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Posted September 06, 2019

Byron King

By Byron King

Billions of Barrels Produced... But Debt Kills Oil Profits

Right now, most of the U.S. oil industry isnt making money. Surprising; but thats the case

U.S. oil production is as high as its ever been. Its up around 12 million barrels per day. But oil companies are losing money, hand over fist.

The problem is high debt levels, which are killing profitability and killing-off American oil companies. The bankruptcy numbers are soaring.

Were looking at a huge problem that could tear the guts out of one of the strongest sectors of the economy and wreck a key source of income for millions of Americans.

Heres whats going on

The oil industry has a very long reputation as a place where people and companies make a lot of money. And that used to be the case.

But not anymore, as the oil patch is now where dollars go to die.

Let me get personal for just a moment Back in the 1970s, I began my geology career working for the former Gulf Oil Company in West Texas. Gulf was one of the worlds major oil players at the time; one of the so-called Seven Sisters. In 1983, Chevron bought Gulf.

Gulf ran a tight ship. When I was with Gulf, I assure you that we made money on our oil. Every barrel paid for itself.

I worked in a Gulf field office in a small Texas town called Monahans; an old water-stop on the Texas-Pacific Railway.

We had a morning meeting every day. We looked at production numbers. We examined cost elements. We scrutinized every dime going into the ground and accounted for every dime coming back our way when we moved oil into the transfer pipelines.

If wells didnt pay out, we shut them in. We pulled out the equipment and pipe and plugged the holes with concrete. Gulf Oil Company was nobodys charity case.

Today, its different. The industry is hemorrhaging money

Youve heard about the fracking revolution. Lots of technical terminology like drill bit steering, horizontal drilling, stacked plays, multi-stage completions, pressure-pumping, and sand loads. All that and more

Fracking is supposed to be the great savior of the U.S. energy industry. And dont get me wrong, fracking has delivered a heck of a lot of oil to the wellheads of America. Its why you can still afford to drive a gasoline powered car.

But fracking is expensive. Lots of moving machinery, steel, equipment, concrete, other materials, trained people. Lots of inputs, and few of them cheap.

With fracking, were looking at numbers like $45 to $50 per barrel, in terms of the absolute costs of finding, developing and producing that oil. And it means that the profit margins for U.S. producers are thin, even on the best days.

Meanwhile, for all the upbeat feelings about fracking, the problems are all starting to come home, big-time. We have problems in the oil patch.

According to a recent account in the Wall Street Journal,

Bankruptcies are rising in the U.S. oil patch as Wall Streets disaffection with shale companies reverberates through the industry. Twenty-six U.S. oil-and-gas producers including Sanchez Energy Corp. and Halcon Resources Corp.have filed for bankruptcy this year That nearly matches the 28 producer bankruptcies in all of 2018, and the number is expected to rise as companies face mounting debt maturities. 1

The fundamental issue has to do with the easy money policies of the Federal Reserve over the past decade.

Many smaller oil companies built their business model around financing up-front operations with debt. Makes sense. Money was available, people lent it out, and other people borrowed it.

The idea behind borrowing to frack for oil was that ever-increasing prices would deliver more and more cash. Then that cash would enable the indebted oil companies to pay it all back to their creditors. Great idea, yes?

Whoops No! That borrow-borrow idea has basically crashed.

Oil prices have been down and/or stagnant since late 2014. Heres the chart.

Oil Price Chart

As you can see, oil prices plummeted in late 2014. Prices were down in the $30 range in 2015. The recovery since then has been spotty on even the best days.

More recently, with oil in the general range of $50 to $65 per barrel, the cash just isnt there to pay for all the expensive operations and tech that goes into fracking. As I mentioned above, youre looking at $45 and more just to find and produce a barrel.

The profit over the cost of production has to support company overhead, and pay back debt. Theres lots of accounting involved, but in essence the money doesnt add up. Its not even close.

This is the devilish side of funding operations with debt.

