Creative Destruction Hits The Energy Industry

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Includes: ABB, AES, BP, CHK, CLR, COP, CVX, EIX, EOG, FSLR, GE, JASO, JKS, LIT, NEE, TSL, TSLA, XEL, XOM
by: Kevin Wilson

Summary

The oil price collapse has caught many shale players with high debt and negative cash flow, leading to a cycle of Schumpeterian creative destruction in the energy industry.

Rig count in the US has dropped to around 465, capital projects worth $380 billion have been delayed or canceled, production is falling, and many more companies will go under.

Rising out of the ashes of all this destruction will likely be a new wave of technological progress (or creative phase) led by wind and solar power companies.

Although shale survivors may bounce back, the revolution in renewable energy could arrive first, further displacing companies and workers as the new energy sources compete directly for market share.

Trades include buying NEE, XEL, EIX, XOM, CVX, COP, BP, EOG, FSLR, GE, TSL, JASO, TSLA, AES, ABB, and LIT.

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Since the oil industry crash began in mid-2014, oil prices have dropped by 65%, the US weekly rig count has dropped from around 2100 to around 465, at least 52 firms have already filed for bankruptcy, and many more are on the edge of the abyss. During the shale boom, interest rates were kept artificially low by Federal Reserve interventions in the markets, and the combination of high crude prices ($98/bbl in mid-2014) and low interest rates made it easy for energy companies to pile on debt to finance their capital intensive operations. The global oil & gas industry's debts rose from $1.1 trillion in 2006 to $3.0 trillion in 2014, according to the Bank for International Settlements (BIS). The debt burden grew even higher in 2015, when prices briefly surged in the springtime, allowing a renewed burst of credit to be issued. In the ten-year period ending in 2013, annual capital spending by 18 of the world's largest oil companies nearly quadrupled, from $90 billion to $356 billion, according to Ed Crooks of the Financial Times.

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(Source: Yardeni Research)

In many ways, this was a classic bubble characterized by irrational asset pricing, euphoric enthusiasm about the future, and speculative finance activity as the bubble inflated, according to energy economist Philip Verleger. All this effort increased US production alone by more than 4 MMBO/D between 2010 and 2015, creating the supply conditions that ultimately ended the boom. The Saudi Arabian decision, confirmed by OPEC, to provoke the price collapse by maximizing production can be seen as an attempt to defend market share and bring rational thinking back to capital allocation in the energy sector. In part, it has been a success because of the carnage in the oil sector already discussed. However, it is not clear that it has really worked yet in all of its details, because US production has only decreased so far by about 600 KBO/D, and there are thousands of Drilled-Uncompleted (DUC) wells waiting to come on-line if prices stabilize at a somewhat higher level.

Indeed, with the first signs of demand decreases coming in recently, it is not likely that OPEC will be able to gain the full advantage they sought, as prices are, in my opinion, destined to return to low (<$30/bbl) levels and stay there for a while yet, perhaps longer than the Saudis expected. This is not to say, however, that the Saudis and OPEC have failed, because the combination of falling prices and massive debt service requirements in the shale energy industry have started an enormous cycle of creative destruction, and it is going to continue mowing down companies and costing employees their jobs like a tsunami hitting the hotel district on a tropical beach.

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Already, equity investors have lost an estimated $2 trillion in paper losses on energy stocks, and bond investors have lost about $150 billion on junk bonds in the energy sector, with much more to come. In reaction to low prices, high debt, and mostly closed (to energy firms) capital markets, a horrifying number of capital projects worth about $380 billion have been delayed or canceled, according to consulting firm Wood Mackenzie.

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Layoffs have hit 200,000 in the US and 65,000 more in the UK in 2015, and they are expected to increase significantly in 2016. The oil glut has produced record levels of storage, including last week's 532 MMBO in the US and around 186 MMBO in global floating storage in early March, according to Deutsche Bank Research.

