Is the U.S. Fracking Boom Based on Fraud?

Yves here. It really is remarkable how super low interest rates have led investors on a widespread basis to pour money down ratholes. Unicorns is one. Another has been fracking, which despite being another widespread cash sink, remarkably has kept sucking in funding. As we pointed out in 2014:

John Dizard at the Financial Times (hat tip Scott) gives a more intriguing piece of the puzzle: the degree to which production is still chugging along despite it being uneconomical. The oil majors have been criticized for levering up to continue developing when it is cash-flow negative; they are presumably betting that prices will be much higher in short order.

But the same thing is happening further down the food chain, among players that don’t begin to have the deep pockets of the industry behemoths: many of them are still in “drill baby, drill” mode. Per Dizard:

Even long-time energy industry people cannot remember an overinvestment cycle lasting as long as the one in unconventional US resources. It is not just the hydrocarbon engineers who have created this bubble; there are the financial engineers who came up with new ways to pay for it.

Justin Mikulka argues that one reason these persistently unprofitable fracking companies keep going is via fraud.

By Justin Mikulka, a freelance writer, audio and video producer living in Trumansburg, NY. Originally published at DeSmogBlog

In a 2016 interview with Fraud Magazine, former Enron CFO Andrew Fastow explained what he thought made him so successful while at the former energy corporation that’s now infamous for financial scandal.

“I think my ability to do structured financing, to finance things off-balance sheet and to find ways to manipulate financial statements — there’s no nice way to say it. Like I said at the conference, I was good at finding loopholes.”

As Fastow explained, in finance, the difference between a loophole and fraud isn’t always easy to identify. And that may be something the U.S. fracking industry is working to its advantage.

Fastow, the convicted fraudster, does admit that what they did at Enron misled investors. “We created something that was monstrously misleading, but any one of those deals alone wasn’t necessarily considered fraudulent,” he said.

Fast-forward to today and a different part of the energy industry: The U.S. shale oil and gas industry has lost more than a quarter trillion dollars since 2007, while being sold to investors as an economic boom, even at oil prices much lower than those of recent years. Does that financial mismatch seem misleading? Or perhaps, familiar?

In an unexpected twist, Fastow now gives talks to the energy industry on ethical leadership.

Sounding the Alarm

Bethany McLean was the first reporter to question whether Enron was a financially sound company in a 2001 article for Fortune magazine. McLean went on to co-author the book The Smartest Guys in the Room, which documented the fall of Enron due to its fraudulent practices, including the ones Fastow engineered.

In 2018, McLean also published the book Saudi America, which highlighted many of the financial challenges the fracking industry has faced. In a recent interview for Texas Monthly’s podcast Boomtown, McLean explained one of the very accepted and blatantly misleading practices of the fracking industry:

I’d raise a couple of points. One is that companies have long hyped these break-even numbers. They say we can break even at $25 a barrel, we can break even at $20 a barrel. And then you look at their consolidated financial statements and they are losing money. And so something is going wrong … the people called it to me [sic] … corporate math or investor economics. So they were trying to put together these investor pitch decks that would show investors a set of economics that weren’t real. So they would show you that they could break even on a well at $25 barrel of oil but then yet you’d go to the corporate financial statements and they were losing money.

Is that a loophole? Where you can openly misrepresent to investors the financial reality of your business? Or is it fraud?

As more and more players in the fracking industry run out of options and file for bankruptcy, investors are beginning to ask questions about why all the money is gone.

The Blank Check Companies

Much like with the housing crisis that caused the financial crisis of 2008, the fracking boom has led to Wall Street bankers finding innovative ways to finance a money-losing endeavor. Some companies are now even selling bonds based on future well performance, a concept similar to the mortgage-backed securities that led to the 2008 housing crisis.

Another Wall Street invention is what is called a “special purpose acquisition company” (SPAC), or, as they are also known, blank check companies. The way these investments work is a big bank or private equity firm backs a management team to raise money for the SPAC with the agreement that the leaders of the SPAC will then at some point make a “special purpose acquisition” — which means they will find an existing company and buy it.

