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.