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Page added on January 17, 2015
Shale Debt and its Implications
We have all been held spell bound by the recent precipitous plunge in oil prices. The implications are the stuff of conjecture, conspiracy theories and just plain interesting conversation. Adding to this conversation, it would appear that another troubling trend has possibly emerged.
It is well known that the Fed has kept interest rates artificially low for a considerable period of time. There are many good arguments to be made as to why this should be so. Nevertheless, there is also a reasonable argument to be made that low interest rates encourage investors to chase yield. In other words, investors may be more inclined to invest in higher risk businesses than usual because these businesses provide a higher return in an otherwise artificially low return environment. Many argue that this encourages bubbles within the markets. What it certainly causes is the increased use of debt by corporations. Debt overall, in the oil and gas industry, has grown threefold since 2006. The “shale revolution”, according to S&P, was approximately 75% funded by junk debt. Further, it was not funding itself out of cash flow. Not even close. It was the product of a grab at extraordinary amounts of cheap money and perhaps gives a whole new meaning to the phrase “the stuff of revolutions”.
Is this a bad thing? It all depends on your perspective.
Examining the debt to equity ratio in some shale companies, it becomes readily apparent that debt was decidedly the preferred choice of funding. This makes sense in that money has been cheap and equity has always been an expensive way to fund. But like all else in life, debt must be managed in moderation. The following chart is taken from company financials at Range Resources, Continental Resources, Devon Energy and Pioneer Natural Resources.
When examining a company, one usually looks for a debt to equity ratio percentage of less than .80. As we can see the only one these companies that is any where near this level is Pioneer and they are still pushing the edge. Looking at Continental in comparison, we see that creditors have twice as much money in the company as equity holders. For Range, it is about 1.5 times as much money as equity holders.
Another interesting way of looking at this is to divide net income, which is a company’s total earnings or profits, into its long term liabilities and see just how long it would take to pay off that debt. In Range’s case, it will take about 20 years. For Continental, about 11 years. And that is using 100% of their profits year in, year out.
While I’m not arguing that taking on debt is a bad thing, I am arguing that it must be done with prudence. The conventional argument tells us that debt is a good way to leverage assets. And this is certainly true provided that the price of oil or natural gas remain relatively high because then debt service can be met. If prices should decline, however, these same companies can quickly find themselves on the wrong side of the debt equation. Particularly with shales. Why? Because they decline too rapidly and production profiles cannot be maintained unless there is continuous and prolific drilling which requires continuous and prolific capital expenditure.
Shales, by their very nature, have extraordinarily high decline rates whether one is speaking of tight oil, such as that coming out of the Bakken, Eagle Ford or Permian Basin or shale gas coming out of formations like the Marcellus underlying Pennsylvania and parts of Ohio or the Barnett in north central Texas. Because of these steep declines, it becomes very difficult for operators to maintain a flat or growing production profile for any reasonably lengthy period of time. Couple this with a fall in price and you have the perfect storm. If one cuts CAPEX then production declines rapidly. But if production declines, then there is not as much money available to meet debt service. And if you should have a significant price decrease on top of this, well…
Interestingly, this scenario has happened twice now with shales since 2011. Firstly, operators overproduced shale gas. It can reasonably be argued that this was in large part to meet production targets, one of the primary metrics used by analysts and investors to gauge the growth of an oil and gas company. But needing to meet debt service also played a significant role. This, in turn, drove natural gas prices below $2/mcf by January 2012. It also caused companies to incur massive write downs in shale assets. For example, in 2013, there was $35B in write downs among a mere 15 shale operators.
With gas prices low, operators turned their attention and capital expenditure to tight oil in an attempt to capture the higher prices available in the crude markets. But once again they overproduced and supply swelled. In late 2014, OPEC made what many in the industry have proclaimed was an unfair move: OPEC refused to cut production. And yet, examining the production figures showed that OPEC production had actually declined for the previous two years. It was the burgeoning production coming from US shale and Canadian producers that had disrupted the market equilibrium and was driving prices toward the floor. Interestingly, many pundits pointed the finger at OPEC and asked with incredulity why they weren’t willing to cut production and bring stability to the world market. It was a ludicrous scenario. Why should OPEC cut production merely to help its competitors, who incidentally, have a higher cost of doing business? Out of the goodness of their hearts? Is this not confusing business with philanthropy?
Shale operators will almost certainly continue to increase production for some period of time though prices have now plunged to about $45/bbl. Many will have no choice. They will not be able to meet debt service if production falls off rapidly. But this added production will merely worsen the glut.
And so the debt spiral has apparently begun.
19 Comments on "Shale Debt and its Implications"
MSN Fanboy on Sat, 17th Jan 2015 7:47 am
Funsies 🙂
Pity though, we need to release as much co2 into the atmosphere as possible.
Makati1 on Sat, 17th Jan 2015 7:57 am
“And so the debt spiral has apparently begun.”
