Next Chapter in the Great American Oil Bust

Every rally in crude oil since June turned out to be a pathetic sucker rally. On Friday, West Texas Intermediate fell over 2% to $45.32 a barrel, back where it had been on January 12, annihilating most of the 12% rally in between. WTI is now 58% below the June peak.

“If prices stay low well into the latter half of this year and next year, borrowing basis will come down quite significantly” for oil-and-gas exploration-and-production companies in the US, “and that is when you can start to see liquidity spiraling out,” warned Tom Watters, a managing director at Standard & Poor’s oil & gas team. And that, he said, is when single-B rated companies could see a wave of defaults.

These “junk” debt issuers that rode up the fracking boom with borrowed money are among the higher cost producers globally. They would be hit first by the declining prices, Watters said according to LCD HY Weekly. Their revenues are collapsing, but they’ve loaded up on debt that is now strangling them. They’re responding with layoffs, and they’re cutting operating costs and capital expenditures, and they’re shuttering facilities.

But some of these players might not be able to hang in there much longer. On January 15, Canada’s GASFRAC, filed for bankruptcy in Calgary, Alberta, where the company is based, and in San Antonio, Texas, where it filed under Chapter 15 for cross-border bankruptcies.

The company prides itself in its patented technology that allows producers to frack a well without water, the scarcity of which being a big issue in Texas, California, and other parched states. Instead, it uses liquid propane gel (LPG), which is similar to Napalm. “As the injected LPG blends with reservoir hydrocarbons and flows back with the production stream, 90 – 100% can be recaptured by the operator,” its website claims.

But that wasn’t the reason it filed for bankruptcy. In its statement, it listed the reasons: operating losses; “reduced industry activity” due to plunging oil and gas prices; the inability to find a buyer that would have paid enough to cover holders of secured and secured debt; and “limited access” – that is, no access – “to capital markets.”

Capital markets have turned off the money spigot for junk-rated companies like GASFRAC that burn through their cash and expect to get more cheap cash from over-eager Fed-blinded investors. Instead, these companies are suddenly finding out that what used to be easy when oil was over $100 a barrel and money was still growing on trees is now nearly impossible.

GASFRAC went public at $5 a share in late 2010 on the Toronto Stock Exchange. In true IPO spirit, its “waterless fracking” was touted to the nth degree. In seven months, its shares soared 180%. Then reality began to set in. Today, its shares are essentially worthless.

But not every company is going to run out of juice today. During the last couple of years, during the greatest credit bubble in the history of the US, when cheap money was thickly growing on trees even for junk-rated companies, they loaded up on debt, and some of that cash is still sitting around, and much of that debt matures in future years, rather than in 2015.

“Despite the lower prices and the potential for high-yield issuers facing borrowing-base reductions at their revolving credit redeterminations in April, S&P found liquidity in general to be adequate for the next 12 months,” LCD HY Weekly reported. So “in general,” many of these companies might make it through this year. Very comforting.

Producers hedged some of their production, and that’s a big help, but hedges expire, and then all heck breaks loose. So these companies are slashing operating costs and capital expenditures so that they can hang on a little longer. Some of these cuts are already showing up in the plummeting number of rigs drilling for oil [read… Oil Drilling Cut Fastest Since Stock Market Crash].

But these cutbacks by producers hit their suppliers and oilfield services companies, like GASFRAC. They lose business and bleed cash. And for them, time is running out: “The second quarter is going to be devastating for the service companies,” John Young of Conway Mackenzie Inc., the largest restructuring firm in the US, told Bloomberg. “There are certainly companies that are going to die.”

They face a “double-whammy,” he said: oil producers are not only imposing price reductions of 20% to 30% on them, but they’re also delaying when they pay their bills. These companies face brutally crashing revenues and suddenly yawning cash-flow holes. Young warned these companies to “keep an eye” on the extent to which oil producers have used hedges and swaps to shield future cash flows from low prices, and how much credit they still have available on their revolver loans.

“When I saw WTI hit $65, I thought we’re going to be really busy with restructurings,” he said. “When it hit the $40s, I knew we were looking at outright liquidations.”

This is what happens to a debt-funded boom that implodes: what investors thought was a low-risk asset with high potential – the true no-brainer – gets eviscerated. This didn’t happen by accident. In its ingenuity, the Fed, in creating the greatest credit bubble in US history, expunged risk from investment equations. No one was getting paid adequately for taking risks. So everyone went to chase yield when there was less and less, and to get any yield at all, even conservative investors ventured out ever further into riskier and riskier assets. This is when money began to grow on trees for junk-rated energy companies, and they took this money and drilled it into the ground.

But there is a bitter irony. The plunge in the price of oil is pushing desperate producers to maximize production from existing wells in order to salvage their revenues to the extent they can, even as they slash operating costs and capital expenditures for new wells. BHP Billiton, perhaps unwittingly, explains this irony: despite the oil glut, collapsed prices, layoffs, and shuttered facilities, US oil production is soaring. Read…  Why the Great American Oil Bust Will Be Long & Painful

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