Capitalism and shale industry

Derek Brower and Myles McCormick from FT have a story for the ages on the rise and fall of the shale industry. It is classic capitalism. 

A new idea emerges at a time markets are primed for growth, entrepreneurs strike out in droves, the confidence fairies are everywhere, capital flies in, investment soars, finance loses its discipline, corporate governance gets tossed out of the window, and growth at all costs becomes the mantra. Then the music stops. Markets tank, animal spirits disappears, investors flee, and the whole edifice comes crashing down. 

Sample this,

Operators drilled more than 14,000 shale wells in 2019, according to Rystad, an energy research company. It helped the US hit record-high oil output near 13m barrels a day, a level unmatched even by Saudi Arabia and Russia, the world’s next biggest producers. That was a rise from 5m b/d just eight years earlier — a surge that sparked booms from Texas to North Dakota and helped drag the US economy out of the mire of the global financial crisis, adding one percentage point to GDP between 2010 and 2015, according to the Federal Reserve Bank of Dallas. But it required huge infusions of cash offered at basement interest rates. Rystad says the sector spent around $400bn capital in those years, but by 2019 free cash flow arrived only once, in 2016. 

“The fundamental problem with the shale model over the past decade has been the pursuit of growth over return on capital employed or returning capital to shareholders,” says Ben Dell, managing partner at Kimmeridge, a private equity firm that has built up an activist position in the sector. Investors that rushed to finance shale’s recovery from the 2014-15 price crash — an earlier Saudi price war to capture market share — were fleeing by 2019. As capital markets began to close for shale companies, operators were forced to trim spending plans, reducing new drilling activity. With profits still absent and growth prospects diminishing, the shale patch entered 2020 in distress. A reputation for flagrant corporate misgovernance and excess — from colossal executive bonuses earned by hitting oil output growth targets, not profits, to flashy office developments and rumours of company-funded hunting trips — didn’t help. 

Then came last year’s price crash, including the symbolic moment in April when West Texas Intermediate, the country’s benchmark crude contract, traded below zero for the first time. “Covid hits, oil prices collapse, everyone has to cut their capex, valuations crash,” says Aaron DeCoste, an equity analyst at Boston Partners, an institutional investor. “And it’s effectively reset the entire industry.”

The article describes a wave of consolidation and return to cautious growth in the industry in the aftermath of the bust. Investments are rising slowly, being sourced from free cash flow than from debt.  

Early this month, Chesapeake Energy, which embodied the excesses of the shale revolution, emerged from Chapter 11 bankruptcy,

Chesapeake’s debts as it filed for bankruptcy last year were more than $9bn. The court-approved deal struck with its creditors last month eliminates about $7bn of debt and will permanently reduce $1bn of annual operating costs. The company has also secured $2.5bn in exit financing, and lenders have agreed to backstop a $600m rights offering. Chesapeake will end 2021 with just $500m in net debt — less than the annual interest payments it was making in recent years — and generate $2bn worth of free cash flow in the next five years... The company would in future reinvest 60 to 70 per cent of its cash flow into production... Chesapeake lost its New York Stock Exchange listing after its bankruptcy last year, but will begin trading on Nasdaq on Wednesday. The Houston court that approved the company’s reorganisation last month valued the company at about $5bn, although some analysts now say it could be worth almost $8bn.