Going Broke In The Shale Patch——Debt Service Rises From 40% to 80% Of Operating Cash Flow In Last 3 Years

By WILLIAM WATTS at Marketwatch

Times are tough for U.S. shale-oil producers—and the situation could get even tougher next month when lenders are set to reassess oil-and-gas loans.

The pressure isn’t a shock given the sharp drop in oil prices CLV5, -5.22% since mid-2014. Throw in already high debt levels for U.S. onshore oil producers, who leveraged up to ramp up production as oil prices soared, and the recipe is complete for a squeeze. The chart below from the U.S. Energy Information Administration, based on second-quarter results from 44 companies, illustrates the growing chunk of cash flow that goes to servicing debt.
From July 1, 2014, to June 30, 2015, 83% of the companies’ operating cash was devoted to debt repayments—the highest since at least 2012, the EIA found. Read the EIA report here.
The agency noted that some companies have managed to refinance their debt, but that maneuver has become increasingly expensive since interest rates for debt issued by energy companies have been on the rise as oil prices have declined. The spread energy companies have to pay to borrow in the high-yield bond market are wider than for any other business sector (see chart below).
Read: Oil price drop keeps junk bond stress at five-year high

Meanwhile, companies that rely on bank credit to meet short-term cash needs typically go through a reassessment—or “redetermination”— process twice a year. This is when banks reassess the value of the borrower’s oil wells and other assets. As explained by analysts at Bank of America Merrill Lynch in a note last week:

If the value of the assets has fallen below the drawn amount of credit at the time of redetermination, the company will need to make up the shortfall, known as the borrowing-base deficit. Therefore, the longer oil stays at depressed levels, the harder it becomes for cash flow generated by the depreciated asset to sufficiently pay back the gap in funding/asset value. Borrowing from Peter to pay Paul works when oil is at $100/bbl. and low-rated energy companies can continue to explore for new assets. It doesn’t work if oil prices remain depressed and funding begins to dry up like the wells themselves.

So what’s an energy company to do? It isn’t all doom and gloom.

There are several options, but the most relevant might be to “monetize current hedges or lock in hedges” above the banks’ October price deck—the price the banks use to value reserves, the BofA Merrill strategists said.

A company can hedge by selling part of its expected future production in futures, options or swaps markets—effectively locking in a price. A summer rebound that took the U.S. crude benchmark back above $60 a barrel in June offered some hedging opportunities.

For its part, the EIA noted that net hedging assets stood at $8.8 billion in total for the 44 companies it studied as of June 30—the third highest for any period since 2011. Also, oil and gas expenses have declined.

Still, with redeterminations around the corner, it looks like some companies could face challenges raising enough cast to continue capital spending and meet liabilities, the EIA noted.

Source: Chart shows pain ahead for U.S. oil producers – MarketWatch