26 July 2018
The financing model underpinning the US shale oil industry is fundamentally different from that of large companies producing predominantly in conventional oil. Small and medium-size independent producers, which dominate the US shale industry, generally have much higher leverage with high levels of debt and hedging. Since its inception, the industry has been characterised by negative free cash flow as expectations of rising production and cost improvements led to continuous overspending in the sector. Over the last few months, the industry as a whole has seen a notable improvement in financial conditions, though the picture varies markedly by company, and the overall health of the industry remains fragile.
In order to try to assess as precisely as possible the developments of shale industry throughout the decade, we identified four distinct phases that have characterised the shale industry since 2010 up to now.
2010-14: The start-up phase
In the 2010-14 period, technology developments and high and stable oil prices triggered a massive investment wave in the US shale sector. Investment more than quadrupled, leading to an eightfold increase in shale oil production, from 0.44 million barrels per day (mb/d) to over 3.6 mb/d - the fastest growth in oil production in a single country since the development of Saudi Arabia's super-giant oilfields in the 1960s.
However, the growth came with a huge bill. The sector as a whole generated cumulative negative free cash flow of over USD 200 billion over those five years. Throughout this phase, companies were forced to rely extensively on external sources of financing, predominantly debt and receipts from the sale of non-core assets, in order to finance their operations. In addition to issuing bonds, companies benefited from the reserve base lending structure - a bank-syndicated revolving credit facility secured by the companies' oil and gas reserves as collateral. This structure was used heavily by small and medium-sized companies with non-investment credit rating that did not have as easy access to the corporate bond market.
2015‑16: The survival phase
The collapse of prices in the second half of 2014 and throughout 2015 and early 2016 had a major impact on the way the shale industry operates. Companies switched to survival mode, focusing on improving efficiency and cutting costs. The number of firms declaring bankruptcy and filling for Chapter 11 protection, a form of bankruptcy involving reorganisation, skyrocketed to almost 100 in 2015-16.
The fall in prices also changed the way the shale industry was financed. Debt finance dried up as banks were unwilling to lend during a period of market turmoil, with bond yield spreads widening to over 1 000 basis points and the credit rating of the majority of companies being downgraded. Asset sales also dropped by 70% in 2015 as owners were unwilling to part with assets at the much lower prices on offer. While the main buyers of the assets were US independent companies, the market turmoil discouraged bank lending, opening up opportunities for financial firms such as private equity firms, which typically have a higher risk profile. Those firms accounted for around 30% of reported asset deals over 2015-16. Available funding from the reserve base lending structure also declined as the value of proved reserves for collateral shrank with lower oil prices. The net result was that companies were obliged to raise equity to finance their operations - a more expensive option.
Despite the slump in revenues throughout this period, the shale industry actually saw an improvement in free cash flow as a result of huge cuts in capital spending and costs. Between 2014 and 2016, investment fell by 70% and costs by around half. Cost reductions helped to offset the impact of less investment, such that shale oil production declined only modestly in 2016.
2017: The consolidation phase
The recovery of oil prices since mid-2016 following the collective decision by the Organization of the Petroleum Exporting Countries (OPEC) and some non-OPEC producers to cut output led to a revival in confidence in the US shale sector. Further advances in technology, huge efficiency gains and cost reductions, and an upward revision of the shale resource base triggered an increase of 60% in investment in 2017. In the meantime, the shale industry proved that its upstream cost structure had been rebased as it was able to offset inflationary pressures coming from overheating of the supply chain, further reducing the overall costs per barrel produced.
Despite the improvements achieved, however, the shale sector continued to slightly over-spend the cash flow generated from its operations, with 2017 cumulative free cash flow remaining overall negative. Asset sales once again became the main source of financing operations, with most transactions occurring between US independent companies. Asset sales involved mainly acreage rather than whole companies, as companies sought to do relatively small deals as a way of making gains in operational efficiency. The confidence in the shale sector, traditionally dominated by private investors and small and medium-sized companies, received a boost from announcements by large US oil companies of their intention to make substantial investments.
