The Fuse

Panel: Market Sentiment to Make or Break Future of Shale Producers

by Leslie Hayward and Matt Piotrowski | April 28, 2016

How has U.S. shale maintained its resilience in the face of the massive price fall from above $100 in June 2014 to as low as $26 this February? What forces are currently at work in managing shale’s debt problem? And what will determine the future of the industry? An expert panel addressed these issues at an event at the Center for Strategic and International Studies (CSIS) this morning, exploring the fact that for most industry players, survival now depends on continued improvements in market sentiment, against a backdrop of tremendous volatility and uncertainties.

So far, the industry’s resilience has stemmed from a variety of funding sources, including revenues from existing production, hedges along the futures curve, bonds, equity issuances, loans and distressed exchanges. The shale boom was fueled by cheap debt at a time of high prices and the conviction that production would continue to grow.

“The shale industry has never been self-financed,” said Sattler. “It wasn’t self-financed at $100 per barrel, and it definitely isn’t at $40. And we still don’t know what tight oil looks like when it’s self-funding.”

At present, companies are simply trying to survive quarter to quarter with the hope that the market will ultimately fix itself. But that is not a sustainable strategy, particularly if prices turn back around. “All companies want production to fall, but none of them want to decrease their own output, and that push-pull is why this process has been so messy,” pointed out Casey Sattler, News Editor-Western Hemisphere for Energy Intelligence.

Debt remains critical to the industry

Cheap debt—the instrument that enabled the tight oil boom to take place to begin with—is now its greatest vulnerability, and the panel discussed the various financial instruments being used to manage and restructure the long shadow of debt over the industry.

“The shale industry has never been self-financed,” said Sattler. “It wasn’t self-financed at $100 per barrel, and it definitely isn’t at $40. And we still don’t know what tight oil looks like when it’s self-funding.”

Sattler referenced that the beginnings of the tight oil boom came from a “seemingly endless” supply of investors looking to capitalize on near-zero interest rates. Many large E&Ps have debt that is multiple times their market cap.

debt and market cap

Naturally, much of that debt is barely being serviced—but that won’t necessarily be enough to force banks into action. “U.S. banks do not want to take ownership of oil and gas assets, but they are having to come to terms with borrowers that are out of compliance with loan terms and/or have seen their reserves bases greatly reduced,” Sattler said. Albert Helmig, the CEO of Grey House trading consulting firm, echoed the sentiment, saying, “Banks will just keep rolling bad shale debt over until it becomes a small enough part of their portfolio that they can take the hit. They have seen this before.”

In terms of additional financing, equity flows dried up early in 2016 as oil prices dipped below $30 per barrel. However, according to Energy Intelligence Research, some appetite has returned to the market as prices have risen—especially in the Permian region. When it comes to mergers and acquisitions, companies are trying to sell assets in order to raise cash and stay afloat, but the challenge can often be finding a buyer. Some well-positioned companies that are acquiring assets noted recently at a conference in New York that the quality of assets available for acquisition is improving. There are also buyers in the midstream, where low prices haven’t had quite as severe an impact on cash flow.

Opportunists are also waiting for the right moment to strike. “Private equity is very content to wait for companies to go through bankruptcy so they can pick up assets for pennies on the dollar,” according to Sattler.

Surviving the price collapse

There’s no question that production costs have fallen, but it’s not necessarily enough to transform the landscape for the industry. “Even if only 4 percent of Occidental Petroleum’s wells are profitable at $40 per barrel, it was unthinkable 18 months ago,” said Sattler. “Breakeven price points don’t capture the number of wells, the number of remaining drilling locations, the full-cycle costs of development, and the oil price that a company needs to sustain its operations indefinitely.” Additionally, these efficiency gains have not come without costs to other players in the industry, particularly the oilfield services sector, which has been hit hard by the dramatic downturn in drilling activity, and lack of money to spend from their customers—the E&Ps. Rigs are extremely cheap, and service companies have slashed their workforces and costs, but both Helmig and Sattler agreed “there’s no more blood in that stone.”

Regarding other ways the industry has survived the price downturn, Sattler commented that hedging has gone a long way, and revenues has held up better than expected. The first quarter of 2016 was especially brutal because prices dropped below $30 per barrel while very few were hedged.

Helmig pointed out that although the prompt price for NYMEX WTI fell from $107 in June 2014 to $26 earlier this year, the back of the curve fell at a much smaller scale during that time period, declining from around $80 to about $40. This ultimately gave producers the flexibility to lock in better prices for their sales.

Companies are also using the NYMEX WTI futures curve for financing purposes, according to Helmig. “The oil futures market is a phenomenal tool for the industry,” he said, noting that as the prompt month price has risen in the past couple of months, so have prices further out on the curve. The recent price rally from $26 to the mid-$40s has been the result of both short-covering in the NYMEX WTI market and new players taking long positions—betting on higher prices—in ICE Brent. Most trading activity takes place for contracts for the 1-3 months, but hedgers have made more deals along the curve lately as prices have risen, with non-commercials taking the other side of the trades. Through hedging, producers are able to sell production above the $50 level to continue to finance drilling. Helmig pointed out that, in the past eight weeks, open interest for the December 2018 contract has spiked by 50 percent, a sign of how much more active producers have been during the current price upswing. Helmig pointed out that although the prompt price for NYMEX WTI fell from $107 in June 2014 to $26 earlier this year, the back of the curve fell at a much smaller scale during that time period, declining from around $80 to about $40. This ultimately gave producers the flexibility to lock in better prices for their sales.

Uncertainties looking forward

The future of the industry will depend on a number of factors, most important of which is market sentiment, according to Sattler. Notably:

  • The bond markets will be prohibitively expensive for most players.
  • Investors have warmed to dilutive equity issuances, but the question is for how long will they continue to do so?
  • Banks are under pressure to “quarantine” bad loans.
  • Investors are less interested in taking hits on distressed assets.
  • Oilfield services have little else to give.
  • Private equity is becoming more disciplined.
  • Drilled Uncompleted Wells (DUCs) distort the production outlook.
  • A number of risks and wide bid-offer spreads complicate M&A activity.
  • The pace of bankruptcies is picking up but there’s little impact on production.
  • Hedging is “layered but limited.”

For all players, including E&Ps, service companies, banks, and lenders, everybody is simply waiting for prices to improve, which will “fix everything,” said Sattler. And both Helmig and Sattler agreed that improving market sentiment—which has pushed WTI prices from $26 in February to $45 today—will ultimately determine how the industry fares in the coming 18 months, and impact each of the factors listed above.

Helmig argued that the industry “will quickly reboot. Oil companies and banks adapt really quickly—that’s how they survive.”

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