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Chuck Ponzi Treks to the Oil Patch: A Dangerous Corporate Debt Bubble

The Wild Ride

On any given day, you can find numerous articles about the hazards posed by our federal debt, municipal debt, consumer debt, and so on. The list is long and plenty scary.

But there is surprisingly little talk about one of the most dangerous situations of all: the trouble in America’s recently booming oil patch.

Most people may not realize that the largest oil producer in the world today is not Saudi Arabia, nor Venezuela, nor Russia. It’s the U.S.  

The extraction of fossil fuels from shale formations, via fracking and horizontal drilling, has sparked a revolution so all-consuming that it’s forged an entirely new reality. About 20 years ago, fracking technology hit a point where it suddenly started to make a lot of economic sense. It “crossed the chasm” as they say in Silicon Valley, going from an expensive developing technology with its roots back in the 1960s to a mature and (frankly) cheap way to extract a familiar resource more easily (much like LED lights, which came out of RCA in 1964, but have only recently become ubiquitous).

Since then, the drilling of fracked wells has proceeded in earnest, exploding over the past decade.

What an amazingly fast, wild ride it’s been. It has:

  • catapulted the U.S. from back in the pack to the top of the list of global oil and natgas producers, with the Dept. of Energy (perhaps through slightly rose-tinted glasses) predicting the country would be a net exporter of both by 2022.
  • transformed obscure rural areas like Williston, North Dakota into rowdy, populous frontier towns.
  • provided high-paying jobs to those willing to relocate to Texas and North Dakota. The latter vaulted from 45th in the nation in per capita income in 2004 to 2nd in 2013; though it’s since pulled back, it’s still 6th as of 2017.

This has not happened without controversy. Objections have been raised about earthquakes, air and water pollution, disturbances to land and animals, and exploding pipelines. Environmental concerns have, if anything, intensified. Though they have not yet disrupted the industry, neither are they going away.

Like information technology saw setbacks in the early 2000s only to continue apace, the fracking boom experienced its own short-lived crash from 2014-16, when a global supply glut drove the price of oil as low as $26/barrel. During this period, according to The Economist, writing in March of 2017: “The number of drilling rigs in America dropped by 68% from peak to trough. Companies slashed investment. Over 100 firms went bankrupt, defaulting on at least $70B of debt.”

Yet today, the boom goes on. And on. Again, in The Economist’s wry words of 18 months ago: “Exploration and production (E&P) companies are about to go on an investment spree. Demand is soaring for the industry’s raw materials: sand, other people’s money, roughnecks and ice-cold beer.”

That’s just what has happened. Written off as dead in 2016, the fracking industry has roared back to life. In a 2018 forecast, the Energy Information Administration predicted that production across the U.S. oil patch is expected to average almost 10.6 million barrels per day this year, and to reach 12.1 million barrels a day by 2023. That’s about two-thirds of U.S. national usage.

The Rub

But no new industry—no matter how productive or essential to American security—can endure while ignoring the basic laws of finance. And that’s where we find the rub.

Very few E&P companies in the fracking space actually make money. It doesn’t matter which of the four major extraction areas they’re located in—the Permian Basin (the biggest, in west Texas); the Bakken (North Dakota); Eagle Ford (southeast Texas); or the Niobara (Colorado/Wyoming). Look at this graphic, courtesy of Bloomberg:

As you can see, that graphic is based on 33 shale-weighted E&P companies. But if you widen the view, and nearly double the number of companies, things don’t look any better. The 60 biggest E&P firms, between mid-2012 and mid-2017, had negative free cash flow of $9 billion per quarter.

Cash flow is what you need to cover operating and capital expenses. Clearly, they aren’t making it.

Even some on Wall St. have taken notice. “The industry has a very bad history of money going into it and never coming out,” says Jim Chanos, legendary short-seller and founder of hedge fund Kynikos Associates.

One of the primary reasons for this is that fracked wells have an extremely rapid decay rate, as opposed to traditional drill sites. All fossil fuel deposits are finite, of course. Typically, a conventionally-drilled well will reach peak production in the first couple of years, then fall sharply. After that, though, its decline tends to level off, and can proceed (i.e., remain economically viable) over a long period of time. At worst, there might be a 10%/year decline. But some U.S. wells have remained in production for over 100 years.

Fracked wells are far more volatile. After the first year, they go into what is known as “hyperbolic decline,” with production losses ranging from 50% to as high as 70%. After three years, they may be off by as much as 85%.

Analyst Nick Cunningham, writing on Oilprice.com, sums up: “A rush of output occurs at first, but almost immediately after the well comes online, the flow rate drops off precipitously. And within just a few months the well is a shadow of its former self. That is typical.”