(Source: US EIA)

Projections of supply and demand like the one charted above generally depend on assumptions of rising demand along the long-term trend line and falling non-OPEC production in response to low prices and crippling debt service levels. However, I think it might turn out that the assumption of rising demand (on trend) is wrong, because it doesn't fully take into account the incipient global slowdown or recession. Some countries or regions have already seen falling demand, including France, Russia, Canada, Latin America, and Japan. And at least so far, production declines total only about 840 KBO/D worldwide from all causes since year-end, far less than what's needed to restore balance and stabilize prices. The excess supply has been variously delineated at somewhere between 1.5 and 3.0 MMBO/D, according to reports from the EIA, IEA, Société Générale, and others.

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(Source: Forbes)

One very important constraint on oil prices going forward might be the amount of spare capacity remaining under then-current conditions. It appears to have already fallen from very high levels around 6.5 MMBO/D in 2011 to perhaps only 2.9 MMBO/D now, and most of that is low quality (heavy, sour crude). This is adequate for now, but cutbacks in Nigeria, Iraq, the US, and elsewhere may further reduce the level of spare capacity unexpectedly. And the risk of this will increase over time due to canceled oil & gas expansion projects. This may cause some volatility going forward, because small supply shocks could be amplified by (future) low spare capacity. This is one way oil bulls could see their dreams come true, at least in terms of a short-term trade.

So then, the question arises, "How long will oil stay down?" This spare capacity factor could make an answer hard to come by, and of course, the massive destruction wrought by the oil price collapse carries within it the seeds of an eventual recovery, since production in the shale plays is likely to fall for a year or two, and surplus supply should fall as well. However, I will discuss below two scenarios in which the destructive part of the cycle continues longer than expected.

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(Source: Energy Matters blog)

In the coming months, defaults in the energy sector are expected to rise dramatically, spreading mayhem through the capital markets. One report (Anne VanderMey, Fortune) suggests that bankruptcies could increase dramatically, as estimated by accounting firm Deloitte, potentially adding another 175 companies to the list of failures in 2016. This could trigger at least another $150 billion in bond and loan defaults, but I think the figure will be much higher than that if the incipient global recession is confirmed. Indeed, a recession is one of the scenarios that would make the destructive phase last longer than expected. This combination of bad loans and credits may even have a significant impact on the banking industry (JPMorgan (NYSE:JPM), BOK Financial Corp. (NASDAQ:BOKF), etc.) this year. The good news is that all these energy industry bankruptcies are likely to pull production down even further, taking some of the pressure off oil prices.

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(LSI = Moody's Liquidity Stress Index; Source: MarketWatch)

The economic concept of creative destruction was proposed by economist Joseph Schumpeter in the 1940s and became widely known in the 1950s. It involves "the process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating the new one," (J.A. Schumpeter, 1942, Capitalism, Socialism and Democracy, republished 1994, Routledge, London, pp. 82-83). It was originally at least partially a Marxist idea about how capitalism works, but became accepted in modern Western economic circles because of its application to situations like downsizing of companies to increase efficiency, etc. Unlike Marx, Schumpeter emphasized the creative aspects over the destructive aspects, and that is what we will now attempt to do here as well. A good modern example of creative destruction might be the destruction of newspaper ad volumes in the last 20 years and their replacement by Google (GOOG, GOOGL) ad volumes.

Example of Creative Destruction

(Source: Wonderwave Design)

In the current discussion, we can use the Schumpeterian argument that entrepreneurs produce innovations that act as a disruptive force to destroy the value of established companies and workers, replacing them with new enterprises, new technologies, and newly skilled workers. In the case of the shale boom, entrepreneurs like Harold Hamm of Continental Resources (NYSE:CLR) and Aubrey McClendon of Chesapeake Energy (NYSE:CHK) revolutionized the oil & gas industry by making large-scale shale plays economic (at some level). Horizontal drilling had long existed, as had hydro-fracking technologies, but in the shale revolution, these two were blended into a tremendously effective new combination technology that led to a massive increase in oil production, especially in the US.

