Who Will Wind Up Holding the Bag in the Shale Gas Bubble?

We’ve been writing off and on about how the sudden fall in gas prices has been expected to put a lot of shale gas development on hold. In fact, quite a few analysts believe that one of the big Saudi aims in refusing to support oil prices was to dent the prospects for competitive energy sources, not just renewables like wind and hydro power, but shale gas.

Even though OilPrice reported that US rig count had indeed fallen as oil prices plunged, John Dizard at the Financial Times (hat tip Scott) gives a more intriguing piece of the puzzle: the degree to which production is still chugging along despite it being uneconomical. The oil majors have been criticized for levering up to continue developing when it is cash-flow negative; they are presumably betting that prices will be much higher in short order.

But the same thing is happening further down the food chain, among players that don’t begin to have the deep pockets of the industry behemoths: many of them are still in “drill baby, drill” mode. Per Dizard:

Even long-time energy industry people cannot remember an overinvestment cycle lasting as long as the one in unconventional US resources. It is not just the hydrocarbon engineers who have created this bubble; there are the financial engineers who came up with new ways to pay for it.

And while the financial engineers will as always do just fine, lenders are another matter:

By now, though, there is an astonishing amount of debt that continues to build up on the smaller E&P companies’ balance sheets. According to Gavekal, the research group, even before the oil price plunge, aggregate debt-to-equity ratios in the smaller publicly traded energy companies are now at 93 per cent, up from around 70 per cent in 2012 and 2013, and around 50 per cent between 2005 and 2011. This in a highly cyclical industry that used to go through periodic banker-driven shakeouts and even bankruptcies.

One example is a KKR deal gone a cropper, Samson. As an aside, it is hard to think of an industry less suited to private equity investing than oil & gas development, since the companies have a great deal of operating leverage and the industry is highly cyclical. KKR apparently did not learn that lesson in bankruptcy of its giant energy play turned mega bankruptcy TXU. Or maybe it did. While the other lead investor in that deal, TPG, has had a hard time fundraising as a result of the TXU debacle, KKR has sailed on unscathed. This early November Reuters article describes how KKR is struggling to rescue this transaction*:

KKR & Co which led the acquisition of oil and gas producer Samson Resources Corp for $7.2 billion in 2011 and has already sold almost half its acreage to cope with lower energy prices, plans to sell its North Dakota Bakken oil deposit worth less than $500 million as part of an ongoing downsizing plan, according to people familiar with the matter.

KKR, one of the world’s biggest private equity firms with $96 billion in assets under management, overpaid for Samson, and persistently low natural gas prices have hampered its ability to finance the company and added to its debt burden, the people said. KKR’s plan was to shift Samson’s assets from natural gas production more into oil and liquids.

With U.S. crude oil futures down 25 percent since June, Samson has hired Bank of Nova Scotia (to sell the Bakken assets, and the company is contemplating more asset sales to raise cash, the people said, without specifying which other assets.

In the medium-term, Samson may look at acquiring higher-income properties, turning to its private equity owners or external investors for financing, one of the people said.

KKR closed on Samson in November 2011. Industry experts believe one of the reasons they overpaid is they used conventional oil and gas models that showed much longer production lives for each well. Yet by spring of 2012, there were reports in conventional media about how shale gas wells have short production lives. So how could KKR have missed this issue?

In the new normal of lower energy prices, developers are apparently playing a game of chicken, hoping that competitors will cut production first. Dizard again:

Particularly in the gas and natural gas liquids drilling directed sector, every operator (and their financier) is waiting for every other operator to stop or slow their drilling programmes, so there can be some recovery in the supply-demand balance. I have been hearing a lot of buzz about cutbacks in drilling budgets for 2015, but we will not really know until the companies begin to report in January and February. Then we will find out if they really are cutting back, using their profits on in-the-money hedge programmes to keep their debt under control, and taking impairment charges on properties that did not really pay off.

