The oil and gas industry’s most recent cyclical downturn, triggered by the Covid-19 global pandemic in March, has yet again invited close scrutiny of the U.S. shale industry. At one point, prior to the turn of events, shale was seen giving American hydrocarbon production a position of market superiority.
In many ways it still does, especially if the sheer volume of barrels produced is all that matters. Despite a projected post-Covid production decline in the range of 1.5 to 1.75 million barrels per day (bpd), U.S. headline output would still remain comfortably above 11 million bpd, the highest in the world.
But hardly a week has gone by since the market chaos of April in which there hasn’t been a U.S. shale bankruptcy via a Chapter 11 filing. The biggest scalp in a dire Q2 2020 was that of shale pioneer Chesapeake Energy, which filed on 29 June. More are guaranteed to follow with the most recent case being that of Rosehill Resources.
Among the companies that have filed for bankruptcy, nearly 30 are carrying liabilities of at least $50 million or higher, according to Deloitte. Rosehill for instance owes $100 million on paper to senior bondholders alone.
High production figures often mask rising debt levels and dismal break-evens. Since 2010, frackers have burned through $300 billion. Despite having brought millions of barrels of U.S. crude oil to market, only a third of them can barely break-even at $35 per barrel.
Overall, between the last industry downturn (2015-16) and the current market upheaval, over 230 North American, largely U.S., oil and gas producers filed for bankruptcy owing at least $152 billion, says law firm Hayes & Boone. Debt liabilities of those who filed in Q2 2020 alone stood at $30 billion.
Covid-19 upheaval or not, there is no denying that it isn’t a pretty picture. But what’s problematic here is how those predicting the demise of the U.S. shale industry are yet again talking up Chapter 11 bankruptcy filings as a distress benchmark. It proved to be a mistake back in 2015-16 when U.S. crude production volume not only bounced back but exceeded pre-crisis levels.
Whether the same might happen again or not remains to be seen but talking up Chapter 11 numbers and talking down the agility of shale players often bottles down to a profound lack of understanding of U.S. bankruptcy norms. The country’s existing framework often allows companies at risk of a bankruptcy to resurface in a new restructured form in the very same space they previously occupied.
In the main, a Chapter 11 bankruptcy filing involves a reorganization of a company’s business affairs, debts, and assets, named after the U.S. bankruptcy code 11. The accounting and audit world calls it the “reorganization” bankruptcy as it gives corporate entities time to arrest a decline rather than slump towards oblivion.
Companies of all stripes use it as a fresh start subject to the fulfillment of debt obligations under a plan of proposed reorganization that’s largely in the best interests of the creditors. If the companies can’t propose such a plan, the creditors may put one forward instead.
“In most cases the firm will remain open and operating as a corporate entity. The court where the Chapter 11 has been filed will help the business restructure its debts and obligations. Despite the seriousness of the situation, it does not spell the end of the company and many in the U.S. oil patch have deployed it effectively to redefine their business, while others have used it to survive,” says Deborah Byers, Americas Sector and Solutions Leader, and U.S. Oil and Gas Leader at EY.
Let alone smallcap shale producers, even companies as big as United Airlines and General Motors have used Chapter 11 filings to re-shape their business. So assuming a Chapter 11 filing to be the demise of a firm is erroneous.
Then there is also the correlation of the oil price and how it prevents what does or doesn’t constitute a technical insolvency in the mind of investors and companies alike at various points in the trading or hedging cycle, says Regina Mayor, Global Head of Energy and Natural Resources at KPMG.
A technical insolvency is said to occur when the value of a company’s liabilities rises at a faster rate than its assets due to operating issues, debt or borrowings.
“Hypothetically, if a shale producer falls into a technical insolvency say below a $35 per barrel oil price and the price stays above that level for an operating quarter; unless there is an accounting insolvency – such as an actual failure to meet liabilities – concerns about the viability of the operator, while valid, do not spell its end as a going concern.”
Mayor says an overt focus on Chapter 11 statistics and so-called technical insolvencies stateside during the previous downturn led many to predict a premature end to the U.S. shale industry. At the time of the last glut even OPEC perhaps looked too keenly at such data.
“Yet, the end never came. After a period of distress, the U.S. industry bounced back. Depending on where oil demand and the debt markets go, and how deep the current downturn is, the market can expect a gradual U.S. shale recovery this time around too.”
That recovery would come via those who have earned it, says Jim Johnson, CEO of FTSE 250 services and products provider Hunting Plc (LON:HTG). “While those who paid silly money for acreages will suffer, viable parts of the Permian Basin of West Texas and New Mexico, and Eagle Ford could remain competitive at $30 per barrel both via efficiencies and cost cuts.
“There’s going to be a whole of lot of pain as we’ve already noticed but it will not be a killer blow. We expect the market to pick up early 2021.”
And if smaller, agile players will lead that recovery and some in that category are looking to reorganize via Chapter 11 proceedings, they might be better placed in the current downturn compared to the last one courtesy of U.S. Small Business Reorganization Act of 2019.
The act, which went into effect on 19 February, 2020, added a new sub-chapter to Chapter 11 designed to make bankruptcy protection easier for small businesses defined as “entities with less than about $2.7 million in debts”, although certain other U.S. Department of Justice criteria need to be met in order to qualify.
The new act “imposes shorter deadlines for completing the bankruptcy process, allows for greater flexibility in negotiating restructuring plans with creditors, and provides for a private trustee who will work with the small business debtor and its creditors to facilitate the development of a consensual plan of reorganization.”
Ultimately, it will narrow down to the survival of the fittest in the shale patch and not the number of Chapter 11 filings that seem to be piling up in the initial stages of the downturn. Cyclical downturns or market corrections always weed out the weak, and 2020-21 will be no different. That full picture is yet to emerge.