Abstract:
· Starting in 2010, shale oil production intensified, thanks in particular to massive capital inflows into this sector, which was then considered the solution to the energy independence so coveted by the United States.
· However, between the peak in oil prices in June 2014 and the trough in January 2016, the profitability of shale oil was seriously called into question.
· Fears about the profitability of companies in the sector began to emerge among their creditors, then spread to the financial markets. Bankruptcies began in 2015.
· The companies that are surviving the current price correction in the shale sector are those considered to be the most financially sound.
· With the recent rise in oil prices, the purge resulting from the bursting of this bubble would appear to be a saving grace.
The rapid development of the shale industry in the United States has led many players to invest in this promising sector. Supported by a favorable economic environment—strong demand for hydrocarbons and high prices—production has intensified particularly in recent years. Furthermore, this phenomenon was (irrationally) supported by excess global liquidity resulting from ultra-accommodative monetary policies and, consequently, an exacerbated search for yield by investors. These two effects combined enabled companies to take on massive debt, particularly with a view to financing new drilling.
The recent fall in oil prices has sparked a wave of concern among creditors and financial markets about the profitability of players in this young industry. As a result, the amount of loans granted to these companies has been reduced, forcing them to clean up their balance sheets. Nevertheless, a wave of defaults is already underway and banks are increasing their provisions for non-performing loans. So much so that some observers are now drawing parallels between the bursting of the shale bubble and that of the subprime mortgage crisis. Against this backdrop of consolidation, we analyze the outlook for the shale sector in the United States.
The shale sector in the United States: a few reminders
1) Characteristics of shale exploitation
The shale sector in the United States is divided into two main types of production: shale gas[1] and shale oil[2]. Large-scale exploitation of shale gas and oil began in the mid-2000s against a backdrop of stagnant supply and strong growth in demand for hydrocarbons—particularly from China—and therefore relatively high prices. The extraction techniques are the same for both gas and oil, i.e., hydraulic fracturing.
After a phase of geological exploration and estimation of the volume of hydrocarbons contained in the source rock, a vertical well is drilled to a depth of up to 3 kilometers, then drilling continues horizontally and can also reach up to 3 kilometers in length. The drilling equipment is then dismantled and steel pipes are installed to bring the gas and/or oil to the surface using pressure differentials. This technique is therefore particularly costly given its sophistication, and production volumes remain relatively low compared to conventional production. In addition, production volumes vary greatly from one field to another.
With regard to shale oil (see report on global shale gas and oil resources), the International Energy Agency ( IEA ) estimated in 2013 that the United States had 48 to 58 billion barrels of shale oil, including 15 in the Monterey Santos formation in California, 4 billion in the Bakken formation in North Dakota, and 3 billion in the Eagle Ford formation in Texas.[3]
2) Global shale consumption and production
However, these volumes are small compared to estimates of global conventional onshore and offshore oil resources. According to the EIA, oil consumption, all types combined, will continue to increase from 90 million barrels per day (Mbbl/d) in 2013 to 104 Mbbl/d in 2040. This is despite the gradual slowdown in growth, mainly due to China, which is still expected to overtake the United States as the world’s largest consumer by around 2030. Unfortunately, shale oil will not be able to meet these needs because its extraction requires the drilling of numerous wells, whose yield declines very rapidly.
On the production side, the United States is by far the leading producer of shale oil, with nearly 4 million barrels per day according to BP. It is set to become the world’s leading producer of hydrocarbons (oil and liquefied natural gas) between 2020 and 2025 with 12.5 Mbbl/d (more than half of which is shale oil, again according to BP), ahead of Russia (11 Mbbl/d) and Saudi Arabia (10.8 Mbbl/d). Finally, in the longer term, the kerogen-rich oil sands of Canada, Brazil, Mexico, and Kazakhstan could take over from the United States. However, OPEC countries, particularly those in the Middle East, are expected to maintain a significant global market share as their resources remain enormous.
The shale sector in the United States: the rush for black gold
Ten years ago, the United States began extracting and marketing shale oil on a large scale, mainly in the pioneering states of North Dakota and Montana. The subprime crisis hit in 2007, calling into question the promising future of the shale sector as low oil prices greatly undermined its profitability. It was not until 2010 that production intensified, thanks in particular to massive capital inflows into this sector, which was then considered the solution to the energy independence so coveted by the United States—the world’s largest oil consumer with more than 19 million barrels per day in 2014, according to the US Energy Information Administration (EIA). It was against a backdrop of global excess liquidity – fueled in particular by the ultra-accommodative and unconventional monetary policies of the central banks of developed countries, led by the Federal Reserve – and therefore increased yield seeking on the part of US investors that the shale sector developed rapidly.
However, between the peak reached by oil prices[4] in June 2014 (USD 115.5 per barrel) and the low reached in January 2016 (USD 27.8 per barrel), the profitability of shale oil was seriously called into question. During this period of drastic decline in oil prices (more than 75%), the majority of players in the shale sector saw their financing conditions deteriorate very rapidly, and a wave of bankruptcies ensued. As payment defaults multiplied, the issue of systemic risk quickly took center stage. Between the securitization of corporate bonds—many of which are listed on high-yield markets—and the increased exposure of certain players in the US banking sector, fears of a new cataclysm reminiscent of the subprime crisis resurfaced.
