Rice Energy (RICE), a natural gas producer with a low credit rating, raised $900 million in a bond sale in April, $150 million more than it originally sought. Investors snapped up the bonds even though the Canonsburg (Pa.)-based company has lost money three years in a row, has drilled fewer than 50 wells (most named after superheroes and monster trucks), and said it will spend $4.09 for every dollar it earns (before interest, taxes, depreciation, and amortization) in 2014.
“This is a melting ice cube business. If you’re not growing production, you’re dying.”—Mike Kelly, Global Hunter Securities
The U.S. drive for energy independence is backed by a surge in junk bonds that has been as vital to the boom as the breakthroughs in drilling technology. While the high-yield debt market has doubled in size since the end of 2004, the amount issued by exploration and production companies has grown ninefold, according to Barclays (BCS). That’s what keeps the shale revolution going even as companies spend money far faster than they make it. “There’s a lot of Kool-Aid that’s being drunk now by investors,” says Tim Gramatovich, chief investment officer of Peritus Asset Management. “People lose their discipline. They stop doing the math. They stop doing the accounting. They’re just dreaming the dream, and that’s what’s happening with the shale boom.”
Rice Energy’s April bond offering was rated CCC+ by Standard & Poor’s (MHFI), seven steps below investment grade. S&P says that of the 97 energy exploration and production companies it grades 75 are rated below investment grade. Because investor demand was so strong, Rice was able to borrow at 6.25 percent, according to data compiled by Bloomberg. That compares with 9.5 percent paid on other bonds with similar ratings. “Who can, or will want to, fund the drilling of millions of acres and hundreds of thousands of wells at an ongoing loss?” Ivan Sandrea, a research associate at the Oxford Institute for Energy Studies in England, wrote in a March report. “The benevolence of the U.S. capital markets cannot last forever.”
Rice Energy will outspend its revenue through 2015, according to Moody’s Investors Service (MCO). The company says it plans to invest $1.2 billion this year in pipelines, land, and drilling in Pennsylvania’s Marcellus shale and in the nearby Utica shale. Its first well in the Utica failed, resulting in an $8.1 million write-off last year. Even so, Rice canceled the last of four planned presentations to investors in April because demand for its bonds was so strong, according to Gray Lisenby, Rice’s chief financial officer, who says the company could have borrowed more than $3 billion.
Rice was able to borrow so easily because of the quality of its holdings and its drilling record in the Marcellus shale, Lisenby says. “Asset quality and operational success drive returns,” he says. “Investors are pretty smart in recognizing this.”
About $156 billion will be spent on oil and gas exploration and production in the U.S. this year, according to a December report by Barclays. That’s 8.5 percent more than last year and outpaces this year’s expected 6.1 percent growth in global oil and gas expenditures, the report said. Since output from shale wells drops sharply in the first year, producers have to keep drilling more wells just to maintain production. That means more borrowing. “This is a melting ice cube business,” says Mike Kelly, an energy analyst at Global Hunter Securities in Houston. “If you’re not growing production, you’re dying.”
The recent battering of Forest Oil (FST) shows how the borrow-drill strategy can backfire. Forest generated $1.3 billion by selling assets in 2013 to pay down debt and finance its drilling as it focused on its Eagle Ford acreage. In February the company reported disappointing well results. Forest didn’t have enough revenue coming in to keep from running afoul of its debt agreements. Both S&P and Moody’s cut its credit outlook to negative. The way the shale boom is being financed is “a perfect setup for investors to lose a lot of money,” Gramatovich says. “The model is unsustainable.”