The prospect of rising interest rates could dramatically slow the growth of the U.S. shale industry in the coming years, as higher financing costs have the potential to wipe out much of the efficiency gains achieved by drillers since the oil price downturn began in 2014.
Debt levels for a group of 63 shale E&Ps nearly quadrupled between 2005 and 2015, surging close to $200 billion.
The shale revolution, to a large extent, was built on debt. Small- and medium-sized exploration and production companies (E&Ps) drove shale growth, but they lacked the financial heft of the oil majors. The independents borrowed heavily to finance the drilling frenzy. Debt levels for a group of 63 shale E&Ps nearly quadrupled between 2005 and 2015, surging close to $200 billion, according to a new report from Columbia University’s Center on Global Energy Policy (CGEP).
Debt-financed drilling was possible for two reasons. First, oil prices were sky-high between 2011 and 2014, so the steady cash flow kept creditors and equity investors at ease even if profitability remained elusive. Second, the era of ultra-low interest rates following the 2008-2009 global financial crisis made debt readily obtainable for companies below investment grade.
Oil prices collapsing in 2014 pulled the rug out from beneath the industry. Between 2015 and 2016, an estimated 114 North American oil and gas companies filed for bankruptcy, according to law firm Haynes and Boone.
The crash in oil prices has arguably made the industry much healthier. Before the market downturn, E&Ps saw their debt levels rise faster than their cash flows. Even investment grade drillers saw their net debt more than double in the decade to 2014, while their EBITDA (a proxy for cash flow) only increased by roughly 30 percent, according to Columbia University’s report. These days, lenders are more cautious and producers are prioritizing profitability rather than a growth-at-all-cost approach. As a result, the survivors of the downturn have become leaner and more efficient, lowering breakeven costs to the point that they turn a profit even with oil wallowing at $50 per barrel and below.
Will higher rates threaten shale?
Even as debt levels quadrupled between 2005 and 2015, interest expenses for the 63 shale companies surveyed by Columbia University grew by only 150 percent—the result of plummeting interest rates. In other words, near-zero interest rates made debt cheap, allowing many more companies to drill a lot more shale wells.
However, interest rates will not remain low forever. The U.S. Federal Reserve has already hiked interest rates twice from between zero and 0.25 percent up to 0.75 percent. The central bank has signaled several more rate increases in the months and years ahead. The action could result in rates jumping as high as 2 percent next year and maybe to 3 percent in 2019.
Because interest makes up somewhere between 25 and 33 percent of the total cash cost for these companies, the higher cost of capital would eliminate “a significant portion of the gains from operational efficiencies.”
While the oil majors will likely take higher interest rates in stride, more expensive credit would threaten the financial health of shale drillers that are below investment grade. For example, a 2 percent increase in the London Interbank Offer Rate (LIBOR), combined with a 1.5 percent increase in credit spreads for shale companies with credit ratings between B and CCC-, would lead to a surge in interest expenses by 30 percent, according to Columbia University’s CGEP. Because interest makes up somewhere between 25 and 33 percent of the total cash cost for these companies, the higher cost of capital would eliminate “a significant portion of the gains from operational efficiencies,” Amir Azar of CGEP wrote in the report.
Moreover, if interest rates return to levels not seen since before the financial crisis—above 5 percent— small and medium-sized drillers may be hit particularly hard. “Since shale oil production is highly capital intensive, the high cost of debt could drive up total cost of production to an unsustainable level,” Azar concluded.
Although the Federal Reserve has begun the process of monetary tightening, the timing and frequency of further rate hikes are uncertain. Interest rate hikes typically come when an economy starts to overheat. But first quarter U.S. GDP expanded at a meager 0.7 annual growth rate, the weakest performance in three years. Moreover, commodity prices typically rise when the Fed moves to hike rates, because demand and overall economic growth tend to be strong.
But commodity prices today are relatively weak. Brent crude recently tumbled below $50 per barrel before rebounding. And it isn’t just oil prices; prices for gold, iron ore and coal tumbled recently, with particular concerns about the health of both the U.S. and Chinese economies. Muted economic growth and low commodity prices could push the Fed to delay hikes.
On the other hand, inflation is starting to creep up as the U.S. labor market tightens with the unemployment rate below 5 percent, making higher interest rates very likely. “The best labor market in nearly 30 years should tell Fed officials that additional monetary stimulus is not required. We expect them to put another rate hike notch on their belts at the upcoming June meeting,” Chris Rupkey, chief economist at MUFG Union Bank in New York, told Reuters in an interview.
Drilling costs rise again
More drilling will grant leverage to service companies, raising the cost of production.
Rising interest rates will increase interest expenses, but drilling costs could also rise. Some of the efficiency gains over the past three years were cyclical, resulting from squeezes on drilling rigs and well completion services. More drilling will grant leverage to service companies, raising the cost of production. “All E&Ps voice the best intentions to keep a laser eye on costs. But, continued productivity and drilling efficiency gains over 2016 will be difficult to achieve as operators pivot to a more aggressive development mode,” Jackson Sandeen, Senior Research Analyst at Wood Mackenzie, wrote in a recent report. Wood Mackenzie predicts the industry will see cost inflation on the order of 15 percent this year, although it will hit shale basins differently, with stronger increases in costs in the Permian, for example.
The shale industry appears to be on sounder footing than at any time in recent memory, but it faces significant headwinds in the coming years with potential interest rate increases and a rebound in drilling costs.