Cassandra and the Gates of Troy

So, according to the myth, Cassandra was the daughter of the King of Troy… she was cursed by being given foresight but was not able to make anyone believe her (remember the old saying “Beware of Greeks bearing gifts”? That’s her.). When oil prices started falling last year, I lamented that this felt more 1986 than 2008… At the time, most people around here looked at me like I had a third eye blinking in the middle of my forehead.

Now I continue to read assessments like the one here, which indicates that the “inevitable” slowdown in U.S. shale production is just around the corner… Any minute now, we’ll see a dramatic drop off in production… Soon, the reduction in the number of active wells will certainly create a curtailment in the amount of production… any minute now.

I ,for one, am a contrarian… I do, however, possess at least some support for my contrary position. You see, there are at least three reasons why you will never see a dramatic decline in production unless and until the M&A activity or number of bankruptcy filings for oilfield companies increase: 1. “Zombie” oil companies need to maintain cash flow; 2. Leaseholds require continuous development; and 3. Most debt facilities executed in the last few years have similar requirements.

First off, allow me to define the zombies. According to Wikipedia, a “zombie company” is one that is able to pay interests on its debts but cannot reduce its debt load. Sound familiar? Hark back to the link embedded above… the author of that article argues that companies will continue to exist into next year because there is still enough available leverage, or debt, available in the marketplace to protect them until the oil prices magically return in the second half of 2016.

What the author of that article fails to capture, as does everyone else in the current discussion, is that oil companies must continue to service that debt. In order to do that, they must continue pumping. This is not a syllogism, this is just a factual set of circumstances. As others have noted, currently, exploration and production companies are running debt loads that equal roughly 80% of cash flow… that means that they cannot stop pumping – and, in fact, need to increase production – to stay afloat. Many companies have already cut dividends, taken write-downs on those assets on which they can afford to and have laid off as many workers as possible to right-size their business practices. This means that they are almost out of bullets to fire in this fight to the death… the only answer they have is to return to the bond market. This, in turn, means that they will have to continue to generate cash flow (and increase cash flow) to maintain the debt service.

Second, experts attempting to read the tea leaves in the oilfield market fail to grasp the nature of the agreements between the oilfield companies and the mineral interest owners. Most, if not all, current leases signed by oilfield service companies (at least those I have read… which are numerous), contain continuous development clauses. A continuous development clause says that, after an operator drills a single well, the operator must continue to drill more wells until a reasonably prudent operator would consider the field fully developed. A lot of emphasis has been placed on the so-called “fracklog”, but this is where that fracklog is being generated…. However (see above) the e&p company must both pay for this development and also show a return on the investment for drilling equipment, manpower, etc. out of these fields; meaning that it must, at some point, actually produce minerals from at least some of these wells. Thus, the leasehold interests held by these companies require a certain baseline of activity – once again leading to the opposite conclusion from the financiers, who state almost universally that the death of American production is just around the corner.

So, why do these companies not just let the leaseholds expire? First, I think, there is the problem with sunk costs… Though many business people will often pull out the hoary old rule that one should never make future decisions based on sunk costs, I think that, in practice, this rule is largely honored in the breach. Upper management of these companies have spent, quite literally, millions of dollars acquiring these leasehold interests between  bonus and delay rentals, costs for real estate title work, etc. To “cut bait” and let these interests expire and revert back to the land owners would a. show weakness to the board of directors or other management and b. put valuable land in the market to be bought up at a discount by their competitors. If you have ever met managers for many of these organizations, you would understand that neither of these is an especially palatable proposition. Second, these managers cannot let these interests simply expire because they have bank notes financing them (as I will explain further in a minute). The reason that every company fears the soon-to-come recalculation of the underlying asset value by banks (which takes place every six months in the oilfield) is because the oil underneath these lands is now less valuable than it was when most debt instruments were originally generated. If a manager were to allow these leaseholds to expire, the banks would be exposed to an even greater risk – meaning that such an action risks being an event of default by a given company… again an unpalatable proposition for the management team.

Finally, there are the debt instruments themselves… Once again, being a West Texas real estate attorney, I’ve read a LOT of these documents. The funny thing about the numerous credit facilities, deeds of trust, notes, etc. is that they, too, almost universally contain language that binds the operator into actually developing the mineral interests underlying the extension of credit! What this means, again, is that they have to continually develop and produce minerals at a certain baseline or, again, risk default.

Lest it not be sufficiently clear, the reason why the event of default on even a single note is a disaster is because a. defaulting on one note often triggers default on other notes (creating a cascade of claims) and b. the companies often do not have sufficient reserves to payoff a single holder and avoid bankruptcy.

All of this combines to lead me, once again, to the opposite conclusion coming from industry experts. The decline in production is occurring, but it will be nowhere nearly as dramatic as the current predictions suggest. Zombie companies will continue to develop until the debt taps are shut off to them. Even then, however, some other buyer will swopp in, snatch up the assets, and be stuck with the same incentives as what are mentioned above – again meaning that there is some baseline of production (above the equilibrium point, I argue) that must be maintained in order to hold the lease…. thus starting the cycle anew. This will only lengthen the time period it takes to recover… for these reasons, the saying “lower for longer” seems to ring ever more true. Until we see bankruptcies and merger activity tick up, we can count on depressed oil prices for the foreseeable future.

In closing, I note that Saudi Arabia has maintained its position as the world’s swing producer because the Saudi royal family owns the minerals in the country. They do not have to worry about losing leases by not producing. They do not have to worry about consolidating with bitter rivals if they cannot keep a sufficient cash flow running to keep the debt markets open. In the United States, mineral ownership is private and companies are (relatively speaking) unregulated except by market forces. This means that, in order to coordinate activity across an industry like oilfield production, there must be either a consolidation of interests in the market, or a coordination of a huge number of stakeholders.

The United States is learning a valuable lesson about swing production and the “holdout problem” that economists of various stripes talk about on a regular basis.

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One Response to Cassandra and the Gates of Troy

  1. Pingback: Get Your Tickets. There’s Gonna be a Zombie Party! | The Wolf Camp

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