Obviously. I’m glad I don’t have any. It took me 40 years to cut the chains of the banksters that started with my first new car in 1965. I pay cash for everything. Owe nothing. Pay no taxes because I have no taxable income or property. But I do have to pay sales taxes … for now. For 10 years, I have been truly free and it is a great feeling!
Plantagenet on Sat, 17th Jan 2015 8:10 am
The FED and their QE program created bubbles in the US economy. The shale oil bubble is popping now. Look for the stock market bubble and the real estate bubbles to pop soon.
Davy on Sat, 17th Jan 2015 8:17 am
Mak, debt is not bad in itself. If you understand how to manage it then you are at an advantage in today’s low interest environment. We have no idea what is coming in this debt spiral that I also believe is coming. If there is a debt jubilee then if you can control the physical the debt is attached to you may have achieved obtaining an asset on the cheap. If that asset is a productive asset the debt costs may be minimal.
rockman on Sat, 17th Jan 2015 8:37 am
M – “I’m glad I don’t have any.” Really??? You wouldn’t want to be making 9.5% interest on your Chesapeake bond? You must be making a great return on your investments. LOL.
CHK is deep in bond debt. But forget the chatter about cheap money: most of their many $billions in debt is at 6.5% to 9.5%. That 9.5% is being paid on a $318 MILLION bond. Bankruptcy fear? A little bit but very unlikely. Large pubcos with many $billions in assets rarely file bankruptcy. They are usually acquired by another pubco with that company taking over the debt. The bond holders don’t take a hit…the shareholders do because the acquisition price include deducting debt from equity. And often much of the acquisition price is composed of stock of the buying company.
The very small companies, many of which no one here has ever heard of, are more likely to file bankruptcy and be liquidated. And often their debt is neither held by banks or bond holders but by investment companies. And they’ll take a hit. But understand the way those debts are structured the investment companies (we call them “mezzanine bankers”) will typically earn a 20% to 25% return. If you’re making 20% return while savings accounts are making less than 3% and don’t think it’s a risky investment you deserve to take a big bite of that nasty debt sh*t sandwich. LOL.
shallowsand on Sat, 17th Jan 2015 8:39 am
Davy. If you and others are correct, and things are headed downhill fast, are we looking at serious deflation? Debt with deflation is a dangerous combination, no matter what interest rates are.
shallowsand on Sat, 17th Jan 2015 8:46 am
It looks to me the market believes oil and gas will not stay down for years based on current oil and gas company equity prices. But 6 months ago nobody was predicting oil below $50 either.
If we are in a multi year period of low oil prices, most of the shale drilled won’t survive.
BC on Sat, 17th Jan 2015 9:53 am
Planet: “The FED and their QE program created bubbles in the US economy. The shale oil bubble is popping now. Look for the stock market bubble and the real estate bubbles to pop soon.”
Yes, real estate’s echo bubble peaked in 2012-13 and began the first stage of deflating in 2014, i.e., falling sales.
The stock market is more overvalued than in 2000 and 2007 when taking into account total market cap and the persistence of the 10-year P/E above 20.
Moreover, non-financial corporate debt as a share of wages and GDP is at the highest level since 1929-30 and Japan in 1989-96.
In fact, the S&P 500 is experienced an exceedingly rare ensemble of technical and valuation indicators that have occurred only two other times since the 1920s: 1929 and 2007, conditions that preceded the largest stock market declines in US history.
Plantagenet on Sat, 17th Jan 2015 10:43 am
@BC
You really know your stuff. +1
shortonoil on Sat, 17th Jan 2015 11:40 am
We never took at face value the shale industries claims of astronomical returns. Most people want to believe that a set of books is proof positive of financial status. Actually, in financial matters, cooked books have a long, and note worthy history. In 477 B.C. it was discovered that Pericles, the head of Athens, had scoffed off through creative accounting, with $3,750,000 from the Delian League Fund. The Fund had been set up by the Greek City States to fight the Persians in case of an invasion. Unfortunately, they entrusted it to the Athenians. Pericles apparently used the money to build the Parthenos by Phidias and enrich himself, and his cronies. Somethings never seem to change!
Early on we decided that a 60% return coming from an 11,200 foot well drilled for $8.5 million dollars, which produced 108 barrels a day, was not passing the “sniff test”. We took a look at the accounts of some of the Majors. Something did not seem quite right. Of course, we didn’t bother to contact them directly. If these guys were a bunch of crooks it is not likely that they are going to tell you that! So we used a different approach.
Since energy is our thing, we concluded that a business in the energy business that is not producing energy is probably just not doing that well. Using the Etp model, and data from the World Bank, and the EIA we calculated how much energy these firms were netting in their operations. It turned out that they weren’t producing any, and in fact owed someone a whole lot of it. The ghost of Pericles seemed to still be about.
