U.S. OIL BUBBLE
America's oil and gas boom was enabled by a huge pile of cheap financing. Many of the leading players in the boom, such as Chesapeake Energy and Continental Resources have for years been making capital investments at levels far surpassing the cashflow generated from operations.
The mountain of debt advanced to drillers in recent years is estimated to be in the neighborhood of $500 billion — some $300 billion in leveraged loans and another $200 billion in high yield debt. That's about 16% of the U.S. high yield debt market, quadruple its share a decade ago. That's a lot, even when weighed against the roughly $1.6 trillion in annual investment required to provide the people of the world with energy.
No surprise, as oil prices have plunged, yields on risky oil company debt have surged in recent months to three times their original yields at issuance. In September, the average energy high-yield issue yielded 450 basis points above Treasuries, according to Bloomberg . Now that premium has increased to nearly 950 bps. As a result, high yield funds have taken it on the chin. The Blackrock Corporate High Yield Fund, for instance, is down 8.25% in six months. According to S&P Capital IQ, leveraged oil and gas loans were trading above par as recently as June, but have since plunged to around 92 cents on the dollar on average, with some issues far lower. Analysts at CreditInsights see a jump in defaults from about 4% to around 8% of issues.
Oil companies had little trouble convincing lenders that these great tight oil plays like the Bakken and Eagle Ford and Permian are so vast, with so many thousands of drilling locations, that all they have to do is to keep drilling and drilling and drilling until eventually they will accelerate their oil volumes to enough of an "escape velocity" where they will finally have sufficient free cash flow to pay down debt and fund capex from operations.
It was a good plan, as long as oil prices stayed high. But now, with oil prices half what they were six months ago, there's tremors in that debt mountain, and concerns that an avalanche could quickly take out the weakest oil companies, which simply won't be able to generate sufficient revenues to service their debt. Not only that, their collateral is evaporating as well. Goldman Sachs analysts figure that $1 trillion of oil investments are virtually worthless as long as prices stay this low, because marginal fields are simply not worth drilling.
As analyst Ed Westlake at Credit Suisse summed up the trouble in a recent note: "in four years of $100/bbl oil, the global oil and gas industry has taken on a quarter of a trillion dollars in debt, has delivered zero production growth outside of North America and is facing a $1 trillion+ reduction in global revenues."
Already, distressed debt investors like Oaktree Capital's billionaire Chairman Howard Marks are swooping down to start picking at the still warm carcasses. As Marks said in a letter to investors this week: "This cycle of easy issuance followed by defrocking has been behind the three debt crises that delivered the best buying opportunities in our 26 years in distressed debt." He's reportedly raising billions to build funds to buy the debt of solid but overleveraged operators.
So which companies are in debt danger? Those with the highest debt loads relative to operating income. Here's a short list, but there are likely many others are on shaky ground:
– Quicksilver Resources: In September, Moody's said the company's debt levels were unsustainable. S&P downgraded them in October. The company just replaced its CFO.
–Goodrich Petroleum. The company says its debt covenants require it to generate annual EBITDA of at least one quarter of its $600 million in debt (about $150 million). EBITDA over the nine months through September was $98 million, and this quarter will definitely come in less than the last three.
– Swift Energy: With surging debt and questionable acquisitions, it's already been targeted for a board shake-up by Baker Street Capital.
– Sandridge Energy: Bonds are yielding 14%. Analysts expect debt load to surpass 4x EBITDA in the second half of 2015 even as it cuts capital spending.
– Energy XXI: After its debt-financed acquisition of EPL, this Gulf of Mexico operator is likely to surpass 4x debt to EBITDA
– Connacher Oil & Gas: This Canadian oil sands developer announced in early December that it had brought in bankers to try to raise additional capital and restructure debt.
– Southern Pacific: Says it doesn't have enough cash to make debt payments and hired bankers to explore a sale of the company.
– Midstates Petroleum: $1.6 billion in debt carried by less than $400 million in trailing EBITDA. Shares down 75%.
– American Eagle Energy: Shares in this Bakken operator are down more than 90%.
So how does this end? All could be ok if oil prices recover, lenders show patience and bigger, stronger oil companies opt to acquire the troubled pipsqueaks. If not, we could see a wave of defaults akin to the telecom collapse, which ended up infecting world capital markets and helping to precipitate the 2001/2 recession.
Something else to worry about: banks have several trillion dollars of exposure to oil and gas derivatives (much of it as counterparties to oil company production hedging), it's plausible that a bottoming out of oil prices could detonate massive losses for banks, even if their oil company clients somehow survive.
Reasons for optimism? The best antidote for low oil prices is low oil prices. Analysts at Tudor, Pickering & Holt figure that if prices stay where they are it will cause U.S. drillers to cut back capital spending by 20% or more and to lay down 800 rigs. Considering the ferocious decline rates on new tight oil wells of 50% or more in the first year, these cutbacks will very quickly shave the top off of America's oil output, enough, they say, to "correct the market" by the end of 2015.
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