“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,” said IEA senior programme officer Alessandro Blasi and IEA energy investment analyst Yoko Nobuoka.
Assessing U.S. shale drilling since its onset in 2019, the IEA sees the whole industry to “finally” become profitable this year, largely 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. Analysts stressed “this result is all the more impressive given the context of rising investment.”
Structural changes, notably the recent $9.5 billion Concho-RSP Permian merger and rising participation of oil majors is likely to 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,” analysts said.
Risks for shale independents come from rising interest rates although the IEA says the actual impact may 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,” they say.
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. Cost of repaying debt, or interest expenses, are a growing burden for U.S. shale producers and had impended many of them from generating profits sustainably.
But 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,” analysts said, concluding that “improving financial conditions mean that shale companies are able to borrow more cheaply than before.”
Passing through choppy waters
The U.S. shale industry has lived through challenging times. A consolidation phase in 2017 followed a gradual recovery in oil prices since mid-2016, amid OPEC’s production cuts, had reignited confidence in the U.S. shale gas sector after a period marked by the survival of the fittest in 2015-16. At time, a price collapse caused nearly 100 bankruptcies which dried up funding from the reserve base lending structure as the value of proved reserves for collateral shrank with lower oil prices. Private equity firms stepped in the void.
Technology advances, huge efficiency gains and cost reductions, and an upward revision of the shale resource base in 2107 triggered an increase of 60% in investment last year. At the same time, the industry proved that its upstream cost structure had been rebased. It managed to offset inflationary pressures coming from overheating of the supply chain, and further cut overall costs per barrel produced.
Still, 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 [like in 2010-14] 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,” analysts explained.
Confidence in the sector, traditionally dominated by private investors and small companies, received a boost when large US oil companies said they were intending to make substantial investments.
Overspending in 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.
The growth, however, came with a huge bill. The sector as a whole generated cumulative negative free cash flow of over $200 billion over those five years, with companies relying on debt financing and receipts from the sale of non-core assets. Overzealous companies also tapped a 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.