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US Oil and Gas Sector Reboots to Survive

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The rebound in crude prices during the past couple of months has sparked a little flicker of optimism over US oil companies. For much of the industry, though, the outlook has hardly brightened at all.

The North American shale boom of the past decade was driven by real technological progress but also a rapid accumulation of debt. Now the boom has gone but the debt remains, and it will hang over the sector for many years to come.

 US crude has risen from about $26 a barrel in February to about $37 on Monday. Over the same period, the S&P 500 exploration and production companies index has increased about 23 per cent, and the Bank of America Merrill Lynch high-yield energy bond index has risen 26 per cent.

For many US oil and gas companies, however, financial pressures are still growing. Hedges that helped support revenues are being used up; banks are expected to reduce many companies’ borrowing facilities in the round of reserves revaluations now under way, and bond markets have been closed for all but the strongest groups.

The rebound in oil makes a big difference to some companies and not much difference at all to many others, according to Jeff Schlegel of Jones Day, the law firm.

“There are companies where the price could go to $50 and it still wouldn’t help,” he says.

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In mid-2014, as US oil prices began to fall from a peak of $107 a barrel, the industry had a cost structure and a debt burden that were manageable if crude stayed at about that level. Since then, production expenses have been driven down as companies have struggled to stay afloat. Productivity has kept rising, and service companies’ profit margins have been crunched.

Chesapeake Energy, for example, told investors at a conference last month that it had cut the cost of drilling a well in the Eagle Ford shale of south Texas from $5.9m in 2014 to an expected $4.2m this year. Every other company has a similar story.

The process of restructuring the industry’s debt burden, however, is only just beginning.

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Steven Woods of Moody’s, the credit rating agency, says the entire US oil industry is under financial stress with prices at today’s levels.

“At $40, the industry doesn’t work,” he adds. “Companies can’t earn an adequate return on capital.”

Some companies, though, are more stressed than others. It is no coincidence that the four US exploration and production companies that sold bonds in the first quarter were some of the largest and most secure in the sector: Occidental Petroleum, ConocoPhillips, Anadarko Petroleum and EOG Resources.

There have also been 17 US oil and gas producers that have held share offers this year, raising a total of $10.6bn, the second-highest tally of any quarter on record, according to Dealogic. They were typically ones with assets that have attractive long-term potential, including Pioneer Natural Resources, with its shale position in the Permian Basin of west Texas.

Those companies with access to the capital markets may be able to hang on and wait for the eventual upturn. But many do not have that option. The gulf between the stronger and the weaker companies is widening.

“The longer this goes on, the more you will see companies either filing for bankruptcy or selling all their assets,” says Dewey Gonsoulin of Bracewell, the law firm.

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Last week brought another string of companies approaching default on their debts. SandRidge Energy, an Oklahoma-based gas producer, said it had hired advisers to look at a possible bankruptcy, and warned there was “substantial doubt regarding the company’s ability to continue as a going concern as it is currently structured”.

Privately-held Chaparral Energy said it was considering bankruptcy, Ultra Petroleum missed a $26m interest payment and Goodrich Petroleum said it would enter bankruptcy as part of an agreed restructuring.

Attempting to avoid the same fate, US oil and gas companies cut their capital spending by about 40 per cent last year on average, and are planning for a further 50 per cent reduction this year.

The number of rigs drilling for oil and gas in the US has dropped 77 per cent since September 2014, falling a further 14 last week to 450, the lowest level since the data were first collected in 1940.

As a result, US oil production has started declining, too. The drop has been modest but it is expected to continue through the year. Although there are a few exploration and production companies still forecasting growth in 2016, most expect their output to fall.

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When the oversupply in the global oil market that has been depressing prices finally ends, and crude starts to rise again, more US production will become commercially attractive once more. A price of $60 a barrel looks like a critical level in terms of stimulating a revival in drilling. Occidental told investors recently that just 14 per cent of its potential shale well locations in the Permian Basin would be economic to drill with oil below $50 a barrel, but 40 per cent would be viable below $60.

The rate at which those potentially profitable opportunities are drilled will depend on how much money companies have to spend. For now, the inflow of new capital from private equity is sluggish.

Merger and acquisition activity, which could reallocate assets to companies that have the financial resources to develop them, has also been slow, dropping to its lowest quarterly level for at least a decade.

Bitter experience, including the shortlived rally in crude prices in the first half of last year, has taught investors to favour caution.

“Growing for growth’s sake worked in a world of $100 oil. It doesn’t work now,” says Brad Carpenter at Cantor Fitzgerald.

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Espen Erlingsen of Rystad Energy, a consultancy, says the guiding principle among the shale companies now is to cover their capital spending from their cash flow.

To stabilise total US production and stop it falling, oil would need to be about $40 to $50 a barrel, he adds. To go back to the boom years of 2012-14, when the US was adding about 1m barrels a day of additional supply every year, oil would need to be more than $80.

The shale revolution will not be reversed; in fact, the technology is continuing to advance. But every revolution needs to be followed by a period of consolidation, and this one is no different. The high-growth period of the industry’s history is over, perhaps for a long time.


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