The Shale Patch – Money for nothing and the risk for free!


The shale revolution has touched everyone’s life here in the United States. As I drove home recently, I noticed that regular unleaded gas was $2.63 per gallon. A year ago, according to the American Automobile Association (AAA), the national average was $3.72. Prices are down by a cool $1.09 per gallon in a year, or 29 percent. Production from North Dakotas “tight” oil fields and the Eagle Ford region of Texas have been huge contributors to this decline. The US is back to being one of the largest producers of energy as a result of horizontal drilling and hydraulic fracturing in shale formations. The science behind shale-oriented techniques — drilling horizontally and injecting water, sand and chemicals under high pressure to release hydrocarbons — is well known. There is also much discussion about whether fracking is good, bad or indifferent for the environment. We’re going to leave the environmental issues for another day, and instead examine the shale revolution from an investors perspective.

Most of the firms driving the shale revolution were small exploration and production (E&P) companies. Chesapeake Energy (CHK), one of the early innovators, came public in 1993 and focused on horizontal drilling and fracking from the beginning. During the 1990s, the market capitalization of the company ranged from $200 million to $435 million, leaving it squarely in the small cap realm. However, after it developed a very productive area of gas-rich shale in Louisiana early in the new millennium, its share price climbed sharply, giving it a valuation of $36 billion by 2008.

Also contributing to the rise in share prices of firms like Chesapeake was the rising price of natural gas. A growing US economy and a dearth of conventional gas wells drove natural gas prices upward from 2005 to 2008, until they peaked in June of 2008 at $13.31. The escalating price of gas and newfound techniques for unlocking it from shale created an energy boom — the shale revolution had begun.

Concurrent with the success of fracking came the great recession — and with it the unprecedented low interest rate environment in which we now live. Given the risky nature of the oil business and volatile energy prices, oil and gas companies have historically borrowed at higher interest rates than other firms. But the US Federal Reserve flipped this rule on its head. With money cheap for everyone due to ZIRP (zero interest rate policy), even the riskiest credits have been able to borrow at low rates. Dozens of E&P companies saw this cheap funding as a chance to raise large amounts of capital and “get big fast.” Between January 2011 and today, that is exactly what they did. Domestic E&P companies issued $187 billion in new debt during this period. Last year was a record year for issuance, at $57 billion, and 2015 is setting up to beat that number handily.

Further feeding the demand for capital in the oil patch are the generally higher drilling costs and steep production declines associated with shale wells. Costs are higher in shale formations, as shale wells are generally deeper and require costly fracking to release reserves. The productive life of a shale well is also normally much shorter than that of a conventional well. Shale wells can be quite prolific, at least at first. In fact, if an energy company picks the right spot to drill, it can generate an almost immediate payback. But to remain in business, a driller must continue to produce beyond the brief life of a single well. During the boom, many E&P companies got into a cycle of borrowing to pay for leases and drilling, then using the proceeds from production to make interest payments and pay operating costs.

As the boom proceeded, the number of players in shale areas and the amount of capital invested grew rapidly, as did the supply of gas, oil and natural gas liquids. The logical outcome was lower prices. Benchmark natural gas fell from $13.31 in June of 2008 to $3.24 just one year later. It currently trades at $2.58, and has traded above $5.00 only twice in the last 5 years. The story is the same for crude oil, although it took a little longer for the price to collapse. Crude was selling at $110 per barrel in early 2014, and fell to less than half that by December 2014. Because many shale areas also produce (more valuable) natural gas liquids like propane, butane and ethane, companies turned to developing these areas when “dry” gas prices fell. Eventually this created an oversupply of these hydrocarbons as well.

Today, many energy firms are unable to produce profitably at prevailing prices. As a result, they’ve been renegotiating service and supply contracts and trying to lock in longer term contracts with customers, who are often willing to pay a somewhat higher price to attain pricing certainty. For some, the real problem is that their (substantial) debt has to be serviced regardless of the weak commodity pricing environment.

Low oil and gas prices are wearing on heavily indebted producers. Some companies paid too much for leases. Some overpaid the service companies that actually do the drilling and fracking. Some simply borrowed too much money. The entire energy complex is in pain. Cheap gas may spell doom for some, but its actually a logical and even healthy outcome for the industry. We look forward to further consolidation in the E&P industry. When it happens, it may be time to begin purchasing shares of service providers, equipment manufacturers and E&P companies themselves.

Nathan Boxx, Bradley Newman, Jason Seltzer

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