"I have known no wise people who didn't read all the time — none, zero." – Charlie Munger

The Frackers: The Outrageous Inside Story of the New Billionaire Wildcatters

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The Frackers is the story of how a group of oil and gas entrepreneurs went against the crowd to pursue unconventional oil and gas plays in the U.S. that the majors dismissed for years.  The story demonstrates how quickly an industry can change, making industry and government experts’ predictions seem foolish (in this case only a few years out) and also how the combination of reckless ambition and leverage can very quickly destroy fortunes.  Most notably, Exxon’s headquarters were within miles of the Barnett Shale, while the company was solely focused on opportunities in Africa and Europe and in 2003, Alan Greenspan touted the benefits of natural gas import infrastructure.

The book centers around five entrepreneurs, George Mitchell (Mitchell Energy), who for years pursued the Barnett Shale against the recommendation of many at his company, Harrold Hamm of Continental Resources who developed the Bakken, Tom Ward and Aubrey McCLendon of Chesapeake Energy, which built the 2<sup>nd</sup> largest natural gas producer through a levered land grab and Charif Souki of Cheniere Energy, who originally built a natural gas import terminal and then later converted it to an export terminal after the shale revolution drove prices down.

The entrepreneurs showed perseverance with George Mitchell spending 17 years drilling in the Barnett before any meaningful developments and Harold Hamm failing in the Bakken for over a decade.  The group also outstretched their good fortune, particularly Tom Ward and Aubrey McClendon, by spending excessively (both personally and at their companies) while employing leverage and this eventually led to their demise.  Interestingly, at Tom Ward’s lowest point, he was bailed out by George Kaiser, who is patient and frugal value investor and Harrold Hamm chose to fund his E&amp;P efforts in part with funds from other business vs. leverage.  Another key mistake they made was not foreseeing that the fracking and horizontal drilling techniques that made outsized profits in these plays possible caused a huge influx of capital and drove down the price of natural gas.  The book was written in 2013 and the events in shale industry since then highlight these issues (at the time of reading in late 2016), as (i) Charif Souki was pushed out of Cheniere Energy by activist investor Carl Icahn, (i) Tom Ward’s Sandridge Energy filed for bankruptcy, (iii) Aubrey McClendon was killed in an auto accident after being forced out of Chesapeake Energy, which narrowly avoided bankruptcy in 2016 and (iv) natural gas prices have remained below $3.00 for nearly two years.  The book also reminds me that you want to avoid industries that are undergoing an inflated capital infusion, as detailed in the book Capital Account by Marathon Capital – when bankers line up to provide cheap financing and companies make irrational acquisitions, you wait patiently on the sidelines for the party to end.

While many fortunes were won and lost in the shale revolution, the shale entrepreneurs have advanced U.S. energy independence and provided the runway for the transition to renewable energy (natural gas is complementary to intermittent wind and solar generation).  At the time of the book, U.S. oil and gas imports from OPEC had decreased 25% since 2009 and the U.S. was a net exporter.

Key Takeaways

  • The shale revolution demonstrates how quickly an industry can change
  • Aubrey McClendon and Tom Ward are excellent examples of how not to manage wealth and run a company – their spending and use of leverage was beyond reckless
  • The most innovative ideas come from experimentation – using more watery fracking liquid, a major breakthrough in fracking techniques, was found by mistake by Mitchell in the Barnett
  • Perseverance is critical for entrepreneurs – it took decades for Bakken and Barnett to develop and Cheniere was successful through a complete change in strategy (import to export).

Quotes

  • “I didn’t have much to start out with in life, so without leverage I wouldn’t have anything” – Tom Ward
  • “I don’t like using other people’s money, it changes you. You believe your own bull, it distorts you” – Harold Hamm
  • “In the United States, rising demand for natural gas, especially as a clean-burning source of electric power, is pressing against a supply essentially restricted to North American production. We are not apt to return to earlier period of relative abundance and low prices anytime soon” – Alan Greenspan in 2003