They are called blank check companies because the management is given a blank check to buy whatever they choose. In the 1980s, the Wall Street Journal (WSJ) noted that “blank-check companies were often associated with penny-stock frauds.” In a 2017 article on the oil industry, the WSJ reported that “SPACs were a hallmark of the frothy days before the financial crisis [of 2008].”

Understandably, SPACs were often seen as a risky investment, but much like with the housing crisis, the biggest names on Wall Street are getting involved and giving the concept legitimacy, with Goldman Sachs starting to back SPACs in 2016. And new fracking companies have come about as a result.

Ben Dell, a managing partner at investment firm Kimmeridge Energy, explained one of the risks of SPAC investments to the Wall Street Journal. “SPAC management teams have an incentive to spend the money they have raised no matter what, so they can collect fees and pay themselves a salary and stock options at the company they purchase,” Dell said.

SPACs are the most egregious example in the industry of executive misalignment with investors,” Dell told the WSJ.

As I have previously reported, one of the problems with the fracking industry is that CEOs are paid very well even when the companies lose money. According to Dell, SPACs take this problem to a new “egregious” level.

Alta Mesa: A Star Is Born

To successfully raise money for a blank check company, having some star power in the management helps. As the Wall Street Journal has noted, investments in SPACs “are largely bets on their executives.”

Jim Hackett would seem to be the ideal candidate to lead a SPAC in the fracking industry. Hackett has an impressive resume: the former CEO of fracking company Anadarko, former chairman of the Federal Reserve Bank of Dallas, an executive committee member of the industry lobbying group American Petroleum Institute, and partner at the major private equity firm Riverstone Holdings.

In 2013 Hackett retired from Anadarko to attend Harvard Divinity School to get a degree in theology. However, he was still a partner at Riverstone and in 2017 was lured back to the fracking business to run a SPAC backed by Riverstone.

The SPAC raised a billion dollars while being advised by the biggest names in the business, including Goldman Sachs and CitiGroup. The initial blank check company was called Silver Run Acquisition Corp. II.

Hackett used the money to buy two companies in Oklahoma — an oil producer and a pipeline — and the new combined company Alta Mesa was valued at $3.8 billion.

The Future Was Bright for Alta Mesa 

Hackett and Alta Mesa had big plans for making money fracking wells in Oklahoma, which included forecasts for big increases in oil and gas production from the newly acquired assets with very low break-even numbers.

When the Wall Street Journal reported the creation of Alta Mesa, it noted, “Alta Mesa’s core acreage in Northeast Kingfisher County has among the lowest breakevens in the U.S. at around $25 per barrel, the company said.” Because oil was well over that price at the time, the future looked good, according to Hackett and Alta Mesa. Forbes reported that Hackett said Alta Mesa’s holdings were “oil that will be economic even at $40 WTI [West Texas Intermediate]” and oil has been well over that mark since Hackett made that statement in 2017.

Like break-even numbers, another area where misleading investors in the oil industry might be particularly easy is making overly optimistic forecasts about how much oil will be produced by future wells. The Wall Street Journal has documented this as a significant problem for the U.S. shale industry.

Description of Alta Mesa assets in investor proxy statement. Credit: Screen capture from proxy statement.

In early 2018 when touting the potential of the proposed new company Alta Mesa, Hackett said that “its average well would produce nearly 250,000 barrels of oil over its life.” A year later, Alta Mesa said it expected those wells would produce less than half that, only 120,000 barrels of oil over the life of the well.

In May last year, Alta Mesa was under investigation by the Securities and Exchange Commissions (SEC) “for possible issues in its financial reporting.”

Later in 2019, Alta Mesa filed for bankruptcy after writing down its assets by $3.1 billion. The billion-dollar blank check had been spent, and it took less than two years to lose it all.

