“Two things become clear in an analysis of the financial health of US hydrocarbon production: 1) the sector is not at all homogenous, exhibiting a range of financial health; 2) some of the sector indeed looks exposed to distress [and] lifelines for distressed producers could include public equity markets, asset sales, private equity, or consolidation. If all else fails, Chapter 11 may be necessary.” That’s Citi’s assessment of America’s “shale revolution”, which the Saudis have been desperately trying to crush for more than a year now.
As Citi and others have noted - a year or so after we discussed the issue at length - uneconomic producers in the US are almost entirely dependent on capital markets for their continued survival. “The shale sector is now being financially stress-tested, exposing shale’s dirty secret: many shale producers depend on capital market injections to fund ongoing activity because they have thus far greatly outspent cash flow,” Citi wrote in September. Here’s a look at what the bank means:
Of course this all worked out fine in an environment characterized by relatively high crude prices and ultra accommodative monetary policy. The cost of capital was low and yield-starved investors were forgiving, allowing the US oil patch to keeping drilling and pumping long after it should have been bankrupt. Now, the proverbial chickens have come home to roost. In the wake of the Fed hike, HY is rolling over and as UBS noted over the summer, “the commodity related industries total 22.8% of the overall HY market index on a par-weighted basis; sectors most at-risk for defaults (defined as failure to pay, bankruptcy and distressed restructurings) total 18.2% of the index and include the oil/gas producer (10.6%), metals/mining (4.7%), and oil service/equipment (2.9%) industries.” As Bruce Richards, chief executive officer of Marathon Asset Management told Bloomberg last week, "the price of a barrel of oil could fall below $30 due to a "glut of supply," and as many as a third of energy companies will default over the next three years."
"This is the the worst non-recessionary year we’ve ever had for high yield," Richards said. New York-based Marathon has added to short positions on energy bonds, he said.
This week’s gains notwithstanding, and a likely misguided assumption about the impact the lifting of America’s crude export ban will have on WTI aside, the fundamentals here are a nightmare. Iraq is pumping at record levels, Iranian supply is set to ramp up starting next month, once sanctions are lifted, and OPEC is completely disjointed. Furthermore, producers are bumping up against the limits of how many jobs they can cut and how much capex can be slashed (ultimately, you have to retain enough human capital and capacity to remain operational). The takeaway: the bankruptcies are coming.
As the Dallas Fed notes in its latest quarterly energy outlook, bankruptcies in the space are now at their highest levels since the crisis and things look bleak going forward. Below, find excerpts from the report.
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From The Dallas Fed
West Texas Intermediate (WTI) crude oil prices have fallen around 23 percent so far in the fourth quarter. Expectations have shifted toward a weaker price outlook because sanctions against Iran are likely to be lifted in early 2016, the Organization of the Petroleum Exporting Countries (OPEC) has scrapped any pretense of a production ceiling, and U.S. production declines have slowed. Supply Glut Drives Oil Prices to 10-Year Lows The imbalance in global supply and demand has led oil prices to slump to levels last seen over 10 years ago. World petroleum production will exceed consumption by an average of 1.7 million barrels per day (mb/d) in 2015, according to December estimates by the Energy Information Administration (EIA). This excess supply is higher than during the Asian financial crisis and the Great Recession. OPEC supply has bloated markets with nearly 1 mb/d more this year than what the EIA initially predicted in November 2014. In 2016, global supply is expected to exceed demand by 0.6 mb/d on average (Chart 1).
At OPEC’s December meeting, the impending lifting of sanctions against Iran contributed to increasingly vocal dissonance within the cartel. The meeting ended in disarray, and oil ministers abandoned any pretense of a production ceiling for the first time in decades. A strong divide appeared to develop between Saudi Arabia and its Gulf allies on one hand and Iran and remaining OPEC members on the other. These divisions are driven by three underlying causes. First, there is strong disagreement on how to accommodate Iranian oil supply once sanctions are lifted as Saudi Arabia, Iraq and others seek to maintain market share. Second, heightened tensions in the Syrian conflict have deepened regional rivalries. Third, low oil prices affect member countries differently because of their different fiscal positions.1 These underlying causes will make any agreement on reinstating production ceilings or other coordinated action by OPEC unlikely in 2016.
Oil and gas sector bankruptcies have reached quarterly levels last seen in the Great Recession. Lower oil prices have taken a significant financial toll on U.S. oil and gas producers, in part because many face higher costs of production than their international counterparts do. At least nine U.S. oil and gas companies, accounting for more than $2 billion in debt, have filed for bankruptcy so far in the fourth quarter. If bankruptcies continue at this rate, more may follow in 2016. Upstream firms have also adjusted to low oil prices by slashing capital expenditures; spending is down 51 percent from fourth quarter 2014 to third quarter 2015 (Chart 5).
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As Goldman put it earlier this month, "...we reiterate our concern that 'financial stress' may prove too little too late to prevent the market from having to clear through “operational stress” with prices near cash costs to force production cuts, likely around $20/bbl."