In many ways, the US shale industry is emblematic of why failing to normalize monetary policy after seven years of largesse can be extremely dangerous.
As discussed at length in these pages and then subsequently everywhere else, access to cheap cash via capital markets allows otherwise insolvent producers to keep drilling even as prices collapse, creating what are effectively zombie companies [8] (to use Matt King’s words) on the way to delaying the Schumpeterian endgame and embedding an enormous amount of risk in HY credit by flooding the market with supply just as demand from investors (who are delirious from hunger after being starved of yield by the Fed) peaks and secondary market liquidity continues to dry up.
This dynamic has served to create a supply glut in a number of industries and has suppressed commodity prices in a self-feeding deflationary loop.
Thanks to SEC rules [9] on how drillers are required to value their reserves, producers are effectively forced to overstate the value of their O&G businesses by nearly two-thirds, which can lead unsophisticated investors who don’t bother to read the 10K fine print to believe that the businesses are healthier than they actually are.
Furthermore, the next round of revolver raids [10] for the industry isn’t due until October, meaning investors may also believe the industry has easier access to liquidity than it actually does. As a reminder:
[11]
As if all of the above weren’t enough, there’s yet another reason why the shale default cascade has thus far been forestalled, giving many the impression that perhaps a “crude” awakening (pardon the terrible pun) has been averted: hedges.
Here’s Bloomberg with more [12] on why some US shale drillers may soon be zero hedged (ahem):
The insurance protecting shale drillers against plummeting prices has become so crucial that for one company, SandRidge Energy Inc., payments from the hedges accounted for a stunning 64 percent of first-quarter revenue.
Now the safety net is going away.
The insurance that producers bought before the collapse in oil -- much of which guaranteed minimum prices of $90 a barrel or more -- is expiring. As they do, investors are left to wonder how these companies will make up the $3.7 billion the hedges earned them in the first quarter after crude sunk below $60 from a peak of $107 in mid-2014.
“A year ago, you could hedge at $85 to $90, and now it’s in the low $60s,” said Chris Lang, a senior vice president with Asset Risk Management, a hedging adviser for more than 100 exploration and production companies. “Next year it’s really going to come to a head.”
The hedges staved off an acute shortage of cash for shale companies and helped keep lenders from cutting credit lines, many of which are up for renewal in October. With drillers burdened by interest payments on $235 billion of debt, $89 billion of it high-yield, a U.S. regulator has warned banks to beware of the “emerging risk” of lending to energy companies.
Payments from hedges accounted for at least 15 percent of first-quarter revenue at 30 of the 62 oil and gas companies in the Bloomberg Intelligence North America Exploration and Production Index. Revenue, already down 37 percent in the last year, will fall further as drillers cash out contracts that paid $90 a barrel even when oil fell below $44.
For SandRidge and other drillers, the hedges, required by some lenders, gave them enough time to cut spending. Costs in shale fields have fallen by 20 to 30 percent and productivity has increased as producers moved rigs to the most prolific regions. Producers were able to raise about $44 billion in equity and debt in the first quarter, according to UBS AG.
“That postponed the day of reckoning,” said Carl Tricoli, co-founder of private-equity firm Denham Capital Management.
At Goodrich Petroleum Corp., hedges accounted for 35 percent of revenue in the first three months of 2015. Most of its insurance runs out at the end of the year, company records show.
In short, the last line of defense against terminal cash burn for the beleagured US shale complex is about to fall and when it does, it's going to take bank credit lines down with it.
This means October is the expiration date for heavily indebted US drillers and perhaps for HY credit as well, because once the defaults begin in earnest and HY spreads start to blow out, the BTFD-ing retail crowd will head for the exits, triggering a very non-diversifiable, unidirectional flow for bond fund managers who will then be forced to hold their noses and dive into the ever-thinner secondary corporate credit market.
It is precisely at that point when everyone's worst nightmares about shrinking dealer inventories and illiquid credit markets will suddenly be realized.