SEC Investigation and Multiple Investor Lawsuits

Alta Mesa’s assets were sold off earlier this year. The SEC declined to comment on the status of the investigation.

In May 2019, the Houston Chronicle reported, “Alta Mesa also is facing a series of lawsuits. Some shareholders are suing claiming they were defrauded and lied to about the value of the company and its assets when the company was formed.”

One lawsuit filed by the Plumbers and Pipefitters National Pension Fund claims that the proxy statement for Alta Mesa contained materially false and misleading information. That filing lays out a lot of facts to support that claim.

Statement for complaint for violation of the Securities Exchange Act of 1934. Credit: Screen capture of court documents

Another lawsuit alleges that Alta Mesa didn’t pay the proper amount of royalties to landowners, with state investigations into this issue.

Yet another lawsuit has been filed against Riverstone for “misleading statements.”

Investors are saying they were misled by Hackett and Riverstone. The allegations are based on the claims that were made about how much oil the company could produce. In hindsight, those claims appeared wildly inaccurate and misleading. But is that fraud? Or just taking advantage of a loophole?

In January, the Houston Chronicle summed up the situation as it described Alta Mesa’s downfall: “It was a dramatic fall from grace after significantly overestimating its potential in Oklahoma’s STACK shale play…”

While Alta Mesa is a spectacular example of how fast the fracking business can make large sums of money disappear after “significantly overestimating its potential,” it also likely marks the beginning of investor lawsuits against many other failing fracking companies with similar histories.

Learning From Enron

When Jim Hackett decided to go to Harvard Divinity School, several favorable profiles about his choice were written, including one on the Harvard website. That article noted that one of the reasons Hackett decided to go to school was because of “the collapse of Enron, a disaster that he attributed to ‘a failure in leadership’ among people he knew well.”

The speed with which Hackett and Alta Mesa went bankrupt is remarkable, indicating a likely failure in leadership.

However, Hackett seems to have learned something from former Enron executive Andrew Fastow: that there is work for former executives like them to teach the energy industry about ethics and morality.

Hackett is now a lecturer at the University of Texas at Austin Center for Leadership and Ethics.

Fraud? Or Just a Laughing Matter?
Good reporting is hard work but sometimes involves a bit of luck. Like when a Wall Street Journal reporter, in a room full of people hired to make forecasts of fracked oil and gas production, learned about the existence of much more accurate methods for predicting that oil production. And also learned that with accuracy comes much lower estimates of shale oil reserves.

The WSJ article that followed quoted Texas A&M professor and expert on calculating oil and gas reserves John Lee. “There are a number of practices that are almost inevitably going to lead to overestimates,” said Lee. Those are the practices used by the industry, with Alta Mesa serving as just one example.

Overestimates are why Alta Mesa received funding but now no longer exists.

The Wall Street Journal reported that during a presentation given by Lee, an audience member “stood up and challenged the engineers in attendance,” asking why the forecasters weren’t using accurate models like the ones that were available — as Lee had described.

Another audience member explained the reason.

Because we own stock,” replied another engineer, “sparking laughter,” according to the Wall Street Journal.

Is it misleading to laugh at your company’s investors if you know the estimates you are giving them are inflated, but because you own the stock that benefits from those estimates, you do it anyway? Is that fraud? Perhaps that depends on if you get you get ethics lessons from Andrew Fastow and Jim Hackett.

Will the biggest innovation of the fracking revolution be making financial fraud a laughing matter?

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  1. PlutoniumKun

    While I’ve little doubt there is a lot of fraud, so much of the stupidity around fracking comes down to the old saying that its hard to make a man undrestand something when his job is to not understand it.