Detailed Notes

  • Entrepreneurs
    • George Mitchell
      • Went to Texas A&M and was an early entrepreneur – sold candy at football games and then started selling gold embossed stationery
      • Started in 1946 in Galveston drilling for oil and natural gas with the support of wealthy Jewish businessmen – by 1950’s the Wise County field in TX was their largest natural gas field. Gas prices were very low, but there was increasing demand from Chicago markets and the acreage was only $3.00 per acre
      • Mitchell also led the development of the Woodlands in the 1970s
      • By late 1970s he ran into issues as he had fixed obligations to supply Chicago and the Wise County field was running dry – read a paper of large deposits (but economical) in nearby Barnett Shale and started drilling there in 1981
      • By 1995, the company had continued to experiment with fracking techniques in Barnett with limited success and Mitchell was getting pressure within the company to give up – Mitchell sold the Woodlands division to continue to pursue E&P
      • Engineers by mistake noticed that a more watery version of fracking fluid worked better than traditional chemical and sand mix – less sand created smaller fractures to let the gas flows
      • Spent 17 years trying to make shale gas work in the Barnett
      • In 2001, Devon Energy purchased Mitchell Energy (who had accumulated 600K of acreage in Barnett) for $3.1bn.
    • Tom Ward and Aubrey McClendon
      • Ward background
        • Went to University of Oklahoma and worked at a land brokerage firm right out of college in 1981 – oil prices fell in the 1980s and he was forced to manual labor and then saved money to go out on his own
        • In OK, landowners are forced to lease their land or drill themselves and Ward got a list of people that had turned down from majors and went back to them to sweeten the deal – McClendon was his biggest rival
      • McClendon background
        • Great Uncle was a senator and founded Kerr-McGee, which eventually purchased Oryx
        • Grew up well-off, but not wealthy – attended Duke as undergrad and was very well-liked and a campus leader there
        • Had an entrepreneurial start – sold holiday cards door to door, mowed lawns, etc. and had a passion for geography
        • Married Kate Uptown, who was the granddaughter of the founder of Whirlpool
        • Started in Uncle’s energy leasing business as accountant and then shifted to land leasing
      • For six years, they were landmen (basically flipping the leases to operators) and would participate to some extent in the drilling, but it was not a way to get rich – so started CHK with $50K – raised $1mm and drilled first well in 1989 and went public in 1993 (kept a right to purchase a 2-3% interest in each well CHK drilled personally)
      • By 1996 due to success in Austin Chalk, the stock went to $70 and market cap of $1bn – most of reserves were proved undeveloped – they got burned in LA and had to write off $200mm
      • They tried to convert the company to a traditional oil and gas company and acquired $800mm of conventional reserves, but prices fell and by 1999, the stock was trading at $0.70
      • 1999, Ward and McClendon were convinced that natural gas prices were going to rise – they had heard that large utilities (Calpine was building capacity for 15bn cubic feet a day – 1/3 of current consumption in U.S.) were going to switch to natural gas leading to a supply and demand imbalance – they decided to acquire as much land as possible
      • Acquisition spree – in 2003, spend $500mm acquiring assets and had 1mm acres across the country. They had 1,000s of landmen and would digitize court records for free to facilitate leasing
      • By 2005, stock price had recovered to $30 an gas prices soared past $10.00 – acquired Columbia gas in WV for $3bn and CHK controlled 8mm acres, but had $5bn of debt – spent $5bn in 2005 in total and $10bnn since 1998
      • Ward and McClendon had huge margin accounts at banks and even started their own hedge fund to trade commodities
      • McClendons personal spending was out of control – $12mm collection of oil and gas maps, $40mm home in MI, $20mm home in Virgin Islands – they bought the Seattle Super Sonics and had a 70,000 sq. ft. fitness center
      • In 2006, Ward was overwhelmed with the acquisition spree and quit (later to form Sandridge)
      • In 2006, CHK had spent $6bn on natural gas acreage – prices in Powder River had increased from $11 to $900 in 2007 (just within that year)
      • To fund the acquisition spree, Wall Street created the volumetric production payment (VPP) in which CHK would receive upfront cash in exchange for production to be delivered to a vehicle sold to hedge funds and banks
      • Ward left to form Sandridge and focused on convention gas plays and acquired an energy company from Carl Icahn (National Energy Group)for $1bn and a stake in Sandridge, but Carl sold his shares in Sandridge with the IPO
