The so-called “shale revolution” in the U.S. may be powered by innovation but it feasts on the financial equivalent of junk food, according to a recent report that questions boom’s the long-term sustainability.
Although share prices for most U.S. exploration and production (E&P) companies are at all-time highs, the elephant in the room is an industry financed by the high-yield debt market, better known as “junk bonds.” The S&P says that 75 of the 97 energy E&P companies it rates are below investment grade.
“The less talked about but highly critical questions are related to the economic model, the viability promised to investors that companies will extract large volumes of resources and the sustainability of these new plays that have been de-risked and are in the development/growth stage,” writes Ivan Sandrea, in the Oxford Institute for Energy Studies report “US Shale Gas and Tight Oil: industry performance, challenges and opportunities.”
The E&P sector as a whole has proven it can capitalize on opportunities, innovate, address environmental issues and navigate the rough-edge of public opinion.
“What is not clear from higher-level company data is: if the industry (both large players and independents) can run a cash flow positive business in both top-quality and in more marginal plays and whether the positive cash flow could be maintained when the industry scales up its operations,” Sandrea writes.
A year ago Royal Dutch Shell rocked the industry by announcing it was taking a $2.1 billion write-down on its U.S. shale oil investments, showing that results from drilling on its shale properties wasn’t hitting production targets. “Shale oil bulls take note,” wrote analyst Oswald Clint of Bernstein Research.
The report says since the shale boom began a total of $35 billion has been declared in write-downs by just 15 of the industry’s largest players. If the write-downs from all companies, both U.S. and non-U.S., are counted the figure “increases significantly,” the report notes.
“While most of the companies that have made write-downs are not quitting, many players in this industry have already noted that the revolution is not as technically and financially attractive as they expected,” writes the Sandrea. “However, to deem the model flawed due to the investment write-downs of some large companies would be misleading and tool early in the evolution of the business for some players.”
Piling on the Debt
The report cites a recent analysis by Energy Aspects, a commodity research consultancy, of 35 independent companies that shows a steadily worsening financial picture across the last six years. The analysis showed the companies spent as much as they brought in and “net cash flow is becoming negative while debt keeps rising.”
To meet their capex requirements “the companies have had to take on increasing levels of debt, and this is where we highlight the key risk to the business,” says the Energy Aspects report.
Sandrea writes, “The funding machine is undergoing rapid changes.” He says the funding is led by laundry list of sources that include: junk bonds, private equity and the sale of non-core assets. He estimates that for a “large group of companies” involved in shale oil and gas production some 60 percent of their total cash needs come from non-operational cash flow.
For all the gloom and doom in the report, Sandrea sees some bright spots. He says from an “industrial point of view” these trends aren’t necessarily problematic, “assuming that there will be a positive inflection point for cash flow and a full cycle risk-adjusted return,” which he says major players in the industry see coming in five years time.
Until then, it’s a matter of just holding on. “But who can, or will want to, fund the drilling of millions of acres and hundreds of thousands of wells at an ongoing rate?” Sandrea writes. “After all, the benevolence of the U.S. capital markets cannot last forever for all players, especially the marginal players, regardless of how deep and specialized the U.S. market is.”
More likely, the way things shake out will be that parts of the industry will have to restructure and focus on the “most commercially” sustainable shale plays, which Sandrea says are probably 40 percent of the current acreage and resource estimates, “possibly yielding a lower production growth in the U.S. than currently expected, but perhaps a more lasting one.”
Brock N Meeks is editor-in-chief of Ideas Lab.