Despite headline-grabbing production numbers, the shale oil industry in the United States may be heading into a death spiral, according to a recent analysis on Resilience.org.
While low oil prices have certainly been a headache for the industry, Kurt Cobb of Resource Insights points to other signs of a more dire decline. “Oil production, it seems, is being overstated industry-wide by 10%, and 50% in the case of some companies,” he writes, citing a Wall Street Journal report. “The CEO of one of the largest players in the industry, Continental Resources, predicted that growth in shale oil production could fall by 50% this year compared to last year. In reality, we should expect worse, as the industry for obvious reasons tends to exaggerate its prospects.”
If that’s the way things go, the impact will fall hardest on private investment firms that bet big on shale oil bonds. “The plan for the firms was always to unload the debt on somebody else when better opportunities presented themselves,” Cobb writes. “But the firms overstayed their welcome and are having a hard time even finding a bid in the market for these bonds.”
Now that Wall Street skepticism is sinking in, a grouping of companies that must constantly raise new capital to stay afloat hasn’t concluded a single bond issue since November. And ironically, an industry that is working so hard to drive climate change may now be running afoul of one of the local impacts it produces. “The future of U.S. shale oil production seems to be in the Permian Basin in Texas, which has been providing the lion’s share of oil production growth for the entire country,” he states. “But ongoing drought in an already arid West Texas has raised doubts about whether the Permian will have enough water to meet all the demand for fracking new wells.”
Those observations kick off a downward spiral that has some analysts describing shale oil as a Ponzi scheme, Cobb writes. With production from existing sites declining fast, companies have to drill enough new wells to offset their losses, “a task akin to walking up the down escalator.” As the number of wells increases, companies are now spending more than half their capital budgets on the replacement sites, a figure that could hit 75% by 2021, and might eventually reach 100%. And after all that, the companies’ expenses come in far higher than their revenues.
“That means the companies must borrow from investors (usually in the form of high-yield debt) or get them to buy new shares in order to raise the money needed not only to drill enough wells to make up for lost production from declining wells, but also to drill enough to grow production—something investors have been counting on to secure the value of their bonds and increase the value of their shares,” he explains. “If the needed capital is not forthcoming, it means companies will be faced with declining revenues from declining production. With lower operating cash flow and little access to additional capital, these companies will be unable to drill enough wells to offset declining ones. That means even lower revenues in the future, which will mean even lower investment in new wells. That’s what a death spiral looks like.”
The industry might have a chance of bouncing back if oil prices surge. But if and when that happens, Cobb asks, “will investors risk getting caught during a subsequent downturn with shale oil company bonds that can’t catch a bid in the market (or shares that could end up worthless)?”