      • McClendon turned to other sources of financing – joint ventures in Haynesville to continue the spree, in which the JV partner would share in the drilling costs
      • In 2008, Ward and McClendon bought $200mm of shares in their company each and predicted that gas prices would be around $9.00
      • He had borrowed a total of $500mm and used CHK as collateral and the banks were forced to sell 96% of his company at $15 per share or so – he had borrowed 1 for every 3 value of stock and thought that was conservative enough – Ward had also lost a $1bn in his personal trading account and was forced to sell 25% of Sandridge to George Kaiser at $5 per share – down 90% from the last year (incredible deal for George Kaiser) – Ward repositioned the company to oil, stating that it was less impacted by U.S. impact due to transportation
      • McClendon offset the stock losses by pushing the board for $112mm in compensation in 2008
      • In 2010, Icahn acquired 6% of CHK and forced them to sell $6bn of assets to payoff debt – the stock reached $35 and Icahn got out of the stock – pocketing $500mm
      • Lou Simpson of Geico started pushing to remove McClendon – he thought McClendon was not considering the risk of natural gas prices not rising with the company’s debt load – “the company’s culture had to change”
      • In 2012, natural gas prices were at $2.50 and shares were around $17 – McClendon was forced to stepdown as Chairman and Icahn took another stake in CHK – late 2012 he was forced out – Icahn and Longleaf were convinced there was a discount on the stock due to McClendon
      • Ward was also getting pressure from investors (Mount Kellett and TPG) – he was being paid $50mm a year and the company had huge overhead – in 2013 he was also forced out
      • Ward and McClendon went on to raise money from private investors after being forced out of their respective companies
    • Harrold Hamm
      • Grew up poor and did not go to college – started working at a filling station in OK where he was exposed to the oil and gas business
      • Got a job working for a hauling company – hauling oil and water from the fields – at age 20 he borrowed $1,000, assumed debt and bought his own hauling truck (1966 or so) – outworked competitors, saved money and learned the industry – soon had a large business and at age 22, established his own E&P company
      • In 1982 he sold the trucking business for $32mm and in late 1980s and early 1990s acquired acreage that larger companies were discarding for cheap prices
      • Incredibly focused on self-improvement – took speech classes at Dale Carnagie
      • Competition in OK increased in 1990’s so in 1994, they looked to North Dakota – acquired land for $25 per acre – Hamm funded everything with money from the services business
      • By 2004, Continental did not have any success in ND and they sold ½ their acreage
      • With the development of segmentation technology, Continental started having success – their wells were producing 1,000 barrels a day by 2009
      • By 2014, Hamm was worth $18bn, making him one of the wealthiest people in the world
    • Charif Souki
      • Born in Egypt in 1950s and father was a well-known journalist – went to Colgate in 1971 and then Columbia business school
      • Started out working for an investment bank raising money in the Middle East and then went off on his own at around 30 – later on he retired in Aspen and started opening restaurants and then opened Mezzaluna in LA, the restaurant where Nicole Simpson and Rob Goldman met – after OJ murder case, running the restaurant was no longer fun and he left the business – he had run out of money and only had $300K to his name
      • In 1996 the oil and gas industry was in a downturn and he thought there was money to be made – people were focused on tech stocks
      • Bought a shell company and moved family to Houston – raised $20mm for exploration and then from Warburg Pincus – thought he could not make any money and realized that gas prices had to rise, so started exploring an LNG import terminal (currently only 4 in the U.S)
      • In 2000, stock price was $0.50, but by 2003 there was significant interest to import natural gas and he had signed contracts with Chevron and Total (France) to import ~3% of natural gas needs in U.S. ($125mm to convert 1bn cubic feet a year).
      • In 2009, CHK approached Cheniere about building an export terminal – but he had no support from Blackstone or Paulson and in 2011, Cheniere got a permit to export natural gas and an $8bn price tag for the facility
      • In 2012, Blackstone and Temasek (Singapore) gave Cheniere the money to building two LNG processing units and raised the rest from banks
    • Shale Revolution Timeline
      • 1950’s natural gas was selling for $0.07 per MCF – as there was not the interstate pipelines and infrastructure to carry it to homes – as a result majors were focused on oil