    The financing of the oil and gas industry is almost entirely dependent on projections – projections of flow per well, and projections of future prices. All you need to do is make a few optimistic projections of one or both, and you’ve suddenly turned a dud into a highly valuable asset. Anyone can look at the pricing and question it, but with oil/gas, that is much harder with ‘novel’ types of well as there are few if any precedents. So if someone says ‘the well is producing X per day, we can continue this flow for 3 years and when thats finished, we can drill down another 200 metres and replicate the same flow’, there is nobody to contradict it. The drilling guys aren’t going to argue, they want to keep their jobs. The geologist isn’t going to argue, he has his mortgage to pay. The senior manager won’t argue, he wants a promotion. The drilling company owners won’t argue, they want to cash out. And the Wall Street financier won’t argue, because he can pass on the risk to the equivelent of the last booms ‘German bankers’.

    So when someone like Arthur Berman – a geologist who has continuously being questioning the underlying geological assumptions – raises concerns – he’s listened to politely, even invited to some conferences, but is otherwise ignored. Because its not in anyones interest to listen. There is literally nobody who’s job it is to shout ‘stop’. So much for self regulating markets.

    While there may well be very severe economic consequences if and when this blows up in everyones face (and I suspect that Covid-19 will be the catalyst for this, oil demand is collapsing day by day), the big loser is the planet we depend on for our survival.

  2. jackiebass

    I live in NY on the PA border. Fracking is still happening south in PA but is only a fraction of what it once was. If you drive into PA you will see lots full of fracking materials that have sat there for a long time. At first for about two years it was a boom. The activity from fracking was amazing. Then as fast as it started it slowed down to a crawl. There are a few reasons in my opinion. The so called sweet sports were quickly fracked leaving less attractive sights. It was concealed that a fracked well produced most of it’s gas in the first two years. After that the production from a well dropped off drastically. Locals soon lost their enthusiasm for fracking.There is still some fracking but it is hardly noticeable. Local people thought this would be great but attitudes soon soured. A few made big bucks at the expense of the rest. The fracking was in former coal country. The difference is coal lasted a lot longer. Now the majority of people in the area oppose fracking. I’m thankful that NY state banned fracking because of the negatives associated with fracking. I own 50 acres near the PA border. Before fracking was banned I was constantly hounded by leasing companies. I refuse to lease because to me my land was more important than a few bucks. I hope in my life time NY doesn’t reverse the fracking ban. On another note there are wind farms where I live. I would leas to a wind company because there are fewer negatives and it’s less intrusive.

    1. jefemt

      The good news is that if the companies were chasing you, you own the minerals. You can donate them to a conservation land trust and assure that no mineral extraction takes place, and get a tax benefit for the foregone production.

      Win Win!

    2. Wat3rm370n

      That’s because the gas fracking boom in Pennsylvania was almost entirely just a real estate speculation bubble.

  3. Ignacio

    So, one first profits from fraud to later profit by lecturing everybody about ethics?

    1. Kevin C. Smith

      BIG red flag for me when someone like Jim Hackett decides to go to Harvard Divinity School …

      1. Shiloh1

        Daniel Plainview was baptiized, but that was so he could drink Eli’s milkshake later and club him to death with a bowling pin.

      2. Colonel Smithers

        Thank you, Kevin.

        That sounds like my former CEO and chairman, Stephen Green, becoming an Anglican clergyman.

    2. norm de plume

      Would the Romans have appointed thieves to lectureships in ethics?

      One of the tropes I grew up with was the idea that the Romans, unlike us, knew what to do with thieves – they chopped off their hands.

      But since then I have immersed myself in ancient history as a hobby so I know that thievery was at the upper levels was not just winked at but institutionalised into systems of dispossession and control.

      So Prof Fastow and Dr Hackett might well have kept their digits, the better to point out to their students what they did, how they did it, and how naughty it was of them.

      1. Leroy

        Ah, Andrew Fastow , fresh out of prison , well tanned , and ready to engage in the time honored tradition of trying to justify behavior that has no justification , all at high speed so as to snag the slow ones !! GREAT JOB , ANDY , look forward to attending one of your “conferences” in the future !!!

