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After-hours on July 31, Concho Resources (CXO), the biggest producer in the low-cost, high-yield Permian Basin, reported earnings of 69 cents a share for the second quarter of 2019. That missed the Wall Street consensus by 3 cents a share. Revenue climbed 19.3% year over year to $1.13 billion, slightly better than the $1.11 billion revenue consensus on Wall Street. (Please note that these 69 cents in earnings are based on non-GAAP income. If you use Generally Accepted Accounting Principles, the company shows a loss of $97 million or 48 cents a share for the quarter. The company’s “earnings” in the version that Wall Street watches came from (perfectly legitimate) accounting items such as depreciation.)

The next day, shares of Concho Resources fell 24%.

That’s not just a reaction to the small three cents a share Wall-Street earnings miss. It is mostly a reaction to the deteriorating fundamentals for oil shale producers. And if you want to understand why most of the sector is now a sell in my opinion–and why it is one of the four sectors that I’ve recommended as sells in Step #2 of my Special Report on getting your portfolio ready for the next Big One–I can’t think of a better example than Concho Resources.

First thing let’s start with that revenue figure. The company produced an average of 329,000 barrels of oil equivalent a day in the quarter. That was above the company’s guidance. And that higher production was essential for generating that better than expected revenue number since the company got less for a barrel of oil this quarter–$56.02 on average–than it did in the second quarter of 2018–$60.98. (Just for context, West Texas Intermediate closed at $56.19 a barrel today, August 19.)

The bad news for Concho is that it’s getting harder to expand production to offset low oil prices. For the third quarter Concho said it would produce between 316, ooo barrels of oil equivalent and 322,000. That’s lower than in the second quarter.

That reflects a slowdown in the company’s drilling program. Concho is running 18 drilling rigs now, down from an average of 26 in the second quarter and way down from 33 rigs in the first quarter of 2019. That means fewer new wells coming on line.

Part of that is for a company specific reason. Concho completed a 23-well spacing test in the Delaware Basin’s Upper Wolfcamp geology The wells were very tightly spaced–too tightly it turned out. Performance suffered and the company has incorporated wider spacing in its second half drilling program. But that still contributes to the drop in drilling rigs in operation.
A bigger part of the reason, though, isn’t company specific. The slowdown in drilling reflects pressure on cash flow at Concho and across the sector.

For the first half of 2019, Concho reported net cash from from operations of $1.402 billion. Plenty to fund drilling, right?

Not really since most of that cash isn’t actually cash. Net income in the period was a loss of $792 million. Most of the “cash flow” was actually bookkeeping adjustments. $943 million for depreciation, depletion and amortization, for example. Another $868 million in impairments of long-lived assets. Those are absolutely proper accounting measures for oil companies. It’s just that they don’t actually generate any cash that a company can use to pay the bill for steel pipe or workers’ paychecks.

It’s “interesting” (and not in a good way for companies across the sector) that in the first half of the year when Concho generated, according to the accounting, $1.402 billion in cash flow, the company borrowed $2.06 billion under its bank credit line. In that period Concho spent $1.726 billion to acquire oil and natural gas properties.

And $1.905 billion for repayments to its credit facility. Repayments that it looks like Concho promptly borrowed again. On its balance sheet, Concho showed $4.35 billion in long-term debt on June 30, 2019. That long-term debt stood at $4.194 billion on December 31, 2018. No net $2 billion repayment  visible in those figures.

In fact if you look at the balance sheet what you see is a company with a lot of paper assets–such as accounts receivable–and a lot of tangible property assets–oil wells, for example, but no cash or cash equivalents.

You could make the case that this is a company totally dependent on its bank lines of credit–and any other ability to raise cash in the financial markets.

None of this means that Concho Resources isn’t a going concern. As the biggest oil producer in the Permian, the company carries a lot of clout with banks and in the financial markets. I’d say that unless oil prices really, really plunge, Concho Resources will have no problem raising money from those sources or from selling assets to international majors.

But that’s not true for smaller oil shale producers with fewer tangible assets and less actual quarterly production.