The No.1 Trade-Off For U.S. Shale Companies

by on 26 Ιουνίου 2019

Volatile but range-bound oil prices are limiting the ability of U.S. oil firms to pay down the debts they had accumulated in order to boost drilling activities and production.

On the one hand, WTI Crude prices in the $50-65 per barrel range are limiting the options for the U.S. shale patch to grow cash flows and profitability.  

On the other hand, shareholders are increasingly pressing oil producers to start rewarding them with higher returns in the form of share repurchases and/or higher dividends, which eat into what little cash flow companies manage to receive from operations.

This heightened focus on rewarding shareholders is weakening the creditworthiness of U.S. oil firms, which will likely see their debt reduction efforts stalled this year and next, due to higher distributions to investors and the prospects of little to no growth in earnings because of the range-bound oil prices, Moody’s Investors Service said in new research this month.

The ‘capital discipline’ mantra has helped some companies to finally start turning in free cash flow in recent years. But this cash is increasingly channeled to fund growing distributions to shareholders, despite the still relatively large debts, Moody’s says. Before investors became frustrated with the paltry returns, U.S. oil drillers reinvested most of this excess cash into increasing production.

“Better capital efficiency and higher cash flow should ultimately enhance shareholder returns,” Amol Joshi, a Moody’s VP-Senior Credit Officer, said.

“But when companies are struggling to grow due to range-bound prices, the risk of share buybacks and shareholder activism increases, with both developments weakening their credit quality,” according to Joshi.

Although higher oil prices and strong growth in production have helped U.S. oil drillers to materially improve their debt metrics over the past two years, further debt reduction is doubtful in 2019 and 2020, according to Sajjad Alam, a Moody’s VP-Senior Analyst.

The shale patch’s answer to investor demands—raising share buybacks—will be eating into cash flows, while there’s little room left for capital efficiencies in 2019 and 2020 with costs for many products and services still rising, Moody’s said.

Lowered production costs have largely stuck since 2016, but costs increased by 6-7 percent annually in the past two years. This year, drilling and completion costs have somewhat eased, but labor, land acquisition, and steel costs continue to increase, the credit rating agency said.  

“In 2018, North American E&P companies’ capital efficiency markedly improved following capital and operating cost cuts in the wake of the oil price collapse,” Arvinder Saluja, a Moody’s VP-Senior Analyst, said. “But today firms have fewer options to further improve efficiency,” Saluja noted.

Moreover, it shouldn’t be taken for granted that U.S. oil companies are paying investors with free cash flow only. Many E&P firms are not booking cash flows at all, according to research from Rystad Energy, which showed that nine out of ten U.S. oil drillers are actually burning cash. Rystad has studied the Q1 2019 performance of forty U.S. shale-focused firms and found that just four of them reported positive cash flows, with the combined cash flow from operating activities (CFO) at its lowest since Q4 2017.

Debt is a serious concern for small, third-tier U.S. oil drillers who were struggling to restructure or pay down debt even when WTI Crude traded above $60 a barrel earlier this year.   

“Even with the relief in oil prices, some companies remain financially stressed and may not be able to avoid restructuring their debt through bankruptcy. And some companies may be heading for Chapter 11 for a second time,” Haynes and Boone said in its Oil Patch Bankruptcy Monitor published in the middle of May, when WTI Crude had been comfortably sitting above $60 per barrel for nearly two months.

Debt reduction will be a challenge for the U.S. oil patch through 2020 as companies are torn between deleveraging and pleasing (and appeasing) investors who are fed up with meager returns.

By Tsvetana Paraskova for Oilprice.com

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