The Fuse

Will Financial Stress in the Shale Sector Slow Production Growth?

by Nick Cunningham | June 13, 2019

The recent downturn in oil prices creates new headaches for U.S. shale drillers, who were already struggling to turn a profit.

Turning a profit was going to be an uphill battle to begin with, but the latest crash in crude prices makes that task much more difficult.

The first quarter of 2019 saw yet another period in which most U.S. oil producers burned through cash. Top shale executives promised a renewed focus on capital discipline, eschewing reckless growth in favor of a priority on shareholder returns. Turning a profit was going to be an uphill battle to begin with, but the latest crash in crude prices makes that task much more difficult.

Negative cash flow continues
In the first three months of the year, roughly 9 out of 10 U.S. shale drillers were cash flow negative, according to Rystad Energy. The consultancy and data tracking firm studied 40 U.S. shale companies and found that only four had positive cash flow. “The gap between capex and CFO has reached a staggering $4.7 billion. This implies tremendous overspend, the likes of which have not been seen since the third quarter of 2017,” Alisa Lukash, Senior Analyst at Rystad Energy’s North American Shale team, said in a statement. “Recently released data, which confirmed dismal first quarter earnings, only served to cement negative market sentiment.”

A separate report from the Institute for Energy Economics and Financial Analysis and the Sightline Institute came up with different numbers but the same conclusion. After looking at 29 U.S. shale companies, they found a combined negative cash flow of $2.5 billion in the first quarter, which they said was “another gusher of red ink.”

After years in which U.S. E&Ps promised blistering growth would translate into juicy profits, investors are beginning to run out of faith. New equity issuance has dried up, and interest rates for high-yield energy debt, or junk bonds, have soared as investors shun risky shale companies. Companies have turned to asset sales to raise funds, but those are one-off strategies intended to buy time.

“It’s been a 10-year run and the equity markets are closed, and the investors want return to themselves,” Pioneer Natural Resources’ CEO Scott Sheffield said, according to the Wall Street Journal. He was referring to the growing practice of drillcos, which are arrangements in which outside investors gain control over a portion of oil and gas production from a project in exchange for financing. Shale companies are turning to these more onerous financing mechanisms because of the inability to raise capital elsewhere.

Bankruptcies could begin to rise if oil prices fail to rebound.

Bankruptcies could begin to rise if oil prices fail to rebound. In May, Weatherford International, a large oil field services company, reached an agreement with creditors to restructure some of its debt and plans on filing for chapter 11 bankruptcy protection.

In fact, so far in 2019, energy-related bankruptcies have trailed only those in discretionary consumer goods, according to Bloomberg. “A lot of people see the $60 or $70 and assume everything is great,” Spencer Cutter, an analyst at Bloomberg Intelligence, said in a Bloomberg interview in mid-May. “I think 2019 is going to be a bigger year for bankruptcies than 2018.” That assessment came before the latest downturn in prices, which is likely to deepen the pain for drillers, as well as increase the scrutiny on them from investors.

On June 11, another shale E&P succumbed to bankruptcy. Legacy Reserves Inc., a Permian-focused shale driller, announced an agreement to restructure debt and file for chapter 11 bankruptcy protection. More than 170 U.S. E&Ps have filed for bankruptcy since 2015, according to Haynes and Boone.

But can production still grow?
Despite the financial stress spreading across the industry, oil production continues to grow, at least for now. Rystad Energy expects the U.S. to end the year with output at 13.4 million barrels per day, before rising to 14.3 million barrels per day at the end of 2020. Both figures would amount to extraordinary growth rates by any measure.

There are some signs of a slowdown, however. U.S. output growth slowed in the first part of 2019, with quarter-on-quarter production having flattened out, although some of that was due to offshore maintenance. The rig count is also down by more than 10 percent since last November.

The EIA released its Short-Term Energy Outlook on June 11, making a significant downward revision to its forecast for U.S. supply. The agency slashed its estimate for WTI for 2019 by $3.50 per barrel, an acknowledgement of weaker demand. But lower prices will also curtail supply growth. U.S. supply may average 12.32 million barrels per day in 2019, the EIA said, down 130,000 barrels per day from last month’s report.

It may be too soon to tell what the recent slide in oil prices will do. With the U.S. shale industry already burning through cash, more red ink may finally begin to cut into the aggressive growth rates seen over the past few years. “From an equity market perspective, Q1 proved a difficult quarter for most US energy companies,” analysts from Standard Chartered said in a June 11 note. “Few upstream oil and gas producers were profitable, and high debt proved a significant drag on results for most of the pure shale oil companies. Unlike most recent quarters, there was no comfort to be drawn from higher output.”

The investment bank said that the roughly $55-per-barrel price for WTI in the first quarter is not high enough for the shale industry to be profitable, and not high enough to support supply growth in the coming years.

“Prices need to move higher to allow enough investment in new wells to offset the high decline rate of existing wells,” Standard Chartered analysts wrote. “We think that the dominant view in commodity and equity markets is different. While many oil market traders assume that shale oil growth can accelerate even as prices fall, equity markets do not appear to find oil companies attractive at current prices.”