Because the technology is so new, we have no data on what happens after 10 years, but it seems safe to say that none of today’s fracked wells will still be operating half-a-century down the road, like we find for big mid-century oil discoveries like aforementioned Saudi Arabia, Venezuela, or the greater OPEC regimes.

Moreover, the pace of decline seems to be accelerating, as the industry becomes something of a victim of its own success. Analysts say this only makes sense. Producers, trying to stay ahead of decay rates by opening new wells, are placing them ever closer together. Those in close proximity then reduce pressure in each other, reducing the amount of oil that can be recovered from either.

As Russell Clark, investment manager at Horseman Capital Management, puts it: "New well production is increasingly cannibalizing legacy production." Or, as Alice learned in Wonderland, you must run faster and faster to remain in the same place.

It’s a situation that reeks of the rapid and unexpected turn from euphoria to panic that characterizes the bursting of a bubble.

The hard truth is that the fossil fuel business is highly capital-intensive. It takes boatloads of cash (i.e. debt) to explore, drill, and then if you’re lucky, put your wells into production. The major oil giants stay in business because they go after elephant deposits, ones that will continue to gush profit, year after year, for decades on end. Yes, they have to find replacements as their resources are drawn down, but it’s a long-term venture.

E&P fracking is a short-term game. Thus companies in the space have to come up with a different strategy. However, the evidence suggests that while they are desperately trying to generate positive cash flow, they are actually falling further and further into a financial black hole.

They lose money one year, and then more the next. How can this be?

The Fed Helps Out

The needed capital does not derive from cash flow. So where is it coming from? Or, to put it baldly: who’s propping them up?

Here’s a shocker. The answer is: Wall St, with a little help from Washington, DC.

Let’s return to those 60 leading E&P firms we referenced earlier. According to Reagan’s former OMB Director, David Stockman, “From 2012 through 2017, these 60 E&Ps burned [through] $212 billion in the shale patch. Half of that came from the liquidation of balance sheet capacity through borrowing and asset sales. The other half was through new equity issue. Yes, the ‘shale revolution’ put the U.S. on a path toward ‘energy independence.’ All it took was the massive falsification of asset prices on Wall Street.”

That’s quite a charge, Mr. Stockman. But it’s spot on. In fact, it may turn out to be a bit of an understatement.

First, Washington: As we all know, the Federal Reserve responded to the financial crisis by dropping interest rates to around zero. The idea was to stimulate the economy by encouraging borrowing. Which many did, especially in the burgeoning frack patch.

Writes Bethany McLean, in the New York Times: “Amir Azar, a fellow at the Columbia University Center on Global Energy Policy, calculated that the industry’s net debt in 2015 was $200 billion, a 300 percent increase from 2005. But interest expense increased at half the rate debt did because interest rates kept falling. Dr. Azar recently called the post-2008 era of super-low interest rates the ‘real catalyst of the shale revolution’.”

The italics are ours. They explain why the oil glut that drove prices below $30/barrel by the end of ’15 didn’t kill the U.S. shale business. The glut was orchestrated by Russia and Saudi Arabia with that specific intent. And they almost succeeded. But not quite. Although the more marginal companies were unable to stay afloat as the market price fell below the cost of production—something state-owned producers like the Saudis don’t have to worry about, as we know—others retrenched and just kept borrowing from that well of nearly-free money.

Ok, you will remember that we mentioned Charles Ponzi at the outset. It was for a reason, and here’s where he makes his appearance.

What’s happening in the oil patch is not precisely a Ponzi scheme, i.e. one in which new investors are lured in by promises of outsized returns and then their money is used to pay off earlier investors. But when you are consistently paying off earlier debt by taking on new debt, and not because your cash flow is increasing, that’s close enough.

And pretty soon we run smack into what Bloomberg calls the Debt Wall.

Under this projection, the bond debt rockets from $110 billion this year to $260B in 2022.

Granted, this debt is spread across all energy companies, but which ones do you think comprise the great majority of those below investment grade? You guessed it.

But remember, shale oil and gas producers are using most of their free cash flow to drill more wells, to try to produce more oil and keep the scheme running.  Little or none of their profits or free cash flow are going to pay down debt. Worse yet, rising interest rates make borrowing both more difficult and more costly.

The writing is on that debt wall. At some point -- maybe in 2022 when Bloomberg projects, maybe much sooner, they’ll be overwhelmed by their debt load, unable to borrow more, and there simply won’t be any funds to continue drilling.

Which is when the whole thing comes crashing down.

Wall St. Chips In

But as we said earlier, Washington’s easy money policy is not the only donkey to pin the blame-tail on. There’s also Wall Street.

What do you do when your company is hemorrhaging money?