      • Fracking (term was first used in 1970s) is the process of completing wells (or preparing them to produce energy) by fracturing the rocks by pummeling them with various liquids to free up the gas in these rocks – it was started in 1860s when a Civil War veteran developed a “torpedo” method with capsules that created an explosion horizontally (vs. historical black powder methods that worked vertically)
      • Shale gas is often called “source rock” because it is believed to be the source of most of the oil and gas deposits near the surface
      • By 1970’s, producers were realizing that there was less oil and gas in the U.S. – American oil production peaked in 1970 at 9.6mm barrels a day
      • Mineral and energy deposit rights are held by the landowner in the U.S., not by the government as in Europe and other regions
      • Oil prices had fallen in 1981 from $36 to $15 by 1986 causing a crisis in the Southwest
      • Mitchell’s activity in Barnett peaked the interest of other entrepreneurs and majors – in 1992, Chevron formed a “unconventional play” division lead by Ray Galvin
      • Mid 1980s, Robert Hauptfuhrer of Oryx Energy had developed horizontal drilling techniques – gas and oil deposits are very long and narrow with only a few “payzones”, so vertical drilling is hard to pinpoint the payzones – horizontal drilling was first tested by the Department of Energy in the 1970s with coal deposits
        • Oryx was the E&P spinoff of Sunoco and was focused on the Austin Chalk region – their success lead to interest from majors by 1990
        • Initially horizontal drilling was very expensive – $2mm per well vs. $350K for a vertical well – horizontal wells could go as far as 4K feet laterally
        • 1990 – Oryx paid $1.1bn to buy BP portfolio in the North Sea and then in 1990 made the critical mistake of buying 20% shares from Pew trust (using debt) – stock price was at $50 a share. Fears of oil shortage with Iraq invasion of Kuwait in 1990 drove prices up, but they quickly fell afterwards as the U.S. invaded.  Oryx could not make money in Barnett w/ horizontal drilling only as they were not as productive without fracking – the company had too much in debt and was forced to sell to a rival (at $15 per share)
      • In the mid 1990’s Chevron’s unconventional unit discovered that Mitchell’s Barnett shale position had multiples more energy than the company thought – however, the leader retired and successor abandoned the unit and engineers went elsewhere – Ken Broker went to Mitchell and explained there was 4x what they thought there was – 185 bn cubic feet of natural gas per square mile (1998)
      • S. Geological Survey had estimated just 10 trillion of cubic feet in the Barnett
      • In late 1999, the frackers predicted double digit gas prices – by 2000 gas prices were at $5.00
      • By 2002, Devon and Hallwood had a breakthrough of combining horizontal drilling with fracking
      • In 2005, U.S. was only producing 50bn cubic feet a day and that was expected to decline to 40bn in five years and only 5% of natural gas came from shale – in 2006, oil production declined to 5m barrels a day from ~10 in 1970s
      • In 2006, EOG and then Continental hit a new fracking breakthrough – by focusing on sections (“swell-packers”) one at a time that were sealed off to increase pressure in that area
      • In 2007, everyone thought natural gas production was ending and prices were set to rise – TXU buyout for $45bn was a bet that wholesale electricity prices would rise
      • In 2007, some in the industry (Mark Papa of EOG, formerly a unit within Enron) realized that there was going to be a glut of cheap gas
      • In 2008, U.S. came out with a survey estimating 4bn barrels of oil in the Bakken – 25x previous estimates. Also estimated that Marcellus had 50 trillion cbf of recoverable gas – 25x previous estimates making it the largest field in the world – then increased to 450 trillion or equivalent of 20 years of U.S. gas consumption
      • In 2008, Cheniere held a press conference with government officials to open the new import facility – the stock was tanking during the presentation and Souki was forced to sell most of his stock
      • In 2008, import estimates were slashed to 1.2tr a year from 6.4tr
      • Exxon acquired XTO Energy for $31bn making it the largest producer of natural gas
      • In 2010, Continental had developed “pad drilling” which allowed it to have 4 wells on each drilling pad that increased production
      • Held by production – companies drill wells within 3 to 5 years, while also paying royalties or lose the leases even after paying the landowner $20K as part of the leasing transaction – in 2010, ½ of CHK drilling was involuntary (not driven by oil prices)
      • Huge shale formations in other continents – 400+ trillion cubic feet of gas in Europe, 285 trillion in Russia, 800+ trillion in Argentina, 1.1trillion in China

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"I have known no wise people who didn't read all the time — none, zero." – Charlie Munger

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