Since January 2016, the situation has improved in terms of oil prices alone. As Olivier Rech, energy analyst at Beyond Ratings, points out, excess supply has decreased, particularly due to economic factors (huge fires in Fort McMurray, Canada, and a strike at the Nigerian National Petroleum Company).
Oil prices (USD per barrel) and natural gas prices (USD per MMBtu)
Source: BSI Economics
Oil prices have risen by nearly 80% and are now approaching the psychological threshold of USD 50 per barrel, heralded as the « magic number » that could save the oil industry (see Bloomberg). According to sources, this threshold also represents a minimum break-even point for many players in the shale oil sector. Beyond this break-even point, these players would once again become profitable. In addition, the learning curve observed in this type of industry suggests that shale oil extraction costs should continue to fall in the coming years. The question is therefore whether the current purge will save this industry. We provide some answers in this article.
Is the bubble in the US shale sector deflating or bursting?
1) Reversal of fortune in the shale sector
The rapid decline in oil prices since 2014 has raised questions about the profitability of companies in this sector. These concerns first emerged among creditors, before spreading to the markets. And with good reason: according to the Bank for International Settlements, the amount of loans granted to oil and gas companies has almost tripled in recent years, rising from USD 1.1 trillion to USD 3 trillion between 2006 and 2014 , an annual increase of nearly 13%. This massive debt has enabled them to undertake colossal investments.
Total return rate of the Merrill Lynch US High Yield Index vs. Energy sub-index
(100 = August 31, 1986)
Sources: Federal Reserve Bank of St. Louis, BSI Economics
As highlighted in a recent Fed report, a significant portion of these companies’ spending has been devoted to improving their production facilities, both qualitatively (through productivity) and quantitatively (through drilling ). However, the return on investment was quickly called into question with the rapid decline in oil prices. Loan amounts granted by creditors to players in the sector are generally renegotiated twice a year. According to Reuters, the latest rounds of negotiations have led to a reduction of nearly one-third in the amounts granted by investors. Combined with a deteriorating economic climate, this negative signal quickly spread to the markets. While the S&P 500 Energy Index reached its lowest level in five years in January 2016, bond spreads widened rapidly and CDS spreads in the sector soared, as illustrated by the S&P/ISDA CDS US Energy Select 10 Index.
Average purchase cost of a 5-year CDS based on a basket of representative companies
Sources: S&P Dow Jones Indices LLC, BSI Economics
2) Defaults and contagion risk
As a result of this tense climate, the trend in the shale industry is clearly toward budget cuts: job cuts, asset sales, reduced capital expenditure, fewer drilling operations, etc. The priority has been to preserve cash flows. Despite these efforts, some companies have seen their ratings downgraded and have swelled the share of US high-yield securities: their proportion has doubled since 2008 and now represents more than 15%. Other companies, industry giants such as Energy XXI, Peabody Energy, and Samson Resources Corp, have gone bankrupt. And these are not isolated cases. As Bloombergreported last March, 48 North American companies in the oil and gas sector have defaulted since the beginning of 2015, representing a total debt of USD 17.3 billion. What’s more, this trend is continuing, with Sanridge and Breitburn Energy being the latest companies to file for bankruptcy. However, the companies that are surviving the current correction are those considered to be the most financially sound, those that have managed to make their massive investments profitable.
Defaults are accumulating. The question now is to assess the sustainability of this phenomenon and its consequences. While the increase in bankruptcies among shale oil companies is already a bad sign in itself, some funds and banks that have invested heavily in this sector (such as Third Avenue in the United States and Bank of Nova Scotia in Canada) are also in difficulty.
The value of assets in portfolios is deteriorating rapidly, leading to massive withdrawals by investors. As a result, large banks are increasing their provisions allocated to this sector in order to protect themselves against a rise in defaults. In a recent report, Goldman Sachs argues that these provisions have increased by 4% on average. Smaller institutions, such as regional banks in oil-producing states, for example, are potentially more vulnerable due to their increased exposure. Furthermore, the big unknown in the equation remains the volume of securitization of these loans. Some observers, portfolio managers, and market analysts argue that the amount of loans granted to companies in the shale sector is 25% higher than that of subprime loans. Furthermore, Fitch forecastsa default rate of 30% to 35% in the high-yield exploration and production sector for 2016 alone.
Conclusion
After falling below the psychological threshold of $30 per barrel in early 2016, oil prices are rising again towards another psychological threshold: $50 per barrel. The cascade of defaults in the US shale sector should therefore be seen as a purge of players. This market shakeout is simply the fallout from an industry that has been artificially propped up by the unique economic and financial climate of recent years—excess global liquidity resulting from ultra-accommodative monetary policies.
Ultimately, the current turmoil facing producers should lead to relative stabilization of the shale market in North America. The purge resulting from the bursting of this bubble is therefore beneficial. With a bullish outlook for oil prices, the shale sector once again has a bright future ahead of it. If this is not the case, it would not be surprising to see further bankruptcies…
[1]These are fossil fuels contained in porous, low-permeability geological formations, often shale or sandstone. Geologists generally refer to these as « source rock » rather than shale.
[2]Shale oil is lighter than conventional oil and therefore easier to refine.
[3]By way of comparison, Russia is estimated to have 75 billion barrels of shale oil in its subsoil, while China is estimated to have 32 billion barrels, according to the EIA.
[4]We are referring here to Brent crude oil, which is the most traded type of oil worldwide.