One gas-orientated industry man in Houston I know thinks that the banks are going to call a halt to the madness of permanent negative operating cash flows. “What is the timing of their borrowing base renegotiations (with the banks)? That is the most important thing; can they borrow more money?” If not, he believes drilling and producing on uneconomic terms will slow or stop, and with the high depletion rates of unconventional reserves, such as shale gas, supplies will fall and gas prices will rise.

In other words, if the industry doesn’t discipline itself, the money sources will. Or will it?

If the bankers reduce the borrowing base for the E&P companies, there could be a lot of private equity or high-yield investors with covenant-light deals to offer who might take their place. Not to mention cash-rich majors who would like to take the billions they can no longer put into Russia or Venezuela, who would not mind picking up more North American properties on the cheap.

Although Dizard does not discuss the downside directly, he sets forth a fact pattern that could lead to some ugly ends. US shale gas production needs to get to $6 per mBtu or more for players who aren’t very leveraged to get to break-even cash flow; they hope to make more two to three years after that on presumably higher prices.

But if super low interest rates keep money flowing into the shale bubble, another set of issues emerges: US production is set to considerably outstrip domestic uses:

So much gas is being developed in the Marcellus and Utica resources of the northeastern US that it really cannot be absorbed by the US market. Suzanne Minter, manager of oil and gas consulting at Bentek in Denver points out: “Over the next five years, daily production in the US is forecast to grow by more than 16bn cubic feet per day, with about 10bcf of that coming from the northeast. Of that, at least 8.5bcf has to be exported. Domestic demand does not grow enough.”

That means a lot of infrastructure like pipelines and storage facilities needs to be built. But that requires regulatory approvals and possibly government intervention. And even then, with US shale gas production projected by the IEA to peak in 2020 and fall slowly over the next decade, this extraction boom is nowhere near as durable as development of conventional oil has proven to be.

An additional question is whether investment in infrastructure will look attractive if fracking continues to be shown to have safety risks (water supply contamination, earthquakes). The New York Times just released an impressively-researched story on regulatory abuses in North Dakota. It does not make for pretty reading. And if Dizard is right, that bottom-fishers swoop in to pick up producers gone bust, headlines about bankruptcies and distress are not conducive to downstream development.

In other words, there’s a not-trivial possibility, as Dizard explains, that US production does not get throttled back much by falling oil prices, that the wall of money willing to invest in energy overcomes normal supply and demand factors. If that takes place, there could be a further leg down if US producers lack the capacity to send enough production overseas.

Now remember, Dizard already warned that smaller E&P players were already overlevered. Some, perhaps many, lenders will take losses. Private equity bottom fisher-wannabes will also come in using other people’s money. But cheaper doesn’t necessarily mean cheap enough. Recall all the sovereign wealth funds that took equity stakes in banks in 2007 thinking they had gotten a good deal.

A reader points out that this all feels a lot like the last oil boom gone bad. I’m old enough to remember how pretty much every bank in Texas was sold as a result (and that helped speed the liberalization of interstate banking, since no one in state had the wherewithall to act as a rescuer). Via e-mail:

This whole situation is very similar to the oil and gas boom of late 70’s and early 80’s. It was driven by letters of credit deals which were used to secure debt. A little bank called Penn Square Bank upstreamed those loans to Continental Illinois and Sea First in Seattle. All financed by debt and wells being drilled which were not economical. When the music stopped the debt came crumbling down taking down Continental and Sea First (two of the ten largest banks in the US) as well as many others. Many banks did not even know they were lending to oil and gas because they were lending on like real estate. Well when the oil and gas industry collapsed so did real estate. Practically every significant bank in Oklahoma and Texas failed due to this.

Is the Fed teeing up an even bigger energy boom and bust? Admittedly, several adverse scenarios have to play out in succession for the downside case to kick in. But the first one, of shale gas producers not cutting very much despite the plunge in energy prices, is already under way. One might peg the odds of a major levered energy bust at 20%. That’s still uncomfortably high for the amount of damage that would result.

* Note that in the “heads I win, tails you lose” world of private equity, KKR can still come out ahead in a restructuring by virtue of being able to buy the debt at a discount.

