Since the 2nd Quarter of this year, WTI crude oil has plunged from $103 a barrel to $55 at the time of this writing, over a 46 percent drop in six months. Since it is highly uncertain when and to what extent prices might regain those losses–or drop even further–it is important to examine what a prolonged hit to oil companies' top and bottom lines says about their future growth and financial performance.
Nearly all major fracking companies have taken advantage of available capital to grow their operations through exploration, acquisition, and development expenditures (EAD) that exceeds their operating cash flow. Obviously when prices drop, cash flow drops (after any price hedges expire, or are sold off as in Continental's case), which puts more pressure on external financing to maintain the company's growth. The problem here is that additional capital might not be available under those conditions, and future growth could be limited. That can lead to an even bigger problem.
Since production rates are highest in the beginning years of a well's life, a company's growth could be limited to the point where total production can no longer increase and begin to decline. And that's the real problem.
Even with Continental's 40 percent budget cut from its 2014 level, total property and equipment assets (TPE) will still grow by 17 percent while growth in production is expected to be about 18 percent, which is over 70 percent of 2014's increase of about 25 percent). This shows how much production inertia exists due to previously planned and committed drilling schedules.
Production could continue to drift up until topping out in 2018, 47 percent higher than 2014 before beginning to decline.
However as shown in Fig. 1, expanding TPE by just 10 percent annually going forward would require long-term debt to more than double by 2020 two years after production has peaked. How feasible is that kind of capital availability under those circumstances? (Clearly Continental's decision to grow significantly more in 2015, and selling its hedges, indicates its belief that current prices are a likely temporary.) But what if the bottom drops out of the financing market for frackers generally?
Fig. 2 – Available Financing Commitments Are Drawn Upon Then Long-Term Debts Are Retired.
In this scenario (again using Continental Resources' data) untapped credit commitments are used to fund 2015's EAD costs (almost reaching Continental's planned 17 percent growth in TPE). We then assume that external financing is terminated and what cash flow remains after completing the development of existing assets is used to retire debt.
Fig. 2 at left shows this opposing scenario with annual production rising by 34 percent by 2017 before again tapering off. By 2020 over a billion dollars in debt remains with production continuing to decline.
Finally we can examine an intermediate scenario wherein debts are maintained at roughly flat until the towel is thrown in on further financing due to declining production. Fig. 3 below illustrates this.
Fig. 3 – Existing Debt Is Held Approximately Flat Until 2020.
In this scenario TPE growth is kept constant at just under 6 percent, financed entirely by available operating cash flow. Annual production rises by just 29 percent by 2017 and again declines afterward.
Since industry pricing does not improve to again attract capital, debt begins to be retired.
After any hedging offsets in the near-term, today's low oil prices represent a loss of revenue that ultimately falls to the bottom line. This directly puts a dollar-for-dollar demand on additional external financing to maintain the growth required to keep production on the rise or even to maintain a steady plateau.
Unfortunately, “keeping production on the rise” to increase future cash flow for debt retirement–or any hope for a return
on equity–only delivers additional volume to an ongoing saturated market with the negative feedback loop putting more pressure
on prices. With production efficiencies unlikely to make up the difference, the situation can only be remedied by
regaining former price levels.
Here are some ways that could occur:
1) Supply and demand could reverse themselves just enough in a price-elastic environment to elevate prices to a higher equilibrium
(most likely but how high is unknown).
2) People hop in their old SUVs and start gas-guzzling again (if so, a tragic mistake; the family vacation might be back on but more may trade driving for the latest gadget, night out, or to pay off debt).
3) Enough marginal projects and producers anywhere are shut-in or put out of business, (more likely but may have negative consequences for the economy or financial system due to cascading defaults).
4) OPEC recants its supply stance in order to raise prices (but they have no incentive to consequently lose market share in deference to non-OPEC producers, unless they get Russia to go along).
5) Russia and/or Iran implode (both are notoriously resilient and capable of exercising counter strategies of their own).
6) Increasing world conflicts that disrupt supplies (also with unforeseen negative consequences, and a really bad way to “solve” the problem).
7) The anti-fracking movement takes hold, maybe over an environmental incident (would raise prices all right but by putting the brakes on the industry itself).
8) Long speculators eventually stop unwinding their paper oil positions and commercial hedgers reduce their net shorts (only time will tell if this was a primary influence for the price drop).
9) Some kind of government intervention takes place: price supports, import tariffs, tax or export policies (not likely in today's politico-economic environment).
10) The oil market simply reverses itself just as unexpectedly as it fell in the last six months (possible but nevertheless that's just a bet, see #1).
11) A North American based oil and gas cartel (ONAPEC) is formed, acting as the new “swing producer” to control prices (an interesting idea, but presently unthinkable in Western capitalism).
12) Some “White Swan” event occurs that saves the day (but “Black Swans” are more probable in this day and age—as they say, it always gets darker before it goes totally black).
U.S. economic growth is leading the OECD western world at the moment. But for a U.S. economic recovery to "make up the difference" in oil prices means demand for, 1) housing and vehicles, and 2) industrial CAPEX in plant, machinery and equipment would have to pick up significantly. Regarding the first, “Gen Y” (mostly those 15 to 35 years old) has a relative disinterest in car ownership versus social media and mobile electronics while an excessive student debt overhang may deter their future demand for home ownership. Industrial CAPEX meanwhile suffers from current excess capacity while a significant amount of built-up cash reserves are being spent on stock buy-backs to inflate valuations. Also, the the national debt coupled with the current political impasse precludes any substantial future investment in public infrastructure. China's growth (on dubious statistics at least) is higher but has been declining and is still accommodated by debt-driven infrastructure spending, shadow financing, and ethereal reform policies. Might interest rates and the stock market implode enough to keep 5 to 10 percent energy junk bonds (for those able to service the debt) attractive to big investors chasing yield? Not a solution since another recession would depress oil demand even further. Unfortunately none of this leaves any way one can really plan on to reverse the current pricing dilemma, at least one which wouldn't necessarily inflict significant pain on both the industry and the economy in general.
What the model clearly indicates is that a continuation of low prices against a backdrop of a tightening or collapsing high-yield debt market means production might continue to increase a bit for a few years, at least for the largest producers, and then start to decline because not enough new wells can be drilled. With debt retirement making additional demands on cash flow, even major fracking operations are threatened. But the certain damage that could occur much sooner to smaller, financially marginal companies could limit the overall growth across the entire industry much sooner. A shake-out like this (#3 above) could be the catalyst for prices to start rising again in just 1-2 years, unless of course bad debt contagion throws everything into turmoil. The supply-side stage is set, for now. Demand? Watch that one closely.
Yes, we do live in interesting times.
[UPDATE 1/19/2015. Prices are currently down 54 percent from the 2nd Quarter average. If this level were to be maintained and all further additions to property and equipment abandoned after 2015, additional shut-ins would only have to reduce current capacity to 70 percent from the currently assumed 80 percent for production to be held flat and declines to set in a few years out, even for large-scale operations like Continential. Any of these scenarios, without access to adequate capital to tap additional reserves, would spell nearly certain decline across the entire industry 2-3 years before 2020. Again, this is more likely to be even earlier if enough smaller producers at the margin have to shut down in 2015-16.]
*DISCLAIMER: This model is NOT intended to be used to forecast the future performance of Continental Resources or any other individual company, and it may under any given set of assumptions project results that may differ significantly from any particular company's actual performance in the future. The model also is not intended to provide any investment guidance about any company involved in the oil and/or natural gas or other energy business.