One of the refrains I often hear about the oil industry — particularly on those focused on shale and tight oil — is that it collectively doesn’t make any money. There have been many stories over the past few years about the ongoing negative free cash flow (FCF) problem among the shale producers.
It is true that in recent years oil companies have collectively outspent their revenues. But two important issues are often overlooked in the stories about negative cash flow.
First is the question of the reason cash flow is negative. To better understand this, let’s talk about what cash flow actually represents.
What is Free Cash Flow?
FCF measures cash generated by a company in excess of its spending, including capital expenditures. There are some differences between how different analysts measure FCF, but I use the levered FCF definition from the S&P Global Market Intelligence database.
This number is calculated by starting from net income, adding back depreciation and amortization (because those non-cash costs relate to historical expenditures), adjusting for impairments to oil and gas properties (those non-cash impairments are applied against net income but not cash flow) and then subtracting interest paid, changes in working capital and capex.
This is a more accurate and comprehensive definition of cash flow than the one used by many, which is simply cash generated from operations minus capital expenditures.
The Reasons for Negative Cash Flow
It is true that capital expenditures are the main reason that FCF went deeply negative for so many companies in recent years. When oil prices were $100 a barrel, oil companies invested every penny they could get their hands on into producing more oil. There were no guarantees of how long the high prices would last, but it’s understandable why they were plowing all their cash back into their business.