A swift drop in oil demand from China and the oil price war between Saudi Arabia and Russia have led to a global crude surplus. The oil industry in the United States faces tough times ahead as the coronavirus pandemic continues to inject uncertainty into oil markets, and shale producers especially are expected to feel the pain.
In March, West Texas Intermediate oil prices plunged from $60 per barrel to below $30 per barrel, the lowest the market has seen since the early 2000s. With uncertainty around the outcome of supply cut negotiations and the duration of restrictions in place on the public to prevent the spread of COVID-19, the outlook for the recovery of oil prices remains unclear.
Several factors pose challenges specifically for producers of U.S. shale, which has for years been a leader in the march toward energy independence for the country. From the dawn of shale oil production in 2011, there has been a 133% climb in U.S. production, with a significant portion of the increase driven by a technique that combines horizontal drilling with hydraulic fracturing – also known as fracking – to allow the extraction of previously inaccessible shale resources. In September of 2019, the United States exported 89,000 barrels per day more than it imported, making the country a net exporter of petroleum products for the first time since government records began in 1949. In the fourth quarter of 2019, the country reached an all-time high production rate of 12.8 million barrels per day.
But the tide has since turned as the coronavirus pandemic has turned the global economy on its head. Nearly 40% of U.S. drillers may be wiped out if the oil rout persists, according to a report released Tuesday by the Federal Reserve Bank of Kansas City.
Firms asked by the Fed about solvency expectations “anticipated on average that 61% of firms would remain solvent in the next year if the WTI price of oil were to stay at $30 per barrel,” the report found, “and 64% of firms would remain solvent if the WTI price of oil were to stay at $40.”
Here are some reasons we may see a shakeout in the shale industry this year and in 2021, with more marginal producers failing:
- Shale oil production declines at a faster rate than most conventional resources, resulting in the need for continuous increase in drilling activity to keep up with production levels. This causes an ongoing burden on producers to continue to increase CAPEX costs year-over-year to replace output.
- The industry has a large debt load, with the top 29 U.S. shale producers (who collectively accounted for 50% of U.S. shale crude production in 2019) expected to spend $133 billion on debt installments and interest payments between now and 2026, according to research performed by Rystad Energy. This makes the ability to access cash to pay down debt extremely important. In this COVID-19 environment, the inability to refinance or access new sources of liquidity may lead to bankruptcies and/or consolidation in the industry.
- During the last collapse in oil prices in 2014, private equity funds provided bailouts for some producers. However, this time around will be different. Even prior to the most recent dip in pricing, private equity backing in the shale sector had begun to diminish. According to recent Bloomberg research, oil- and gas-focused funds have been among the lowest-yielding asset classes for private capital over the last 10 years, with a median internal rate of return about five percentage points lower than those of comparable buyout firms. With these lessons under their belt, private equity will most likely not be coming to the table to bail out producers given their current profitability and cash positions.
Weathering the storm and looking ahead
Reactions of U.S. shale producers will depend on the size and variables of their producing portfolios. Producers may find relief in their inventory of wells that have already been drilled, but not completed. These wells require a fraction of the typical cost in a new spending period to bring oil to the surface. In addition, shale plays – especially the Permian Basin – give producers the ability to halt production without the risk of damaging their wells. Experience has shown that the wells are still prolific after prolonged “shut-in,” allowing producers to step away and return when commodity prices recover. This is not the case for conventional resources, such as those in Saudi Arabia, Russia and the global offshore market.
The top 25 oil and gas companies lost more than $810 billion in the first quarter of 2020, according to Business Insider. Oil companies big and small are taking action to save themselves Here are some trends to watch for as they adapt:
- Increased capital discipline: With the price of WTI well below the breakeven price of most oil and gas companies, producers will be forced to take drastic measures to cut spending. Expect to see continued reduction in active drilling activity. According to the Baker Hughes rig count, the number of U.S. operating rigs dropped by 62 in the first week of April 2020, the largest single-week drop since 2015. Rig count is widely known as a leading indicator of production activity in the United States. With the reductions in drilling activity, there have been layoffs and furloughs industry-wide and those are expected to continue. As rig counts decline, fewer employees are needed to run the businesses.
- Shift in focus: As oil production has become uneconomic in the short-term for most producers and oversupply causes a traffic jam in the pipelines, large oil companies will be able to shift their CAPEX towards more economical pieces of their businesses. Chevron CEO Mike Wirth announced on March 24 that the company plans to cut spending in the Permian Basin by 50% in 2020 to focus on assets that are more profitable. Large international oil companies will have the ability to survive this because of their mass diversification of assets and ability to remain agile, but this is not the case with most shale producers.
- Debt restructurings: Last year, 42 oil companies with a combined $26 billion in debt filed for U.S. bankruptcy protection, according to the law firm Haynes & Boone, up from 28 companies with $13 billion of debt in 2018. In an attempt to improve balance sheets and avoid bankruptcy, many companies will be looking to restructure their debt.
We expect producers will continue to face challenges in the near term, with crude prices hampered by the continuous slowing in global economic activity. The industry has proven resilient in the past, but players of all sizes will need to become lean, efficient and agile in the way that they do business to get to the other side.
For more information on how the coronavirus is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.