The risk was reduced substantially (i.e., success ratios were around 96% in many shale plays), but the costs soared to as much as $10 million per well in 2011 in some plays. Due to continued innovation, however, those costs have since dropped in late 2015 to around $5.9 million in the Bakken, $6.5 million in the Eagle Ford, $6.1 million in the Marcellus, and $5.2 million in the Permian Basin, according to a report by IHS Global Inc.

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(Source: SilverDoctors)

The huge competitive advantage of shale plays over conventional plays shows up when we compare the time that's needed to bring on new projects in shale plays versus conventional offshore plays, such as those in the Gulf of Mexico. Shale wells take only a few weeks or months to go from map table to operating production facilities. On the other hand, small offshore plays can take as much as three or four years, and major plays can take as long as seven years to reach first production. Famous energy analyst and author Daniel Yergin has said that this difference in time frames has made the US shale industry the "inadvertent swing producer" on the global crude oil markets. This is a new role, and not one American industry is used to, and it carries with it the implication that creative destruction will play a more prominent role in the energy industry going forward.

The competitive advantage enjoyed by shale players was offset a bit, however, by the fact that the shale industry has been incredibly capital-intensive, so much so that almost all shale play companies were operating on a cash flow-negative basis by 2014, according to investing blog Zero Hedge. This meant they were (and are) vulnerable to oil price volatility because of the effects that such volatility has on cash flows and access to capital markets. Initially, much of the price volatility risk was hedged away, but going forward, that is going to fade as hedging trades expire.

Now that the speculative bubble has burst, and the assumption of high prices that drove the shale plays has been proven false, where do we stand in terms of this concept of creative destruction? It is arguable that this time around, some permanent damage has been done to the innovators of the shale energy industry, because so many firms have gone or will go under, and so many assets have been or will be sold for a song. Hundreds of thousands of highly paid jobs are likely gone forever, if previous energy cycles are any guide. In other words, we see that creative destruction played a role in building the shale boom, and we see the destruction side again as the energy bubble collapses - but where is the creation? I am going to make the argument here that the creative side of Schumpeter's creative destruction will come as a result of the window of opportunity now opening for alternative energy technologies.

This so-called window of opportunity may seem counterintuitive to those who have noted the long-term correlation between oil prices and clean energy stock prices. High oil prices allowed enthusiasts to claim that otherwise uncompetitive new technologies like solar, wind, and geothermal would make sense if properly subsidized. What is new and perhaps strange is that even though oil prices have plummeted, the cost per kWh of (even unsubsidized) power being generated by solar (Trina Solar (NYSE:TSL), First Solar (NASDAQ:FSLR), JA Solar (NASDAQ:JASO), JinkoSolar (NYSE:JKS)), and wind (General Electric (NYSE:GE)) has also dropped, and is now roughly competitive with the costs of both coal and natural gas. Yet, despite this, the alternative energy subsidies were renewed for another five years in December by Congress. This move was supported by those who are concerned about global warming, those who dislike the oil industry for political reasons, and those who wish to be seen as sustainable growth advocates; in any case, it had broad support.

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(Source: Green Econometrics)

In an ironic twist of fate, just as oil & gas are declining to record low levels, the cost of solar and wind energy will likely drop within another two years to levels significantly cheaper than conventional coal and natural gas production, according to analyst Andreas Vagn-Hansen. In addition, a relatively new breakthrough has happened involving a material called hybrid lead halide perovskites (HLHPs; in nature, perovskites are calcium titanium oxides similar to rutile, but generally found in metamorphic rocks). It promises to make solar cells capable of re-transmission of light, which will boost the available power efficiency much closer to the theoretical limit (i.e., 33%). This will also make solar power much cheaper.