The shale industry now appears to be going down the tubes in spectacular fashion. In 2,491 years we hope someone is still around to remember the story of Pericles, and the Shale Revolution.
http://www.thehillsgroup.org/
penury on Sat, 17th Jan 2015 12:25 pm
As long as the FED can create fiat for nothing, loan it to the players at zero interest and guarantee that the banks loaning the money are fully backstopped by the taxpayers, and everyone continues to accept the excrement as “money” the system will continue. BRICS meanwhile are having their currency destroyed by the strong dollar and their interest payments in dollars increases while the U.S. continues to enjoy zero interest as everything is bought by the FED and is interest free. Eventually there will be no money left to borrow, if you could look into the future try to imagine a world where nothing can be bought or sold due to non-acceptable currencies. The time is approaching rapidly that loans must be re-paid, economies must heal or fail and we all now what the FED will do. But regardless of Dr. Krugman a large war will not cure our economy, that time has passed and all we can do now is watch as it all disintegrates.
Davy on Sat, 17th Jan 2015 12:55 pm
Spec, deflation is the grey clouds off in the distance. It is not apparent now because of the alternative financial reality the global central banks have created. The Swiss made cheese of the central banks forward guidance guarantees that are increasing nothing more than fiction.
The real economy is in a deflationary spiral. It is a bumpy shallow descent at the moment but a perfect storm is brewing of all the predicaments we discuss daily here. Yet, Spec, until the hurricane is upon us you have to be active boarding up the house and moving stuff to the second floor. IOW you still have to dance even with dim lights next to the cliff.
Debt that is fixed supported by fixed returns I have no problem with. Low debt to net worth and income is not an issue. Debt is a tool that has a place especially in today’s world of debt based activities.
I see the reality of deflation in the conditions of excessive debt, unfunded liabilities, and sovereign deficits as leading directly to hyperinflation at some point. This movement could be extremely swift eventually because of the herd instinct. Once global hyperinflation hits that’s all she wrote for BAU baby.
shortonoil on Sat, 17th Jan 2015 1:12 pm
As long as the FED can create fiat for nothing, loan it to the players at zero interest and guarantee that the banks loaning the money are fully backstopped by the taxpayers, and everyone continues to accept the excrement as “money” the system will continue.
Well – not really. There is another player in this game, and it is far bigger than the FED. It is called the derivatives market, and it has been estimated at $1000 trillion. About half of it is in interest rate derivatives, and they are primarily bought and sold by the big banks. If there was a significant change in inter bank rates, counter party exposure could be in the 100s of trillions over night. No one would know who was solvent and who wasn’t. Banks could literally stop doing business with each other; the entire system would come to a halt.
This almost happened after the Lehman collapse. Lehman had a huge derivatives book, and no one knew who was holding it. These things are sometimes sold ten levels deep. A counter party that may be solvent when they bought the contract could very well not be when the contract comes due. This market is equivalent to a financial nuclear bomb, and the chances are that it will go off at some point. If, and when it does it will turn the FED into a sheet of smoldering glass in a flash.
bobinget on Sat, 17th Jan 2015 1:54 pm
OMG
Davy on Sat, 17th Jan 2015 2:45 pm
Yes and no short. Derivatives are meaningless in aggregate and as such they will be swallowed up in the black hole of a major crisis. IOW that part of the system is so widespread and interconnected a significant default is meaningless and in reality will be disregarded.
There is zero chance of this global derivatives market having liquidity in a global crisis. It will wiff into the ether like a popcorn fart. That was the no. The yes is the known unknown of this whole process. That is the danger and that danger is the not knowing. Nothing scares people more than the unknown. It is the getting from here to there that is dangerous because what is left is dead bodies.
brent on Sat, 17th Jan 2015 4:58 pm
The more I research what is going on I starting to think that demand may never return. As supply shrinks more people will just not be able to buy oil thus keeping the price low. Especially since QE just ended and our current debt levels ect.
Financier43 on Sat, 17th Jan 2015 5:12 pm
Evidently the author of this blurb hasn’t done
her homework. She erroneously lumps Range Resources, a natural gas producer, in with companies that primarily produce oil and then admonishes the company for its debt to equity ratio.
The fact is, that in the last 9 months, RRC has
reduced its debt to equity ratio from 2.03 to l.53.
The cash flow of natural gas companies has been steady. Actually, RRC and SWN look like good
investments.
coffeeguyzz on Sat, 17th Jan 2015 6:02 pm
Financier, The ignorance of so many as regards particular companies – Range Resources, as you correctly pointed out – is fairly extensive.
Any attempts that I have witnessed over time for people to point out obvious shortfalls in analysis in regards to the financial status of numerous shale-oriented companies or the entire shale production arena in Toto, is regularly met with ludicrous, generalized disparagement of the most baseless nature.
To steer folks to sources – both government and private sector sourced that validates the enormous expenditures of capital, time, personnel is simply dismissed by those who choose to not know.
A glance at today’s pricing is not sufficient to invalidate long – term prognoses of scarcity … it’s just GOTTA be something’ else.
Oh, well …
andya on Sat, 17th Jan 2015 6:37 pm
No mention of what happens to debt/equity levels as the values of your product falls. Debt stays the same, equity gets smaller.