  4. Ignacio

    It can be argued that the money invested in many fracking companies with such inflated pay-back periods, ROIs or breakeven estimates, apart from fraud, could be considered as a private subsidy, just like Uber investors subsidize Uber taxi services. If we can blame it to low interest rates resulting in such subsidies, for fracking oil, unicorns, education, housing etc. to my knowledge this has only been argued in very few sites like here at NC or Wolf Street but merits a close examination. If pension and mutual funds are pouring a lot of money in such business with low to negative returns what consequences are to be expected in the future?

  5. Trent

    Eight to Ten years ago you would have seen giant trucks moving water and dirt from fracking sites when you got off the turnpike around Donegal PA. Since about 2015 or 2016 i’d say that completely died. Pittsburgh actually had one year of population gain due to the fracking boom but thats done. Yves mentioned investors and low interest rates chasing bad investments and fraud. I’d say the same thing is going on in healthcare based on my exp. of it and the amount of money floating around. We need higher interest rates to nip this stuff in the bud and re-balance the economy.

    1. Wat3rm370n

      Like I said above…That’s because the gas fracking boom in Pennsylvania was almost entirely just a real estate speculation bubble. It worked in a few ways and with a little underlying gas in some areas has sustained it to some degree. It’s been making a little comeback I think just from the gas industry propaganda levels ive encountered. They ebb and flow and I’m convinced it’s all lockstep with the housing market to some degree. I wish there was someone with a reason to study this truthfully. But everyone involved in putting out info including the government seems to have financial interests in fitting the facts to a story that makes money

  6. tegnost

    This pretty much says it all regarding the health of our eCONomy, but hey, after it all falls apart we should have plenty of reformed criminals to teach ethics classes…

    “The Wall Street Journal reported that during a presentation given by Lee, an audience member “stood up and challenged the engineers in attendance,” asking why the forecasters weren’t using accurate models like the ones that were available — as Lee had described.

    Another audience member explained the reason.

    “Because we own stock,” replied another engineer, “sparking laughter,” according to the Wall Street Journal.”

  7. fresno dan

    In a 2016 interview with Fraud Magazine, …
    I have to say, I was shocked, SHOCKED to find that there is a magazine actually, only devoted to fraud – that is published bi-monthly.
    AND … than I was shocked to find out that the magaine actually, only devoted to fraud is ONLY published bi-monthly…

    1. Zamfir

      That’s what they say. After you take subscription, you’ll find they publish monthly.

  8. The Rev Kev

    Is the U.S. Fracking Boom Based on Fraud? Is the Pope Catholic? There are going to have to be major structural changes in the world’s economy in the next few years and with the demand for oil dropping, prices have gotten cheaper which is turning fracking into a non-profit industry. In any case, how are you suppose to frack with sick crews? This is one industry that needs to go away before it causes any more damage. You’d find more honesty in a boiler room brokerage firm than in this industry.

  9. Carolinian

    There’s a recent documentary called The Price of Everything that is about the enormous sums being paid for every latest fad in modern art. The show says that all the great masters, old and new, have been locked up by museums or the super rich and so a recent flood of new investors are looking for any excuse to spend lots of money on paintings. Apparently there is so much money sloshing around at the top of our unequal economy that that these plutocrats don’t even care if they lose their shirts on bad investments. The main thing is to keep it out of the hands of the poor.

    Clearly we as a society are suffering from affluenza, at least among the elites who should all be virus quarantined and then maybe we will forget to check back.The show tries to pretend that this money driven art world is a cool thing. It had this viewer thinking of guillotines.

    1. xkeyscored

      Unfortunately, those most negatively affected by affluenza are those not infected with it.

      1. JBird4049

        Yes, like all the people who cannot see the art. It’s mostly buried in storage. What is the point of having over two thousand years of art from multiple civilizations, if most of it is hidden away and often only known from catalog descriptions or cramped tiny pictures.

    1. a different chris

      Because people can still make money off it.

      No, not *you*. Not *us*. But people that “matter”.

      1. lyman alpha blob

        You must mean the insiders who suckered the rubes into taking shares off their hands at the IPO. IIRC the IPO price was over $70/share. Right now it’s just under $32 with no signs of every being a profitable enterprise.

