. Because a lot of BMPs have two of the three, but a lot of times -- I'd say 90% of the time, at least from what I saw -- very poor free cash flow profile. Do you just have to spend, spend, spend, just be very bullish on...?

Crowe: Am I doing this from...

O'Reilly: Future demand, or...

Crowe: Am I doing this from a producing company's perspective, or from an individual investor's perspective?

O'Reilly: This is The Motley Fool, so I'm going to go with option B. Individual investors.

Crowe: Well, that's a simple one. First and foremost I'm going to say "free cash flow". Followed by, reserve replacement. The nice part is, by only picking two, I can get the third one by default. That's almost like the third one for free. If I have a company who can consistently generate excess cash from its production while at the same time replacing the reserves that it's doing...

O'Reilly: In a cost effective manner.

Crowe: In a cost effective manner; then I immediately have a company that has extra 'money', extra 'earnings' leftover to do what it needs to do to grow. It can either do it through growing production, it can do that through paying a dividend, it can do that from buying back shares. Either way, by having that free cash flow it can grow. If I've got that and it can replace its reserves at, hopefully, even better than what it's producing, then all of a sudden I've got a sustainable platform to work off of.

If I am just growing production for the sake of growing production, I would say it's killing my cash flow, while at the same time I may be able to keep up with my reserve replacement rates. You're killing value over the long term. You may be keeping the lights on today, but three, five years from now you're not. You may be at a point where you're taking on debt to finance those options, or to finance that growth, then all of a sudden...

O'Reilly: Or issuing equity.

Crowe: Or issuing equity and then you could find yourself in the position that you see a lot of companies in the space today.

O'Reilly: Well, that's what led me to ask this question, because I looked at the cash flow [of] four companies. I don't want to get too crazy here with the numbers on air, but 2012, 2013, 2014. SandRidge Energy (NYSE: SD), 2012, negative cash flow of $2.2 billion, 2013 negative $645 million, and last year was $950 million. Halcón (HK) ranged from negative $1.1 billion to -$900 million, EOG Resources (EOG -0.68%) -- the winner of the bunch behind the next guy, Exxon -- in 2012 they had negative free cash flow of $2 billion, but they've been growing production like crazy.

They had positive free cash flow the last two years. $269 million and $403 million, and the winner of the bunch -- and we now see why Goldman Sachs likes them so much -- Exxon: 2012 $22 billion in free cash flow.

Crowe: Oh, that's such a nice, big number.

O'Reilly: I had to double check that. I was like "Good, Lord!"

Crowe: Yeah.

O'Reilly: That's how they can buy back all that stock. 2013: $11.3 billion, and then last year $12.1 billion. What was staggering to me with SandRidge and Halcón was, this is when oil was at $100.

Crowe: Well, as a business, these guys -- these were very entrepreneurial people when it got started three to five years ago. Basically they were...

O'Reilly: This gets into what you were saying about wildcatters versus investors.

Crowe: Right. As a wildcatter, sometimes...

O'Reilly: I'm picturing guys with ropes and cowboy hats and just "Yee-haw", and...

Crowe: A little different. Divining rods. The divining rod of oil. Trying to go find oil out in the...

O'Reilly: Do you own one?

Crowe: No, I don't.

O'Reilly: Okay.

Crowe: Maybe I should though.

O'Reilly: You should.

Crowe: I should keep it at my desk. One of the things that you see with these guys -- I don't want to disparage them in any way because they have completely transformed the energy landscape in the United States -- but a lot of times they get ants under the skin. Like "I am going to find oil here. It's going to happen." And come heck or high water, I am going to do it here."

And they'll pour a ton of money into the initial wells, into the initial production and once they do they find themselves in the hole. Once that production starts to come online, then they have to keep growing to keep the lights on. Keep paying the bills and cover the expenses from that initial well. Sometimes I find that their best option -- what they see is -- "We just need to keep growing production and everything will take care of the rest."

It's like "Oh, well these guys produced more. Once we get up to that level we'll be fine." That's not always necessarily the case. From an investor's standpoint, when I see that, I can respect it, I just -- as an investor -- who's looking for something sustainable over the very, very long term -- I just see that and go "It looks too risky for me. I'm looking for somebody who has that free cash flow that can ride out a low oil price environment like we're in today."

O'Reilly: It seems like there are certain businesses where there is a residual/repetitive nature to it where that does work. I remember this great business case I read about how Michael Bloomberg actually runs Bloomberg LP and everybody in that place is a sales person. He just wants them to sell those terminals that cost $15 to $20 grand a year and everything else will save itself.

But, Bloomberg LP does not have declining reserves.

Crowe: Yeah. That is a way, way different sort of thing. This is a business that is built on the idea of high capital intensity. The minute that a well is drilled, that reservoir is declining. There's less in it than the day before and you have to go somewhere else to find new ones. It takes an extreme amount of capital to do it, and the companies that can keep production going grow a little bit while maintaining the capital discipline to have a little bit of cash left over at the end of the day. It's gold.

O'Reilly: And that's what you want to look for in an oil company.

Crowe: Free cash flow, baby.

O'Reilly: Boom. Very good. Well, thanks for your thoughts, Tyler. That is it for us, Fools. But before we go I wanted to make our listeners aware of a special offer. If you found this discussion informative and you're looking for more Foolish stock ideas, Stock Advisor may be the service for you. It is our flagship newsletter started more than 10 years ago by Motley Fool co-founders Tom and David Gardner. We're offering the lowest price out there for our Industry Focus listeners. It is $98 for two a two year subscription.

You'll get two stock recommendations every month with insights from our team of analysts. Just go to focus.fool.com to take advantage of the deal. Once again that is focus.fool.com. As always, people on this program may have interests in the stocks that they talk about, and the Motley Fool may have formal recommendations for or against those stocks. So, don't buy or sell anything based solely on what you hear on this program. For Tyler Crowe, I am Sean O'Reilly. Thanks for listening, and Fool on!