The dramatic rise and fall of shale oil
On the morning of March 2, 2016, a large SUV smashed against the side of a bridge overpass in Oklahoma City. The driver was Aubrey McClendon, 56, one of the most aggressive CEOs in America and the founder of Chesapeake Energy. He helped trigger the shale oil boom, single-handedly transforming the global oil and gas (O&G) industry and making America the world’s top oil producer.
The US now produces 13.6 million barrels a day, ahead of Saudi Arabia’s 12 million barrels and Russia’s nine million barrels. The country’s once massive petroleum deficit — US$436 billion in 2008 — is now a surplus.
Although McClendon was driving very fast, he was not intoxicated, and indeed there were no brake marks on the road, leaving the police puzzled over whether it was an accident or suicide. Just a day earlier, the shale pioneer had been indicted by the US federal court for allegedly orchestrating a conspiracy to rig the price of oil and natural gas leases in Oklahoma.
McClendon was a larger-than-life former billionaire who had lived through several boom-and-bust cycles in the oil business. At its peak, Chesapeake had a market capitalisation of US$35 billion and McClendon was the US’ most highly paid CEO, taking home US$100 million a year and boasting the world’s largest wine collection and biggest known collection of antique maps.
Four years after his tragic death, the loss-making US shale industry is in turmoil, oil prices are in free fall, a huge debt crisis is looming as US stocks are in bear market territory for the first time since the 2009 financial crisis, and the world is grappling with the coronavirus pandemic, which threatens to trigger a global slump.
Last week, as a battle raged between Saudi Arabia and Russia over production volumes after the Saudis cut prices and boosted production, oil prices plummeted. At one point earlier in the week, the benchmark WTI crude plummeted to around US$28 a barrel from a high of US$68 early last year. On the face of it, the oil war of 2020 looks like a childish power feud between Crown Prince Mohammad bin Salman (MBS) and Russian strongman Vladimir Putin. Yet the real target of both men is the US’ shale business, which has left the Saudis and Russians as smaller players in a global industry that faces structural issues like the rise of electric cars and increasing concerns about the impact of fossil fuels on climate change. If Putin and his frenemy MBS can bankrupt the US shale sector, it will substantially boost oil prices, and the money the Saudis lost in SoftBank’s Vision Fund as well as its investments in dodgy start-ups like co-working outfit WeWork would look like chump change.
Rising to prominence
What is shale and how did it become so big? In the aftermath of the global financial crisis, as the cost of capital plunged and financiers looked around for new businesses to fund, they stumbled upon shale, hydraulic fracturing or fracking, a new technology to extract gas from shale rocks, or parts of earth that had never been drilled before. Money poured into Montana and North Dakota’s Bakken formation, South Texas’ Eagle Ford, West Texas’ Permian Basin and West-Central Oklahoma’s Anadarko-Woodford. As time went on, drillers were able to extract oil from the same rocks, triggering a shale oil boom.
US oil production burgeoned nearly tenfold in 10 years, catapulting it to top place ahead of Saudi Arabia, and earning the moniker, Saudi-America. The shale revolution has had profound effects on the US, creating jobs and cutting energy costs. Nearly 6.5 million people are employed by the US’ O&G industry, mostly in the shale sector. Add to this the oil services business and ancillary industries and nearly 20 million jobs depend on the O&G sector.
The US Geological Survey estimates that up to six trillion barrels of crude can now be extracted from shale formations in the country. Little wonder then that Wall Street investment bankers and cash-flush private equity firms have poured over US$430 billion (RM1.8 billion) into shale companies, hoping to benefit from the rising global demand for oil. The shale business model was simple: Anyone could just buy wheat fields or barren land and drill for oil in the resource-rich regions of Texas, Montana or North Dakota. If you had land and were a willing driller, there was no shortage of banks or investors willing to lend you as much as it took to get oil out of the ground. The mantra was “drill, baby, drill” and, more often than not, if you just kept drilling, you were bound to eventually strike black gold.
