The tide of liquidity is going out for the U.S. shale industry and every disciple of Warren Buffett knows what happens next.
Markets have lost no time in realizing that the breakneck boom in oil shale was the prime target of the Organization of Petroleum Countries when it chose last week to keep pumping at current levels and start a global price war.
But the shake-out in this sector is going to hit more than stock investors. It’s going to be a huge test for bond markets, which have piled into energy companies’ debt–particularly into high-yield (aka ‘junk’) debt like never before in the last couple of years.
The fact is that the biggest rise in U.S. oil production in modern history has been underpinned by two assumptions, both of which are now invalid: first, that OPEC itself would take the pain of keeping oil prices steady at $100/barrel or thereabouts, and second, that the flow of nearly free money from the Federal Reserve, via the capital markets, would never end.
According to data from Dealogic, U.S. energy companies high-yield issuance in the last three years alone has totaled $120 billion, accounting for over two-thirds of such issuance worldwide. Barclays’ High-Yield U.S. Bond index, which covers $1.3 trillion in debt, includes over $140 billion in energy bonds.
A lot of those bonds are going to come under stress if, as many now predict, oil prices only average $70/bbl for the next year or two. Morgan Stanley’s Energy High-Yield Total Return Index has already fallen over 11% since September and is rapidly disappearing off the bottom of the chart. Clearly, the market believes that solvency is going to be challenged if prices stay low for long.
So much for the bad news. But there is plenty of stuff on the other side of the ledger too. For a start, break-even oil prices for many U.S. producers may be a lot lower than the $80 level bandied around at OPEC’s meeting in Vienna last week. Consultancy IHS says around 80% of new ‘tight’ oil production planned for 2015 would cover capital and operating costs and generate a 10% rate of return at prices of $69/bbl (some will manage to do that even at $50/bbl, it adds).
Mark Sadeghian, a senior director for Fitch Ratings Agency, argues that the very variety and flexibility of the shale universe makes it more resilient to price-war pressures.
“Shale is easier to flex up and flex down than conventional upstream projects so it’s a harder competitor to eliminate as a business model,” he says. “Long-lead projects (that demand big investments up front) are more vulnerable.”
According to that line of reasoning, inefficient state behemoths like Brazil’s Petrobras or Venezuela’s PdVSA will find it harder to get projects off the ground than wildcatters in Texas and North Dakota. Small wonder that PdVSA’s 2017 bonds are already yielding over 11% despite having the Venezuelan sovereign standing behind them: cheap oil is going to bankrupt that sovereign before it bankrupts Bakken and Eagle Ford.
And if the worst does come to the worst, and natural selection weeds out the overextended and the underperforming, even that won’t kill the shale challenge to OPEC, because the losses will be absorbed, albeit with some pain and upheaval by the world’s most liquid capital market. Whether through mergers or through the bankruptcy courts, viable assets will find their ways into the hands of financially adequate owners who will continue to keep the oil flowing.
That won’t stop a few yield-hungry bond fund managers having sleepless nights for the next few months, but quite whether they’d like to swap their headaches for OPEC’s is another question.