The Fuse

Shale’s Dirty Secret: Citi Research on Why Capital Markets Are the New OPEC

by Leslie Hayward | September 09, 2015

It’s well known that the shale boom was built on cheap credit. And just as shale producers found themselves at the whims of OPEC when the cartel declined to cut production last November, now they find themselves at the whim of investors and liquidity levels in capital markets. A new report from Citi Research explores this dynamic, arguing that low oil prices have exposed “shale’s dirty secret: many shale producers outspend cash flow and thus depend on capital market injections to fund ongoing activity.” In fact, almost half of the 135 public exploration and production (E&P) firms analyzed by Citi Research are outspending their cash flow, and the U.S. could lose up to .5 million barrels per day of production before the end of the year. Some .2-.3 mbd barrels per day of shale production is in direct risk of shut-in from financial distress, while 1.5 mbd of production from stripper wells is likely unsustainable.

Citi: The U.S. could lose up to 500,000 barrels per day of production before the end of the year.

How did this happen? From the very beginning, capital markets and the shale revolution had a pretty cozy relationship. Shale producers needed a lot of cash to buy land and required high capital expenditures (capex), but they were innovative, oil prices were high enough to keep money flowing in, and the issuance of equity and credit grew in lockstep with the E&P sector. “This enabled the explosive growth of cash-flow negative drilling which pushed U.S. oil production to near record highs,” Citi writes.

Now, we are at the beginning of a massive but necessary “shakeout” in this sector, likely to result in bankruptcies, mergers and acquisitions, and a great deal of streamlining across the board. Here are a few of the notable conclusions from the research, as they relate to industry health and the American production outlook.

In the aggregate, North American crude oil producers are not cash flow positive, and they haven’t been since the beginning of the shale boom. In Citi’s words, “Capex has consistently exceeded cash flow, causing some prominent critics to argue the business model of shale production is fundamentally unsustainable.” Before the price collapse, it was expected that producers would have positive returns for the first time in 2015. Those hopes were dashed last October.

cash flow negative

Capital is getting tighter, more expensive, and regulators are watching. Lenders were willing to continue supporting shale producers through the low price environment, expecting the downturn to be short-lived. However, Citi notes that the performance of these “second liens” in the spring have been extremely poor. At this point, the cost of capital for shale companies is largely dependent on oil price levels, and in addition to creating concerns for investors, low oil prices have sparked scrutiny from the Shared National Credit Program oversight group, which reviews large loans over $20 million. This group has flagged low oil prices as an issue in its monitoring of risk assessments, and Citi’s research shows they have “focused disproportionately on oil and gas credits and the ratings were worse than expected.” To avoid scrutiny, lenders and investors are likely to charge oil producers higher prices for credit, or avoid the sector altogether.

Much like OPEC, capital markets are unpredictable and self-interested.

Expect volatility on top of volatility, with a side of volatility. Much like OPEC, capital markets are unpredictable and self-interested. In March, there was a massive injection of equity and credit into the E&P sector. Prices for WTI crude oil had dropped to $45 per barrel, and Citi believes that investors were trying to “call the bottom” of the market and jump in before oil prices rebounded. They did, briefly, but ultimately such infusions are simply prolonging the inevitable. Cash injections are unlikely to change the fact that the shale industry is inflated, overleveraged, and increasingly desperate. Citi expects H2 of this year to be a far more challenging financial environment for drillers than H1 for the reasons mentioned above, as well as the anticipated hike in interest rates.

Still, recalibration won’t happen overnight. It’s a long road from distressed to bankrupt, and “if liquidity is ample, the shakeout could take up to several years to work its way through the sector, creating volatility in prices.” Citi also points to the fact that the incentives for producers are highly distorted. Their priority is not necessarily to turn a business that is cash flow negative to one that is cash flow positive. Instead, it might be a simple matter of continuing to make payroll and keep pumping as long as possible, since the largest risks fall to the lenders. Citi writes, “A hypothetical scenario for a manager: If my operating cash flows are slightly negative and I’m collecting a salary and have equity compensation, I might as well keep producing and burn through the cash I have; if crude rebounds I get a payout. If the crude price stays low, creditors bear the losses.”

Bad companies don’t mean bad assets. The shale industry is not homogenous, and the companies at highest risk for bankruptcy are those with poor assets, high leverage, little hedging protection, and dwindling cash flow. When looking at the U.S. production outlook, there are likely to be a number of companies that file for Chapter 11 whose resources keep producing even as creditors take possession. Bankruptcies without production shut-ins won’t rebalance the market—ultimately, shutting down production in fringe and marginal areas will be required.

Shale producers remain highly innovative, and technological progress will play a role in insulating the sector as a whole.

Prepare for Shale 2.0. Yes, now is a tough time for oil producers everywhere, and in North America in particular. That doesn’t mean the shale industry will collapse. Some of the bigger players are cash flow positive, and we can expect the oil majors and private equity to come in and scoop up some of the more promising assets. Additionally, the sector remains highly innovative, and technological progress will play a role in insulating the sector as a whole. Citi concludes that “After a period of distress where weaker producers are weaned out and bad investments are written down, shale eventually emerges even stronger for Phase Two.” That said, there will likely need to be some repricing of oil-related risks by investors. Additionally, Izabella Kaminska in the Financial Times notes that it is likely to be the most brutally aggressive and cost-cutting firms that survive this period, which will create unforeseen social and environmental costs in the future. However, perhaps most importantly, capital markets will largely determine who survives this period, and which companies emerge well positioned to thrive when oil prices rebalance at higher levels.