From the concrete canyons of Lower Manhattan to the shale basins of West Texas, a new report from Citigroup underscores the degree to which Wall Street has financed the U.S. oil boom, with analysts warning that the slow grind of lower oil prices could spell tough times ahead for shale producers and their creditors.
Cash-hungry shale producers have relied on a mix of bond sales and loans to finance capital-intensive gas explorations, with the interplay between the two types of financings now under the spotlight as oil companies face an intensifying credit crunch.
"The shale sector is now being financially stress-tested by low prices, exposing shale’s dirty secret: many shale producers outspend cash flow and thus depend on capital market injections to fund ongoing activity," Citi analysts led by Richard Morse wrote in research published on Tuesday.
Shale financing has zoomed into focus as U.S. oil companies embark on the latest round of semiannual discussions with lenders, known as the "redetermination of the borrowing base." The discussions take place twice a year, in April and October, and involve shale producers and banks renegotiating the worth of oil assets securing credit facilities. With the price of crude now down 59 percent from its 2013 peak of $110 a barrel, October redeterminations are likely to crimp the amount of funding available to shale companies.
The Citi analysts expect this year's redeterminations to result in a 5 percent to 15 percent reduction in the borrowing base, which could in theory help spur the long-awaited shakeout in U.S. shale as producers either have to find fresh capital, merge with competitors, or simply shutter their businesses.
When it comes to the latter option, Citi argues that capital markets now wield unrivaled influence on who lives and who dies as investors choose how and at what price to fund shale producers. The wrinkle, however, is that shale companies may hang on for dear life as long as possible, thanks to perverse incentives in their corporate structure.
"In an additional twist of capital markets’ influence on supply, incentives created by the capital markets may actually slow the supply rationalization for some producers in a classic case of 'risk shifting,'" said the Citi analysts.
The dynamic has been exacerbated by the large swath of U.S. oil companies that have taken advantage of intense demand for higher-yielding assets by issuing bonds that come with fewer protections, or covenants, for lenders. Such "cov-lite" debt could come back to haunt energy bondholders if shale companies attempt to stay afloat even in the face of negative profitability.
Shale executives may "be willing to produce below break-even prices as long as they have liquidity because producing has value as a real option" on the company's assets, the analysts wrote. "This would represent a shifting of risk to the creditors, who in many cases have not put in restrictive covenants — in the case of unsecured high-yield debt — that would allow them to easily counteract these incentives."
Still, there's no denying that shale will have to grapple with a higher cost of capital that will ultimately give investors extra sway over the future of U.S. shale and, by extension, oil prices.
Where once even the riskiest shale borrowers were able to tap return-hungry financiers at a rate of just 7 percent, the Citi analysts are forecasting that shale's cost of capital will move closer to 15 percent, shifting the industry's breakeven price higher by from $5 to $15 a barrel.
"After a period of distress where weaker producers are weaned out and bad investments are written down, shale eventually emerges even stronger," the analysts concluded. Nevertheless, "investors should re-price what is clearly greater oil-related risk than many had anticipated in the first phase of shale development."