2018: Profitability at last?
Current trends suggest that the shale industry as a whole may finally turn a profit in 2018, although downside risks remain. Thanks to a 60% increase in investment in 2017 and, based on company plans, an estimated 20% increase in 2018, production is projected to grow by a record 1.3 mb/d to over 5.7 mb/d this year. Several companies expect positive free cash flow based on an assumed oil price well below the levels seen so far in 2018 and there are clear indications that bond markets and banks are taking a more positive attitude to the sector, following encouraging financial results for the first quarter. On this basis, this we estimate that the shale sector as a whole is on track to achieve, for the first time in its history, positive free cash flow in 2018. This result is all the more impressive given the context of rising investment.
Structural changes also augur well for the sector. Recent consolidation, such as the recent USD 9.5 billion Concho-RSP Permian merger, and the increased participation of the majors and other international companies could bring significant economies of scale and accelerate technology developments, including through digitalization. Larger companies generally have a more robust financial structure and rely less on external sources of financing, so their shale investment will be less vulnerable to future downswings in oil prices and financial conditions.
The potential risks for shale independent from rising interest rates are currently attracting a lot of attention. The impact of rising interest rates on independent oil and gas companies in the US shale industry may also be small. Most companies are highly leveraged, benefiting from the ample availability of low-cost bond finance. However, given the high depletion rate, the time horizon of shale projects is so low that the discount rate has only a minor impact on the net present value of a given project. Rising interest rates often coincide with tighter lending conditions, which may make it harder for companies to service their debts and refinance their operations. But this risk can be managed through asset sales to less-capital-constrained companies, such as the majors, and increased reliance on equity raising through IPOs and private equity.
A lot of attention has been focused on interest expenses - the cost of repaying debt. The development of shale production has been accompanied by constantly rising interest expenses, which has impeded companies from generating profits sustainably. For the first time, the overall amount of interest expenses paid by shale companies declined in 2017. While US shale companies remain far more leveraged (measured by the net debt/equity ratio) than traditional operators, leverage is falling from its peak in 2015 and the average interest rate paid by shale companies - currently around 6% - has been broadly stable in recent years despite rising interest rates generally since the end of 2015, though they still pay more than conventional oil producers. Improving financial conditions mean that shale companies are able to borrow more cheaply than before.
The US shale industry seems to have reached a turning point with the recent significant improvement in its financial sustainability. But major uncertainties and important downside risks to the future of the shale industry remain:
Above-ground constraints: With production rising very rapidly in certain basins, such as the Permian, timely investment in takeaway capacity and pipeline infrastructure will be vital to the further expansion of the industry. At present, several producers in the Permian Basin are forced to discount their crude oil by more than USD 15 per barrel compared with the price on the Gulf Coast due to a lack of pipeline capacity. No significant pipeline capacity expansion is expected before 2019. The importance of infrastructure applies not only to oil but also to associated gas production, wastewater and other products. In the absence of new pipeline capacity, companies might be forced to curb drilling or ship their production using trucks or rail, which are usually much more expensive.
Further productivity gains: The continued ability of the companies to offset inflationary pressures with improved productivity stemming from technology or improved project execution remains very uncertain. In most active basins, especially the Permian, there are clear signs of overheating and bottlenecks in skilled labour, materials and equipment. In addition to the potential for further technological advances, there may be scope for more efficiency gains, for instance by expanding operations in continuous acreages, improved understanding of the resource base and more accurate spacing of wells.
Grabbing the fruits of the 'digital revolution': Companies are putting more effort into developing and adopting innovative digital technologies and big-data analytics in order to reduce costs, by optimising operations, improving reservoir modelling and enhancing processes.
Competition from other sources of oil: The US shale sector has not been alone in reducing its costs and will need to continue to do so to remain competitive in international markets. Most onshore resources, especially in OPEC countries, cost less to produce than shale oil, while the bulk of new deepwater projects are competitive with the cheapest shale basins. Consequently, the US shale industry is required to keep improving.