The big shale capital crunch
US tight oil producers are pulling out all the stops to get through the sector’s first major test
It's survival time for America’s shale drillers. At $30 a barrel, it’s not a profitable business. Dozens of companies have already been forced into bankruptcy and many more are likely to follow without a swift price recovery. The sector is overburdened with debt and isn’t generating anywhere near enough cash. Things are so bad in the US oil patch that some have starting to draw parallels with the US telecom bust in the early 2000s that tipped the US into recession. The gloomiest forecasters – whisper it – even compare things with the 2008 mortgage crisis.
The sector’s finances have eroded with each step down in the oil price. The $200bn in debt taken on by shale drillers supercharged the sector’s rise and helped reverse decades of declining US oil output. But that debt is now a millstone that threatens to drag the drillers deep under water.
Most operating cash flow now goes towards servicing creditors. The weakest companies going into the downturn have found themselves in a debt trap, drilling unprofitable wells just to generate enough cash to repay their lenders, hoping against hope a price recovery will bail them out.
S&P, a credit-rating agency, rates half of the 91 US oil producers it covers at B- or lower – ratings agency-speak for barely hanging on. Even blue-chip shale producers like EOG Resources and Devon Energy have been downgraded. The number of US oil bankruptcies is likely to surpass those seen during the price collapse of the Great Recession.
A major concern for shale drillers over the coming months is that most will see their hedges – a lifeline last year and a key pillar of the industry’s resilience – roll off. US producers had roughly 30% of their output hedged at an average of close to $60/b in 2015, 20% higher than WTI’s average of $49/b, according to data compiled by Raymond James, an investment bank. This year, those same companies have just 15% of production hedged at an average of just $41/b, barely higher than the strip price. The picture is even worse for 2017, when just 5% of output is hedged. The weakened hedge positions leave producers exposed to a brutal oil market that shows no signs of a swift recovery.
Companies aren’t better hedged for a couple of reasons. For one, as Raymond James notes, before the downturn the WTI futures curve had been in backwardation – with strip prices below spot prices – for several years, providing little incentive to hedge. At a time when $100/b felt like a pretty firm price floor, it would have been difficult for a chief financial officer to justify to his board and investors that locking in future prices for 2016 at less than $90/b was a smart move.
Then, as prices fell, last year most shale producers underestimated the depths of the gloom to come, and overestimated the likelihood of a quick recovery. When oil prices briefly stabilised at around $50/b last spring, the collective sigh of relief coming from shale executives was loud enough to hear in Riyadh and Moscow. Continental Resources, led by perennial oil bull Harold Hamm, sold its hedges in November 2014, just as the oil market was entering its worse decline in more than a decade.
Survival of the fittest
Not all were caught wrong-footed. While most celebrated the market’s false bottom, others saw it as an opportunity to lock in hedges for the next couple of years, a decision that is being rewarded today.
If prices remain in the $30s for a sustained period, this could even be the difference between surviving or not. “This severe price collapse has exposed those with naked production and debt-laden balance sheets to substantially worse – and even existential – balance-sheet conditions than the hedgers,” Raymond James analysts wrote in a recent research note.
Pioneer Natural Resources and Concho stand out for their strong hedge positions. Pioneer has around 86% of its oil production hedged in 2016 at an average of close to $60/b. Concho, a Permian basin-focused driller, has around 60% of its expected 2016 output locked in at an average of $70/b, a position that will give the company an enviable amount of security and flexibility.
But as the rest of the sector’s financial position worsens, companies are finding it increasingly difficult and costly to access new capital. Bond markets are largely closed off to shale producers, and if they’re open the market is demanding very high interest rates. New equity issues are mostly unattractive because of the battering companies’ share prices have taken. Dividends are hard to find anymore in the shale patch as even the biggest companies focus on preserving cash.
For many companies, their bank-lending facility is the last line of liquidity. But even that financing is starting to dry up as Wall Street looks to shield itself from growing energy-related loan losses. The major banks, whose lending was the lifeblood of the shale industry, are starting to get skittish about their energy loans. Wells Fargo, the largest energy lender, took a $90m hit in the fourth quarter due to bad energy debts, and the bank’s chief financial officer John Shrewsberry says he expects those losses to grow in 2016. Moody’s, a credit-rating agency, reckons 40% of Wells Fargo’s energy loan portfolio is at risk of delinquency.
It isn’t just the big banks that are exposed. Moody’s has put six smaller banks around Texas and the Midwest that have been particularly active in the oil patch on review for downgrade.
