5 Triggers to Come-To-Jesus Moment for Tight Oil
Watching paint dry is not a favorite pastime for most people for two reasons (okay, there are actually more).
One reason is that it is incredibly boring because exactly ‘nothing happens’ in pretty much the entire time when ‘events’ unfold. Another reason is that the drying process is gradual and imperceptible to untrained eyes (yes, we can get into the technical details of paint drying but I’ll spare you), and the slow progression it takes from start to finish is way beyond the attention span of the instant-gratification audience.
Fortunately, or unfortunately as the case may be, witnessing the unfolding of the shale oil and gas revolution is hopefully not too boring. Nor does it take more than a decade or even a lifetime to get to at least the car-chase scenes if not the finale, which makes a good real time case study which observers get to read the final chapters of before their attention span or lifespan expires.
We have arrived at the car chase scenes so to speak.
It has been almost a year since our Nov 2014 missive on the shale oil and gas fracking chronicle in which we presented a nightmare oil price scenario which would cause significant distress to the high yield (aka junk) bond markets which, thanks to the endless supply of cheap capital from yield starved investors courtesy of the insane zero interest rate policies (ZIRP) by the central banks the world over, were THE enablers of said revolution in the first place.
We quoted from Deutsche Bank and concluded with the following punch lines:
(From DB) “If this scenario were to materialize, the US energy Bs/CCCs would have to trade at spreads north of 1,800bp, or about a 1,000bps away from its current levels. Such a spread widening translates into a 40pt drop in average dollar price from its current level of 92pts for energy Bs/CCCs.”
Translation: all of a sudden terms like ‘bloodbaths’ and ‘wipe-outs’ are starting to fly.
(From DB) “Finally, our stress-test shows that a further 20% drop in WTI to $60/bbl is likely to push the whole sector into distress, a scenario where average B/CCC energy name will start trading at 65% D/EV, implying a 30% default rate for the whole segment. A shock of that magnitude could be sufficient to trigger a broader HY market default cycle, if materialized.”
Translation: at $60 per barrel, the entire energy HY sector will be pushed into distress with a 30% default rate. This shock wave will not be contained just within the energy sector but will spread across the whole HY market.
As of this writing, crude oil price is struggling to stay above the 4 handle.
With the nightmare price ‘scenario’ now being reality, the distress scenario presented in the previous article is unfolding pretty much according to the script as predicted.
Quite a few events have transpired during this time, not the least of which is the breathtaking collapse of oil prices, dropping below what most observers thought possible. But let’s first recap some notabe events from where we left off.
- In the face of an oversupply of oil due to subdued economic activities around the world, the Saudis decided to increase oil production to maintain market share. Whether they are doing it to punish the Russians for taking the other side of the Syrian conflict or trying to squeeze out the high cost US tight oil and Canadian oil sands producers, only the Saudis will know.
- A sudden bout of volatility hit investment grade bond markets in Europe in Q1 as bond yields actually rose in the face of the ECB’s rounds of money printing. The high yield junk bond markets also started to see yields widened, a sign of global market volatility to come.
- Global stock markets ran into some sharp turbulence, ostensibly precipitated by China’s tweaking of its currency peg.
- After years of central bank induced slumber, global financial markets seem to have entered a distinctively new phase.
The fact that the energy sector is going through difficult times in the wake of the oil price slump is pretty much public knowledge by now. The point of this article is not to kick it while it’s down and beat the dead horse that is the fracking industry. Rather, the point is to bring to your attention to a few significant sources of instability over the event horizon which could totally throw over the entire apple cart and then some.
Sustained Low Oil Prices
Let’s start with the basics: continued price weakness. Increasingly evident from a wide array of metrics, the global economic activities are clearly and significantly downshifting, and with it, putting pressure on the demand side. The refusal of the OPEC producers and US shale operators to cut supply in the face of a slack in demand means that in the intermediate term the upside for oil prices are capped.
As pointed out on numerous occasions, shale oil and gas operators failed to make a profit when oil was above $100 per barrel. Despite claims that advancing technology has made the drillers more efficient, which is probably true to some extent, and the fact that the drillers are retreating and concentrating on the sweet spots, it does not take a high school math student to figure out that at around $40 a barrel, this commercial activity is profoundly uneconomic.
The chart below, courtesy of domain expert Art Berman’s latest article, provides a survey of how the major names fared in 2015 compared to last year. On average, the drillers spent $2.2 for every $1 they earned instead of spending ‘only’ $1.2 for each dollar earned last year. Barring a miracle, one in which the Saudis do an about face or there is a surge in demand from the cooling economies of China or emerging Asia, this horrendous sea of red ink is unlikely to improve anytime soon.
Rolling Off the Hedges
Much as you might be alarmed by the deterioration in the revenue-vs-expenses department, the numbers actually would have been much worse if it was not for the mitigating effects of hedges, the insurance which producers bought guaranteeing price floors prior to the price collapse.
