In previous articles I have argued that Saudi Arabia (and the other oil sheikdoms) are making a concerted effort to destabilize the investment market for shale oil and other new oil competitors. The key to their plans is to keep the price of oil low (less than $50) for years and to use their substantial trillion-dollar sovereign wealth funds to make up for the difference. This latest pronouncement adds credence to my hypothesis.
In my first article, "4 Reasons Why Saudi Arabia Will Keep The Spigots Open Until 2018," I outline an argument that Saudi Arabia's goal is to make investors think twice (or three times) before they ever invest in shale again. To do that, the Saudis need to keep the pressure on for two to three years, thereby driving many oil and gas companies into bankruptcy. In my second article, "Saudi Arabia And OPEC Are Going To Keep Pumping Until Shale Investment Is Crushed," I continued with that theme and addressed some data on shale production and default odds based on the oil price.
In this article, I will look at what actually happened in 2015 to see if there is a trend going forward that supports my thesis.
"Power has no limits" - Tiberius
In 2015, Oil and Gas Bankruptcies Totaled $13 Billion
The Texas law firm Haynes and Boone, LLP specializes in energy bankruptcies and actually operates a website called "Bankruptcy Monitor." The following chart is from that site (modified by the author):
Note the largest BR, Samson Resources. This was a company bought out by high-powered, sophisticated investment firm KKR & Co. in the largest leveraged buyout ($7.2B) in shale oil history. How long do you think it will be before KKR invests in shale oil again?
Here's the unhappy couple, Henry Kravis and James Robinson III, founders of KKR:
Source: MarketWatch and Getty Images.
Negative Free Cash Flows Are Almost Universal in the Oil Patch Today
As prices have fallen, O&G companies have taken a huge cash flow beating. If we just take a look at Whiting Oil (WLL), one of the largest shale players, we can see that even after cutting capex by almost $600M the company had negative FCF (free cash flow) last quarter of almost $50M.
And WLL is not alone, as shown in this chart:
Credit Downgrades Are Happening by the Hundreds
Moody's puts out a list of ratings for the E&P industry, and the most recent from Dec. 16, 2015, has 756 downgrades. You can see Whiting on the list, as well as four government bodies (AK, LA, TN and MD) that issued revenue bonds. I assume that these revenue bonds were to be paid off by specific taxes or fees assigned to oil wells that no longer are providing enough revenue to pay the bonds off. One has to wonder how many more of these government-related issues are in trouble.
There is even oil behemoth ConocoPhillips (COP) -- the third-largest E&P company in the U.S. -- with 16 different issues on the list for downgrades. If we have another year or two of sub-$50 or even sub-$40 oil, how many more majors will be on this list?
Supplies Are Set to Increase Again
With Iran likely coming on in the first half of 2016 and Libya looking for all the oil it can, production is set to increase again in 2016 despite the slowdown in demand growth.
Even the North Sea production is increasing after 15 years of decline.
Source: The Telegraph.
Another possible source of production is when BR companies like Samson reorganize under Chapter 11, eliminating much of the debt and providing valuable assets on the cheap. This, in turn, will lower costs and could make production cash flow positive at a much lower price than prior to the reorganization. This could present two significant problems. First, by increasing production the low-cost, reorganized companies might force even more marginal producers into BR, perpetuating the problem going forward. Second, this process might make it impossible for Saudi Arabia to raise prices adequately when the time comes for it to do so. This is a potentially very ugly scenario for all parties concerned.
Where Are Prices Headed in 2016-20?
OPEC produced a report titled "2015 World Oil Outlook," a massive 406-page tome on the economics and future of oil. One of its conclusions was that the price of oil should rise to about $70 by 2020 (in 2014 dollars) based on an average ORB (OPEC Reference Basket), which is a combination of all the prices realized by OPEC members for a given day. The 2020 price was based on an average ORB price of $55 for 2015, when in reality it turned out to be $50. And even that may be high since the average for the second half of 2015 was only $45. So if you adjust the projected price downward to reflect the latest numbers, you would get $60-$65 by 2020.
And OPEC does not expect to see $100 oil until after 2040, stating: "The price of the ORB in real terms is assumed to rise from more than $70/b in 2020 (in 2014 prices) to $95/b in 2040 (in 2014 prices)." So, OPEC does not see a return to $100 oil for decades. This report should temper those who think oil will return to $80 or $90 in 2016.
As we look at the $13 billion worth of bankruptcy carnage coming out of 2015, what should we expect for 2016? If prices stay below $50, I think we can easily see another $20 billion. And if it averages nearer to $40 or even sub-$40, then the numbers could be huge. Remember that hedges will run off this year, exposing even more companies to negative cash flows and lowered credit ratings.
Of course, the one event that could raise the price dramatically would be a conflict in the Middle East. The current reports on the Iran/Saudi conflict reminds us once again that that is always a possibility lurking in the background. Let's hope cooler heads prevail in this latest Sunni-Shia dust-up.
I will conclude in the same manner as my last article on Saudi Arabia: People tough enough and determined enough to cross the Empty Quarter are formidable adversaries when it comes to their own economic survival. Years of losses weighed against trillion-dollar wealth funds are nothing compared to what they survived in the 1,500 years before oil was discovered at Dammam in 1938. The Saudis and sheikdoms are playing a very long game of Risk. And history has shown they are very good at it. Invest in oil at your peril.
This article was written by
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.