Today's cost of capital thread starts with a trick question: what has a higher cost of capital: PDP or prospective land? And the conventional answer is prospective land. I think that answer is wrong, or at least incomplete. Implications for renewables at the end. /1

PDP-co is a dirty business. Acquire producing assets at a discount and hopefully with low decline rates. Push out abandonments as long as possible. Slash costs. Lever up based on easy reserve-based lending terms. /2

If commodity price increases, use the double/triple on levered equity to do it again, maximize dividends according to lending covenants. If commodity falls, then abandonments are the bank's problem. Every model in a PDP-co looks great. Lots of hedging. Looks low risk. /3

But in the real world, I see PDP-cos fail everywhere. They can't accept the leverage they are saddled with. Why not? /4

Remember that cost of capital is proportional to operating leverage? The proportion of costs that are fixed. Corollary: where management has limited ability to manage revenue and expenses in the future, cost of capital is higher. /5

That pretty much describes the PDP business. Production is absolutely locked in. Costs, like in all E&P, are a small portion of revenue. Cut cost by $0.20/Mcf or $2/bbl. Woo hoo. And a bad entry point stays with you forever. /6

Undeveloped land, on the other hand, has more management decision-making embedded into the asset. Develop now or later? That's an important and valuable option!!!! Basically, I maintain that E&P opportunity cost of capital acts inversely to development risk in shaleworld. /7

Ironically, I would say that buying locations at $2million per might have a lower discount rate than buying PDP at $25k/flowing. That's because there's no decisions on the PDP. Oil goes to $20, still producing. The location purchase can defer capital, painful but not deadly./8

The locations can accelerate investment if commodity increases, as well. PDP cannot. There's a risk-reduction benefit to staging capital investment and production to market demand, is my point that I'm belaboring. /9

Okay. What are the strategic implications? (1) Sell the PDP to someone who wants it. Use that cash to buy undeveloped resource. Imply a higher discount rate on the PDP and lower on undeveloped. I think the market rewards this... /10

As it did in the Canadian income trust days. Managements competed to go from 500-5Mbbl/d, not to run the PDP. They knew what buttered their bread, and it wasn't Penn West. /11

(2) PDP is actually high risk and should be priced that way. That also means that discount rate arbitrage on PDP could add huge value. Sell PDP to Europe/Asia for LNG, say. Strapping a ratebase onto PDP assets can goose returns hard. /12

(3) As investment declines, PDP decline shallows. That means discount rate might increase a touch because the average resource duration lengthens, a negative feedback. Still trying to think this through. /13

(4) Renewables. So much cost of a renewable investment is at the front end. Opex is very low. Dispatch is uncontrollable. Renewable portfolio standards, guaranteed feed-in tariffs, investment by natural shorts (rooftop solar) can fix this. /14

Basically, for renewables, I think a ratebase backstop will have to be part of the answer for a long time to come. Not sure what the merchant renewable space looks like, but let's be extra careful out there. /15

Obligatory, I'm not making a moral or normative statement here. If taxpayers need to backstop solar dev risk to save ourselves from killing ourselves w/climate change, obviously that's money well spent. /16