GOLD & COMMODITIES

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The US shale oil industry is rapidly shrinking, and dozens of companies face bankruptcies in the months and years ahead. 
But the coronavirus pandemic isn’t entirely to blame. The shale industry started slipping years before oil markets tanked, as producers accrued debt and failed to deliver strong returns.
That’s according to Adam Waterous, the former head of investment banking at Scotiabank and founder of a $1 billion energy fund.
US crude prices will have to near $70 a barrel for the shale industry to grow once again, according to his firm’s research.
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Like any other energy investor, Adam Waterous couldn’t have predicted a global pandemic that would cause oil markets to collapse almost overnight. 

What he did foresee was a reckoning for America’s shale industry.

In the last five years, shale companies turbocharged oil output, he said, making the US the largest crude oil producer in the world. But in the process, they accrued billions of dollars of debt, while failing to yield returns for investors, who are starting to back away from the industry. 

Now, dozens of American shale companies are at risk of bankruptcy. And hundreds more that are backed by private equity are in trouble as they fail to find prospective buyers, according to Waterous, founder of a $1 billion energy fund based in Calgary. 

"We forecasted this months ago," he said. "The returns weren’t there, capital was being withdrawn from the industry, and consequently, the industry was going to be forced to contract." 

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That was in January, he said — well before the pandemic evaporated demand for gasoline and jet fuel, causing the price of oil to plummet to 20-year lows.

"All that this has done is increased the slope of the curve," Waterous said of the pandemic, "from a bunny run to a double black diamond."

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The rise of shale and American energy dominance
It may be hard to imagine today when the world is awash with oil, but the period from 1970 to around 2009 was considered an "age of scarcity," said Waterous, the former head of investment banking and North American energy and power at Scotiabank.

Then, the dominant view among energy investors was that oil would become increasingly precious; over time, it would be harder and harder to find and extract. 

"Oil and gas companies thus tried to grow reserves to grow production because they [thought it] would be worth more in the future," Waterous said. 

Profits were reinvested into production and, aside from some of the majors, shale producers did not offer dividends.

Instead, private investors — who were behind much of the industry’s capital — sought returns when those companies were acquired. 

For a while, this strategy worked.

Starting around 2009, in the aftermath of the financial crisis, loads of private investors saw an opportunity to "buy on the dip" — in other words, to get in when oil prices were low, Waterous said. 

Over the following years, billions of dollars flowed into the industry and fueled the growth of a breakthrough technology known as hydraulic fracturing. Using horizontal drilling, a perforating gun, and pressurized liquids, fracking allows drillers to extract oil and gas trapped inside shale rock.

"Overnight, the industry went from being drilling-location poor to drilling-location rich," he said. 

From 2009 to 2014, US production grew from about 5.4 million barrels per day (bpd) to almost 9 million bpd, according to the US Energy Information Administration. 

With the price of oil over $100 for much of that period, returns were strong, too, Waterous said. Though fracking wasn’t cheap, investors earned about an 8% to 10% return on investment, he said. 

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Investor returns evaporate
Then starting around 2014, everything changed.

The oil market entered another downturn, driven by both an oversupply and drop in demand, causing the price of US crude to fall from over $100 to less than a third of that at some points in 2016.

To many investors, it seemed like another good opportunity to buy on the dip, Waterous said — especially considering that fracking technology was improving. To them, it meant companies could eke out a profit even if oil prices only climbed back up to $55 a barrel, he said. 

Once again, investment caused production to balloon.

Between 2015 to 2019, the US oil output grew by another 3 million barrels or so, up to more than 12 million barrels per day — more than double what it was in 2009. 

Reuters

This time, the returns didn’t materialize. 

"The industry was just vaporizing capital," Waterous said, referring to the period between 2015 and 2019. 

The industry was burning about $100 billion a year, he said, adding that there was "approximately $500 billion in capital destroyed over that five year period." 

So what happened? 

According to Waterous, investors mistook a fundamental, structural change in the market for a cyclical one. 

The fracking revolution made it much easier and less risky to find and extract oil, Waterous said. And so companies focused on that task — many of which were backed by private equity firms — were much harder to sell, especially if they were producing lower-quality oil.

That meant that investors who were counting on using deals to generate a profit from their investments were out of luck. Making matters worse, the price of oil never fully recovered, even before the pandemic took hold. 

Andrew Cullen/Reuters

Heading down a double-black diamond
The investor calculus for US shale was challenged going into this year when US crude was at about $60 a barrel, Waterous said.

Then the coronavirus pandemic struck, pulling the bottom out from oil demand almost overnight. Today, a barrel of US crude costs about $25.

Cheap oil is only hastening a constriction of the industry, he said. 

Of the 500 or so oil and gas companies backed by private equity firms in North America, Waterous said he thinks an astonishing 80% of them won’t be able to find a buyer. Without access to more cash, they’ll be forced to stop spending on their oil assets, causing production to decline.

There will likely be plenty of bankruptcies, too.

If the price of US crude remains at or below $20 a barrel — where it spent much of the last few weeks — Chapter 11 bankruptcy cases could reach 140 this year and increase in 2021, according to an analysis by Rystad Energy, published in April.

Read more: The oil industry is bracing for an onslaught of bankruptcies. Here are the 25 companies Fitch says are most at risk.

For some companies, it’s no longer a hypothetical. Whiting Petroleum and Diamond Offshore Drilling have already filed for bankruptcy, while Chesapeake Energy and Unit Corp. are preparing to potentially follow suit, according to reports from Reuters and the Wall Street Journal. 

By the end of next year, Waterous predicts that US oil production will have fallen by 3-4 million barrels of oil per day. More remarkably, his firm’s research suggests that it won’t grow again until US crude oil is priced at about $70 a barrel.

"What you’re seeing is the rapid shrinkage of the industry," he said. "A lot of companies are going to cease to exist."
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