Houston-based Flotek, a supplier of specialty chemicals to the oil and gas industry, markets CnF as a high-potency fracking additive that it claims enhances the extraction of oil and natural gas from horizontal wells by 30% to 70% relative to similar additives. Touted as its "crown jewel," CnF has long been Flotek's primary driver of revenue and profitability, which is sold to operators of hydraulic fracturing oil and gas wells across the United States. Flotek sells CnF at a premium that is multiples of the price of widely available generic surfactants.
New York-based FourWorld Capital is an SEC-registered investment advisor focusing on event-based investments prompted by specific tax, legal or regulatory drivers. The firm was founded by John Addis, formerly head of Americas Equity Finance at Bank of America Merrill Lynch.
FourWorld's analysis reveals that Flotek overstates the impact of CnF on well productivity. In addition, an analysis using publicly available data on oil and gas wells shows the vast majority of major oil and gas producers have discontinued their use of CnF products in well completions in recent years.
"Through a painstaking analysis of CnF performance – using publicly available data on shale production from the leading industry data sources – we found that CnF has no measurable impact on oil production in fracked wells," Mr. Addis stated.
Among its findings on CnF, FourWorld's investigation has determined that:
- Flotek may not have provided critical information to an independent consulting firm, MHA Petroleum Consultants, commissioned by a special committee of the Flotek Board of Directors to evaluate the product earlier this year. FourWorld contends that the resulting study, published by Flotek this past January, was based on incomplete data and used an evaluation technique that failed to control for key variables in the oil extraction process.
- Employing evaluation techniques that properly control for the key variables in the oil production process (e.g., location, well length, water and sand volume), the estimated impact of CnF on oil production is indistinguishable from zero. The analysis covered the same focus areas indicated in DJ Basin report from MHA commissioned by Flotek.
- Studies of CnF use in fracking completions from a nationwide database of over 117,000 well sites from over 1,000 oil and gas operators across 25 states, shows nearly 85% of the end users of CnF products since November 2012 are no longer using Flotek's CnF product in their reported well completions. Among these are major operators like Anadarko Petroleum, Devon Energy, Aera Energy and ConocoPhilips, who all rank in the top ten operators by overall well count in the database during the study period.
- In recent earnings presentations, Flotek highlights the "resilience" of CnF sales volumes stemming from its broadening base of CnF customers. FourWorld's analysis shows the growing concentration of CnF use by just three operators - due to changes in well design - has masked the true level of CnF end user attrition, and demonstrates that consumption by new operators has been minimal.
- Flotek's financial condition is heavily dependent on CnF. FourWorld believes anyone reviewing the Company should carefully consider the impact on Flotek's income statement if CnF sales were materially reduced from either a reduction in pricing more in line with competitor products or a decline in volumes from existing customers.
As of the publication date of the report, FourWorld, and FourWorld managed accounts, have a direct or indirect short position in Flotek stock, and stand to realize significant gains in the event the price of Flotek stock declines. The consulting firms hired by FourWorld, and referenced in the report, are receiving a fee based on the performance of FourWorld's positions in Flotek stock, and, independent of FourWorld, may have a direct or indirect short position in Flotek stock.
Incomplete list of CnF trade names provided by Flotek helped overstate product's efficacy
FourWorld believes that the list of trade names provided by Flotek to MHA, a Denver based consulting firm hired by a special committee of the Flotek Board of Directors, was incomplete and materially affected the results of their study in Denver-Julesburg Basin of Colorado. MHA relied on these trade names in order to determine which wells had Flotek's CnF products in them. The trade names present in the focus areas of the published study include at least two CnF products not present on the list provided by Flotek, which accounted for an estimated 22% of CnF wells in the focus areas reported to show materially improved results from CnF. Without these additional trade names, wells that used CnF would be misclassified as wells not using the product.
Using its own comprehensive data set of wells in the same focus areas of the DJ Basin, FourWorld shows the impact of mislabeling these wells in a simple control study, like the one conducted by MHA, is material. The largest number of mislabeled wells in the data-set belonged to Noble Energy. The MHA study was commissioned by the Special Technical Committee, a committee formed from Flotek's own Board of Directors, which was tasked with handling an SEC inquiry into Flotek marketing practices and evaluating the efficacy of CnF. Among the members of the Flotek Board is Ted D. Brown, senior vice president of Noble's Northern Region, including operations in the DJ Basin, until January 31, 2015.
