After a decade of unprecedented growth and seemingly endless investments, the writing is now on the wall: the Great American Shale Boom is slowing down and this could have some grave consequences both the industry and the financial markets.
A total of 32 oil and gas drillers have filed for bankruptcy through the third quarter, with the total number of bankruptcy filings since 2015 now clocking in at more than 200.
Unlike Phase 1 of the oil bust that featured shale production declining due to an epic global price collapse, the current slowdown is being driven partly by industry-wide core operational issues, including declining production due to wells being drilled too close to one another as well as production sweet spots running out too soon.
Yet, the most important underlying theme precipitating the collapse is a growing financial squeeze as banks and investors pull in the reins and demand that shale drillers prioritize profitability over production growth.
The shale industry has been built on mountains of debt and the day of reckoning is finally here.
As many company executives who hoped to drill their way out of debt are belatedly discovering, trying to squeeze a profit from shale-fracking operations is akin to trying to draw blood from stone with the industry having racked up cumulative losses estimated at more than a quarter of a trillion dollars.
From the Permian of the Southwest to the Eagle Ford in Texas and the Bakken of central North America, the future is looking decidedly bleak for shale companies that racked up the most debt and expanded too aggressively.
Bingeing on debt
Chesapeake Energy Corp. (NYSE:CHK) is widely considered the posterchild of debt-fueled shale investments gone woefully wrong. A decade ago, the company’s deceased CEO, Aubrey McClendon (aka the Shale King), was the highest paid Fortune 500 CEO. McClendon had a rather unusual modus operandi: instead of trying to sell oil and gas, he was essentially flipping real estate using borrowed money to acquire leases to drill on land, then reselling them for 5x- 10x more.
He was unapologetic about it, too, claiming it was far more profitable than the drilling business.
McClendon’s aggressive leasing tactics finally landed him in trouble with the Oklahoma authorities before he was killed in a car crash shortly after being indicted.
He left the company that he founded in a serious liquidity crunch and corporate governance issues from which Chesapeake has never fully recovered--CHK stock has crashed from an all-time high of $64 a share under McClendon in 2008 to $0.60 currently.
The shares plunged 30% in early November after management fired a warning that the company was at risk of defaulting on an important leverage covenant, something that would trigger the entire balance immediately coming due:
‘‘If continued depressed prices persist, combined with the scheduled reductions in the leverage ratio covenant, our ability to comply with the leverage ratio covenant during the next 12 months will be adversely affected, which raises substantial doubt about our ability to continue as a going concern.’’
Unmitigated disaster for shareholders
Yet, if shale companies are having it rough, shale investments have been nothing short of disastrous for individual shareholders and investors.
As Steve Schlotterbeck, former CEO of largest natural gas producer EQT, has attested:
“The shale gas revolution has frankly been an unmitigated disaster for any buy-and-hold investor in the shale gas industry with very few limited exceptions. In fact, I'm not aware of another case of a disruptive technological change that has done so much harm to the industry that created the change.”
According to Schlotterbeck, the scale of value destruction has been mind-boggling with the average shale company obliterating 80% of its value (excluding capital) over the past decade.
Chesapeake and the 200+ companies that have gone under should serve as a cautionary tale for an industry that’s big on promises and loves to finance its big ambitions on borrowed dimes with little to show for it in the way of profits.
Yet, the vicious cycle of high debt, high cash burn and poor returns refuses to go away. Starved for cash, energy companies have devised a new instrument with which to court investors and continue bankrolling their operations: shale bonds. These companies are now floating asset-backed securities wherein producers transfer ownership interests to investors with proceeds from the wells used to pay off the bonds.
A good case in point is Denver-based oil and gas company Raisa Energy LLC, which closed the first shale bond offering in September. Raisa will pay nearly 6% interest on the best quality wells, with higher rates offered on riskier assets.
After years of low interest rates, fixed-income investors are finding junk bonds increasingly attractive and might find the lure of shale bonds irresistible. But these bonds are a potentially high-risk investment considering that modeling future production remains an inexact science due to the complex geology of shale basins.
Investors will only have companies’ estimates when trying to model potential returns, never mind the fact that there are literally thousands of shale wells that are pumping well below forecasts.
To get a better grasp of the underlying risks, consider Whiting Petroleum (NYSE: WLL) whose June 2018 unsecured bonds recently traded as low as 57.8 cents on the dollar.
It’s not just retail investors getting torched in this shale snafu.
Bloomberg has reported that former shale billionaires Farris and Dan Wilks have seen their Permian shale investments decimated in the latest oil bust.
As Schlotterbeck deadpanned:
“Nearly every American has benefited from shale gas, with one big exception--the shale gas investors.”
No one can deny that the US shale industry has been highly beneficial to the country in a number of ways. For starters, it has helped to lower gas and energy prices for the consumer while freeing the nation from over-dependence on oil imports. Indeed, in November, the US posted its first full month as a net exporter of crude oil in 70 years, with Rystad Energy predicting the country is only months away from achieving total energy independence.
But unless these companies can figure a way to drill profitably and stem the ballooning debts, this is going to continue being a race to the bottom with investors at the bottom of the totem pole paying the highest price.