The Upcoming U.S. Shale Boom (or Bust?) - Alpcan Efe Gencer

The U.S. shale boom of the 21st century had remarkable significance not only for its wildcatters but also for the nation’s energy policy. Having been externally dependent for most of its energy needs, the improvisation of horizontal drilling and hydraulic fracturing in the shale layer created a new reality for the upstream sector. According to the Energy Information Agency’s estimates, 6.5 million barrels of oil are being produced from shale resources today. The figure roughly equates to about 59% of the U.S. domestic oil production. On the natural gas side, the story is no different. In 2018, U.S. dry shale gas production was estimated to have been around 20.95 trillion cubic feet, which is equal to almost 60% of U.S. dry natural gas production. Alongside securing domestic production of the hydrocarbons, the U.S. Chamber of Commerce’s 21st Century Energy Institute estimate that the extraction of unconventional shale oil and gas has created 1.7 million jobs already and a total of 3.5 million jobs are projected to be created by 2035. This immense growth has indeed unlocked a lot of the underlying resources for the use of the public. It has also led to sudden overproduction of the resources and led to a supply glut. Since then, the natural gas prices in U.S. have gone down and have not recovered yet. The already existing high-cost nature of fracking is putting profitability pressures on the producers. It is now estimated that for oil, producers need at least $50 bbl to break even.

At this point, it should also be noted that a prime difference between the independent shale producers of the U.S. and the large-scale National Oil Company’s is that shale is backed largely by instruments of capital markets when compared to IOC’s and NOC’s that have a variety of different funding sources. As a result of the Quantitative Easing (QE) programs that followed the 2008 financial crisis, significant amounts of cash were held by investors at near zero-cost and some of this money was redirected towards shale companies in line with the booming shale industry. According to a research paper by Amir Azar, a fellow at Columbia University’s Center on Global Energy Policy, the North American Exploration and Production (E&P) companies held a net debt of $50 billion in 2005 which ballooned to $200 billion by 2015. Indirectly, the drilling and well service companies that work with these E&P firms also have a stake in the payment of this debt. The 2014-2015 oil price shock had a devastating effect on these producers as the general drilling rig count in the U.S. showed which neared a record low of 404 functioning rigs in 2016.

Coming to 2019, the WTI benchmark price is once again hovering between $50-$60 bbl and with the uncertainties surrounding the U.S.- China trade war, no sure way of determining upside risk currently exists. What has changed this time when compared to ’14-’15 crisis is that, according to Rystad Energy, the top 40 shale companies have about $100 billion dollars of debt that will be maturing within the next 7 years. In a separate estimate from the Wall Street Journal, between 2020 and 2022, a colossal $137 billion in shale debt will be maturing. While the interest rate cuts from central banks are creating accommodative conditions for the debt markets, capital markets are wary of the financial troubles the industry is experiencing due to the persistent low commodity prices and access to financing through these markets remain relatively restricted when compared to the boom periods of the industry in the late 2000’s.

From a cash-flow perspective, the shale producers are already in a hard position. As part of their lease contracts in U.S. and of legal mandate in some states, they have to distribute at least 12.5% of their oil sales to the landowners. Based on rough estimates and of 2018 average market conditions, 29% of the shale production in the U.S. is used to pay back just the interest on their loans. Adding the high cost of the operations of shale drilling on top of these costs, it is not hard to see why the shale producers might be struggling. Based on the opinions of some industry veterans, a fairly decent share of this shale debt will be virtually impossible to be paid back. On the other hand, some of the recent events in the industry tell a different story. During a federal government auction for a Permian Oil lease in Sept 2018, a record was broken. In a two-day auction, $972 million was raise for 142 parcels of land and $95,000 per acre was the recorded price for some of the lands in the New Mexico side of the Permian. The industry itself is either expecting a future boom in its business cycles or the irrationality of the sector, as emphasized by some critics, is purely on the play. Whatever it may be, players in the industry are certainly pursuing aggressive policies.

With regards to the current status of the markets, the shale industry will be depending on a multitude of price factors to determine its future. On the production side, the stability of Saudi Arabia as a swing producer and the general condition of the U.S. producers will be key. On the supply side, geopolitical risks surrounding the Hormuz Strait should be watched for potential disruptions for the shipments and the attacks on the Abqaiq infrastructure highlights the present tensions and the risks for the producers in the region. On the consumption side, the negotiations surrounding the trade war talks should be watched closely and the activities of the refiners in India and the Mediterranean would also be good points for forecasting the future demand. On the demand side, the sanctions against Iran should be monitored as Iran is thought to be storing its extracted hydrocarbons in storage facilities and also using its Very Large Crude Carrier (VLCC) vessels as floating storage by docking them close to their potential customers in Asia. When considering the financial aspects of the industry, the risk-averse nature of investors based on the on-going trade war can be changed based on the outcomes of the negotiations. If an agreement can be reached, then for a short period of time, investors with higher risk tolerance can engage in lending to the distressed producers just as how investing in junk bonds of distressed companies in 2017 was on the rise before the increase in tensions between U.S. and China. If that will be the case, then the Federal Reserve might again embark on its gradual interest increase program, which would be raising the cost of borrowing in the medium-to-long term for these companies.

In a case where the talks go without a resolution, then the market dynamics would likely be hard to predict at this point, and the most likely scenario would involve expecting an economic slowdown along with decreasing commodity prices, which would negatively impact these debt-loaded firms. A defense on behalf of the firms and the market dynamics is that technological improvements might play out increasing the well efficiencies of these firms, but having the current problems existing at the macro level, a single micro solution such as this will unlikely be able to solve the general problem. The currently distressed firms are also not observed to be engaging in an increased number of mergers, a move that usually entails companies across similar sectors coming together with the hopes of consolidating their activities in anticipation of preparing for possible economic slowdowns. In a potential fallout scenario, a good outcome might be that the companies with actual operational efficiencies and sound financial policies would likely survive and emerge as the new major players in a relatively more competent industry. Whatever the case may be, the next ten years for the shale industry will probably be much different than how the previous ten years have played out.

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