FourWorld's own comparative study of 604 wells in the DJ basin shows no CnF benefit
FourWorld, working closely with two Houston-based energy and performance measurement consultants, RK Trading LLC and Sylvania LLC, tested CnF extensively using various methods.
The group performed analyses to evaluate the performance of wells located in the eastern Colorado section of the DJ Basin, the area reported in the study published by Flotek to show the highest levels of oil production outperformance from wells labeled as using a CnF product compared to wells determined not to contain a CnF product by MHA.
These analyses demonstrate that simply controlling for the key variables known to affect oil production, such as well length, location, water volume, sand use and operator, reveals that the estimated effect of CnF on oil production is indistinguishable from zero. In simpler terms, where and how you frack the well matters.
RK and Sylvania used robust regressions and Generalized Additive Models to demonstrate that production in the DJ Basin wells varies systematically with these key variables. The analysis indicates that all of the outperformance of wells using a CnF product was attributable to variable affecting oil production, and not the presence of CnF. RK and Sylvania indicate similar conclusions have been obtained for a large sample of wells completed in the Permian Basin, one of the most prolific oil and gas producing regions in the country.
An analysis of a publicly available database shows 85% attrition of CnF end users
Using FracFocus, the industry standard source for finding chemical data on oil and gas wells, FourWorld conducted a study of over 117,000 well sites from over 1,000 operators in 25 states to evaluate the use of CnF in fracking completions. The results of FourWorld's analyses show that of the 334 operators who have used CnF in any well completion over the last four years, nearly 85% of them no longer report using a CnF product in well completions. Among them are major operators like Anadarko Petroleum Corp. (APC), EOG Resources Inc. (EOG), Devon Energy Corp. (DVN), Aera Energy LLC and ConocoPhilips (COP). FourWorld analysis shows 160 of 183 operators are no longer using CnF products in well completions when the analysis is limited to horizontal fracked wells only.
Flotek highlights new CnF customers while avoiding the turnover among existing users: "[T]he base of CnF users broadened meaningfully in the third quarter" Flotek CFO John Chisholm said in a 3rd Quarter 2016 earnings call. Analysis of Flotek's own presentation materials from an industry conference in November 2016 shows evidence of customer turnover of nearly 70% since the start of 2014, while the operator study described above shows a similar yet slightly higher attrition rate of 85% of CnF end users. Furthermore, using FracFocus data, FourWorld has identified just 19 "new" CnF end users in 2016, who have completed a combined total of 50 wells with CnF out of the 285 total well completed in the period.
FourWorld believes Flotek's new customers have been almost exclusively smaller operators with minimal revenue potential. Water usage studies conducted by FourWorld show that the top three users of CnF have propped up CnF sales volumes despite a massively fall in CnF well completion counts for operators outside the top three, which highlight a worsening customer concentration problem and calls into question Flotek's claims of a broadening customer base and accelerated adoption of CnF chemistries.
The collaboration of FourWorld, RK Trading and Sylvania produced multiple studies to measure the efficacy on CnF under strict variable controls. This powerful combination brought together expertise in data collection, database management, and statistical analysis of well chemistry and completion design.
Dr. Jefferis, partner at RK Trading and consulting statistician, added, "The analysis is very cut and dried. We evaluated the DJ Basin data using several different approaches, and obtained the same answer in every case. Once you recognize that a well completed by someone who has already drilled several hundred wells in a given location is bound to behave differently than a well completed by party who has much less local experience, and acknowledge the challenge of pushing oil through an 8,000-ft. wellbore, the results more or less fall into your lap."
FourWorld's full thesis, along with a white paper authored by RK Trading and Sylvania discussing their regression analysis and generalized additive model study, are available at www.fourworldcapital.com.
About FourWorld Capital
FourWorld Capital Management LLC is an SEC registered investment adviser based in New York. FourWorld focuses on event-driven investing, with an emphasis on tax, legal and regulatory catalysts. For more, visit www.fourworldcapital.com.
Following publication of this report, FourWorld intends to continue transacting in the securities covered herein. The firm may be long, short, or neutral at any time hereafter regardless of its initial recommendation.
Please see the full Disclaimer appearing in the report available on the FourWorld website at: http://fourworldcapital.com/research-flotek.
FourWorld Capital Management, LLC is a member of the Financial Industry Regulatory Authority, CRD number 284138.
Contact: Allan Ripp 212-262-7477, firstname.lastname@example.org
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SOURCE FourWorld Capital Management LLC