US shale’s financial blanket at risk of wearing thin in 2019
All industrial revolutions need two things: technology and finance. The US shale revolution was made possible by the advances in horizontal drilling and hydraulic fracturing that allowed oil and gas to be released from previously unyielding rocks. But the industry’s financing was equally important in turning those innovations into a production boom that has shaken the world. The financial model that has dominated the industry has been a highly competitive group of exploration and production companies using debt raised from bond markets and bank loans secured on oil and gas reserves. Often they use derivatives to hedge some or all of their revenues, giving lenders confidence in their ability to make interest payments if oil and gas prices fall. For most of the shale boom, that financial infrastructure has been underpinned by the low interest rates and quantitative easing that followed the financial crisis. The surge in US oil production has been a result of monetary stimulus, just as much as the tech start-up boom and the rise in the S&P 500 have been. As its output has grown, the US E&P industry has been unable to finance its drilling programmes from its operating cash flows, and a constant inflow of capital has been essential for keeping it afloat. With stock markets and oil prices falling, and while the Federal Reserve is still signalling its intention to keep raising interest rates, the financial conditions that have protected the shale industry like a warm blanket may next year start to wear thin. One issue that has been highlighted by Philip Verleger, an energy economist, is the outlook for the hedging used by E&P companies to protect their revenues and reassure their lenders. Strategies vary, but the standard practice is for companies to put a floor under the effective price of some or all of their production by buying put options. Mr Verleger argues that those options have been an important factor in the collapse of oil prices to a 15-month low since October. The investment banks and others that sold those put options have to hedge their own positions, typically by selling oil in the futures market. The more likely it is that the options will be exercised, the more oil the finance companies have to sell, in a practice known as “delta hedging”. That creates a positive feedback loop: as prices fall, financial companies that have sold puts need to sell more oil, which drives the price down further. The scale of US E&P hedging programmes is large enough, Mr Verleger has calculated, to explain much of the fall in crude since October. Once oil started to fall, tipped lower by the Trump administration’s decision to ease off on blocking exports of Iranian oil, and concerns about global growth, the delta hedging effect kicked in, turning the retreat into a rout. This dynamic does not go on forever. Eventually the banks and other traders who sold puts will have fully covered their positions, and the selling pressure eases. Most of the options bought by the listed E&Ps, as disclosed in their regulatory filings, had strike prices between $50 and $60 a barrel for US benchmark West Texas Intermediate crude, implying that prices are under pressure when they are inside or close to that range. Now WTI is at $45.59 a barrel, it may become more stable. Goldman Sachs suggested last month that once the delta hedging effect had played out, oil prices could “snap back”. Mr Verleger raises the possibility that there could be a sustained impact on US E&P companies, however, if they find it has become more difficult to hedge. Reduced hedging means reduced borrowing capacity, which means reduced drilling. He suggests US output could drop 5-10 per cent next year if that kicks in. That potential squeeze on hedging would add to the other pressures already accumulating for the US E&P groups as a result of the falling oil price, weak stock markets and rising interest rates. Lower oil prices will hit the valuations of reserves used to secure bank lending, and the debt markets have become less welcoming for oil company borrowers. The plunge in E&P share prices, with the S&P oil and gas exploration and production industry index dropping 43 per cent since early October, makes it harder to raise equity finance, too. The US Energy Information Administration noted recently that US E&Ps were in roughly the same financial position heading into the latest oil price fall as they were when prices slumped in 2014. If we are in for a rerun, that would be a reasonably encouraging prospect: most E&P companies survived the last downturn, and many thrived. But as the EIA noted, “oil price volatility and uncertainty remain high”. US oil groups have overcome many challenges in the struggle to make shale viable for the long term. Next year, they can expect to face some more.