In the fallout of the current crisis, one more statistic can be added to the toll of Covid-19 – US Energy Independence. The Shale Revolution was responsible for the growth in US oil and gas production that lead to the President, Energy Secretary and industry bodies heralding the era of US energy independence and US energy dominance.
But, with the oil markets in turmoil, US shale producers who account for over two-thirds of US production (and in particular the Permian Basin which accounts for almost forty percent of total US production) have been ‘tapping the mat’ urging President Trump to save the industry through various means of subsidies, bailouts and tariffs. Shale producers have been arm-twisting US politicians into cringeworthy calls with Saudi Arabian officials because of their belief that Saudi Arabia, as a strategic ally, shouldn’t be following free market practices to harm the US Energy Independence narrative they all promoted.
So much for the US being the world’s champion of the ‘free market’!
US shale producers have firmly placed Saudi Arabia as the ‘bogey-man’ of their current problems, accusing them of taking advantage of the global pandemic to use predatory pricing to dump excess oil into the North American market. What they are so conveniently forgetting is that it was left to OPEC/OPEC+ shouldering production cuts since December 2016 which kept oil prices at a level that meant that shale producers were able to propel the US to become the largest oil producer in the world.
As the US kept producing more, negating the previous OPEC/OPEC+ production cuts and bringing the balance of global oil supply under pressure, OPEC/OPEC+ continued to cut more. But hey, it was all about ‘free markets’ they would say, and the party continued fuelled not responsibly by well performance and free cash flow – but by a gorging on cheap and readily available debt.
But the US shale market was blowing up before the Coronavirus came along. As is the case with most viruses, it doesn’t kill you, it just makes the weaker ones more obviously weak.
A bloodbath is coming with record Chapter 11 bankruptcies expected in US upstream E&P companies. Equity markets had long turned off from the ‘growth at all costs’ shale story, leaving banks, credit markets and Private Equity companies that know more about raising money than investing it, as the sources of funding the unsustainable (i.e. loss making) production growth. They will now have to choose which are the best positions to support through the crisis and which ones will go. How did we get here? Like all parties, eventually they end, most of their own accord, the more out of control ones when the house burns down.
US Shale has been eating OPEC’s lunch
In December 2016, after eighteen tough months of lower oil prices following the July 2014 crash, OPEC instituted the first of its production cuts. The commentary at the time was that Saudi Arabia was abandoning its attempt to ‘bankrupt’ the US shale industry. US shale gave itself a victory lap of celebrating its resilience and lower cost base – the mantra was shale could pay its way – and they believed it. When OPEC complained that its balancing of the market was artificially supporting the market for shale’s growth, they were told that it was all about free markets and the President called them a cartel.
The business model - growth at all costs
The truth was it wasn’t about greater business efficiency and self-funded development, it was about the massive pump of liquidity by equity, debt and credit markets that encouraged shale producers to pursue a ‘growth at all costs’ model. No one cared about self-funded development, free cash flow and real profits, it was all about the growth in the Permian which saw acquisitions top $100K an acre. The markets had something to sell and were throwing money at producers, backstopping aggressive merger, acquisition and production strategies.
But it was a house built on sand. At the commencement of the ‘growth at all costs strategy’ in 2016, of 40 dedicated US shale companies analysed by Rystad, less than half were operationally cash flow positive over capex. By 2019 that had dropped to less than 10%.
Following the sharp collapse in oil prices at the end of 2018 equity markets had stopped believing the shale story, slashing the market capitalisations of E&P listed stocks and limited equity was raised after 1st quarter 2019. But, in a lower for longer interest rate environment, private equity, debt and credit markets continued to fund the shale story. But even then, the shale market story started to lose its followers through 2019.
After commencing a trade war with China in late 2018 that saw the sentiment towards global growth take a hit (as did oil prices), President Trump announced an increase in the size and scale of the Trade War in August 2019. Trump threatened China with $300B in additional tariffs which led to the largest one-day fall in oil prices for four years.
In response, economic growth forecasts were slashed and whilst the threat of the increase in tariffs was ultimately walked back, the damage was done. Bond yields fell to such an extent that the bond curve inverted signalling a looming recession and China looked to elsewhere for its oil imports.
With the continuing aggressive tariff rhetoric from Trump we can see that from this point the narrative of the oil market changed from one of hope for modest recovery and growth to one of looming recession and falling demand. Whilst backwardation steepened as the markets came to see the party was ending, producers continued their growth at all costs strategy and production continued to hit record highs month-on-month.
The shale industry started being asked to produce positive financial results — not just promises of new super wells, cube development or artificial intelligence. Unfortunately, the industry hasn’t delivered profits while arguably drilling all the best acreage during these last five years.
