The way business works is that you have some assets and they’re funded by some liabilities. The assets generate some income which you use to pay back the liabilities. You borrow some money, you buy a machine for your factory, the machine makes widgets, you sell the widgets, you get money, you pay back the money you borrowed, you have some money left over as profit, life is good. One way to make more profit is to make the assets worth more, to make them produce more income; if you can tune up the widget machine to make more widgets then you will have more profit.Another way to make more profit is to make the liabilities worth less. This is the weirder way. If you borrow $100 to buy a widget machine, and the widget machine produces $120 of widgets, then you have $20 of profit. If you go to your lenders and say “instead of $100 what if I paid you back $75?” and they say “sure that's fine no problem” then you have $45 of profit. You got an extra $25 of profit from not having to pay off all your debt. Why would that work? It doesn’t generally work. But sometimes it could. A while back, people sometimes got worked up about how banks were accounting for the changes in fair value of their own debt. Basically if a bank issued a $100 bond for $100, and then its credit got worse and the bond only traded at $95, the bank would say “well we sold something worth $95 for $100 so I guess we have $5 in income” and add $5 to its net income. The result was that when banks had a really bad quarter — when investors started worrying that they were riskier and might fail — their credit spreads increased and they reported billions of dollars of gains due to changes in the value of their debt. (Conversely, when things got better, they reported big losses.) This feels wrong. Your own credit getting worse doesn’t get you more money. People got mad about this, about how the accounting failed to match the reality of the cash flows; eventually the accounting was changed. But if you’re a financial engineer this is nothing to get mad about. If you’re a financial engineer this is an inspiration. “How can we turn our own credit getting worse into cash,” is the correct question to ask. Here is one way. You borrow $100 to buy an asset worth $100. You use it for a while, it makes widgets that you sell for a profit. It depreciates, it gets old, it produces fewer widgets. Now it’s worth $50. You still owe $100 on the loan. The asset plus the loan are worth negative $50. If you sell them together — the asset and the loan — a buyer should be willing to pay you negative $50 for them. That is, you’d have to pay the buyer to take on the asset plus the loan. But what if you find a buyer with terrible, terrible credit? The buyer will say “I can buy this asset and it will generate $50 of profits for me, which I will spend. Then I will have to pay off this $100 loan, but — and here's the trick — I won’t do that.” Eventually the lender will sue the buyer for the money, the buyer will turn their pockets inside out and gesture comically to their lack of money, and the lender will get, you know, nothing.[1] How much will that buyer pay you for the asset plus the liability? I dunno, probably not $50, but more than negative $50. Maybe they’ll pay you $5 for it, which is $55 more than it’s worth to you. Maybe they’ll value the package at $25 (or $50?) on their books, reporting an immediate gain of $20. Everybody wins! Except, to be clear, the lender. The lender loses $100. Lenders do not like this sort of thing and they try to avoid it; you probably cannot do this trade with your actual widget-making machine. But there are other sorts of liabilities. Here’s one. The way a natural gas well works is that you drill a well, and then you pump gas out of it for a while, and then it runs out of gas, and then you have to “cap” the well, fill it in with concrete so it doesn’t just leak methane into the atmosphere forever. In the U.S., state laws impose this capping requirement on the owner of the well; it is a sort of liability that comes with the well. If you drill a successful well, you get an asset (a hole in the ground that produces natural gas that you can sell for money) and a liability (the obligation to spend money in the future to fill the hole with concrete). Early in the well’s life, the asset is worth a lot (it produces a lot of gas) and the liability is worth a little (you will not have to fill it in for many years, so the net present value of the money you will eventually spend to fill it in is low). You open the well and you have a $100 asset and a $5 liability. Good work. But then you pump for a while and you deplete most of the gas and now the asset is only worth $10 because it won’t produce much more gas. And you know that in a year or two you’ll have to pay $20 to cap it, so you record that liability at a present value of, you know, $18 or whatever. But then someone comes to you and says: Look, this well will produce $10 more of gas, and I can sell that gas and make a profit and spend it. And I can do this much slower than you: You will just pump the rest of the gas out and have to cap the well in a year or two, but me, I’m in no rush. I will drag out the process so that I can produce a little gas for like 20 years. Then in 20 years regulators will say “okay time to cap the well” and I will turn my pockets inside out and gesture comically to my lack of money. Maybe I’ll say “just give me 20 more years,” and the regulators will say okay, because what’s the alternative? And then in 40 years, who knows, maybe I’ll cap the well, but I’ll definitely have spent all the money by then. How much is that well worth to that buyer? I dunno? Maybe $7? They get $10 worth of gas and have $3 of hassle and expense in deferring the capping liability indefinitely? If they buy it from you for $2, you make a profit — you had the thing valued at negative $8 ($10 asset, $18 capping liability), and now you have sold it for positive $2 — and they make a profit (since they paid $2 for a stream of profits worth $7). Everybody wins! Except, you know, the well never gets capped and methane leaks into the atmosphere forever. This is apparently a standard business model in the natural gas industry. Big well-capitalized companies drill and operate productive wells, but as the wells get depleted, they are sold to small poorly capitalized companies to get the capping liabilities off the big companies’ books. Here is a fascinating story of financial engineering from Bloomberg's Zachary Mider and Rachel Adams-Heard: American oil executives talk about a food chain in their industry. Big, well-capitalized companies tend to be the ones to drill wells and harvest the first years’ production. As output tapers, wells typically change hands a few times, then spend their golden years with a smaller, more financially shaky company. If that company goes broke, there’s no money to plug the well. In most states, previous owners aren’t liable. That helps explain how an industry that created some of the biggest fortunes and most valuable companies has also produced hundreds of thousands of orphaned wells, with no owner around to clean them up. The Interstate Oil & Gas Compact Commission estimates the number across the U.S. may be as high as 800,000. In August the U.S. Senate approved an infrastructure bill that includes $4.7 billion to begin tackling the problem.