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  1. Pepsi

    It’s emblematic of the neoliberal dogma, no questions allowed, no imagination permitted, there is no alternative. We will keep doing this until it explodes, and we’ll probably continue after that.

      1. Pepsi

        What are you trying to say, that we live in the flower of an age of creativity and critical thinking? I would argue that, economically, we do not.

        1. NOTaREALmerican

          No, i’m saying it’s no better or worse than it ever was.

          Neo-liberal dogma = ask no questions. No imagination permitted.

          non-neo-liberal dogma = ask questions, imagination permitted.

          Neo-liberals entered the picture at which date in history?

          Prior to this date there was questions and imagination.

          Just wondering what the date of neo-liberalism was.

  2. peteybee

    The $6 breakeven figure is some kind of national average, which is the wrong way of analyzing it. All the action flocks to the cheapest play, I.e. Marcellus, for dry gas. It’s somewhere in the $3 range there, last I checked.

    1. Yves Smith Post author

      What about average don’t you understand?

      Those pricier production wells are still getting financing. Someone will wind up eating losses on that debt, particularly if it keeps going on. And some of the Marcellus shale won’t be exploited. New York has a fracking ban in place via the courts, and it does not poll well, so the legislature might not interfere.

      1. peteybee

        Yes, the existing dry gas plays outside Marcellus are losers, I dont disagree there. But that won’t prevent future investment from being routed to the one spot which put all the others out of business due to its lower cost. As you know, wall st. has infinite financing.

        1. An arb is a beautiful thing

          Peteybee, you are looking at it correctly. Yves’s snide comment aside, the national average price means nothing. Pricey natural gas wells aren’t getting financed (or if some are, they are a small % as to be no matter) without some NGL/Condensate angle. Natural gas is a done story, 5 years after the paradigm shifted, there is little new these days. It’s just a grind through to better times.

          Pricier OIL wells are being financed to see if new fields can turn into the next Bakken, Eagleford or bless her the old Permian (extra Oxy). Maybe they won’t, but no E&P company ever succeeded by giving up before their money ran out.

          Dizard’s oil industry friend was saying the same thing 4 years ago when gas prices kept falling. Whatever. So were we all, we’ll change our attitude when they stop drilling…oh wait, expensive fields did that. Gas rig count peaked years ago.

          As to the idea of stopping production, please make it stop. That is ridiculous. After you’ve paid for land, pipe and well drilling, why would you cut off your cash flow? They will flow until they are blue in the face, I bet OPEC won’t cut until $50 bbl and that would be for show only. The saudi’s got burned in the 80’s cutting back, they shouldn’t do that again. The notion that afalling oil price is a plan by the Saudi’s to get after the Russians is most likely bunk IMO.

          The blog post is ignorance run amok, I wonder how many other topics NC grossly misunderstands. Quoting bentek…dear lord.

          The Bust is on, let’s see how bad it gets.

        1. An arb is a beautiful thing

          Spot on Peteybee. Also, don’t look now but CHK (sadly no Aubrey) saying they are getting costs down in the Haynesville to start drilling again. I wonder if they really can…

        2. Nathanael

          Marcellus is going to hit the wall; they’ve got a couple of sweet spots to exploit, but it looks like there’s a lot of nothing outside that.

          As for CHK, their business model is land-flipping. They’re pretty upfront about it in the reports. Obviously they’re going to SAY that they’ve lowered drilling costs whether they really have or not.

  3. Jim Haygood

    Who will wind up holding the bag … is this a rhetorical question?

    To quote that great American, Jonathan Gruber:

    ‘Lack of transparency is a huge political advantage. And basically, call it the stupidity of the American voter or whatever, but basically that was really, really critical for the thing to pass …’

    Shale bailouts … for the children!

    1. NOTaREALmerican

      That’s how the railroads were built. And, this was before neo-liberals (I’m guessing, as I’ve never seen a date of transition to neo-liberalism but it is probably post 1920 when all the railroad scams run their course).

        1. Nathanael

          And caused the first major union movement, and in the wake of the bankruptcies, multiple major third parties, and even some small localized wars between competing state legislatures.

