Double or bust? The US shale sector

The global oil price slump has claimed its first big victim. Chesapeake energy, a pioneer in the US shale oil and gas industry, filed for bankruptcy last week. The company collapsed under a $9bn debt pile that its dwindling income couldn’t cover. This could be an early sign of more to come as Deloitte analysts consider that over half the US shale operators are either financially stressed or technically insolvent at an oil price of US$35/barrel (at the time of writing the WTI oil price benchmark was at $40/barrel, and NYMEX futures suggest a similar level through 2021). Deloitte estimate the average breakeven price for shale operators to be around $50/barrel.

A big shake-out of the US shale sector would see cheers in Riyadh and Moscow. The OPEC+ international oil cartel, which has limited effectiveness at controlling oil prices at the best of times has been confounded by the spectacular rise of the shale sector over the last decade. Previous attempts by the cartel to flood the global market in order to reduce prices below shale’s breakeven simply resulted in operators finding operational and financial efficiencies and pushing that breakeven price lower. Budgetary requirements meant that the OPEC+ countries couldn’t sustain the low prices for long enough.

But the collapse in demand following COVID-19 lockdowns may have succeeded where Saudi Arabia and Russia failed. One view may be that shale oil was always running to stand still – while not quite a Ponzi scheme, many companies were operating on a “jam tomorrow” basis with today’s drilling providing just enough revenue to pay yesterday’s bills. Deloitte estimate the sector has burned through $300bn of free cash flow in the last decade – as the report noted “the reality is that the shale boom peaked without making money for the industry in aggregate”.

One of the industry’s problems was the gas price. Many operators were oil-focussed and treated the gas that flowed out with the oil as a slightly inconvenient by-product. IF they didn’t flare it, they just sold it on the market for whatever they could get. This glut crashed the US gas price, which has bumped along at about US$3/MMBtu (roughly A$4.50/GJ) for the last few years. It’s no coincidence that Chesapeake was more a gas producer than an oil producer. As a result, gas has arguably done more than renewables mandates or environmental constraints to eat into coal’s share of US electricity production.

A permanent curtailment of activity in the sector would result in longer-term higher US gas prices and global oil prices than otherwise. But the sector has already survived 190 bankruptcies – the typical route, known as Chapter 11 is designed to allow a business some breathing space to recapitalise, and so Chesapeake may live to fight another day. The Deloitte report argues that the time is ripe for consolidation in the sector, which is dominated by independent producers rather than a few oil majors. The relentlessness of American business optimism may see the sector come out the other side leaner and more financially robust than before.