It all makes for a toxic environment as oil and gas companies head into April and May, when their semi-annual review of standing credit lines will take place. This is when banks look at borrowers’ financial position, reserves, cash flow and the price outlook to determine how much credit to extend. Given oil prices have fallen by a third since the last review and companies are being forced to write down huge chunks of their reserves, the review is expected to be harsh and banks are likely to use the occasion to start trimming their exposure to the ailing shale sector.
A survey of lenders and borrowers carried out by the consultancy Haynes and Boone found that most expect lending facilities to be cut by between 20% and 30%, much more than the 5% to 10% decline seen last autumn. Cuts that deep will pull billions of dollars out of the sector and could be enough to push some companies into default.
That said, Wall Street may not be as hard on the industry as some expect. Banking executives continue to defend their energy loans and some see little upside in pushing companies into bankruptcy.
“A bank is supposed to be there for clients in good times and bad times,” Jamie Dimon, JP Morgan’s chief executive, recently told analysts. “So when we can responsibly support clients, we are going to. And if we lose a little bit more money because of it, so be it… If banks just completely pull out of markets every time something gets volatile and scary, you’ll be sinking companies left and right.”
Wells Fargo’s Shrewsberry echoes that sentiment: “We’re working with each customer to help them work through this. It doesn’t do us any good to accelerate an issue or two, and to end up as the holder of a number of oil leases as a bank.”
Deal-making activity should also pick up as 2016 moves on and more companies need to raise cash to bolster their balance sheets, though this has been slower to play out than most expected. Just $12bn in shale deals was done in 2015, the lowest level since 2009 and 76% less than 2014.
Part of the reason is that buyers and sellers haven’t been able to come together on prices. With the low oil and gas prices and so many more sellers than buyers, asset prices are at such low levels sellers are only using asset sales as a last resort for fundraising.
But as company finances deteriorate, the fire sales are nearing. When that time comes there will be bargain hunters ready to swoop – but not necessarily the oil majors and national oil companies that would normally be sitting on the other side of the table. Private-equity firms raised more than $100bn to invest in energy last year, but that money has mostly sat on the sidelines as investors wait for the sector to hit bottom.
For most, there is little left to do but batten down the hatches and wait for the storm to pass. This means embracing austerity and keeping spending within cash flow, a fundamental change in the business model for an industry used to spending somewhere around 150% of cash flow and relying on borrowing to cover the rest.
Bringing spending within cash flow levels will require brutal spending cuts. According to a Petroleum Economist survey of 18 companies, 2016 capital expenditures will be around 50% lower than they were in 2015 and 66% lower than 2014. Total 2016 spending from the 18 shale producers will be $26.2bn, $55.6bn less than the $81.2bn the same companies spent in 2014.
Steep cost reductions, which could total 20-30% in 2016 after similar declines last year, will take some of the sting out of the spending cuts – though they will put more pressure on the services sector. So too will continued improvements in well productivity, though these gains are already slowing sharply compared with 2015.
But it is a new reality for the shale industry. Companies are laying off workers by the thousands, pulling rigs out of action and, in a major reversal from 2015, giving up on production growth. In some smaller shale plays nearly all drilling activity will come to a halt this year. And even in the best shale plays, production will fall sharply. The oil-directed rig count across the four largest shale plays is already down close to 75% from their September 2014 peaks, and companies’ 2016 spending plans indicate another 40% to 50% decline from February levels could be coming.
“Our top priority in this environment is to protect the balance sheet by balancing spending requirements with available cash flow. We also see no reason to accelerate production growth into these weak markets,” David Hager, Devon Energy’s chief executive, told investors in February.
Not everyone will survive. Among the most prominent names at risk of failing is Chesapeake Energy, a pioneer of the shale business. Chesapeake expanded aggressively throughout the shale boom and carried a heavy $10bn debt burden into the downturn. Now that debt is threatening to sink the company.
The company’s share price has fallen by more than 90% over the past year, from more than $20 a share to less than $2. Investors worry that without a recovery in oil and US natural gas prices the company won’t be able to cover around $2bn in debt payments due over the next 18 months. S&P called the company’s debt “unsustainable” and its August 2017 bond is trading at around 35 cents on the dollar.
Those that come out the other side of the downturn strongest will be those with the best acreage and strongest balance sheets. Right now, the best acreage is in the Permian Basin. Permian wells have the lowest break-evens and acreage there is still in high demand.
The ramifications of all this will be felt well beyond Texas and North Dakota. When Saudi Arabia led Opec down its current path, it set out to inflict a painful lesson on rival producers. Even the kingdom’s oil strategists probably didn’t realise at the time how harsh the price shock would be. It is a lesson that the shale sector won’t soon forget.