FreightWaves Oil Report: The Debt Burdens Of The Shale Companies May Throttle Output Growth

A weekly look at what occurred in the oil markets of the U.S. and the world this past week and what's ahead.

U.S. crude oil production is bound to keep going up…right? The Energy Information Administration said so just a few weeks ago when it reiterated in its Short Term Energy Outlook that U.S. crude production, now about 12.2 million barrels b/d, would average 13.3 million b/d next year. 

But a report from S&P Global Ratings released earlier this month is a sobering document. It's especially notable given that it is coming from a company that rates the quality of debt for corporate America.The U.S. shale explosion has been fueled by debt. 

What S&P sees is not encouraging. This year alone, 10 oil and gas companies rated by S&P Global Ratings have seen their debt ratings cut to D or SD. The D stands for default; SD is selective default, a rating that is handed down when a company voluntarily restructures their debt with their creditors.

The S&P Global Ratings partially blames "hydrocarbon price volatility" for the problems encountered by these companies. But the reality is that the last time hydrocarbon prices were  not volatile was maybe back in the 1960s (if then) and the trend for this year has been mostly up. West Texas Intermediate crude opened 2019 at less than $50/barrel, got as high as $66/b and is now still more than $50 (but not by much.)

A broad criticism of the shale business is that it has always had hints of a Ponzi scheme. Maybe it's not that bad; the operators do produce an actual product. But the road to get there involves borrowing lots of money, drilling lots of wells, generating little to no cash flow, certainly not paying any dividends, borrowing more money, maybe selling some assets that were financed by earlier borrowings, and so on. Investors recently have decided they don't want to sink money into that sort of operation, and the shale companies are feeling it.

"The lower echelon of rated issuers is struggling to meet market demands of operating within internally generated cash flow and is experiencing investor fatigue due to disappointing returns," the report said. "Moreover, with a tighter spigot for new financing, many companies are also facing liquidity constraints, refinancing concerns and exploring various strategic alternatives often driven by disillusioned stakeholders."

One of those alternatives might be just to sell the company. Earlier this week, Carrizo Oil & Gas (NASDAQ: CRZO), which operates in the Permian basin in West Texas and the south Texas Eagle Ford, sold itself to Callon Petroleum (NYSE: CPE), which has been known as a pure play operator in the Permian. The ugly numbers that Carrizo faced is that its stock in the last 52 weeks is down about 66% and Bloomberg reported that its total five-year return is negative 84%. Callon's stock price in the last 52 weeks is down about 56%. 

Concho Resources, one of the largest operators in the Permian, has fared a little better: its 52-week decline is about 33%. 

The report has some staggering numbers on where the bonds of some shale operators are trading. All of these companies are carrying debt ratings of CCC+ or less. The "indicative bond price" for Denbury Resources — indicative because a firm transparent number for illiquid debt can be hard to come by — is at 51 cents on the dollar. For Sanchez Energy Corp (OTC: SNEC), it's four. That's the price for EP Energy (OTC: EPEG) debt as well.  

To reflect the level of financial engineering that some of these companies have to go through, look at what S&P Ratings wrote about Denbury Resources DNR. It merged last year with Eagle Ford company Penn Virginia, a transaction S&P referred to as "ill-fated." It is now trying to "push out" some debt maturities through exchange for new debt "and preserving liquidity on its undrawn revolving credit facility" that expires in 2021. The rest of the report has similar tales of woe for other companies.

One development that S&P Global Ratings noted in its report is that some of the companies that are finding themselves in trouble are ones that already have been through the Chapter 11 funhouse, so they entered their second life with balance sheets free of debt. Such companies were "remodeled to thrive in a ‘new normal' range-bound commodity price environment." 

But, as S&P Ratings adds: "This has hardly been the reality."

Some of those companies may end up in what S&P Ratings calls Chapter 22, a euphemism for a second trip through chapter 11. The report lists the debt price of some of these companies, only slightly less ugly than the non-reorganized companies: Halcon Resources HK at 30 cents to the dollar; Ultra Petroleum UPL at 10 cents. 

The Carrizo-Callon deal was announced after the S&P Global Ratings study came out. But the report cited several other similar transactions that looked to cost-cutting and other synergies as the basis for their success. Most of the deals did not receive much applause on Wall Street. The report said one got an "indifferent" reaction and another a "lukewarm response."

"The jury is still out on whether contemporary consolidation initiatives will enhance viability for some of the industry's speculative-grade issuers," the report said.

This brings the question full circle back to the assumption that U.S. production is heading to a level north of 13 million b/d next year, as the EIA has predicted. 

If there's been one constant through the shale revolution, it is that most skepticism from analysts has been answered by an industry that continues to find creative ways to find new hydrocarbons and keep the financing afloat even with paltry to non-existent returns. 

The oil and gas team at Merrill Lynch is confident that it will find a way again this time, but hints that it might be at lower levels than predicted (though Merrill doesn't actually make a production forecast itself.) "While still early, we believe industry commitments to capital discipline are real, leaving the US on the cusp of a transition to more measured growth that can coexist with OPEC and begin to address fragile market confidence that oil can be sustained above levels currently discounted across the US oils," a recent Merrill report said. 
The question is whether "coexisting with OPEC" means less production than what the EIA predicted. It would certainly take some of the burden off the cartel.

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