source: company website
While I'm very bullish on the U.S. shale industry over the long term, and for some companies even with the price of oil around $40 per barrel, I'm cautious in general for those not able to cut costs like some of the market leaders have.
For example, EOG Resources (NYSE:EOG), which is my favorite play in U.S. shale, is able to produce oil at a 30 percent profit when oil is at $40 per barrel. That means it produces at an average cost of just under $31 per barrel. I haven't found any other shale company able to produce at that level.
Even though there has been big push by the financial media to suggest the price of oil will probably go much higher by the end of 2016, I don't think that will be how it plays out. It could even get much worse if a supply war breaks out between Russia and Saudi Arabia, with the two rattling sabers over who is able to grow market share by increasing output.
I don't see production leaders really wanting the price of oil to jump even to $50, as it would bring a lot more supply to the market, giving competitors a chance to take away market share from them. It's one of several reasons I said numerous times there would be no production freeze agreement at Doha. The only countries and companies benefiting from that would be those unwilling or unable to bring production costs down. Rewarding weak competitors isn't good for the industry.
Need to be cautious with shale producers
As mentioned, I'm very bullish on the general U.S. shale industry over the long term, and some individual companies even in the short term and under these price conditions. But there needs to be a lot of research and discernment concerning U.S. shale producers, as it's easy to get caught up in the outlook of the industry and not focus on the short-term pressures associated with companies weakly hedged or with less than stellar balance sheets.
In other words, there will be a robust shale industry in the U.S. for many years, but a lot of the upstream companies today won't be around even by the end of this year.
Haynes and Boone says over 60 oil producers in North America have filed for bankruptcy since 2015, representing about $22 billion in debt. Deloitte sees it getting a lot worse, with a projected 175 publicly traded companies being at risk of filing for bankruptcy by the end of 2016. Together they represent a debt total of about $150 billion.
The point is there will be a tremendous shake out in the U.S. shale industry before we find out those that will thrive and survive, and those that dive. Liquidity will determine the outcome, outside of some unforeseen event driving the price of oil up.
EOG Resources has done very well since trading at a little over $60 per share since the middle of January 2016, but in general, the market hasn't rewarded it as I thought it should. It appears there needs to be confirmation of its production and cost improvements from the next couple of earnings reports before it garners an increase in confidence from investors.
In its last earnings report it stated its strategy is to end up with all of its wells being premium wells. It defined premium wells as those able to generate at least 30 percent at a price point of $40 per barrel. It would keep wells it is able to transition to premium wells from what it identified as high quality wells. The goal is to have all its wells in production able to generate earnings at $40 per barrel; over time it wants to improve that to be able to compete at any price level against global competitors.
As for its balance sheet, there is no risk to it, even with no hedges in place as of the most recent quarter. Its debt is under $7 billion. In order to protect its balance sheet it has cut CapEx from 2014 to today by about 70 percent. For 2016 it is focused on spending primarily on its premium well initiative. Excluding acquisitions, its 2016 budget will be in a range of $2.4 billion to $2.6 billion. Exploration and development represents 80 percent of the budget.
What has been impressive about EOG is while slashing expenditures it has been able to keep production close to level. In 2016 it has a goal of completing 270 of its drilled but uncompleted wells.
The challenge for EOG is after being rewarded for its solid performance, a lot of it has already been priced in. It'll be hard for it to improve on its numbers in the short term, although I am interested in seeing the impact of its well completions on the top and bottom lines for this year.
I've focused primarily on EOG Resources in this article to offer a comparison between a strong company and many of its weaker rivals. There are a handful of other shale producers that are positioned well, but not at the level EOG is. They should do okay under these market conditions, but as with EOG, they aren't representative of the health of the U.S. shale industry as a whole.
My concern is investors, because EOG and some of its peers tend to get a lot of coverage from the media. That could skew the outlook of the U.S. shale industry, giving the impression it's doing okay. But as the numbers show, it is very likely bankruptcies could reach from 150 to 200 in 2016.
On the other side of the picture, an increase in bankruptcies isn't reflective of the better-managed companies either. They should do okay over the next year or so. It's a mess because managements were somewhat lazy and riding the high price of oil. Once prices fell, the high cost of doing business, along with the enormous debt levels, revealed how inefficient many U.S. shale producers were.
When considering the opportunity, it's inexcusable to not have prepared for the inevitable drop in the price of oil. Bankruptcies will hopefully train the survivors concerning the need to reduce costs in the long-term low-price environment they're now operating in.
That's one reason I like the way EOG has handled this. Not only is the company shooting to improve in response to the short-term challenges, but it has the goal of improving costs in order to compete against low-cost producers like Saudi Arabia and Iran. It can do so not because it will necessarily ever reach the production cost levels of these countries, but because they are countries it doesn't have to. EOG doesn't have to fulfil promises to citizens or police any geographic region. It only has to do business. It doesn't have to have a premium added to the costs in order to offset costs of running a country.
Higher oil prices aren't going to save inefficient shale producers
There is nothing to suggest the price of oil will rebound to the level it will be able to offset the inefficiencies of poorly run companies. Even if it was to get closer to $50 per barrel it wouldn't be able to do much to change the number of bankruptcies coming. Maybe a few of them could hang on, but most would still have to have the price of oil jump higher than $50 to make a go of it.
In my view this companies shouldn't survive, and in most cases, thankfully, won't. With so many producers being able to cut costs and lower risk, there is no excuse for the others to not improve their businesses as well. It will be good for the U.S. shale industry to remove the weak players and have assets under leadership that can profitably bring supply to the market.
I'm aware even the stronger shale producers are under some stress, but they have adjusted to the challenging environment by dealing with the more costly wells, by either getting more production out of them with less spending, or divesting of them altogether. Far too many were lured by the low-interest rate environment which gave them more access to capital than they should have had, which allowed them to go on spending sprees with little thought to building a business.
Fortunately in the oil sector, good management drives out poor management when conditions get tougher. Anyone can make some money when the price of oil is high. It's the ability to generate improve efficiencies when prices fall that separates the pros from the amateurs. Even if oil goes a little higher by the end of 2016 and early 2017, it'll be too late for many of these companies.
Eventually U.S. shale will become much stronger as a result of the ongoing shake out of the industry.
Before the drop in the price of oil, an investor could almost take a dart and throw it at a board with a bunch of U.S. shale oil producers on it, hitting any of them and still be able to make money. Those days are long gone.
All ships were rising with the oil price tide, but once the tide went out it exposed the high-cost producers for what they were: poorly run companies that run up high debt levels which continue to challenge their liquidity.
Now we're down to focusing on companies that have outperformed their peers under these difficult market conditions. There are some decent companies of interest, but that doesn't mean the former strength of the U.S. industry remains. It doesn't. The high price of oil masked the weakness of many of them, but now they are fully exposed as the risky investments they always had been.
News of quality shale producers like EOG Resources needs to be separated from the former idea of everyone can make money in the U.S. shale industry. The price of oil won't save the heavily indebted producers, as there is no catalyst out there that would drive the price of oil up to the point of offsetting their devastating balance sheets and lack of liquidity.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.