In general, if you are looking to monetize something like “we are going to acquire liabilities and not pay them,” you do have to be a smaller, financially shaky company. But Mider and Adams-Heard’s story is actually about a larger and more valuable company, Diversified Energy Co., which is “the largest well owner in the country” with 69,000 U.S. natural gas wells, and which, uh, may or may not be pursuing this strategy at scale? Diversified’s breakneck growth has alarmed some regulators, landowner groups, and industry insiders, not to mention environmental advocates. State laws require that every well be plugged with cement after it runs dry, an expensive and complicated chore. At the rate Diversified is paying dividends to shareholders, some worry there will be nothing left when the bills come due. If a company can’t meet its plugging obligations, that burden falls to the state, which means Ohio, Pennsylvania, and West Virginia could be stuck with a billion-dollar mess. “The model seems like it’s built on abandoning those assets,” says Ted Boettner, who’s studied abandoned wells at the Ohio River Valley Institute, a regional research organization. “It looks like a liability bomb that’s destined to explode.” [Diversified founder Rusty] Hutson says there’s no cause for worry. He claims to be able to squeeze more gas out of old wells than other companies can and keep them going longer. On average, he figures his wells have an additional 50 years in them, which means there’s no hurry to start socking away money to plug them.
It also means that the present value of the capping liabilities is a lot lower than it would be if the wells were going to be shut down tomorrow: Sometimes the most profitable reason to extend the life of an old well isn’t the extra oil or gas that comes out. It’s the delay in the date when a well has to be plugged. When companies tell investors how much they expect to spend on retiring wells, they discount it by how far away that day of reckoning is. On the books, a 50-year timeline makes Hutson’s cost almost disappear. Because it plugs so many wells and keeps much of the work in-house, Diversified says it can retire wells for under $25,000, less than industry norms. Thanks to that, and the unusually long time horizon, Diversified often records its plugging liabilities at a fraction of what other companies would. In 2018 the company bought a portfolio of wells from CNX Resources Corp. CNX had pegged its cleanup liability at $197 million. Diversified put the liability for the same wells at only $14 million. This may explain why Diversified frequently determines the wells it’s buying are worth far more than what it paid—so much so that it books the difference as profit upfront. Since 2014 the amount Diversified has made from these accounting gains is more than its cumulative reported profit.
Yes, right, if you buy an asset with an embedded liability, and you find a way to defer the liability for 50 years, that asset is worth a lot more to you than it is to the seller. That’s just good financial engineering. But this strategy is complemented by turning your pockets inside out for your creditors so they give you more time to pay: Thousands of wells Diversified bought were producing nothing at all, meaning they were already out of compliance. State laws require nonproductive wells to be plugged promptly, so they don’t endanger groundwater or catch fire. But enforcing this law is difficult. Regulators worry that if they push companies too hard, it can cause financial distress and reduce the chances that anything will be plugged. “If the burden is so high to plug a well, then a company may not be able to do it, and you’ve defeated the purpose,” says Eric Vendel, chief of Ohio’s Division of Oil and Gas Resources Management. That concern was especially acute for Diversified, which was juggling an unprecedented number of idle wells in multiple states. Instead, four states—Kentucky, Ohio, Pennsylvania, and West Virginia—cut deals that give Diversified about a decade or more to bring roughly 3,000 idle wells into compliance. If the company revives enough of those wells, it’s required to plug only 20 unsalvageable ones a year in each of the four states.
If Exxon Mobil Corp. owned 3,000 idle wells, regulators could say “cap these wells or we’ll fine you a ton of money” and Exxon, which has a ton of money, would go cap the wells. But if Diversified owns 3,000 idle wells, regulators say “hmm, that’s a lot of idle wells, better not push too hard,” and make them cap 80 a year. Gesturing threateningly at your own creditworthiness can reduce your liability! Anyway the actual point of the article is that a lot of these uncapped wells are spewing methane into the atmosphere and contributing to global warming, but I mostly wanted to talk about the financial engineering. If you can offer a service like “we will take your liabilities off your hands and then defer them by 50 years,” that is a valuable service and you can make a nice profit from it. But it is not a value-creating service. It is a value-shifting service. You take the value from the creditors and split it up among the buyer and seller. Here the “creditors” are environmental regulators; ultimately the value is taken from the environment. We have talked a lot recently about environmental, social and governance investing through the lens of externalities. An important idea in ESG investing is that companies that impose costs on the environment or stakeholders or society will eventually be forced, by regulation or social norms or whatever, to pay those costs. If you operate a profitable factory that produces a ton of pollution, you will eventually have to pay to clean up that pollution, and so measured correctly based on total costs the factory isn’t really profitable. The assumed mechanism for this is often future regulation: Eventually governments will wise up to climate change, the theory goes, and so they will impose carbon restrictions that make fossil fuels far less profitable than they are now. But here is an example of existing regulations requiring gas companies to internalize their externalities, to budget for capping their wells to avoid pollution. And it turns out that there’s a business opportunity there: If you can sell the service of re-externalizing the externalities, you can make a nice profit. | 
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