The Fuse

Appalachian Shale Drillers Still Losing Despite Spending Cuts

by Nick Cunningham | December 08, 2020

The natural gas market in the U.S. went into a deep slump earlier this year, a downturn that pre-dated the pandemic.

Much of the price decline can be chalked up to overproduction from U.S. shale companies, which drilled themselves into financial devastation. As a result, the gas sector made substantial cuts to spending and drilling over the past year. But the red ink continues.

Gas bust years in the making
Part of the problem for gas-focused shale companies, particularly in Appalachia, is that oil market dynamics were affecting their businesses. Drillers in the Permian were adding to the already-well-supplied U.S. market for natural gas, only the gas was coming up out of the ground as a byproduct. The Permian oil boom led to a wave of associated gas production, adding to the ample supplies from Appalachia, contributing to a gas bust. Henry Hub spot prices had been low for years, but fell below $2/MMBtu in early 2020 as the glut continued to grow worse.

One of the bizarre realities of the shale experience over the past decade is that even as production expanded, independent oil and gas companies continued to post financial losses. The industry was already showing signs of deceleration over the course of 2019 and into 2020 as investors began souring and access to capital shrank. EQT, the largest natural gas producer in the U.S., saw its credit rating cut to junk status in January 2020, and the gas giant took a billion-dollar write-down in the first quarter.

That punctuated what appeared to be the end of an era in some ways for the shale gas sector, a trend that was magnified by the pandemic. Profligate spending would have to give way to something more restrained, with a focus on cash flow rather than growth. EQT, and a line of other gas companies, proclaimed a new mantra of capital discipline. “We reduced our 2020 capex budget twice already by a total of $150 million and we’ll look for additional opportunities to reduce the budget,” David Khani, EQT’s chief financial officer, told investors on an earnings call in February. That was meant to be a selling point to investors increasingly scrutinizing the shale industry’s reckless spending decisions.

Another bad quarter
However, more recent performances suggest that the same old problems remain. A group of nine Appalachian-focused shale gas drillers reported a cumulative $504 million in negative free cash flow in the third quarter, according to a recent report from the Institute for Energy Economics and Financial Analysis (IEEFA). It was the latest in a long string of losses. “These results follow a dismal decade for the Appalachian frackers,” the IEEFA analysts wrote.

The glaring problem with that number is that the third quarter encompassed a period in which shale gas companies had already slashed their spending levels. In fact, the nine companies only spent $1.8 billion in the quarter, down 34 percent from the same period in 2019, and the lowest total in six years. Despite spending less, they were still not able to generate positive cash flow.

In a sign of trouble, the oil majors, and their deep pockets, have largely abandoned Appalachian gas.

In a sign of trouble, the oil majors, and their deep pockets, have largely abandoned Appalachian gas. In late 2019, Chevron took a $10.4 billion write-down, half of which was related to its Appalachian assets. Chevron then sold off its Appalachian interests to EQT for just $735 million. Royal Dutch Shell also rid itself of some less-than-desirable holdings. Having spent billions to enter the region in 2010, Shell sold off its Appalachian gas assets for $541 million in May. More recently, ExxonMobil revealed that it would likely take an impairment of between $17 and $20 billion in the fourth quarter, mostly related to its gas assets.

Going forward, independent shale gas companies will have to continue to restrain spending, and they may be forced to resort to hedging, as well as a number of ways to raise short-term cash to pay off debt, such as selling off long-term royalty interests. “Yet these moves would simply reinforce the sector’s pessimistic outlook,” IEEFA said. They point to EQT’s chief executive Toby Rice, who said on the company’s second quarter earnings call: “Based on the current price environment, we expect to run this business at a maintenance level for the next several years.”

On the company’s third quarter call, analysts followed up, posing a question to EQT management about when the industry would begin to step up activity. CFO David Khani fielded the question. “You can say that if you want to use return on capital employed as a long-term return metric for investors to want to come back and really invest in this space, the industry really needs $3.50 gas over the next five years to really generate that return on capital employed,” Khani said.

The problem for the sector is that the futures market has Henry Hub well below $3/MMBtu through the mid-2020s, and below $2.50/MMBtu for a big chunk of that time. On the other hand, natural gas prices could conceivably rebound to higher levels precisely because the industry is has slammed on the supply breaks, tightening up the market. Analysts at Goldman Sachs have been saying for months that they see Henry Hub rebounding to $3.50/MMBtu as soon as the summer of 2021. But in the first week of December, when natural gas prices sold off after weather forecasts predicted mild weather, the investment bank lowered its outlook to $3.25/MMBtu, still at the more optimistic end of the spectrum compared to some of its peers.

Gas is already beginning to see its stranglehold on the electric power sector slip.

Even assuming the more bullish forecasts pan out, if and when prices rise, natural gas begins to look a lot less competitive in the context of the rapid growth of renewable energy. Gas is already beginning to see its stranglehold on the electric power sector slip. A higher input cost would tip the balances further in favor of an energy transition.

Putting it all together, the sector’s heady growth days appear to be over. Or, as IEEFA analysts summed it up more succinctly: “The shale revolution has turned the U.S. into the world’s most prolific gas producer. Yet in financial terms, the gas production boom has been an unmitigated financial bust.”