        Grifters, charlatans and mountebanks everywhere you look.

  10. franklin kirk

    Charging mineral resource rent, which everyone has an equal claim to, would help to reduce the tendency of financial shenanigans. The profit motive is crack to rent seekers.

    1. norm de plume

      ‘The profit motive is crack to rent seekers’

      A usefully concise little sentence, thank you.

      I like your idea. An alternative might be to declare that oil is – like food, water, shelter – essential to the nation and its citizens and nationalise the industry. That way the energy can be harvested without the massive shareholder and management claims to profit. A silverback gorilla off its back. Profit would not be the driver; national need would be and if no profits were made, who loses? Anyway, in this economic boom we’re having, those unfortunates can always find a job, flipping burgers or perhaps lecturing in business ethics.

  11. Colonel Smithers

    Thank you, Yves.

    Speaking of Enron, it is perhaps appropriate that my employer’s head of non core assets, toxic waste for fire sale, came from Enron. Standard Chartered has some, too.

  12. Polar Donkey

    It seems like the Russians today decided to put the final nail in U.S. fracking industry and turn the screws on Saudi Arabia.

  13. xkeyscored

    Personally, I’m well chuffed to hear that fossil fuel investors are getting ripped off. It’s the least they deserve, though I’d rather someone other than the financial sector was benefitting.
    On a parallel note, I hear that some OPEC countries may prefer to kick the US shale industry where it hurts by not cutting production much in the face of the WURS slowdown.

  14. rd

    I think the big issue goes back to the investors and bond rating agencies, similar to the subprime mortgage crisis. If bondholders aren’t willing to do the homework, then they don’t get paid for the risk that they are undertaking. with the multiple prediction tools for well production, you can make up an optimistic and pessimistic case. If the bond yield doesn’t cover that risk to your satisfaction, then you don’t buy the bond or you demand a higher interest yield and lower bond price.

    Instead, it seems like the industry is raising money from people who don’t want to think more than a few months ahead on a multi-year investment. The challenges faced by the fracking industry have been well publicized for several years now. If an investor doesn’t understand those challenges now and isn’t looking at specific methods of calculating production yield etc., then they have only themselves to blame if their investment loses money.

    This is a very different issue than if somebody flat out lies about whether or not wells exist etc.

    A single well can make financial sense even if there will never be a net profit from it. Fracking is pretty similar to the Hollywood film industry where nobody ever has any net profits despite living high on the hog. “Don’t ever settle for net profits. It’s called ‘creative accounting’.” – Lynda Carter:

  15. elkern

    I dunno. There may be a sucker born every minute, but I can’t picture enough of them getting born with a million (or billion) Dollars to blow on rackets like this to keep it going this long.

    Sad to see that the Plumbers’ Union Pension Fund was a victim; I hope that’s not a pattern, but it would make sense. If it’s a pattern, then it’s no wonder the Fed tried so hard to postpone the next Crash until after the elections. How much junk paper has Wall Street sold to other Pension Funds? States & Municipalities are already squeezed by “unfunded liabilities”; how much repackaged funky Fracking paper are held by public (governmental) agencies? Damn, this is gonna be a mess.

    I’d advise investing in popcorn, except that my 401k will probably evaporate soon, so maybe it’s pitchforks.

  16. JBird4049

    CFO Fastow of Enron. How nice to see him land on his feet. The company made listening to the rolling blackout reports for California while driving to work a requirement.

  17. California Bob

    The environmental/financial/fraud aspects of the fracking debacle are bad enough, but I think the USA is banking on the oil in ground in TX, OK, NM, etc. to achieve ‘energy independence.’ When the fraud is totally exposed the price of oil will likely skyrocket–perhaps above $100/bbl–and the US economy will experience a shock that will make the COVID scare seem like a minor setback. Moscow and Riyadh will be ecstatic, but it could put the US, Chinese and European economies into tailspins.

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