Posted on 03/27/2015 5:06:49 AM PDT by thackney
Shale debt, falling prices and slack demand has tight oil producers in trouble. And yet, there is still burgeoning production. Why? Well, we’ve seen this before. It’s the shale debt redux. Operators did it a few years ago in natural gas and prices have yet to recover. Unfortunately cheap money in the form of debt can mean poor investment choices for businesses and for investors. But it can also lead to an aberrant market because operators deep in debt won’t curtail production even though it is glutted. Debt coupons simply have to be met.
The shale revolution has always been funded by massive debt. Operators who were drilling for gas back in 2009-2011 used debt extensively. And just like now, they overproduced. By 2011, supply exceeded demand by four times. Then prices tanked. It is curious that so few asked the questions: why did they produce so heavily and glut the market; and why did they continue to produce into a glutted market? The answer is really quite simple. Many couldn’t afford to pull back production to help stabilize prices. Had they done so, they would not have been able to meet their debt payments. So they kept pumping…and pumping…and pumping.
And now they’ve done it again.
When interest rates are kept artificially low for extended periods of time, investors and businesses begin to take risks. They invest in stocks and high yield bonds, or they issue debt to get more money. In a normal functioning market such investments might not have been considered because reasonable returns would be available in more conservative areas. Some analysts argue that low interest rates encourage bubbles because investors begin chasing the most hyped sectors thinking they will get a better return. And nothing has been more hyped than shales. Low interest rates did indeed create the perfect environment for taking on heavy debt loads by companies and increasing the appetite on the part of investors for junk debt. Neither scenario, however, is ideal. Both can put you behind the eight ball very quickly.
Much of the debt issued by shale operators has been high yield or what is commonly referred to as junk. According to the Wall Street Journal:
“Junk bonds have financed the U.S. shale boom, and now the sharp drop in oil prices could lead to a massive wave of defaults on that high-yield debt.”
JP Morgan Chase estimates that as much as 40% of this junk debt may be defaulted on by shale companies in the next two years if prices stay below $65/bbl. Yeah, you read that right…40%! Prices are currently trading around $45/bbl and operators are still pumping huge amounts of crude into the market so a $20/bbl price rise would seem unlikely.
This picture is complicated enormously by the overwhelming need for cash by shale operators. Energy was the fastest growing sector of junk debt in 2014 and is the largest chunk of the high yield market. Energy junk debt rose from about 14% at YE 2013 to 19% by YE 2014. Prices began tanking, however, in 2014 driving up the yields on these bonds to nosebleed heights. Some big investors took a risk in early 2015 and started buying up this distressed paper. Unfortunately, the markets turned against them again and losses are mounting. According to Oil Price:
“The high-yield debt market is being overrun by the energy industry. High-yield energy debt has swelled from just $65.6 billion in 2007 up to $201 billion today. That is a result of shaky drillers turning to debt markets more and more to stay afloat, as well as once-stable companies getting downgraded into junk territory. Yields on junk energy debt have hit 7.44 percent over government bonds, more than double the rate from June 2014.”
The shale monster eats cash for breakfast, lunch and dinner. Desperate for cash, operators are now turning to equity issuance in addition to their mountains of shale debt to fund operations. Equity is the most expensive form of cash because it dilutes existing shareholders. Many, however, no longer have access to more debt having maxed out their ratios. So energy equity issuance has exploded in 2015 growing at the fastest clip in a decade. Approximately $8B in new equity was issued in the first quarter 2015 though prices continue to fall and shares are being hammered. Further, large investment banks have been left with rotting shale debt on their books that they can’t unload. A recent transaction saw these loans picked up at 65 cents on the dollar.
The shale debt redux is yet another indication that this business model has problems. The shale game cannot be kept going without continuous and breathtaking amounts of cash. Kepler Chevreux recently stated that US shale and Canadian oil sands account for about 18% of global production. They also account for approximately 50% of global CAPEX. So if shales and oil sands really are our energy panaceas, then hold on because prices are going through the roof for anything using crude or natural gas in the coming decades. Costs have simply gotten too high and there is no reason to think that they will abate.
So those non-OECD countries that are choosing to leapfrog hydrocarbons and spend their money on renewable infrastructure may certainly be on to something. With hydrocarbon costs skyrocketing, can the U.S. really afford to be dependent on oil and gas for decades to come? Because it sure would be nice to have energy without fuel costs.
In related news:
Stop Propping Up Zombie Oil Companies
http://www.forbes.com/sites/christopherhelman/2015/03/26/stop-propping-up-zombie-oil-companies/?ss=energy
Perhaps most stunning: the number of lifelines thrown to troubled oil companies in recent weeks. Investors seem to be worried that they’re going to miss the opportunity to buy at the bottom, to grab a piece of a company that most likely wasn’t generating any free cash flow even when oil was at $100. Maybe the deep pockets that have passed out more than $10 billion in equity and billions more in loans in recent weeks know for a fact that oil prices are about to shoot back up. But I doubt it.
This week Linn Energy announced a $1 billion equity commitment from Quantum QTM 0% Resources, while Whiting Petroleum put to rest the rumors it’s on the auction block by announcing a $1.9 billion equity offering. Encana , which overpaid for Athlon Resources at the top of the market, somehow attracted $1.5 billion in new equity. Laredo Petroleum raised $750 million, Concho Resources $650 million, Oasis Petroleum $400 million and Rosetta Resources $200 million. Even Goodrich Petroleum, its shares down 90% from last year, grabbed $50 million in new equity and sold $100 million in debt. Comstock Resources issued $700 million in new bonds in recent weeks. It’s freshly subordinated debt has plunged in value to trade at a yield of 36%.
Energy XXI managed to sell $1.25 billion in second-lien notes at 12%. In doing so they subordinated their existing $750 million in senior notes. Those notes were trading at a yield of less than 2% last April; now they yield 26% (according to Finra’s TRACE site). Juicy, huh? Only if EXXI survives. Its shares are down 85% from last June, when it paid $2.3 billion to acquire rival EPL Oil & Gas at the peak of the market. Without higher oil prices there’s little chance the company will be able to generate any profits from its vast collection of mature oil fields in the shallow waters of the Gulf of Mexico.
“This is a leading indicator of an underappreciation of risk,” one baffled New York hedge fund manager told me Monday. He’s concerned about the potential devastating effect that a wave of high yield bond defaults and oil company bankruptcies could have on the broader economy.
Gee, maybe they paid high interest rates because they were risky investments?
What's interesting about this company is that it chose to borrow more money instead of issuing stock, despite its massive debt load relative to stockholder equity even before the new debt issue. Some of these natural resource CEO's are like degenerate gamblers.
I would expect few wanted to buy more stock in a company so loaded up with debt. Some of these firms have more liabilities than assets at the current oil price.
If you can borrow money, you can issue stock. Debt investors are risk averse, and new debt issues increase risk. Whereas stock investors are, by definition, not averse to risk if the returns are commensurate, and new equity issues decrease risk.
Hey Thack, off topic but do you know where #2 ULS fuel oil supplying the Northeast comes from?
Is it imported?
I think the last paragraph condemns the entire article which until then seems a pretty nice read:
“So those non-OECD countries that are choosing to leapfrog hydrocarbons and spend their money on renewable infrastructure may certainly be on to something. With hydrocarbon costs skyrocketing, can the U.S. really afford to be dependent on oil and gas for decades to come? Because it sure would be nice to have energy without fuel costs.”
this is LALA land territory.
Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.