The bad news coming out of the shale oil fields of America could all be put down to slumping oil prices. That is certainly a big factor. But as investment professionals like to say, when the tide goes out, we all find out who's been skinny-dipping.
The pattern of negative news from shale country is not just related to price, however. Oil production, it seems, is being overstated industry-wide by 10 percent and 50 percent in the case of some companies, according to The Wall Street Journal.
The CEO of one of the largest players in the industry, Continental Resources, predicted that growth in shale oil production could fall by 50 percent this year compared to last year. In reality, we should expect worse as the industry for obvious reasons tends to exaggerate its prospects.
The place where the damage to investors has become severe is in private equity firms who hold a large portion of the shale oil industry's high-yield debt. The plan for the firms was always to unload the debt on somebody else when better opportunities presented themselves. But the firms overstayed their welcome and are having a hard time even finding a bid in the market for these bonds.
With the big Wall Street players now questioning the value of their existing investments in shale oil, the industry is finding it hard to raise money. Not a single bond sale has come off since November in an industry which must continuously raise capital to survive.
To add to the problems, the future of U.S. shale oil production seems to be in the Permian Basin in Texas which has been providing the lion's share of oil production growth for the entire country. But ongoing drought in an already arid West Texas has raised doubts about whether the Permian will have enough water to meet all the demand for fracking new wells.
Because of the rapid declines in the rates of production from shale wells, companies must first drill enough new wells to offset the loss of production from previous wells—a task akin to walking up the down escalator. Related: Is This A Buy Signal For Crude Oil Futures?
This was not such a difficult task when the shale boom was just beginning. But with the huge increase in the number of operating wells, companies are having to spend more than half of their capital budgets on simply replacing lost production before drilling wells that add to production. That number is expected to reach 75 percent by 2021. At some point it could reach 100 percent. (For this reason some analysts refer to shale oil development as a Ponzi scheme.)
With rig counts dropping; capital expenditures likely to be cut in the face of low prices; and more and more of that budget being used simply to replace existing production, it's possible that the death spiral long anticipated by the industry's critics has arrived.
Shale players for years have been unable to finance their drilling programs out of operating revenues as free cash flow (operating cash flow minus capital expenditures) remains wildly negative for most companies. In other words, what companies spend on acquisition of leases and land; drilling and well completion; current operating expenses; and general and administrative expenses far exceeds the cash generated by their sales of petroleum and related products from existing wells. Related: Germany’s Rush To Ditch Coal Is Great News For Norway
That means the companies must borrow from investors (usually in the form of high-yield debt) or get them to buy new shares in order to raise the money needed not only to drill enough wells to make up for lost production from declining wells, but also to drill enough to grow production—something investors have been counting on to secure the value of their bonds and increase the value of their shares.
If the needed capital is not forthcoming, it means that companies will be faced with declining revenues from declining production. With lower operating cash flow and little access to additional capital, these companies will be unable to drill enough wells to offset declining ones. That means even lower revenues in the future which will mean even lower investment in new wells. That's what a death spiral looks like.
Of course, oil prices could revive and with it, investor interest. No one can know for sure. But the big question is this: The next time oil prices do rise, will investors risk getting caught during a subsequent downturn with shale oil company bonds that can't catch a bid in the market (or shares that could end up worthless)?
Of course, if the current downturn in oil prices continues, there might not be a next time for many shale operators.
By Kurt Cobb
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Hardly a day passes nowadays without new pessimistic reports about the future of the shale industry. All are telling one story, namely the writing is on the wall for the US shale industry. It is possible that the death spiral long anticipated by the industry's critics has arrived.
Such news coming immediately in the footsteps of observations by the highly respected economist, Philip Verleger, that projected expansion of US shale oil production could be threatened by the collapse of several energy hedge funds in 2018 and absence of replacements, a prediction by Harold Hamm, a pioneer of US shale oil industry that growth in shale oil production could decline by as much as 50% this year compared to 2018, a report by the Wall Street Journal (WSJ) saying that shale oil production is being overstated industry-wide by 10% and 50% in the case of some companies and a spate of recent reports from International oil service companies such as Schlumberger, Baker Hughes and Haliburton about declining well productivity, slowing drilling activity, plunging US rig count, a huge backlog of drilled but uncompleted wells (DUCs) and rising drilling costs can’t be ignored.
The most recent report from the world’s largest oilfield services company ‘Schlumberger’ says that the slowdown in shale drilling activity is creating uncertain outlook for US shale oil output in 2019.
While relatively low oil prices could be a big factor, the pattern of negative news from shale is not just related to price. With the big Wall Street players now questioning the value of their existing investments in shale oil, the industry is finding it hard to raise capital and without continuously raising capital, the industry can’t survive.
The Achilles heel of US Shale oil is that its wells suffer precipitous depletion rates estimated at 70%-90% soon after a well is completed. Because of the rapid declines in the rates of production from shale wells, companies must first drill enough new wells to offset the loss of production from previous wells.
The US shale oil industry has never been profitable since its inception. Shale oil producers can’t stop production otherwise they can’t get loans to remain afloat. It is becoming like “robbing Peter to pay Paul” or as the author of this article described it aptly as a Ponzi scheme.
But with the huge increase in the number of operating wells, companies are having to spend more than half of their capital budgets on simply replacing lost production before drilling wells that add to production. That number is expected to reach 75% by 2021 rising even to 100% at some point. With rig counts dropping; capital expenditures likely to be cut in the face of low prices; and more and more of that budget being used simply to replace existing production, it's possible that the demise of the industry long anticipated by the industry's critics is neigh.
Dr Mamdouh G Salameh
International Oil Economist
Visiting Professor of Energy Economics at ESCP Europe Business School, London