SHALE OIL GAME OVER
The price of oil fell some more on Tuesday, down as low as $75.84 before closing at $77 a barrel. The decline is blamed on Saudi Arabia cutting prices rather than cutting output amid signs of global glut. That's discouraging to America's highly leveraged drillers, who had been hoping beyond hope that $80 would act as a floor on prices.
If prices don't recover soon this could be the beginning of the end of the Great American oil fracking boom. Already ConocoPhillips and Shell have announced a pull back in onshore investment. But the real pain will be felt by the army of smaller independent producers.
There's been a lot of talk about the breakeven prices per barrel needed to sustain drilling in various oil plays. Some say $80, others say $70. If you have acreage in a sweet spot you might be safe down to $50.
But let's get real — breakeven just isn't good enough. Investors need returns on capital, not just returns of capital. And for myriad small drillers this fall in prices has virtually eliminated any possibility of turning real cash profits. Over the long run, a company that can't generate a profit is worthless.
Though oil prices are down "just" 30%, shares in some drillers with shaky balance sheets have plunged 60%. It is always the case that shares in leveraged commodity producers are more volatile than the underlying commodity. Equities are ultimately priced on a company's ability to generate profit. Small moves in commodity prices have a huge impact on earnings.
At $100 a barrel, the average oil company can generate net income on the order of $15 a barrel. But as prices fall, this margin evaporates quickly. A decline of $10 to $90 leaves a margin of only $5, that means profits plunge 66%. Thus, at current prices, the average oil company won't be profitable at all, and the weaker ones, loaded up with debt, are the walking dead. A perfect example is Goodrich Petroleum, which announced some big new discoveries in the Tuscaloosa Marine Shale. While the oil may be there, "the play is not economic at current oil prices," wrote Cowen & Co. analyst Christopher Walling yesterday, adding that "liquidity is a growing concern." Goodrich shares are down 70% in six months.
The oil industry is a study in contrasts. When you look at the financial statements of Exxon Mobil, you see a fortress — the company generates more than enough cash to pay all its capital spending and still have $20 billion a year left over for dividends and buybacks. Exxon will survive the downdraft just fine — its shares are down just 7% this year.
Contrast that with the small shale-only drillers, which have been borrowing like crazy to acquire acreage and deploy fleets of rigs. They may post net income every quarter, but their profitability is only an accounting illusion. Their capex has outstripped cashflow generation year in and year out. Without big borrowing (backed by rosy forecasts of future production growth) they are toast.
So who's in the worst shape? The companies with a combination of high debt, high costs and relatively poor acreage, like Goodrich. Another early casualty could be Swift Energy, which has piled up $1.2 billion in debt in recent years to drill high-cost wells on marginal acreage. Swift's investors are clamoring for change as shares have plunged 50% this year. Swift's net debt has climbed to more than 3 times estimated 2014 EBITDA, or more than 80% of enterprise value.
According to data from U.S. Capital Advisors, other operators with high leverage that are living well outside their means include SandRidge, which has debt of 2.6 times EBITDA and 51% of enterprise value; EXCO Resources with debt 4.3 times EBITDA and 83% of enterprise value; and Magnum Hunter Resources, with debt 4.8 times EBITDA and 38% of enterprise value.
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