Drilling for oil these days is all about endless amounts of no-questions-asked cheap money. And now, as the price of oil plunges relentlessly, the cheap money is drying up faster than ceiling paint.
WTI traded at $46.90 Tuesday evening. Down 56% from June. At these prices, the entire North American oil equation is out of whack, regardless of what Wall Street is telling investors to bamboozle them into surrendering more of their money cheaply in order to keep the house of cards from collapsing. But it seems, investors are catching on.
After dousing energy companies with super-cheap money for years in a Fed-designed drunken stupor, investors came out of it in the second half of 2014. All heck has since broken loose. Energy stocks, particularly of smaller exploration and production companies, are crashing. Energy junk-bond yields – and spreads over US Treasuries – are spiking beautifully to the highest level since the Financial Crisis (chart).
And new money, the fuel required to keep the mirage going, has suddenly become scarcer and a lot more expensive. With funding uncertain and oil prices collapsing, capital expenditures are getting slashed, and it’s beginning to show up in the Baker Hughes rig count. Rigs drilling for oil and gas in Canada have plunged 64% in five weeks, from 438 rigs on November 26 to 156 by January 2. Canada is shutting down its drilling operations.
Many of these rigs were operated by smaller drillers. But even oil giants have reacted by cancelling or postponing multi-billion dollar oil-sands projects: Shell’s Pierre River project, Total’s Joslyn mine, and Statoil’s Corner project. Cancelling projects before they become massive capital investments is the easier thing to do. It doesn’t lower current production, but it stops the cash drain.
In the US, the trend has started a week later and is happening more slowly at this point. Rig count dropped by 109 in four weeks, from 1,920 rigs in the week ending December 5 to 1,811 in the most recent week. But the side-effects are already rippling through the economy.
US Steel is going to shutter plants in Houston, Texas, and Lorain, Ohio, that together produce annually over 800,000 tons of steel pipe for the oil and gas industry. In total, 756 workers will be axed starting in March, the majority in Ohio.
“The company has suddenly lost a great deal of business because of the recent downturn in the oil industry,” wrote Tom McDermott, president of United Steelworkers local 1104 in Lorain, according to the Wall Street Journal. “What appeared just a few short weeks ago as being a productive year, [with new hires in December and extra turns going on], has most abruptly turned sour.”
The steel industry has been one of the big beneficiaries of the fracking boom. A number of steelmakers from around the world have crowded into the space. As the drilling boom craters, orders for steel pipe and tubes – US Steel’s “most reliable profit driver,” according to Wells Fargo analyst Sam Dubinsky – are fizzling. There will be a lot more bloodletting.
And so, with projects getting cancelled, orders disappearing, and cheap money drying up, the first default stumbles into the scene: privately-held Canadian oil-sands producer Laricina Energy.
As so often these days in the oil and gas business, there is a private-equity and “alternative-investment” angle to it. US private equity firm Lime Rock Partners made an initial investment in 2005 when Laricina was founded. Two other US PE firms have invested in it: Kayne Anderson Capital and Mount Kellett Capital. However, the biggest shareholder is Canada’s largest pension fund, CPP Investment Board, looking to spike its performance with hot “alternative investments.”
In total, Laricina raised approximately C$1.3 billion in equity financings. It also sold C$150 million in four-year notes, secured by the company’s assets, to CPPIB in March 2014. The notes were supposed to provide interim funding for a commercial project.
“Supposed to” because now, that debt is in default.
In a statement, Laricina said that it “missed its bitumen production covenant” of the notes as average production in Q4 was 18% below the minimum of 1,225 barrels a day – “an event of default for which there is no cure period under the indenture.” It’s in discussions with CPPIB, but warns that “the failure to reach an agreement may result in the inability for the Company to operate as a going concern.”
In November, it had already warned that it might not be able to move forward with the commercialization of its projects unless it received C$350 million in additional financing. Alas….
“The capital markets are not putting a lot of new money to work,” CEO Glen Schmidt explained in an interview after the default. “The flow of capital changed materially between the middle of 2014 and the end of 2014 and that clearly had an impact on the numbers of players but also the amounts of capital.”
In other words, his company is confronted with a new reality: there are suddenly fewer investors willing to stick their heads out, and those that are willing, won’t stick their heads out quite as far, and they’re asking for more yield to be compensated for the risk.
Meanwhile, the company is trying to slash operating expenses to remain liquid a little longer, as it said, “in this challenging external environment.”
Wall Street and the oil boom are joined at the hip. Years of ceaseless and extraordinary hype brought in piles of new money from investors driven to sheer madness by the pandemic of central-bank zero-interest-rate policies. It forced even pension funds into high-risk deals to make up for the lack of yield on conservative investments. It kept the boom going for years. The likelihood that the price of oil could ever plunge, as it had done periodically in the past, never entered into the equation because central banks, with their ingenious policies, had eliminated all forms of risk.
Investors in these risk-free investments are learning that some of their capital has already gone up in smoke, and that more of it will go up in smoke. A sense of reality is setting in. Money to fund what is left of the drilling boom is drying up and getting a lot more expensive. And the consequences are spilling into other sectors of the economy.
But there were supposed to be beneficiaries of the oil-price crash. It was supposed to goose consumer spending, and thus the economy. But companies are not seeing it that way. Read… Consumer Companies Issue Most Negative Guidance Ever, Despite Lower Gasoline Prices