Why Shale Producers Still 'Pump and Pray'
As the price of oil continues to fall, the U.S. shale oil industry is showing remarkable resilience. Output is at a 30-year high and stockpiles are the largest since tracking started in 2004. Speculators who push down the price of crude see this as evidence of a glut, but it could actually signal desperation on the part of over-leveraged producers.
It seems counterintuitive: Why would shale operators want to oversupply the market and make their product even cheaper? Two analytical papers out this month suggest it's because otherwise they couldn't service their debts.
The first of these reports comes from derivatives expert Satyajit Das, who points out that energy companies have been raising enormous amounts of capital through new bond issues and loans -- $550 billion from 2010 to 2014. Last year, more than 40 percent of new non-investment grade syndicated loans were to the oil and gas sector. A big part of the industry, Das says, is borrowing at levels more than three times operating profits, a risky amount of leverage:
If the firms have difficulty meeting existing commitments, then the decrease in available funding and higher costs as debt market close for these firms will create a toxic negative spiral. Inability to borrow will reduce production capacity from short-lived shale-oil wells where output can fall by 60-70 percent after the first year. Lower production combined with low prices will reduce cash flows increasing the risk of default, further restricting the supply of debt to the sector setting off a new cycle.
Today, the Bank of International Settlements (the central banks' central bank) weighed in with a similar analysis, backed up by more alarming statistics on oil debt. The sector as a whole, Dietrich Domanski and his collaborators write, increased its debt burden to $2.5 trillion in 2014 from $1 trillion in 2006. American oil companies account for about 40 percent of that outstanding debt, and much of it has been issued by relatively small shale producers, whose capital expenditure far outstripped their cash flow. (Small U.S. producers' capex to cash flow ratio is the yellow line; the red one denotes producers in emerging markets and the blue one, U.S. companies with assets of $25 billion or more.)
As a result, the economists say, "Highly leveraged producers may attempt to maintain, or even increase, output levels even as the oil price falls in order to remain liquid and to meet interest payments and tighter credit conditions." At the same time, highly indebted companies are motivated to hedge their exposure by selling futures or buying put options in derivatives markets. Both responses, of course, lead to lower prices in the short term.
This is a story you won't hear from shale producers themselves, who need to convince investors and creditors that they can weather the storm. An undiminished flow of crude is a show of resilience. The question here is how cash-squeezed companies can maintain output and even raise it to record levels. Bloomberg Intelligence analysts Peter Pulikkan and William Foiles have an answer. "The new oil environment," they wrote last month, "is causing operators to delay well completions while returning to already fracked wells as an investment with a high rate of return to drive production. When completions and re-fracking fail to keep up with the declining output from older wells, production will fall."
The market for oil derivatives, which determines crude prices, has in recent weeks given up on rig counts as a leading indicator of output, choosing instead to trade on stockpile data. Yet the sharply declining U.S. rig count, accompanied by production increases, means a greater reliance on re-fracking -- or "pump and pray," as this is also known, because of its uncertain results. There is no magic about oil production; you can cheat nature for a while, but not forever. The U.S. Energy Information Administration predicted yesterday that the drop in new drilling will soon cause production declines in three key American shale formations -- the Eagle Ford, the Niobrara and the Bakken.
Of course, U.S. shale producers are not the only ones pumping desperately to continue servicing their debt. Producers in major emerging markets -- including Russia's Rosneft and Gazprom and Brazil's Petrobras -- are also leveraged to the hilt. From 2006 to 2014, Russian oil and gas companies increased their annual borrowing by 13 percent, while those in Brazil increased 25 percent and those in China, 31 percent. These companies, however, have a distinct advantage over the private U.S. shale producers: Their governments will take care of their financing needs. Rosneft, for example, gets money from Russia's sovereign funds to meet its foreign debt obligations.
Essentially, in an endurance battle between U.S. shale and state giants from poorer countries, the latter are bound to come out ahead because they're not mere market players but proxies for their sovereigns. That makes output cuts in the U.S. inevitable. The price rebound that will follow should favor the shale producers who manage to stay afloat, rewarding them for their sweaty moments and their "pump and pray" gambles.
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