The world’s gone mad - drilling your ‘best’ wells at the biggest discount
The growth at all costs reached an absurdity when, due to the debt fuelled increase in production, spurred on by the debt and equity pushing investment banks and their fee driven models, volumes produced in the Permian greatly exceeded the takeaway capacity of pipelines, rail and road. The shale industry’s never-ending growth belief saw Producers flat to the floor selling production for almost a year from what were their best wells at discounts of up to $18/barrel to WTI. The business plan was ‘grow, grow, grow’ – all that mattered was higher initial production numbers – then raise, borrow or both. The thought of making a profit was the furthest thing from the minds of the producers and their enablers – just grow – the profits will come.
“It’s the debt, stupid……”
But the profits didn’t come and as James Carville said in 1992, ‘It’s the economy, stupid’ as a statement of the obvious. For the shale market (beyond steep decline curves, takeaway issues, degrading well quality and high-cost of production), there is one issue that above all others ensures that the party will end with the house burning down – debt. Debt is always the difference between being able to tighten your belt and survive a downturn to finding yourself in a death spiral until you hit Chapter 11.
Of the 40 shale companies that we saw with very limited free cash flow above capex, the debt obligations between 2020 and 2026 total approximately $100 billion. This is systematic not just of those 40 companies but the US independent oil producers and even the majors.
As long as shale firms could keep borrowing and losing money to drill new wells, producing more oil was simple. When profits weren’t a concern, the debt-heavy business model worked. But similar to other boom and busts, if you want to stay in business, you need to make a profit.
You can’t repay debt if you can’t cover costs
If the current $20 WTI oil price continues or even rises to $30, the US shale industry will find itself unable to cover every day operating expenses, let alone repay debt as it falls due. From the Industry’s own figures in the recent Dallas Fed Survey of 95 E&P companies (March 11 – 19) there is zero free cash flow for the overwhelming number of US E&P companies with a WTI price at $20.
And when you can’t pay the debt……Chapter 11
Rystad Energy projects that there would be up to 393 US E&P companies that would be forced into Chapter 11 during 2020 if WTI remained at $20. To reference what this would look like, over the entire five year period to 1st of April 2020 (which includes the large portion of the last downturn), 215 producers had filed for bankruptcy since Haynes and Boone’s Oil Patch Bankruptcy Monitor began tabulating E&P filings, involving more than $129 billion in aggregate debt.
For any E&P companies seeking debt - “winter is coming….”
When we look at both charts what we see is the High-Yield Energy Sector on the right showing the severe deterioration in energy sector market sentiment. This deterioration in high yield has led to a general downgrading with even the investment grade energy spreads twice as wide as the broader index.
As the weaker energy companies start to enter Chapter 11, the market will grow increasingly negative towards all energy debt. This will begin a stampede to exit energy debt at any price, causing further dislocations to the market and blow out already wide bid/offer spreads.
These issues manifest themselves in corporate roll risk for all energy companies, not just the weaker ones or those with 2020 maturities. Energy companies will be forced to become ‘price-takers’, rolling debt at any cost (if they can get it) and incurring significantly higher fees when they do. But, as they always do, they will see this as a risk worth taking, seeing the bigger risk as access to liquidity rather than the price, gambling that higher oil prices and increased volumes will let them trade out of difficulties.
The problem is that they never trade out of difficulties, the cost of the high-priced new debt is control of every aspect of operations and cash-flow. They become ‘zombie’ companies – ‘hosting’ the debt holders and only increasing the probability of their insolvency at a time that suits them.
But can’t we solve all of this with tariffs on Saudi Arabia?
One of the recurring themes from the shale industry since the Oil Price War commenced is putting tariffs on Saudi Arabian oil imports, like some magic silver bullet that will amazingly save an industry that hasn’t had the discipline to push itself away from the debt buffet table. But, how is this going to work and has anybody thought this through beyond an initial ‘emotional’ reaction?
If we look at the US EIA data from its ‘Top sources and amounts of US petroleum imports and exports’ for 2019, one has to question how a ‘go-alone’ tariff on Saudi Arabian imports would have any effect at all on global oil prices and the price received by US producers. In 2019 the US imported on average 9.12 million barrels per day. The top 5 locations from which the US imported in 2019 were:
The US receives 56% of its imports from Canada and Mexico and just 6% from Saudi Arabia. By the US going alone and putting a tariff on Saudi oil, what effect would it have on the oil price achieved by US producers when just a negligible 6% comes from the affected country? How would this lead to a price rise in global oil prices when the global demand has collapsed by more than 30%? As it is, Saudi oil exports to the US have more than halved between 2014 (1.166 million) and 2019 (0.53 million).
