Saudi Arabia's price war on the U.S. producers began a year ago, and the shale producers held out as well as they could for most of it, running on bravado, cost-cutting, borrowing and previously bought hedges. By now, all these resources are mostly exhausted for the smaller players.
According to the consultancy Wood Mackenzie, about a third of oil production in the U.S. states, not including Alaska and Hawaii, comes from companies that have borrowed against their oil and gas reserves and that face redeterminations of their borrowing base. Banks recalculate the value of reserves for their oil company clients twice a year, in the spring and in the fall. Forecasts for the October redeterminations are dire. Last month, a survey conducted by the law firm Haynes and Boone predicted a 39 percent decrease in the oil companies' borrowing ability, with 79 percent of borrowers expecting a decrease. The firm quoted Jeff Nichols, a partner at its Houston office, as saying:
What really stood out for us was the contrast between the results of the spring and fall survey. In the spring, it looked like the response was a ‘wait and see’ mentality. But with fall approaching, the ‘wait and see’ mentality seems to have passed and there is recognition that more action needs to be taken to reduce debt through equity investment, restructuring or even declaring bankruptcy.
While this is relevant to small producers that can only borrow against their reserves, bigger ones too will be hurt by banks' and investors' cooler attitude toward the oil industry. Even big companies such as Continental and ConocoPhillips have increased borrowing this year to cover their negative cash flow (which, for the entire industry, hit $32 billion in the first six months of this year, almost as much as for the whole of 2014).
In the second quarter of 2015, 83 percent of U.S. onshore oil producers' operating cash flow was used for debt servicing, according to the U.S. Energy Information Administration -- about twice the level of early 2012.
This is not a sustainable business model. The oil companies can keep up their borrowing only if investors believe prices will rise significantly; that's not the case. December 2016 futures contracts for Brent crude sell for $56 per barrel, about $6 higher than the current price. This makes hedging by selling contracts such as this one rather unattractive, though oil firms still do it to retain their borrowing ability. Wood Mackenzie estimates that the 26 biggest independent oil producers' cash flow from hedging will go down to $2.2 billion next year from $9.1 billion in 2015.
Some industry investors believe all this will result in a U.S. oil rout in 2016 and a steep price rise. Leonid Fedun, vice president and a large shareholder in Russia's biggest private oil producer, Lukoil, predicts that oil prices will rise to between $70 and $80, possibly even to $100 per barrel next year. Speaking at a recent conference, he called shale oil "a typical American bubble, just like the dotcom bubble" and suggested a big shakeout in the U.S. market as oil firms' credit shrinks.
It's difficult to imagine that happening in 2016, however. Though there will be more bankruptcies than the handful the industry saw this year, most of the financially strained companies -- even really hard-up ones such as Whiting and Chesapeake Energy -- can survive by selling off assets to private equity investors, who will drive a hard bargain but won't miss a chance to take part in a buyer's market.
Though these investors will probably keep pumping as much as they can, the U.S. production decline will accelerate, just as the Saudis wanted when they announced their determination to win back some market share from the American upstarts.
OPEC expects U.S. oil production to drop by 100,000 barrels per day after explosive growth in 2014 and a slight increase this year (recent losses haven't completely wiped out the strong growth in the first six months of 2015). That's not a huge decline. Yet OPEC countries, especially Saudi Arabia, will expand their market share by more than that because demand is projected to increase by 1.25 million barrels per day. The forecast, backed up by the International Energy Agency in its October market report, is probably realistic: At current prices, demand is growing everywhere because cars, trucks and planes are cheaper to use. Even China, that cemetery of commodity demand forecasts, is getting hungrier for oil because of a growing domestic demand for cars and travel.
The Saudis -- and whoever else manages to keep up production -- will cover the increase, but the added volume will only approach 1.5 percent of global demand, so there's no reason to expect a big price rise, barring some unexpected supply shock. This means another harrowing year for everyone, but especially for the U.S. producers.
This year, according to the Organization of Petroleum Exporting Countries, U.S. oil companies' spending on exploration and production dropped 35 percent, compared to 20 percent for the industry worldwide. Wood Mackenzie predicts that the effect of the shrinking investment will peak in March, 2017, with production from horizontal rigs -- the most technologically advancedIn and efficient ones in use now -- falling to 6.6 million barrels a day compared with 7.4 million barrels per day this year. By then, investors will have learned their lesson firmly. With the Saudis willing to hurt themselves for the sake of small increases in market share, shale is too risky a bet.
There is not much the U.S. government can do to help. Raising the export ban would probably increase domestic prices by a dollar or two per barrel. Yet the benefit to the industry would probably be insignificant, and a rate hike would immediately wipe it out. All the frackers can do is clench their teeth, hang on and trust that retreat won't lead to bankruptcy as a form of surrender.
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