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The Dawn of Big Shale - Alpcan Efe Gencer

We are currently living through historical times of volatility in the financial markets. The prices at the opening bell do not at all indicate the overall direction of the intraday price movements but rather reflect the magnitude of the differing views on the direction markets is heading. However, the cautionary and relief packages being announced by broad public and financial institutions in the wake of the coronavirus outbreak is reflecting a different reality on the energy sector we previously did not include in future estimates.

The potential economic shock of the coronavirus sparked a panic selloff in the financial markets, and the risk-on attitude of the sector turned risk-averse faster than expected. The lowered oil demand and the oil glut presented by the proposed introduction of around an extra 3.4 mmb/d capacity by Saudi Arabia and the United Arab Emirates alone was enough to drop the prices by over 30% in less than a week. The extra 500,000 mb/d output being proposed by Russia is another factor creating pressure on the prices. These numbers may have been welcome at a certain scenario where the global growth would be at a strong stage. Still, the weakness in the economy created by the coronavirus is the game-changer in our current scenario.

The distress in the OPEC+ arrangement could be examined in greater detail. Still, today we have a different focus where the current moves will certainly be having an immediate effect on—the U.S. shale. Multiple factors need to be taken into consideration when analyzing what might wait for this volatile industry. Being driven by free-market dynamics when compared to its global competitors, including the publicly backed National Oil Companies (NOC’s) or the Western Oil Majors, the shale industry is affected by a multitude of different factors. The Permian Basin producers, in general, need $50 per barrel at a minimum to stay cash-flow positive while certain producers in the U.S. can stay that way in between $30 - $50 per barrel. But with the current influx of excess supply by Saudi Arabia that is especially targeting the U.S. market, as a result of the gap between WTI and Brent closing, the U.S. shale producers are under immediate danger of being pushed out of the market.

U.S. President Donald Trump’s decision to increase the size of the U.S. Strategic Petroleum Reserve’s by 90 million barrels remains relatively outdone in the face of the increase of production and the proposed expansion of production capacities. Still, it should provide an extended lifeline for many of the U.S. producers. Sooner or later, U.S. shale producers will have to slash production to cut down on their capital and operating expenditures, and it could leave the U.S. market particularly vulnerable for entry of foreign oil supplies as the gap between the WTI and Brent could inch closer. The implied market effects of this can already be seen as the stock prices of major shale players including Occidental(NYSE: OXY), EOG(NYSE: EOG) and Apache(NYSE: APA) have tumbled in the recent weeks, and the banks that are particularly exposed through credit to this sector are under scrutiny by investors. The risk-averse attitude of the capital markets, where most of these exploration firms acquire their funding needs, could indeed move away from providing further funding as the general market conditions and the sector-specific conditions deteriorate. This outline could create significant funding problems for the repayment of the maturing shale-debt that has long been the topic of many forecast scenarios.

Hence enter the oil majors. The 1990’s oil crises that created the current oil majors could turn out to play once again. While the recent acquisition of Anadarko, one of the biggest shale players, by Occidental has left the firm particularly cash-strapped and presents a case for why mergers/acquisitions at the small-to-mid bracket cannot be done rationally under the current conditions, the oil majors have suffered less of a setback throughout the present crisis, and the potential for acquisitions of the small shale players by these large majors could soon turn out to be the case. This scenario is being created with the thought that most of the present shale players cannot go down the $30 per barrel cost line with the addition of inadequate funding through worsened capital market conditions. Since 2016, the trend of mergers among the small firms of the oil patch was visible, and the current crisis could serve well as an accelerator for the trend.

While no light can be seen at the end of the tunnel for a pick-up in demand for oil in the real economy, the measures being taken by the U.S. authorities for protecting the domestic players without any direct intervention can only serve to be of help in the short-term and present no real long-term solutions for the oversupply crisis brewing in the markets. The small U.S. shale producers lived and adapted through the 2014-2016 price war, but the lack of any real growth in the economy presents new parameters for the crisis at hand this time. Unless a new technical breakthrough can be achieved and no real intervention is done in the markets, then we can expect to see swift and sizeable movements in the markets with regards to the market share and operating structures.

Not all hope is lost for the American shale producers. The possible decrease in production throughout the Permian fields would also decrease the production of associated gas, which the shale wells are known to be producing at significant quantities. According to recent market analysis, this could open up a new opportunity for the Marcellus producers where gas is produced and capitalized upon as the consumption of gas is done primarily on the Eastern Coast of the U.S. Interestingly enough, this time, an increase in the gas prices could help the local and regional economies. A counterargument to this forecast would be that as oil becomes cheaper and cheaper with the potential of a wild upturn in the mid-term, underground gas storages across the world could be dumped into the global markets for reutilization as oil storages. This thought rests on the fact that at the current production rates, most of the existing storage capabilities in at least the U.S. would run out in less than a year, and new facilities or depleted wells would be needed to store the cheap oil. For traders, this could serve as a great arbitrage opportunity but also create a temporary, but effective, supply glut pressure on the gas prices.

Whatever case it turns out to be unless the oil-price war wanes and reverts to the conditions it was in a year ago, and the U.S. oil market structure will not look the same in a year from now on. If past examples are of any significance for forecasting, then we can expect to see new major oil producers forming or small firms joining the ranks of the existing majors.


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