First… You borrow, as we have seen. And Wall St. has done what it’s designed to do: made that process easier. They’ve facilitated that borrowing by structuring novel high-yield investment vehicles for the E&Ps. That works well in a low-interest-rate environment when demand for above-market returns is insatiable. It works less well as interest rates rise, and investors demand either greater safety or even higher yield. Or when those debts start to turn sour faster than projected, eating into promised returns, like we saw with the last batch of novel debt securities: the mortgage-backed kind.

Alternatively…you issue additional equity. As Mr. Stockman notes, half of the operating expenses of these E&Ps is raised through new equity issues. Investors continue to line up, allowing themselves to believe that oil companies are good long-term holdings. Or that shale drillers are a new and exciting play for quick profits. Or that there will always be a greater fool. Whatever their reasoning, people continue upping their bets on companies that don’t make money and very possibly never will.

So is it a straight-up con, with shareholders playing hot potato? We don’t know. We also don’t know if Wall St. is actively pushing junk E&Ps as vigorously as it did the junk CDOs sold to naïve buyers in the run-up to the financial crisis. What we do know is that the big banks don’t care about investment quality. Why should they? They get their cut every time they float an IPO or a new stock offering; every time they raise capital in other ways, as with private placements; every time they execute a trade. But they have no real skin in the game.

What Comes Next

We can’t say when a bust is coming or even, with any measure of certainty, if it is. The Debt Wall projection is ominous, but charts are just a one-dimensional reflection of the real world. And the future is not entirely bleak. Something might still save the day.

For example, oil prices might rise so high that many more wells start becoming economical. But given the extreme recent volatility in crude (having recently hit a year-low and trading around $51/barrel as of this writing), that can't be the staple of your go-forward business plan, especially given the breakeven prices of new wells.

It's never so simple. For example, many operators entered into derivatives contracts in 2017 that ensured they could sell some of their 2018 output for $50-55/barrel, well above then depressed prices. Any rally above that level left them partially or entirely out of the market, missing out on rare profits. Ironically, belief that high oil prices were here to stay is what sparked the shale boom. And it might be the belief that low oil prices were destined to last a long time which put the nails in the coffin of this tumultuous market.

Only time will tell where the oil price goes -- again bearing in mind the mid-2018 rally has already fizzled with prices dropping from the 70s to the 50s in a matter of weeks -- and whether it justifies the debt accumulated… or if prices dip and we hit the Debt Wall.

Even if higher prices fail to save the industry, perhaps the multinational oil companies might step in, buying up properties and running them more efficiently.

Either is theoretically possible, but the former would be a little self-defeating, as higher prices mean reduced demand (and increased supply competition as more companies once again chase those prices). As for the latter, well, the majors didn’t get to be majors by buying up money losers at inflated valuations.

A much more likely possibility is that the technology will continue to improve, substantially reducing costs and allowing actual money to be made—especially in the Permian Basin. Some analysts estimate that, by itself, the Permian could hold as much as 75 billion barrels of oil. That’d make it the domestic equivalent of Saudi Arabia’s legendary Ghawar field, and if it can be profitably plumbed, we can keep the lights on for a good long while.

So we’re pretty sure the oil is there; it’s just a question of drillers getting it out without going bankrupt. We can be hopeful. Modern technological developments have tended to deliver the goods, continually providing improved hardware at lower costs. Another leap forward in tech would go a long way toward mitigation of these difficulties.

Even right now, the best-run companies in the Permian are making some money. Whether they are doing well enough to sustain the industry long term remains uncertain. And they are still a small percentage of the whole, as their less-well-run competitors sink ever further into the red. Let’s call the eventual outcome a tossup.

Worst case, though: If the industry does crash, then what happens?

It isn’t pretty.

This is not just another Enron, where the damage was limited to a wipeout for investors. Here, it’s America’s “energy independence”—touted by politicians with such bravado—that is on the line. In just 10 years, we have come to heavily rely on fracked petroleum. We need it, as demand ramps up in rapidly-developing countries like China, India and others that have little domestic supply.

As more of the world modernizes, global supplies can only become increasingly stretched, and so it becomes a matter of national security. If the situation in the frack patch becomes sufficiently dire, you can expect that the government will step in, probably with some sort of subsidy program. And if that fails to work, would Washington utter the dread word, nationalization? That seems remote, but not completely out of the realm of possibility.

But, one thing is certain: corporate debt has become a dumping ground for excess capital over the last decade of low interest rates. Shale/fracking has racked up over $100 billion worth of the demand for high-yield debt all by its lonesome. And it shows some serious signs of weakening, especially if prices don’t hold or interest rates continue to rise—or both.

It’s no longer an untapped source of yield. It’s moderately less attractive with each rate hike. And it’s certainly not a safe haven. Another serious market crash could send investors fleeing from this debt, and many other dubious sectors of “junk” bonds. Which spells good things for the few cheap assets still left in the markets today, of which gold is one of the cheapest.

 

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