  4. Code Name D

    There is ideology at work here. “Developing” these fraking and shale resources has been a Libertarian ideological staple for years now, and is connected to conspiracy theories that tell of how “evil government” shut down domestic production in order to favor its communist allies such as the Saudis. (What, you didn’t know they were communists?)

    Global warming and poor production figures are just mechanics of the conspiracy.

    Yves explains something else that I noticed, the lack of “disaster coverage” such as what we saw in 2008. That bad news might slow the “bottom feeders”. It proves my 2nd law of economics – the economy is always in recovery. They seem to think that if we don’t cover bubble collapses, then it’s not a bubble and it didn’t collapse. This happened in 2008 as I recall too, where the news media refused to even discuses the housing crises as it unfolded. How many people bought homes never knowing the markets were collapsing until after they signed the mortgage?

    1. James

      Trouble is, the ideology seems to be working. I’m beginning to think it’s us naive, non-corrupt fools who are the stupid ones.

      1. NOTaREALmerican

        Morality OCD is very debilitating.

        The secret of success is duplicity and the secret of happiness is self-delusion; and bullshit is makes both possible.

      2. Moneta

        Look at pictures from the 1800s to today. It’s amazing how fashion has changed. And these changes reflect the lies we hold dear to our heart.

        It used to be that you could differentiate countries by the attire. Now, every country looks like the US with its poor and rich. The whole world is trying to live like an American when it should not.

        Societies have always been built around ideologies and these persist until mother nature forces them to change.

  5. ambrit

    The gas liquefaction and shipping infrastructure needed for the export of the “excess” gas produced from the shale plays might never get built. Someone with a technical background has to be involved in the decision making process, if only to act as a well informed Cassandra. The production timelines do not predict sufficient length of excess production to pay off the bonds needed to finance the infrastructure building projects. If many big players go ahead with major LNG infrastructure projects, we’ll know without doubt that fraud is being perpetrated.

      1. Nathanael

        My views are informed by reading the corporate annual reports of Cheseapeake and a couple of other frackers in detail. They are *desparate* to unload every field as soon as they frack it — which they wouldn’t be if the fields were actually profitable, you know…

        I don’t think it’s possible to pull the same scam with pipeline infrastructure.

  6. jib

    I think you are confusing oil and gas. Two very different markets (at least in the last 10 years or so), the price of gas has been down for years, well head prices crashed in 2008. It is oil that has gone down recently.

    While some E&P’s use junk bonds, many finance CAPEX by selling next years production this year. No debt but they (usually) sell at a lower price than the current market. They have already sold next years production and locked in the money (at a higher price than current spot) so they are not going to lose money on this years wells and drilling the wells means more production next year which means more income. No reason to stop drilling yet.

    But next year if oil is still at low price then CAPEX will be reduced and fewer wells will be drilled. Of course as fewer wells are drilled, the cost of renting rigs and services goes down so the price point at which the new wells can be profitable is lower. And different fields have different price points. And follow on wells on existing sections are cheaper and more reliable to drill than initial exploratory wells, etc, etc.

    Basically the shake out is coming but it takes longer to hit and it wont be a complete collapse unless oil goes down below $50 and stays there.

    1. Jonathan Nguyen

      That time lag between market movements and their consequences for shale oil balance sheets echoes some of what I heard from Art Berman on the Kunstler podcast a few weeks back. He also mentioned in passing that oil from the Eagle Ford (Texas shale) is of enough lower energy density to cause significant problems for domestic refining. Unfortunately, I wasn’t able to find any obvious support for this claim after some Googling (admittedly very brief). Can anyone with more knowledge comment?

      Shale gas does appear (to this total novice) to be on more solid footing compared to the crude side, but I think the big worry is what Yves hinted at when talking about the longer term production peak. What are the implications of significant infrastructure and financial investment in a gas industry with such little longevity? For all hyperbole about the gas revolution, a quick check with EIA gives us roughly 12 years of proven natural gas reserves at current consumption levels (2013 data in billion cubic feet, US reserves of 308,436 and annual consumption of 26,037). Yes, incremental gains in extraction efficiencies and rising prices will grow reserves some as pricier parts of known resources come online, but it seems hard to justify adopting natural gas for new uses across the economy like LNG autos or the like when the timeline for domestic gas is so short. Both production and financial interests are also at the mercy of the disconnected feedback loop between profitability and valuations.

