Shale production and the problem of finance

A piece in the Economist argue that rising oil prices will not allow the shale industry to recover, “NO ONE can deny that America’s shale-oil industry is having a hard time. In recent weeks it has suffered the indictment and subsequent death in a car crash of one of its pioneers, Aubrey McClendon; a shellacking from Hillary Clinton, who could become America’s next president; and a warning from Ali al-Naimi, Saudi Arabia’s oil minister, to cut costs, borrow money or face liquidation. The data illustrate the extent of its woes. The American government’s Energy Information Administration (EIA) says oil production in December, of 9.3m barrels a day (m b/d), was lower than a year earlier for the first time since early 2011, weighed down by Texas and North Dakota, the heartlands of hydraulic fracturing (fracking). The EIA said on March 8th that it expects American crude production to fall to 8m b/d before it bottoms out in the latter part of next year”.

The piece goes on to note “Against that bleak backdrop, the mere hint this week that American oil prices were rebounding towards $40 a barrel, up from a low of less than $30 a barrel a month ago, must have felt like a get-out-of-jail-free card. With a chutzpah typical of the industry, some shale executives see $40 oil as the threshold above which they can resume drilling and make money again—even if America is still awash with record amounts of crude in storage. If they are right about that, it could change the entire dynamics of the oil market, quickly smoothing any upward or downward spike in prices. But it is not at all clear that they are”.

The report adds that “In theory, it is not hard for the frackers to increase production rapidly, once it becomes economical. Rig and drilling costs have fallen so fast that some wells could make money with prices around $40-45 a barrel, according to Rystad Energy, a consulting firm. Firms have laid off many workers, but with well-paid jobs hard to find elsewhere, it could be relatively easy to attract them back. In preparation for higher oil prices, producers from the Bakken field in North Dakota to the Permian and Eagle Ford in Texas have reported that they have hundreds of “drilled but uncompleted” ( DUC) wells. DUCs should be anathema to a self-respecting shaleman; they sink cash into the ground in the form of wells, but defer the all-important fracking that breaks open the shale rock and produces the oil. They could be a quick way to resume production, however. In late February Continental Resources and Whiting Petroleum, two big operators in the Bakken, said that above $40 a barrel they may begin fracking their rising inventory of DUCs”.

However the piece goes on to mention that “For most of the industry, however, the problem is not finding oil but finding cash. “No one is sitting on any excess capital,” says Ron Hulme of Parallel Resource Partners, an energy-focused private-equity fund. For years the industry borrowed heavily to finance its expansion, because it was failing to generate enough cash to cover investment in new wells. The supply of credit, whether from banks or the high-yield debt markets, has either dried up or is much more expensive than it was. Capital expenditure has fallen as a result, but not by enough to balance the books. In the fourth quarter of last year, American and Canadian oil firms spent $20 billion, while generating only $13 billion in cashflow”.

The piece goes on to note that only the firms with the most money have the ability to resume drilling but even those that wish to do so may find few takers as investors as more wary of shale companies than before, “The weaker firms are unwilling to sell assets to raise cash because the proceeds would go directly to their creditors. “You’d have to prise those assets from their dying hands,” says Mr Hulme. He notes that even firms that are technically insolvent may have enough liquidity to keep them from such potential fire sales. Not all of them, though. On March 8th Goodrich Petroleum, a shale oil-and-gas company, said it would postpone paying interest on its debt, as it puts pressure on creditors to exchange debt for equity in order to avoid a default”.

It finishes, “To provide a sufficient margin of comfort, prices may have to rally a lot higher than $40 a barrel to lure capital back in. Bobby Tudor of Tudor, Pickering, Holt, an energy-focused investment bank, believes that at $40 a barrel production will continue to decline, at $50 it would flatten out, and only at $60 would it increase. “Drilling wells at today’s commodity prices is still destructive of capital,” he argues. One further wrinkle: as oil prices increase, so can costs. Those, then, who hope that nimble shale producers will be able to move the global oil price up and down just by turning the taps on and off may be disappointed. Their financial backers will be the ones really calling the shots”.


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