The (Shale) Zombie Apocalypse

The oil industry is in a freefall. Oil prices have cratered, demand has withered, and there’s a supply war going on between Saudi Arabia and Russia. Credit facilities are drying up, short sellers are dancing in the streets, and $140 billion dollars’ worth of investment grade debt is teetering on the cusp of junk status.

The industry has reacted swiftly and decisively to protect itself.

Yeah, just kidding. What we are witnessing is a mirror of the very actions they took during the last downturn – slashing CapEx, cutting dividends, and praying for either a bailout or a deal somewhere that will save them from themselves. However, this situation is much grimmer – by several orders of magnitude – than the Saudi-led attempt to crush shale back in 2014. I’m about to explain why there’s no getting out of this one.

Demand for oil is going to get much, much worse before it gets better.

1. The coronavirus effect on oil demand is still in its infancy. We have witnessed an already catastrophic collapse in demand due to China, and that same scenario has yet to play out in Europe and the United States. The effects of the coronavirus will be much more difficult to manage in open societies that are unused to restrictions on travel and movement. The infection rates in the West will be higher, the effects more prolonged, and the recovery substantively slower than what we saw in China. Industry has slowed to a crawl, and industrial uses of oil are slowing. They will continue to grind to a halt as greater restrictions are put into place for small and large businesses alike. Oil demand will continue to drop over the next six months, and this corona-virus induced demand side shock will extend will into 2021 and possibly beyond.
2. Manufacturing, although slowing down, has not seen the bloodbath experienced by airlines and the travel industry. As demand for durable goods evaporates, we will see the squeeze applied to this industry as well. However, a greater threat to manufacturing is a disruption of supply chains – if manufacturers cannot get their raw materials or if labor shortages become common (both which happened in China), manufacturing will come to a stop.
3. Airlines – a major consumer of oil – have lost their international routes due to ill-advised policies of governments trying to reduce the rate of infection; even domestic flights are suffering from a decrease in demand, and it is not unreasonable to believe the little revenue airlines are seeing from these routes will also disappear as nations try to localize hot zones of infection. Even travel by personal vehicle is plummeting – no one is driving anywhere, not even to restaurants or parks or local areas of interest. Transportation is slowly creeping to a halt.
4. We are in the middle of a fast-moving contraction of global growth. Global GDP is shrinking, and some economists believe we may actually see negative growth by the end of this year. The effect of this contraction will be manifold but the net effect on oil is clear – reduced trade across the globe will result in reduced demand for oil.

This oil war isn’t going away anytime soon, and oversupply is the new normal.

1. Oil companies learned a valuable lesson during the oil crash of 2014; hedge your production. Most oil companies are hedged through this year; what that means is that we will see increasing production this year from US shale producers. The only hope of slowing down production is the supply of oil will oversubscribe storage and containment. In the last week, we’ve seen a spike in the cost of oil storage – in some cases nearly 700%. In short order, the ability of the world to store this oversupply will be exhausted, and a production cap will be achieved. But until that time comes, expect US oil companies to pump as much oil as they can in order to maximize the value of their hedges.
2. OPEC is not coming back to the table. The insult levied against the Arab states by Putin is a bleeding wound to their relationship; if OPEC is damaged, OPEC+ suffered a mortal blow. OPEC certainly wants to see US shale die, but their target is Russian production and European market share. I have serious doubts about Russia’s ability to withstand $20/bbl oil for a 18 months, never mind the laughable Russian claims of a decade; Putin’s oil oligarchs are going to have to tighten their belts as never before, and the Russian economy is going to go into a tailspin in the second half of 2021. Granted, they are somewhat insulated from price fluctuations since their currency floats, but the five to ten percent they claw back from currency depreciation is in no way going to offset the wrecking ball Saudi Arabia is going to slam into their economy. In any case, we are going to look at oil prices in the teens and twenties for at least the next 18 months, and perhaps going into 2022 and 2023.
3. Right now, oil demand is down a million barrels a day – in six months, we will see an oversupply of somewhere between 4 and 6 million barrels a day as the Saudis and the UAE increase their production by 4 million barrels a day. By the end of the year, this oversupply could be up to 10 million barrels a day as travel and industry slowdowns continue to pummel demand. As the coronavirus continues to shrink demand, OPEC and US shale and the Russians will continue to pump as much oil as they can out of the ground in order to garner market share. This will drive prices down even further than where they are right now. The idea of $10/bbl no longer sounds like a bad joke or the prognostications of doomsayers; it is a new reality we could be seeing by the end of the year, and it could become the new normal for much of 2021.

Other Bad News to Consider:

1. Unlike the rest of the developed world, US healthcare is not nationalized. The government will have to pour tens of billions of dollars into the healthcare system to protect vulnerable citizens from the coronavirus; these monies could have been spent elsewhere in the pursuit of spurring economic growth or protecting industries crippled by the coronavirus. Access to healthcare for the poor and the distressed is a function of economic necessity; people won’t get tested or seek treatment unless there is no other option. Whatever money they have is spend on food and rent, not healthcare. And even those with healthcare still have to deal with high deductibles and out of pocket costs. This will only serve to prolong the unfolding COVID-19 drama in the United States.
2. US shale producers don’t have any good bankruptcy options. A lot of them are still in Chapter 11 and there’s not much left to reorganize. Those that have emerged from Chapter 11 will still have to deal with a credit market that dried up for them last year; the current conditions will not encourage banks to be any more forgiving than they have been, which is not at all. Although banks have no interest in having a bunch of useless oil assets on their books, the writing is on the wall; they will not throw good money after bad when the payback period is going to stretch into a decade or more. The only option oil producers will have is to slash capital investment and hoard the cash that they generate from selling their hedged oil – expect to see an orgy of consolidations, bankruptcies, and abandoned wells in the middle part of 2021.
3. There is no industry bailout that can save oil and gas. Shale production isn’t a function of large supermajors like BP or Exxon – it has been driven by independent wildcatters. There’s no mechanism by which a cash injection will restructure this industry; these guys are all over the place when it comes to organization, capabilities, balance sheets, and fiscal discipline. Quite literally, there’s no one to write a check to. If you do decide to write a thousand little checks, there’s no way to ensure the money won’t end up in someone’s pocket as he abandons his assets and makes his way to Bermuda to retire with his wife.
4. Shale producers are not the same companies they were in 2014. When that oil price war started, they were flush with cash and had access to massive amounts of cheap credit. The ones that survived that war emerged as substantially weaker companies who relied on lean operations to drive viability. Their balance sheets are weaker. They have higher interest debt. They have lower stock prices. Their access to credit exists in a much more restrictive environment.

I’m not going to close with my usual dark and foreboding visions of industry upheaval, halo-effect financial contagion, and the crippling economic environment that will probably unfold as a result of the unbridled greed and disastrous policies of the last two decades. After all, what would be the point? The proof, as they say, is in the oil well. 

Jamal Khawaja

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