      Again coming from Berman, it sounds like many independent shale players are relying on stable/growing Wall Street valuations that are maintained by tracking production growth as an indicator. According to his view, most companies will be unable to meet debt obligations that are triggered when growth slows and asset prices dip. So the bloodbath would bring a severe cutback in production, rising prices and a period of consolidation and inflows of PE money. The companies that are the least levered and/or with the most profitable portfolios would come out on top and then enjoy a 5-10 year run As a very untrained reader here, I’m curious how accurate this representation is? And if so, how is it even possible to tell? Seems to me that neither Berman or Dizard point to any company specific examples that this is the case.

  7. Rosario

    “It is not just the hydrocarbon engineers who have created this bubble; there are the financial engineers who came up with new ways to pay for it.”

    More just the latter and high oil prices. The engineering behind fracking is not new (http://en.wikipedia.org/wiki/Hydraulic_fracturing). It has been around for decades. Look at a chart of oil prices over the past 10 years and fracking production correlates very closely. Producers could not justify fracking at 1990s or 1980s oil prices otherwise they would have been doing it years ago since USA production peaked in the 70s. Similar story for tar sands. The natural gas and water rights to extract the oil is cheap the end product is not (at least it used to be). All these industries, in terms of energy, are robbing Peter to pay Paul, and they are creating a high reliance on very, very low EROEI energy sources. Pair this with mammoth federal subsidies to explore and produce and you have a society stuck in a tight space. What was left in me that trusted the system in 2012 voted Green Party for this very reason. Getting out of this situation will require an immense political undertaking with the oh so feared government planning.

  8. not_me

    Who Will Wind Up Holding the Bag in the Shale Gas Bubble? Yves Smith

    IF we had ETHICAL financing of such things and indeed ALL things then who would or SHOULD even care?

    So reap what you sowed Progressives. After all, despite a Great Depression, World War II and now environmental destruction, we have had Progress, of a sort, haven’t we? The sort the Father of Lies, the Patron Demon of Banking, would love?

  9. MyLessThanPrimeBeef

    Who will hold the bag?

    My first reaction is the little People will be holding the bag. But when we hold the bag, we will be told that we are the Big People.

    Be proud.


  10. different clue

    When the oil and gas boom of the 70s and 80s ( referenced above) finally busted all the way back down, did the amount of oil bought and burned in the U.S. increase over the few years after that? Or decrease in the few years after that?

  11. steelhead23

    I loved this piece Yves. It appears that we all love to see the big guys fall – even if its only a possibility. At any rate, here is a quote from the piece that I hope you can see is a non sequitor.

    KKR closed on Samson in November 2011. Industry experts believe one of the reasons they overpaid is they used conventional oil and gas models that showed much longer production lives for each well. Yet by spring of 2012, there were reports in conventional media about how shale gas wells have short production lives. So how could KKR have missed this issue?

    1. Yves Smith Post author

      I’m not clear on why you are confused, although I might have failed to explain the time line in enough detail.

      KKR bought Samson using models that showed long well lives. The deal closed in late 2011.

      Mere months later, the MSM was reporting on short shale well lives.

      Industry insiders know things before industry publications, and industry pubs are generally months if not longer ahead of MSM. So if KKR was doing adequate due diligence, how could have not known the deal was a turkey (hint, they did but they were ripping out enough in fees that they didn’t care, plus the oil price fall made a little turkey into a big turkey).

    2. Moneta

      Their pay is based on skimming the money they raise. To get this money they need optimistic numbers. As simple as that. This is the quality of business bailouts and QE has brought us.

