The US fracking boom may, with continued oil prices below breakeven levels, give way to fracking bust. Volatile oil prices, coupled with high debt levels, have left many companies in distress. And, with new loans more difficult to access and low hanging fruit transformations completed, the default rates – according to a recent analysis – for energy companies with poor EBIT margins are likely to grow dramatically over the coming years.
The price of WTI crude oil has, following a protracted period of $100 plus per barrel, fallen sharply since 2014, and in recent months has hovered between $40 and $50 a barrel. The effect of the drop in oil price has had considerable impact on the exploration and extraction industry, which has had to contend with often high fix production costs while revenues per barrel plummeted. The low prices, particularly for governments in the Middle East, like Saudi Arabia, have resulted in dramatic changes to their respective business environments and political risks, while, particularly in the US, the fracking boom may be coming to an abrupt and expensive halt.
In a new report from Alvarez & Marsal, titled ‘The Collapse of Crude Oil Prices: How Low and For How Long?’, the consultancy firm investigates the relationship between oil price and default within the US-based exploration & production (E&P) and oil field services (OFS) markets.
Since the early 2000s there has been a massive boom in the oil & gas industry in the US, making the US one of the world’s largest oil and gas producers in the world. Hydraulic fracturing (fracking), which accounted for barely 2% of production in 2000, last year accounted for 51% of production, with additional capacity stemming from the Gulf of Mexico and elsewhere.
The cost of developing fracking from nascence in the early 2000s to a multi-billion dollar industry, has, for many companies – particularly those expanding operations at the height of the boom – come in the form of debt. SME energy companies sold $241 billion worth of bonds from 2007 to 2015. The debt sold tended to be non-investment grade, whereby the normal high nominal yields and default rates associated with high-yield debt. Companies also accessed debt from the banking industry, with the sector accounting for 4.6% of outstanding leveraged loans, up from 3.1% a decade previous.
The plummet in the price of WTI crude has had a considerable, negative, effect on the wider extraction and production sector for oil in the US market. The number of active rotary rigs has tended to keep in relative line with the price of crude, which, given the recent fall in price, has seen a dramatic drop in the number, from almost 2000 rigs to less than 500 in two years. Pre-tax income too has been hit hard, according to a recent BDO study.
Fracking players are thereby facing considerable hurdles. The breakeven point for the industry is, depending on location, estimated by the consultancy firm’s analysis to be between $47 and $79 per barrel, which does not take into account interest payments on debt. Research from J.P. Morgan Asset Management suggests that for the largest shale basins in the US, profitability is scant for prices below $80. The mid-term outlook too remains relatively grim, with McKinsey & Company citing a $60 dollar a barrel price for the years ahead; and, given the move towards more sustainable energy generation and efficient uses of energy, the long-term trend may mean that peak-oil is on the horizon.
According to the research, the current market conditions, coupled with the high debt level means that the long term prospects for a number of players remains weak – with increasing numbers of E&P players, as well as OFS players, risking default. Estimates show that public debt defaults between 2000 and 2015 stood at around 3.5%. The number of companies in sufficient trouble to enter bankruptcy hit 42 in 2015, with $17.85 billion in defaulted debt, with 29% also defaulting on their public debt, thereby accounting for 26% of all corporate defaults (S&P) in 2015.
However, the current trend of improving operational efficiencies, reducing costs and cutting debt can mean that, given the protracted low prices and a decreasing access to new lines of credit to roll over debts, the number of defaults within the sector is expected to increase. The firm cites an analysis from Fitch, published in Q1 this year, which found that around $40 billion in additional debt held by the sector could be defaulted this year, “Leading to a sector-specific high-yield default rate of 20% (and at a rate of 30% to 35% by the end of the year).” Additionally cited by the report is an analysis from Deloitte, which suggests that up to a third of the world’s publicly-traded oil companies are at risk of default, while S&P expects around 6% to do so by the end of the year.
The firm’s own model and analysis finds a correlative relationship between default and a number of key investor indicators. The analysis from the firm finds that as the oil price falls, so do operating profits, and, as the firm’s model finds, a drop in operating profits come rising probabilities of default. The mathematical relationships will, according to the firm, allow banks and investors to better assess and stress test their energy company portfolios in line with changing conditions within the WTI crude market.