The insurance that producers bought before the collapse in oil — much of which guaranteed minimum prices of $90 a barrel or more — is expiring. As they do, investors are left to wonder how these companies will make up the $3.7 billion the hedges earned them in the first quarter after crude sunk below $60 from a peak of $107 in mid-2014.
Payments from hedges accounted for at least 15 percent of first-quarter revenue at 30 of the 62 oil and gas companies in the Bloomberg Intelligence North America Exploration and Production Index. Revenue, already down 37 percent in the last year, will fall further as drillers cash out contracts that paid $90 a barrel even when oil fell below $44.
As the hedges gradually roll off, the drillers would be fully exposed to the full blunt of the price decline.
The term revolver raids, coined during the onset of the previous bubble, namely the housing bubble, refer to the action taken by a bank, which, sensing the deteriorating financial situation of a client, to reduce or remove the secured revolving credit facilities from said company. As Zerohedge explains, a typical scenario would involve a banker calling the CFO and tells him/her “so sorry, but your secured credit availability has been cut by 50%, 75% or worse”. Cutting the credit line from a company when it is in need of cash the most often means the start of a death spiral for the company.
For tight oil companies, the credit facilities typically get reviewed twice a year, in April and October, when lenders re-calculate the value of properties put up by these companies as collateral for the credit lines. Unsurprisingly, the value of the properties is the function of the amount of oil and gas reserves and the prices of these commodities over the preceding 12 months.
While some companies have already seen their credit lines reduced in April, how much additional credit the banks will pull back and from who would be anybody’s guess. The banks are also in a tight position on this one. The regulator has been breathing down their necks to tighten up their risk exposure in the energy sector. If they do not tighten the screw, more credit might get drawn leaving the banks even more exposed. If they tighten too much, it would set off a credit death spiral which would see the already drawn credit go down the tubes as the company bites the dust.
Ability to Raise Additional Capital
In order to plug the cash gap between revenue from hydrocarbon sales and operations, a seemingly permanent cash-flow negative operation since the dawn of the tight oil revolution, drillers regularly tap the stock (secondary offerings) and credit markets (high yield junk bonds) as sources of needed cash infusion.
Sensing the oil price weakness to come, drillers had gone into a frenzy in an attempt to raise enough cash before the window of opportunity closes on them. And raise they did in the first half of 2015 from both the equity and bond markets.
However, with the poor intermediate market outlook for the energy sector and the recent broad based stock market volatility, the money sources from public markets have slowed to a trickle in the second half of this year.
The Approaching Wall of Maturing Debt
The blowout in junk bond yields in recent months especially in the energy sector is making it more difficult to service the bonds. The number of bonds yielding greater than 10% has increased more than fourfold to 80 over the past year, according to data compiled by Bloomberg.
Another problem emerging over the intermediate horizon is the maturing of existing debts which will need to be rolled over.
How much? About $500 billion across the energy sector over the next five years.
Again, Bloomberg provides a numerical perspective:
Debt repayments will increase for the rest of the decade, with $72 billion maturing this year, about $85 billion in 2016 and $129 billion in 2017, according to BMI Research. About $550 billion in bonds and loans are due for repayment over the next five years.
U.S. drillers account for 20 percent of the debt due in 2015, Chinese companies rank second with 12 percent and U.K. producers represent 9 percent.
While the oil majors would be able to roll over their debts with relative ease, the same cannot be said for smaller companies trying to roll over debts yielding north of 10% just as the earning metrics across the entire sector are breaching the lows of the 2008 financial crisis and investors’ appetite for debt instruments from the sector is rapidly souring.
‘Come To Jesus’ Moment
As repeated ad nauseam in this space and elsewhere in the blogosphere, the tight oil and shale gas revolution is the product of ZIRP. If easy money is the enabler of the revolution, then it stands to reason that easy money, or withdrawal thereof, would ultimately be the destructor of said revolution – this leading edge relationship we covered in Tight Oil’s First Domino).
Barring a miraculous turnaround in global world demand which is highly improbable at this juncture, it is increasingly questionable how long the ‘revolution’ narrative can be maintained. As more bankers, pension fund managers, equity investors and bond holders are taking a harder look by the day at the prospect of throwing more good money after bad into the sector, that ‘come to Jesus’ moment, as some analysts put it, is clearly visible in the event horizon when these folks would have to make a hard choice as to how much longer they will let it play.
We leave you by impressing upon you one more time the punch line from our A Nightmare Price Scenario for Tight Oil.
at $60 per barrel, the entire energy HY sector will be pushed into distress with a 30% default rate. This shock wave will not be contained just within the energy sector but will spread across the whole HY market.
It’s for the reason of the 2nd sentence that you should check out why the HY market is a rocket booster filled with liquid oxygen in full throttle with a faulty O-ring seal, as argued in our earlier series: Liquidity: the Next Deadly Buzzword.