As shale oil came on stream, oil prices plunged from US$110 a barrel to under US$90 a barrel. Russia and Saudi Arabia did not like the declining prices, so they flooded the world with oil to drive over-leveraged, small US shale producers out of business. But instead of folding, shale firms just went back to Wall Street, which issued new bonds at low interest rates. Investment banks were able to sell those bonds to high-net-worth individuals or insurance companies hungry for yields. Because shale firms kept getting funded despite the fact that they did not have the ability to pay back their loans, oil prices kept going down until early 2016 when they plunged to US$26 a barrel, or less than a quarter of where they were just three years earlier. The Arabs and Russians had underestimated the resilience of the shale firms and the ability of Wall Street or private equity firms to keep throwing good money after bad.
To be sure, the shale industry had taken a page from Silicon Valley tech start-ups. While they sucked in a lot of cheap capital, they also promised a huge payday to their investors down the road. And shale also had a sexy story to tell. Unlike the old offshore drillers and onshore oil well owners that relied on decades-old technology, shale was constantly improving efficiencies, deploying new technology to bring costs down. The well-worn narrative of old oil, represented by Arabs and Russians, just could not compete with that story.
Debts keep mounting
Here is the dirty secret about shale. Although you can get a lot of oil from a horizontally drilled shale well in the first year of operation compared with a vertically drilled conventional one, production in the shale well starts to decline pretty rapidly in subsequent years. Many wells only produce less than half of the oil in the second year as they did in the first year of operation. Some actually produce just 30% as much oil in the second year. That means shale producers need to drill more wells every year just to match the previous year’s output. That requires more cash, which means they need to go back to their private equity investors for equity or debt, Wall Street banks for new bond issuances or commercial banks for new lines of credit.
The good news is that over the years, the shale firms have operationally become very efficient. They have also been able to squeeze costs down to the barest minimum. Yet, cost savings and dramatic improvements in efficiencies have not made them the lowest-cost producers even as the cost-per-barrel of production on average has declined from US$70 some years ago to between US$40 and US$50 a barrel now. The cost of conventional oil varies — Saudi Arabia can produce at under US$10 per barrel in some of its fields while elsewhere, costs range from US$20 to US$40 a barrel. There are only a handful of US shale firms with production costs of below US$33 a barrel. Even those shale firms do not make money because US$33 a barrel is just the cost of extraction and does not include financing costs.
Having raised US$430 billion over the past decade, shale firms have yet to produce anything in terms of profit. And the debts keep mounting. As interest rates fall, shale companies borrow more to retire earlier high-yield debt, which helps them raise more money to pay for additional capital expenditure for new wells. Ratings agency Moody’s Investors Service says US O&G companies have more than US$40 billion of debt maturing in 2020 and US$200 billion maturing over the next four years. Late last year, with oil hovering around US$50 a barrel, over 60% of shale debt was rated junk. The shale industry has yet to prove that it can produce enough free cash flow to fund itself without resorting to more capital-raising. Shale companies have yet to show that they can outrun the required reinvestment. They seem to need so much money that, in effect, they are running like Ponzi schemes since they always need more capital from outside just to keep going.
McClendon’s Chesapeake, still a shale player, has seen its stock dive 99% from its peak and now has a market cap of just US$297 million. Billionaire Harold Hamm’s Continental Resources, another big shale player, has seen its stock decline 89% from its peak. Most listed shale plays are down 80% to 90% from their recent highs.
So, what’s next for shale? Banks that helped fuel the fracking boom have begun to tighten requirements on revolving lines of credit and are beginning to question the industry’s fundamentals. They are also insisting that companies stop new drilling as well as their relentless pursuit of growth and start focusing on cash flow and profits. That is easier said than done because every year, shale wells are diminishing in resources and frackers need to drill more just to remain in business. Whether oil prices stay at current levels, retest the US$26-a-barrel lows they touched in 2016 or soar to US$100 a barrel, the shale industry has peaked. Even as US interest rates slide to near zero in the coming weeks and months, bankers, private equity players and hedge fund managers that propped up shale for over a decade are no longer willing to keep throwing money at them. Expect more bankruptcies and consolidation in the months ahead.
Source: The Edge Market