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.

Source: Energy Policy Forum

Five years ago, I wrote an article for Reuters titled “Goldilocks and the Three Fuels.” In it, I discussed what I call the Goldilocks price zone for oil, natural gas  and coal, a zone in which prices are “just right” — high enough to reward producers but low enough to entice consumers. Ever since the start of the fossil- fuel era, such a zone has existed. Sometimes price boundaries were transgressed on the upside, sometimes on the downside, but it was always possible to revert to the zone.

But now, the Goldilocks zone for oil has ceased to exist. This will have staggering consequences throughout the economy for the foreseeable future.

During the past decade, the Goldilocks zone for oil steadily migrated higher. As conventional crude reservoirs depleted and production rates leveled off, drillers had to spend proportionally more to develop the capacity to pump the next marginal barrel. Oil prices soared from $30 a barrel in 2005 to nearly $150 a barrel in 2008, collapsed during the economic crisis, then clawed their way back to roughly $100 a barrel, a price that was maintained through mid-2014. But the economy did not do well during this period. Despite massive bailouts, stimulus spending and low interest rates, the recovery following the 2008 crash was anemic.

However, at $100 a barrel, the oil price was high enough to incentivize fracking. Small, risk-friendly companies leased land and used expensive drilling techniques to free oil from rocks that geologists had previously described as too impermeable to bother with. This entailed a tenuous business model that required not only high oil prices but easy money as well, as low interest rates enabled producers to pile on enormous amounts of debt.

Oil production in the United States rose sharply as a result, and this eventually had an impact on prices. Since mid-2014, the oil price has declined by half, settling around the historic, inflation-adjusted mean price of $50 a barrel. Consumers are much happier than they were with oil at $100 a barrel, but producers are wilting. The American petroleum industry has seen more than 75,000 layoffs, the balance sheets of fracking companies are bleeding and drilling rigs are being idled by the score.

For consumers, experience suggests the acceptable oil-price zone is $40 to $60 a barrel in today’s dollars; higher than that, goods and services, particularly transportation, become more expensive than current spending patterns can handle. For producers, the acceptable zone is more like $80 to $120 a barrel; lower than that, upstream investments make little sense, so production will inevitably stall and decline — eventually making consumers even less happy.

You will have noticed that there is no overlap. An oil price of $70 a barrel would not be high enough to give the industry a rebound of confidence sufficient to inspire another massive round of investment. Clearly, consumers would be happier with $70-a-barrel oil than they were with $100-a-barrel oil, but if $70 isn’t a high enough price to incentivize production growth, then it’s not really in the Goldilocks zone.

According to the narrative emanating from most mainstream energy economists, oil production rates will soon slow, prices will rebound and everyone will be happy. That narrative misses the all-important news that Goldilocks is dead. There is no longer a price that everyone can live with. And that’s a recipe for price volatility.

For oil traders, price volatility may offer opportunities for profit. But for everyone else, it is treacherous. Price volatility only hints at the real extent of our peril: We have built an economic system overwhelmingly reliant on a nonrenewable, depleting resource. This is not a sustainable situation. Unless our dependency on oil somehow magically disappears, we are in for a wild ride on an unmapped road.

Source: Reuters