With oil prices on the upswing, and overall U.S. output projected to exceed 10 million barrels per day (mbd), 2018 should be a banner year for the shale industry. But this expected output boom masks a list of underlying problems that confront the sector. Most companies are still not generating positive cash flow and remain highly dependent on borrowing from the debt markets. Across the board, equity investors are frustrated with low or negative returns and pushing for changes in corporate strategies, and a surge in U.S. supply—or OPEC production—could precipitate a significant price drop and endanger the whole enterprise.
Although NYMEX WTI averaged 17 percent higher in 2017 than in 2016, share prices of many shale companies were negative for most of the year.
Although NYMEX WTI averaged 17 percent higher in 2017 than in 2016, share prices of many shale companies were negative for most of the year. Larger independents such as Pioneer, Continental, Hess, and EOG all struggled despite higher prices and a record-setting year for the S&P 500. The XOP Fund, an index of U.S. oil and gas E&Ps, was down 10 percent last year, and the sector overall was the worst performing for 2017.
Investors are calling for capital discipline and for companies to prioritize profits over growth. But production shows no signs of slowing, as of now, especially with the industry seeing the highest oil price since 2014. “The situation will not get any better for shale companies,” one energy investor told The Fuse. “Everyone will want to run flat out as fast as possible to take advantage of the current environment before the OPEC deal eventually comes undone.” The Wall Street Journal reported last month that a group shareholders in U.S. shale producers met in New York City to discuss ways to put pressure on companies to increase capital discipline, limit output growth, and become profitable.
The shale industry needs to be creative in financing to keep pumping oil because of its higher cost of production compared to conventional wells. Unbelievably, on a “full cycle cost basis,” much of U.S. shale production still has never been profitable. New wells must cover full cycle costs, which include the costs of acquiring leases, while half cycle costs consist of only drilling and fracking, but not leases. If full-cycle costs are above oil prices for an extended period, the industry realizes that the investment is not sustainable. As a result, capital spending and production will decline.
Industry turns to bond markets
One of the biggest questions for the future is whether the bond market will eventually reduce the amount of capital available to the sector and deprive it of a major source of financing.
With equity investors increasingly turning away from the sector after it spent $280 billion more than it has generated since 2007, U.S. E&P companies have had to rely heavily on debt markets. Since the shale boom took off at the beginning of this decade, U.S. E&Ps have raised almost $500 billion through bond sales. Bonds have become a popular way to raise money for the sector while interest rates remain low, and because bond sales typically come with low restrictions, but one of the biggest questions for the future is whether the bond market will eventually reduce the amount of capital available to the sector and deprive it of a major source of financing. Companies may also turn to private equity firms, which can provide large amounts of funding, but they tend to demand a large stake of the business. The downside of raising money through bond markets is having to pay interest on a regular basis, a problem if business fortunes change.
The FT reported in December that U.S. shale companies raised more than $60 billion in bond sales last year, a 28 percent increase versus 2016.
This financing allowed companies to continue drilling even as they struggled with negative cash flow. The number of rigs soared by 43 percent last year and U.S. production ended the year at 9.7 mbd, up 900,000 barrels per day versus the beginning of 2017.
Companies also aggressively used hedging as a financing mechanism to manage risk, guard against a price fall, and improve balance sheets, allowing them to grow production for this year. Bloomberg New Energy Finance estimated that in Q3 U.S. companies locked in an extra million barrels per day for the first half of 2018.
Despite the different funding mechanisms, the industry is in a precarious situation. The higher oil price and the fact that companies are well hedged for the year make them attractive for bond sales now. If prices continue to rise, the industry’s structural problems of negative cash flow will again be overlooked. But a shift in market conditions that decreases prices could significantly alter the sector’s funding. And shrinking capital will translate into either weaker production gains or possibly a sharp decline in output. “The risk going forward is the exit strategy risk,” said one energy investor. “At some point, the market expects production to increase with OPEC barrels coming back and the U.S. producing more.”
“Everyone is trying to do the same thing at the same time in the same place,” said an investor, referring to the industry’s rush to the Permian.
Another investor pointed to the risk of companies rushing into shale plays all at once, a situation that would stimulate a large amount of supply all at once. “Everyone is trying to do the same thing at the same time in the same place,” said the investor, referring to the industry’s rush to the Permian, shale’s hottest play, to take advantage of its rich geology.
Tighter bond market to force consolidation?
The U.S. shale sector is not homogenous, and not every company will suffer the same fate from lower prices, operational bottlenecks, or a tighter bond market. The shale industry is comprised of small mom-and-pop types, large independents such as Continental, and the majors, including ExxonMobil. The smaller the company, the more vulnerable it is to high debt levels or consolidation. Smaller independents who rely on debt for funding may be forced to sell their assets, restructure debt, or declare bankruptcy. The larger E&Ps would have to slow activity against the backdrop of reduced financing. They would continue to look for cost reductions and improve risk management, legacies of the price downturn of 2014-16. Meanwhile, majors that have jumped into shale areas are naturally hedged with refineries and overseas assets, and are better prepared to withstand losses in shale.
Industry unlikely to be profitable in 2018
The industry will continue to pump more oil out of the ground, but it still won’t likely turn a profit in 2018. It is clear the current trends of higher production, higher debt, and negative cash-flow is unsustainable, particularly if funding from the bond market subsides. The likelihood is that shale companies do not impose stricter discipline and instead continue to increase production at a rapid pace.
The shale sector has been on the precipice since 2014. It will continue to be, despite today’s higher prices.
The U.S. oil sector has been prone to boom and bust in the past—overproduction creating an abundance, only to be followed by a price collapse. A recent New Yorker article noted a popular bumper sticker in Texas during the bust period of the 1980s and 1990s: “Please, God, send me one more oil boom. This time, I promise not to piss it away.” There are signs that the current opportunity is indeed being squandered: There is limited production discipline, companies are heavily in debt, their means of financing could dwindle, and a clumsy OPEC exit strategy could significantly decrease prices. The shale sector has been on the precipice since 2014. It will continue to be, despite today’s higher prices.