What are the risks to the US of a ‘go-alone’ tariff on Saudi imports? In 2019 the top 5 locations to which the US exported were:
The US exports a combined total of 26% to Canada and Mexico. Assuming Canada and Mexico remain with the US, this still leaves 74% of exports available for Saudi export. The top 6 locations of Saudi exports in 2019 were:
Considering the rancour of the ‘America First’ policy on trade, it is extremely unlikely that the US could form a coalition with other countries to tariff Saudi oil. China and India have been large importers of Iranian oil in violation of US embargos. With the miniscule amounts, numerous other destinations for Saudi exports and the risks of long-term damage to the relationship with an important ally for a short-term solution, tariffs will have no effect whatsoever.
What about trying to wait out the ‘short-term’ correction until you can develop again?
The default model is to always think that you can ride out any correction by viewing them as ‘short-term’ and then going back to business as normal. Unfortunately, with global demand destruction above 30% and a virus that points to the global economy taking longer than first anticipated to recover, no one knows how long the Producers will have to hold out.
With WTI stuck around $20, nearly every producer is a long way from being able to cover costs let alone develop again. In the most recent survey by the Dallas Fed of 92 upstream E&P companies, WTI prices need to be above $50 for almost all plays before wells can be drilled profitably.
The idea that upstream E&P companies will be able to hold out until development wells can be drilled profitably again is tenuous at best. With mounting debt loads, interest and maturities most won’t be able to last beyond the next six months.
If the WTI price continues at $20, Rystad’s predictions show that Lower 48 production could drop to approximately 6 million barrels by the end of next year.
Have the best shale wells already been drilled?
There is no doubt that shale wells with the right geology can produce a lot of oil and gas. The problems encountered with shale wells are that they decline rapidly, are at a higher cost point and we have seen that lately they tend to more gas more quickly than before (which only further diminishes the economic case – especially when you have to resort to flaring or paying to have gas taken away).
As the pressure has grown on shale producers to operate at a profit, the era of ‘super wells’, cube development and AI has been ushered in. But well performance has been declining and initial production expectations have been worse than the wells that came before, which puts the viability of the whole shale business model in focus and leads us to question “has the best rock already been drilled”?
‘Child’ wells are the secondary wells used to infill a Project that is drilled close to an existing ‘parent’ well. Generally, the expectation had been that the performance and recovery of the child well would mimic the parent providing the basis for the development funding! Current well performance data suggests that child wells, when drilled close to a parent, not only do they not perform as expected but they cannibalise the existing production from that parent well. But, spaced further apart, risks leaving oil in the ground.
Subsequent well performance in the Permian has seen instances where the child wells are producing between 20% and 30% less than the parent wells. When extrapolated across a Project, the entire business case for the funding that was provided on the infill drilling model, ceases to be viable. This is a problem not just for that particular Project, but for the shale industry as a whole.
Does shale have a future?
Up until now, the basic premise of the shale business model has been growth orientated and to drill, drill, drill and the income will come. A company would drill a high-volume well, hype to the press this well and the many now proven undeveloped wells on the rest of its acreage, and promise a bright future, all while borrowing huge sums of money to drill and frack the wells. Now, shale companies need to do that with oil wells that may not produce as much.
Fundamentally, the business model of the upstream E&P shale companies is broken and outdated. Funding assets, that in an energy transition climate cannot be classed as ‘growth’, the producers and investors need to move beyond the old equity and debt models.
The upstream E&P industry needs the funding model to be less based on debt and equity at the corporate level and more based on well-by-well funding at the Project level. The current debt model fails to consider the unique characteristics of the decline of the shale wells – having producers pay back capital and interest in the short period of time that a shale well produces economically recoverable oil and gas. In normal price environments, let alone with ‘black-swan’ events like the Coronavirus, it is hard enough to make this economical with the threat of an E&P industry that faces being wiped out.
The investment, operational and management expectations will change but the result will be an industry that can produce on a more sustainable level without the corporate being burdened by any debt and interest or highly dilutive equity issuances. A ‘partnership’ between the investor and the producer, where capex is fully-funded and returns are via a share of resultant production over a period of time no matter what the oil price will become the standard operating model for a sustainable upstream E&P industry, resulting in long-term stability and job security.
In 2012, Rolling Stone Magazine referred to the fracking industry as a scam while profiling the late Aubrey McClendon – I would contend that the current funding model is the scam – the industry would more than survive, it would thrive with a different funding model.
By Mitchell McGeorge for Oilprice.com
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