Boom, Bust, and Hedges, A Part 3 Series - Part 1
In this series, I’m taking a verbal snapshot of where the industry stands financially. First up is my take on How we arrived at where we are today, with an oversupply of both hydrocarbons and investment cash. Next week we’ll take a look at the Why, as in why didn’t everyone hedge to avoid the financial damage potential from a collapse in crude prices? Finally, we’ll offer some guidance on What Next, with a primer on how to use hedges effectively.
Part 1- How did we get here? Great engineering and easy money
The oil and gas industry is going through a sea change in ownership of producing assets. I could easily fill the rest of this page with links to stories of industry veterans currently setting up companies to purchase upstream and midstream assets, and then the next couple of pages with info on the private equity groups raising funds to back them.
In previous downturns, small companies who had taken the risk of exploration and reserve growth and ended up struggling were often gobbled up by major integrated oil and gas companies, who had the balance sheets to buy the assets as well as the economies of scale to bring down costs and make a profit.
This time, dare I say it, is different.
Only half of the story of the shale boom is about drilling and completions technology. Sure, our engineers have made dramatic strides in unlocking much larger amounts of oil and gas than ever conceived. According to the EIA’s most recent Drilling Productivity Report, each rig drilling for oil in the Eagle Ford shale can be expected to add more than 1,000 bbl/d of new production to the basin’s total. And in the Marcellus, each gas rig brings on average 11,000 mcf/d. Fewer days per well (more efficient rigs), more wells per rig (pad drilling), and vastly more production per well (better completions), all add up to more and more (and more) production per rig. All of this, combined with OPEC’s unwillingness to give up market share, led to a global oversupply.
But the other half is about the real juice behind the shale boom, and that is the massive wave of cheap money. As bond yields stayed low after the housing bubble, investors were willing to take on more risk to realize returns. First upstream and then midstream companies were inundated with private and then public money to find and develop our oil and gas resources. Because of this wave of investment, there was immense pressure on the part of the industry to deploy capital. Acreage prices spiked, and the midstream space became immensely competitive with spinoffs from E&Ps as well as established and rapidly growing infrastructure companies.
This tsunami of newly available and cheap debt resulted in highly leveraged oil and gas companies, especially upstream. As the commodity price environment broke down, the cash situation in many E&Ps likewise degraded and operations became difficult. Midstream companies were hamstrung also, but largely because of the MLP structure that allowed them to pay out all profits as distributions, which in turn required loading up on more debt for projects. John Arnold, the famously successful gas trader behind Centaurus, predicted last year that 50% of upstream companies would be bankrupt at $40 crude oil. We haven’t gotten quite to that point, but Haynes and Boone’s Oil Patch Bankruptcy Monitor shows 42 oil and gas companies filing for bankruptcy ($17B worth) in 2015, and 39 companies ($35B worth) in just January- May of this year.
Because of the condition of these balance sheets, larger operators are less willing than in previous downturns to snap up smaller ones. In addition, interest rates remain low and investors are still hungry for yield. In what the WSJ called a “doubling down”, private equity has arrived with a fresh wave of funds, starting the process that I described at the beginning of this article:
Step 1. Private equity opens a fund and raises money
Step 2. Industry veterans create company, gain PE investment
Step 3. Newly-created PE-backed company buys producing assets from struggling and overleveraged E&P
The ongoing shift of oil and gas assets from major integrated oil and gas companies to smaller, PE-backed shops will surely have implications across the oil patch. Loss of efficiencies will be one, since many small companies lack the economies of scale that large operators can bring to bear. Potentially offsetting this will be the fact that these companies will most likely operate leaner, with smaller staffs and more accountability for invested dollars. I’ll be exploring the implications and starting the discussion on these topics as they emerge.
For now though, I’m going to stay focused on how we got to where we are, and why the downturn in prices was so painful for most E&Ps. That is, why didn’t everyone hedge everything?
Next up, Part 2- If the money was so smart, why wasn’t everything hedged?