Those of you who follow the energy exploration and production industry probably know Tom Ward very well. He co-founded Chesapeake Energy with the late Aubrey McClendon in 1989 and later left to start SandRidge Energy in 2006. With Chesapeake struggling mightily these days (there were whispers of a bankruptcy filing earlier this year and shares trade below $4, down from an all-time high of $74 back in 2008) and SandRidge having filed bankruptcy just this month (Ward was fired as CEO in 2013), Ward's two companies are wonderful examples of how the need to grow via debt financing can cripple energy exploration firms. Undeterred, Ward founded Tapstone Energy in 2013 as act number three. Tapstone's web site reads "Tapstone Energy: A Tom Ward Company." I'm sorry, but given Ward's track record that's quite humorous.

I just saw Tom on CNBC discussing the current state of the domestic energy market and one of his comments was very instructive for energy investors. He said the industry's "dirty little secret is that you cannot spend within cash flow and grow production." This comment was following his assertion that lack of access to capital was the real hindrance to the industry right now because banks "want you to spend within cash flow."

I guess banks only want to lend money to energy companies that can operate at free cash flow break-even at a minimum. This is very logical of course, as it means that the profits from the oil and gas sold can cover the interest payments due to the banks. I find it amusing that Ward is in a way criticizing the banks for being so strict so as to want to ensure they can be repaid.

But the "dirty little secret" comment is most important in my view. What Ward is saying is that energy exploration companies cannot grow their production without borrowing money to do so. Put another way, this means that drilling for oil and gas does not generate any free cash flow (after all, if it did there would be excess cash to drill more wells and thus grow production). In financial speak, maintenance capex (the amount of reinvestment requires to maintain a steady level of output) eats up every dollar of operating profit.

This is crucial for investors because stock values reflect the present value of future free cash flow. If free cash flow is never above zero, there is no profit left for equity holders after creditors are repaid. From a strictly textbook definition, that would mean that all of the common stocks are worth zero.

I wish I had heard this comment many years ago, as it might have allowed me to realize a lot sooner just how bad of a business model most independent energy producers are employing. What is amazing is how many people continue to want to invest aggressively in the sector.