  12. Moneta

    KKR apparently did not learn that lesson in bankruptcy of its giant energy play turned mega bankruptcy TXU. Or maybe it did
    Bailouts and QE have sent the message that nothing can fail… that when push comes to shove the Fed will pick up the new defaulting paper because it has painted itself into a corner.

    Furthermore, many players in these private equity firms probably don’t care about the long-term viability of their firm. They just care about skimming money off the money they raise as quickly as possble. And in their minds, the bigger and more complex they make the firm, the higher the chances are that the Fed will be forced to prop them up in a market weakness. It’s called moral hazard but for some reason many don’t understand how it creeps up.

    IMO, this situation will pop one day. The Fed just will not be able to carry the world’s problems on its shoulders anymore. Unfortunately, this could last a few years or a couple of decades. It probably depends on how long the old guard stays in top positions… because of mega debts and expensive lifestyles many don’t seem even close to retiring.

  13. TarheelDem

    Property acquisition for shale gas projects is being done under general mineral rights laws, some of which like North Carolina’s have been rushed into place under Koch-headed legislatures. One wonders what other minerals acquirers of some of these rights might be interested in.

    Also, the way that mineral rights laws separate rights often means the owner of the surface rights owns little at all. I foresee a property-recording mess that will be on the scale of MERS. And I suspect that one of the hidden reasons for the difficulty of economic development in places like West Virginia, Kentucky, and parts of Pennsylvania have to do with the already complex ownership of the rights associated with what are environmentally degraded properties. That situation is about to be extended to states like North Carolina and Mississippi.

  14. Thomas M. McGovern

    Re: “Who Will Wind Up Holding the Bag in the Shale Gas Bubble?” Why do you, Ms. Smith, care? Do you care? If risk-taking capitalists miscalculate about future demand for shale oil, why do you care? If bankers make loans to drillers that don’t get paid back, why do you care? Risk-taking is part of the free-market system. If you are opposed to the free-market system, just say so and say why. I can understand that you’re concerned about the environmental impacts of fracking, but why do care about the profit or loss of drillers and bankers? I doubt that you do.

    1. Vatch

      If the investors are banks, the FDIC or the taxpayers could end up bailing them out. So there’s a very good reason for us to care about this, in addition to the serious environmental damage that fracking causes.

  15. prickels

    Hall’s main problem with the falling-price scenario is that it contains the seeds of its own demise. Shale drilling depends on high prices to survive. If oil falls toward $75 a barrel, much of the wave of new U.S. production would become unprofitable, prompting output to be cut, Hall wrote in April.
    Scarcity would then start to drive up prices. Hall’s position is that the world may be awash in new oil but that new oil isn’t cheap to produce. The fact that the U.S. shale revolution has been able to replace most of the crude lost to strife in recent years in places such as Iraq and Libya is a fluke, in his opinion.
    And while energy powers such as Russia and Saudi Arabia still have plenty of oil, they’ll have to significantly increase investments to maintain production levels. In a June letter, Hall made note of a statement from an OAO Lukoil executive, who acknowledged the “threat” that Russia’s “traditional reserves are being exhausted.”

    IOC Toast

    Hall’s confidence in rising prices is expressed in an April letter to Astenbeck investors in which he poses the seemingly audacious question of whether the world’s biggest oil companies are doomed.
    “Are the IOCs (international oil companies) toast?” he asked. While Exxon Mobil Corp. and its four biggest peers have posted more than $1 trillion in combined profits in the past decade, Hall points out that they’ve subsequently been spending almost every dime they’ve earned.

    1. Yves Smith Post author

      You need to read the underlying Dizard article.

      The majors have been continuing to explore and develop even though the activity has been cash flow negative AND widely criticized by analysts. So your “lower prices choke off production” has not been working as it has historically.

      Dizard argues that the availability of super cheap financing and overly-indulgent lenders is bringing the same syndrome to shale gas. And remember, shale gas is not something that will be exportable until facilities are built, so treating it as part of the global market until that happens is an analytical lapse.

      1. Nathanael

        So what is the endgame? Massive waves of bankruptcies, obviously, but how exactly do they play out? I don’t think anyone will tolerate direct bailouts of wildcatters…

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