You have to take todays money and worse, tomorrows money and pay back yesterdays spending. The more debt, the slower you can run a business; the faster you are on the road to the poorhouse.

So far, its fair to say that large players Chevron, for example are doing alright. They have deep pockets, tightly integrated production chains and ability to fund what they want to do. Chevron is above water.

But smaller oil companies are struggling to service old debt, while they work to secure new funding. All this while investors are spurning the now-broken shale business model of the past decade.

According to the Wall Street Journal,

The current financial strain on shale producers is likely to intensify as many companies that took on debt after the 2016 oil slump face large debt maturities in the next four years. As of July, about $9 billion was set to mature throughout the remainder of 2019, but about $137 billion will be due between 2020 and 2022, according to S&P.

Clearly, $137 billion is a lot of money to roll over; let alone to pay back. Good luck with that, right? So what comes next?

Looking ahead, well likely see more and more bankruptcy proceedings from the mid-sized and smaller oil plays. Indeed, the lawyers are already lined up at the courthouses.

Expect that equity holders will be all but wiped out, while bondholders may emerge as the asset-owners of reorganized shale companies. But what assets? Played-out frack-wells with fast-declining production curves. Not so great...

Meanwhile, in recent years, energy loans have been among the largest components of the high-yield bond market. But now, costs of capital are destined to increase, even in an otherwise low-interest rate world. So, a big part of the U.S. oil biz is rolling full speed towards the edge of a cliff.

Heres the bottom line

Its going to be more expensive for U.S. companies to drill for oil than it has been. And that does not bode well for a key segment of the U.S. economy; energy.

Oilfield jobs tend to be well-paying with solid benefits. Same thing with related jobs in the oil service sector. The industry energizes many a supply chain, from steel and concrete to trucking, machinery, electronics, chemicals and much more.

That is, the oilfield puts a lot of bread on many tables across the country. But the business model of the smaller and intermediate companies has run into a brick wall of debt that cant be repaid.

The U.S. oil biz is about to tighten up as the dam breaks on a massive lake of debt thats backed up behind the industry. Were already seeing the flood of bankruptcies.

The business model is a wreck. The debt-model doesnt work for a wasting, depleting, hard-to-get asset like fracked oil. So, we have dark shadows upon the frack patch.

Where is it all headed? What does it mean to you and me?

Based on my 40-plus years of association with the energy industry, I foresee worsening economics for the onshore side of the oil biz; certainly, for the fracking and tight oil guys.

Plus, I see fewer companies drilling fewer wells, which means less demand for rigs, steel, machinery, service plays and related.

Were looking at less new activity across the onshore energy industry. Likely job losses, reflecting fewer oil and service companies with less business to go around.

Is there a way out of the mess?

Well, the good news is that America still needs its daily dose of oil. The country runs on petroleum fuel. Even the most anti-oil politicians and rabble-rousers still fly around on jet airplanes and get chauffeured to their Save the Planet rallies.

Out in the field, theres still good work for oil companies and service providers, along with skilled people who know what theyre doing. Nobody is turning out the lights on the great American oil industry.

But we have to be clear-eyed here, too. Excess debt has made a total mess of the economics of the industry. Itll take time and new ideas to un-screw the situation.

On the bright side, one of the most neglected parts of the oil industry is the offshore arena. That means offshore drillers and service companies with rigs and systems working on the continental shelf and in deepwater. Its an intriguing sector play for contrarians.

Theres plenty more to discuss. Ill save it for a future note.

For now, the important thing is to understand the frail economics of the tight oil sector.

Beware Its going to come back and bite us.

On that note, I rest my case.

Thank you for subscribing and reading.

Best wishes,

Byron King

Byron King

Managing Editor, Whiskey & Gunpowder

WhiskeyAndGunpowderFeedback@StPaulResearch.com

1 Oil and Gas Bankruptcies Grow as Investors Lose Appetite for Shale, WSJ

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