Hybrid Lead Halide Perovskite (HLHP) Layer - Microscopic View:

(Source: CleanTechnica)

On top of that, the cost of storage (e.g., Tesla (NASDAQ:TSLA) batteries) has dropped down to around $0.07/kWh, which is still fairly expensive, but not prohibitively so. Advances in battery technology may soon improve these storage costs dramatically, perhaps cutting them by half in the next five years, according to Norman Bay, the head of FERC. The growth of solar and wind energy as power sources has furthermore been consistently underestimated, and this trend is likely to continue. But we are now adding 30-47% per year to the total solar power grid (235 GW in 2015) and the wind power grid (64 GW in 2015), and indeed, total new power capacity is comprised of 63% solar and wind alternatives worldwide. For perhaps the first time ever, new investments in clean energy significantly exceeded those in coal and natural gas last year. This reversal of the traditional trends in energy spending is expected to continue in 2016.

(Source: Cleantech Open)

(Source: CleanTechnica)

Some analysts estimate it is unlikely that solar will take more than about a 7% share of the total power grid, in part because of the intermittent nature of both, and in part because the solar and wind tax credits are scheduled to be phased out over time. However, I question that conclusion on both scientific and economic grounds. If solar efficiency improves from the current 21% to, say, 28% with HLHPs, that's an improvement of 33%, which would cut the price per kWh to well below even the current low cost of coal and natural gas, and of course, below oil as well. Even without subsidies, by 2020, renewable energy could be permanently competitive.

If this happens while hydrocarbon prices are still repressed, then subsequent oil price increases would tend to drive adoption of wind and solar power even faster. This scenario could thus result in an increase in the adoption rate of solar power that is actually price-driven, not just tax incentives-driven. This new competition could potentially keep oil & gas down much longer than previously expected. We could then see the creative destruction cycle (in that circumstance) cause even more severe cutbacks in the oil & gas business. I realize that this is mere speculation, but I am concerned that we who have grown up around the oil & gas business may be the last to realize that the energy revolution is upon us.

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(Source: CNNMoney)

At least some of the jobs being lost in the oil & gas industry are being offset by a job boom that's happening in solar energy in the US. This trend is expected to continue, and it seems to at least partially confirm the idea of creative destruction in the energy industry.

Finally, a good historical example of creative destruction comes from the demise of the whaling industry in the late 19th and early 20th centuries. Whale oil was used for lighting, soap manufacturing, and even in the production of margarine. However, once Dr. Abraham Gesner, a Canadian geologist, came up with a methodology for distilling kerosene from petroleum in 1849, as discussed by James Robbins (1992, Foundation for Economic Education blog), the end of whale oil as a major product was inevitable. The decline took many years, but eventually, petroleum and other products replaced all products made from whale oil. The chart below is a good example of resource replacement and creative destruction. It implies that even if I'm right about solar and wind energy replacing oil, it will take decades. Still, there is money to be made on such a major technological transformation.

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(Source: BioFuelNet Canada Inc.)

The trades that might make sense in the scenarios discussed include the following: buy utilities with high solar and/or wind power investments, like NextEra Energy (NYSE:NEE), Xcel Energy (NYSE:XEL) and Edison International (NYSE:EIX); buy large-cap energy E&P or integrated producers able to ride out the storm and benefit from creative destruction, like Exxon Mobil Corp. (NYSE:XOM), Chevron Corp. (NYSE:CVX), ConocoPhillips Corp. (NYSE:COP), BP Plc (NYSE:BP), and EOG Resources (NYSE:EOG); buy up-and-coming solar and wind players that are making money, like General Electric Co., First Solar Inc., Trina Solar Ltd., and JA Solar Holdings Co., but make sure you check their debt levels and valuations first; buy companies that are active researchers in battery storage with a growing product line or experience with large projects, like Tesla, AES Corp. (NYSE:AES), and ABB Ltd. (NYSE:ABB). To get exposure to lithium companies, you could buy the Global X Lithium ETF (NYSEARCA:LIT).

Disclosure: I am/we are long XOM, CVX, BP, EOG, FSLR.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended.