A Shakeout Begins for U.S. Shale-Oil Producers

When we published a report nine months ago urging New York State pension funds to divest from increasingly risky coal stocks, we wondered if there might be a similar case to be made broadly for investors in shale-oil companies.

It turns out there is.

Mark Lewis, a senior analyst at Kepler Cheuvreux, the investment-advisory firm that has 10 offices in Europe and three in the U.S., summed it up well in a research note last week.

Lewis’ main point was, and is, that the capital-expenditure demands of shale-oil extraction are simply too demanding to sustain. One of the core features of fracking is that it requires constant recharging. Shale-fracture wells tap out quickly, and producers must be constantly in motion, drilling new holes, creating new fractures, in constant capital-intensive motion.

This challenge is only exacerbated by the falling price of oil, which continues to plunge. The price of West Texas intermediate crude was down another 4 percent in early afternoon trading today, to $46, less than half of what is was selling for as recently as last summer.

Lewis puts it like this: “The problem is that the U.S. shale sector in aggregate is still not free cash-flow positive even after five years of soaring production, and if the shale model was not able to show positive free cash-flow even when prices had been averaging around $100/bbl from 2011 until the middle of last year, then clearly investors and lenders will be very nervous about increasing their exposure to the sector in the current price environment.”

Indeed, investors “will more likely be looking to reduce their exposure, which explains both why yields on the debt of independent U.S. energy companies (much of it sub-investment grade or ‘junk’) have been rising sharply as prices have fallen in recent months, and why the share prices of independent US energy companies have been tanking.”

U.S. shale-oil producers, Lewis notes, are at risk of not being able even to refinance debt when it comes due and will be hard-hit as well by liquidity problems.

Its seems highly unlikely that oil prices are going to rebound anytime soon—if they rebound at all—as Saudi Arabia continues to signal that it can and will keep prices low for as long as it takes to drive rivals out of business.

What Kepler Chevreux’s note concludes—and what’s beginning to happen already—is that an industry shakeout, in the form of bankruptcies and other changes, is likely as U.S. oil-shale producers realize they don’t have the revenue to keep their capital-intensive businesses going.

Tom Sanzillo is IEEFA’s director of finance.