Zombie Companies And The Anti-Schumpeterian Toxin——How Printing Press Money Is Deforming The US Shale Patch

Earlier today, Chesapeake Energy – in a mad scramble to conserve cash – eliminated its common dividend, a move which i) will save the company around $240 million per year, but ii) caused the stock to plunge to a twelve-year low.

The company said that a “reduction in capital” stemming from the “current commodity price environment” had left it unable to invest as much as it would like in its “world class assets.” Chesapeake also said its “liquidity position remains extremely strong with more than $2 billion of unrestricted cash on [the] balance sheet and an undrawn $4 billion revolving credit facility.”

As we noted this morning, it remains to be seen how that liquidity position will hold up in the face of persistently depressed prices. Of course one thing that’s perpetuating the “current commodity price environment”, is easy access to capital markets. We’ve discussed the dynamic on too many occasions to count, but because it is in fact one of the most important narratives around when it comes to understanding both the current state of the global economy and why illiquid corporate credit markets are so dangerous, we’ll recount it briefly:

Access to cheap cash via capital markets allows otherwise insolvent producers to keep drilling even as prices collapse, creating what are effectively zombie companies on the way to delaying the Schumpeterian endgame and embedding an enormous amount of risk in HY credit by flooding the market with supply just as demand from investors (who are delirious from hunger after being starved of yield by the Fed) peaks and secondary market liquidity continues to dry up. This dynamic has served to create a supply glut in a number of industries and has suppressed commodity prices in a self-feeding deflationary loop.

Unfortunately for retail investors, the read-through is obscured by accounting procedures.

As we’ve outlined previously, thanks to SEC rules on how drillers are required to value their reserves, producers are effectively forced to overstate the value of their O&G businesses by nearly two-thirds, which can lead unsophisticated investors who don’t bother to read the 10K fine print to believe that the businesses are healthier than they actually are.

Meanwhile, as we quipped earlier this month, drillers are about to be “zero hedged” as the price protection which accounted for 15% of Q1 revenue for around half of North American E&P companies (and which also helped keep bank credit lines open), rolls off.

Because the next round of revolver raids for the industry isn’t due until October, investors may have been lulled to sleep by exactly the kind of credit facilities Chesapeake cites as contributing to its “extremely strong” liquidity position. In short, banks are about to run out of patience with this industry. Bloomberg has more:

Halcon Resources Corp. almost ran into trouble with its banks in June 2013. And again in March 2014. And in February 2015.


Each time, the shale driller came close to violating debt limits set by its lenders, endangering a credit line that provided as much as $1.05 billion in much-needed cash. Each time, Halcon’s banks, led by JPMorgan Chase & Co. and Wells Fargo & Co., loosened their restrictions, allowing Halcon to keep borrowing.


That kind of patience may be coming to an end. Bank regulators have issued warningson the risks involved in lending to U.S. drillers, threatening a cash crunch in an industry that’s more dependent than ever on other people’s money. Wall Street has been one of the biggest allies of the shale revolution, bankrolling thousands of wells from Texas to North Dakota. The question is how that will change with oil prices down by half since last year to about $50 a barrel.


“Lenders in general are increasing pressure on oil companies either to raise more equity or do some sort of transaction to pay down their credit lines and free up extra cash,” said Jimmy Vallee, a partner in the energy mergers and acquisitions practice at law firm Paul Hastings LLP in Houston.


Banks are already preparing for the next reevaluation of oil and gas credit lines, reviews which typically take place twice a year in April and October. The loans are based on the value of drillers’ producing reserves, which has shrunk as oil prices fell. Many companies are also losing protection as hedges that locked in prices as high as $90 a barrel begin to expire.


“There’s another redetermination cycle in the fall,” Marianne Lake, chief financial officer at JPMorgan in New York, said July 14 during a conference call to discuss the company’s earnings. “And I’m not going to say likely but it’s possible we’ll be selectively downgrading some clients.”


Banks so far have been willing to keep the money flowing because drillers that come close to maxing out their credit lines have paid them off by tapping public markets. U.S. producers have raised about $44 billion through bonds and share sales in the first half of this year, the most since 2007, according to data compiled by Bloomberg and UBS Group AG.



Now the appetite for that debt is dwindling. Bonds have become more expensive and are laden with more onerous terms, including liens against drillers’ oil and gas assets. The average coupon has increased to 6.84 percent in 2015 from 6.36 percent in 2014, according to data compiled by Bloomberg.

Yes, the appetitie for that debt (and equity) is indeed “dwindling”, which means the practice of keeping banks appeased and credit lines open by raising money from BTFDers may have all but run its course. In fact, a recent UBS study indicates that banks are increasingly bearish on the space making them more likely to cut credit lines:

We’ll close with what we said a few weeks back. Namely that the last line of defense against terminal cash burn (hedges) is about to fall and when it does, it’s going to take bank credit lines down with it.

This means October is the expiration date for heavily indebted US drillers and perhaps for HY credit as well, because once the defaults begin in earnest and HY spreads start to blow out, the BTFD-ing retail crowd will head for the exits, triggering a very non-diversifiable, unidirectional flow for bond fund managers who will then be forced to hold their noses and dive into the ever-thinner secondary corporate credit market and it is precisely at that point when everyone’s worst nightmares about shrinking dealer inventories and illiquid credit markets will suddenly be realized.

And speaking of stress in HY energy, we’ll leave you with the following chart which shows just how risky investors believe the space has gotten versus HY in general: