It appears that Horseman Global's Russell Clark may have been spot on with his bearish take on the US shale sector.
As a reminder, in his latest letter to investors, Clark said that "the rising decline rates of major US shale basins, and the increasing incidents of frac hits (also a cause of rising decline rates) have convinced me that US shale producers are not only losing competitiveness against other oil drillers, but they will find it hard to make money.... at some point debt investors start to worry that they will not get their capital back and cut lending to the industry. Even a small reduction in capital, would likely lead to a steep fall in US oil production. If new drilling stopped today, daily US oil production would fall by 350 thousand barrels a day over the next month."
What I also find extraordinary, is that it seems to me shale drilling is a very unprofitable industry, and becoming more so. And yet, many businesses in the US have expended large amounts of capital on the basis that US oil will always be cheap and plentiful. I am thinking of pipelines, refineries, LNG exporters, chemical plants to name the most obvious. Even more amazing is that other oil sources have become more cost competitive but have been starved of resources. If US oil production declines, the rest of the world will struggle to increase output. An oil squeeze looks more likely to me.
While the bearish thesis has yet to play out, moments ago Anadarko poured cold water on US energy investors after it missed earnings badly, reporting a Q2 EPS loss of 77c, more than double the 33 cent loss expected. However, what was far more concerning to shale bulls (and perhaps oil bears), is that the company admitted that it can no longer support its capital spending budget, and it would cut its 2017 capital budget by $300 million, becoming the first major U.S. oil producer to do so, as a result of depressed oil prices. In March, Anadarko had forecast total 2017 capex of $4.5 billion to $4.7 billion, a continuation of the recent CapEx rebound which troughed in Q3 2016.
Ahead of the Tuesday earnings call, APC CEO Al Walker confirmed Wall Street's growing fears that oil prices are simply too low to sustain ongoing exploration when he said that "the current market conditions require lower capital intensity given the volatility of margins realized in this operating environment. As such, we are reducing our level of investments by $300 million for the full year."
Ironically it was Walker himself who issued a clear warning to Wall Street in June, when he bought up something we first covered in April of 2015 in "When QE Leads To Deflation: A Look At The "Confounding" Global Supply Glut", when he said that it was the relentless supply of cheap capital that was masking the underlying lack of profitability and allowing shale companies to pump beyond the point of negative returns: “The biggest problem our industry faces today is you guys,” Al Walker, chief executive of Anadarko Petroleum Corp. told investors at a conference last month, quoted by the WSJ.
Companies have more capital to keep drilling thanks to $57 billion Wall Street has injected into the sector over the last 18 months. Money has come from investors in new stock sales and high-yield debt, as well as from private equity funds, which have helped provide lifelines to stronger operators. Flush with cash, virtually all of them launched campaigns to boost drilling at the start of 2017 in the hope that oil prices would rebound.
The new wave of crude has again glutted the market. The shale companies are edged even further from profitability, and a few voices have begun to question the wisdom of Wall Street financing the industry’s addiction to growth.
Wall Street has become an enabler that pushes companies to grow production at any cost, while punishing those that try to live within their means, Mr. Walker said, adding: “It’s kind of like going to AA. You know, we need a partner. We really need the investment community to show discipline.”
Ultimately, it was up to Walker to demonstrate that discipline when he voluntarily reduced the amount of capital he would reinvest in his business. And since oil exploration is by far the most capital intensive industry, the hit to revenue will be quick and painful, much to the delight of OPEC which may finally be seeing light at the end of a long, dark tunnel. To that point, Anadarko also said it was trimming its 2017 production forecast to 644,000 bpd, a 2% cut.
Incidentally, Horseman is not the first to turn bearish on shale. As Bloomberg reported earlier, Goldman Sachs Asset Management has been shedding oil and gas-related company bonds in the past few months and shorting oil in some portfolios, according to Mike Swell, the firm's co-head of global fixed-income portfolio management. The investment manager has moved from an overweight position in energy-related corporate bonds a few months ago to neutral today and toward an underweight stance, he said in an interview on Friday.
Some investors seem to agree with Goldman's asset-management arm, at least enough to have a touch of skepticism about the prospect of these oil and gas explorers. Since the end of January, credit traders have demanded slightly more yield to own junk-rated bonds of oil and gas companies than other high-yield debt.
In an amusing twist, we reported last week that the very same Goldman reported last Friday that energy junk bonds are finally starting to notice the decline in oil prices:
Once the APC news reverberates across the industry, this may just be the straw that breaks the energy junk bond market's back, as a scramble out of the sector ensues, resulting in the double whammy of also yanking much needed capital from shale companies. Such an exodus could not come at a worse possible time: as Bloomberg calculated if oil prices were to stay below $47 a barrel, "investors will demand a bigger cushion of extra yield to own junk-rated energy debt. Part of the reasoning is that these firms still require an excessive amount of leverage (and investor faith) to keep operating as junk-rated oil and natural gas producers have more than $25 billion of credit-line commitments expiring in 2019. If oil prices don't rebound, banks have good reason to reduce those lines substantially, siphoning off a crucial funding source."
Think a rerun of the late 2015/early 2016 period all over again.
However, while the Anadarko news is clearly negative for its shale peers, most of whom are set to announce similar capex declines, it will likely end up being positive for oil prices as much of the "swing" crude production courtesy of the US shale basin is about to be reduced substantially, in a clear victory for OPEC which has been waiting long for just this day.
Anadarko's CapEx cut also comes in the same month as the EIA announced that US shale production just hit a new all time high of 5.472mmb/d.
To the disappointment of many energy bulls (and oil bears as a reduction in production means that the shale supply glut is about to get far smaller), it may be all downhill from here.