A couple of recent articles in the New York Times attracted my attention, particularly given the base business of my former employer, Occidental Petroleum. “Oil Patch Deals With New Threat: Rising Debt” appeared February 10. “This Time Cheaper Oil Does Little For US Economy” appeared January 21.
Given numerous advances, non-traditional oil recovery methods, including hydraulic fracturing, became more economically attractive in recent years, and with oil prices around $100/barrel, they were quite profitable. While individual company, country and technology costs differ, it still takes an investment of millions of dollars to drill a well, and all-in costs are in the $30-$60/bbl range. If you’re selling for $100/bbl, that looks like a good bet. Consequently, that price drew lots of production, with companies large and small investing and drilling.
So, where did the investment money come from? Most of it was borrowed—from traditional sources like banks and non-traditional sources like hedge funds. The amounts are kind of staggering. Yahoo Finance reported that the total secured and unsecured debt of oil producers—not including Exxon and Chevron—was more than $200 billion.
As Warren Buffett once said, “Only when the tide goes out do you discover who's been swimming naked.” And when oil is sub-$30/bbl, the tide is certainly out. Smaller companies in this business became highly leveraged in order to take advantage of the boom. At a point where they will be losing money, their liquidity and ability to service loans is highly compromised and they go bankrupt, sticking lenders with a loss. You may have heard of something like this before.
Now, while there has been a lot of cost-cutting, it is highly unlikely that shale oil--unconventional oil produced after hydraulically fracturing oil-bearing shale formations--can be recovered and profitable at current prices. Oilprice.com reports that 42 exploration and production companies filed for bankruptcy in 2015; the Times quotes an industry analyst as saying that 150 companies are at risk. Companies as big as Chesapeake are looking to restructure billions of dollars in debt. For those who have cash, there are assets to be had, and there have been at least some sales. In the Times article from February 10, there is a discussion of one company essentially selling itself off to pay its debt.
How did this happen in a world where not too long ago people were predicting $200/bbl oil? Two words: Supply and Demand. Perhaps the biggest new supply in the game is US shale oil. US production in 2015 had grown nearly 50% since 2008, and more is coming. At the same time, global demand has been pretty flat, and inventories have been increasing. It was just a matter of time before the price responded in the second half of 2014.
The reason things have become so dire in the just the past six months has to do with the way commodities are hedged. Let’s say you’re an airline company and fuel is a huge part of your costs. Now, let’s say you value stability and price increases ruin your earnings story for Wall Street. You might take out a contract to buy oil for the next year at the current price. Both you and the supplier both get stability.
Now, if—as has been the case for the last 18 months or so—prices fall abruptly and you’re the airline, your quest for stability netted you higher prices than you would have enjoyed on the spot market. You bet wrong.
But if you are the oil company, the supplier, you get a reprieve from the price decline. Oil company profitability stayed reasonable until the fall of last year when one-year hedges at the last of the high prices expired and companies were forced to sell at market price. Or, said another way, when the tide went out.
The reason you care about this? Look back at the article about why cheaper oil hasn’t helped the economy. In the past, lower oil prices looked like a tax cut to consumers because all of a sudden we weren’t paying so much to foreign countries who supplied us 60% of our needs. But now, when we import only 27% of our needs, that tax cut for one sector inflicts huge pain on another sector and the whole thing literally nets to about zero. Oil and oil related stock prices go down. Capital expenditures in the oil business and everyone who supplies them have all but dried up. Boom towns in North Dakota became much quieter overnight, and nearly 100,000 jobs have been lost.
While this situation won’t change in the very short term, it is true that non-traditional production acts like swing production. It can be turned on when prices are high, and yet, it is still relatively easy to shut down when prices are low. But the traditional production world plays an enormous game of chicken: no one wants to unilaterally disarm, which is why the Saudis have been adamant about maintaining production. Many oil producing countries need an oil price near$100/bbl to fund the social initiatives they have put into place. And it will probably take a demand increase to snug prices back up to something higher than the current rock bottom.
…Which is why the oil business is rooting for the Chinese economy.
William F. Carroll, Jr. holds a Ph.D. in Organic Chemistry from Indiana University, Bloomington, IN. He received an M.S. from Tulane University in New Orleans, and a B.A. in chemistry and physics from DePauw University in Greencastle, IN. He holds two patents, and has over sixty-five publications in the fields of organic electrochemistry, polymer chemistry, combustion chemistry, incineration and plastics recycling.