Blacked Out: The Energy Boom Goes Bust Part 2

In part one of this series, we discussed how the American oil and natural gas industry was transformed by the sudden emergence of fracking and horizontal drilling.

These two techniques ushered in a new petroboom, creating more than a million jobs, caused domestic natural gas production to double, and oil production to head back up to near peak levels.

But this vast wave of new production has failed to find buyers at acceptable prices during the past year.

With the prices of both oil and natural gas in the dumps, the industry is in retrenchment, with many of the weaker players already having filed bankruptcy. Magnum Hunter was the latest to go dark earlier this month.

The industry has been further rocked this week, as the natural gas sector’s most famous player, Chesapeake Energy, now finds itself facing a run on the bank.

Chesapeake is a storied company. It, behind prior CEO Aubrey Mcclendon, rose to great heights, being one of the greatest successes on the stock exchange prior to the 2008 crisis. During the crisis, Mcclendon was forced to sell all his stock to meet margin calls. The company survived the scare though and almost regained its prior glory as markets recovered.

Mcclendon was eventually forced out of the company after investors got fed up with his tendency to toward making deals that were personally enriching and tainted with potential conflict of interest.

Regardless, the company he built remains a colossus, it is one of the largest natural gas producers in the world, and at its peak several years ago was worth $25 billion.

Its shares now are down 75% from their recent highs however, and are down 27% just over the past two weeks. Its debt is in freefall, with various maturities down as much as 30% this week.

The company’s nearest-term debt, due in 2017, has fallen to 70, down 10 points Thursday, and now yields 30%. Such an eye-popping yield indicates the market has grave doubts as to whether this company can even survive the next two years.

Chesapeake was the standard-bearer of the industry on the way up, and its bankruptcy would be a fitting end to the shale boom turned bust. The company carries $12 billion in debt. Its eventual insolvency will hurt banks and make future investors in the industry much more timid.

Domestic energy companies are already finding it nearly impossible to find new funds with which to maintain their operations, let alone expand capacity. And this will be a big problem in coming years.

There are two types of energy that have come out of this boom, tight oil and shale gas. Tight oil produces crude. A notable example is the Bakken field in North Dakota that has transformed that state into the country’s fast-growing economy in recent years.

The Bakken, and other tight oil fields, see production decline at an astounding 80%-85% from initial production over the first three years. Drill a well that produces 100 barrels a day in year one, and it will only being doing 20 by year 4.

This is contrasted with traditional oil fields that have very slow decline rates. The mega-giant fields such as Ghawar have produced at steady rates for decades with minimal new drilling. Bakken, by contrast, requires constant drilling just to maintain current production levels.

The other type of energy, shale gas, produces natural gas. Major fields are primarily in Texas and the American South. The Barnett in Texas and Haynesville in Arkansas are leading shale fields. Unfortunately, like the Bakken oil field, these fields also show 80-90% 3-year decline rates of production.

All these struggling oil and gas companies that have leveraged themselves to the energy boom find themselves in a terrible position. They’ve driven down the price of their commodities to uneconomic levels.

And by the time the production overhang is gone and prices rebound, their fields will have seen their production output drop 80% or more. There will hardly be any productive asset left to capitalize from by the time energy prices find a better level.

The future of the US fracking play is that companies will start drilling again when prices rise, new production will make prices fall right back down, and these companies will never be more than mildly profitable.

As for the grand talk about the US being energy independent, having a new jobs boom, and becoming the world’s leading petro producer? It’s all unfounded. The shale discoveries are better than nothing, but compared to competition from conventional oil abroad, along with solar, uranium, and coal it’s hard to see shale being a game-changer.

After the initial shale frenzy finishes dissipating, the surviving energy companies will drill much less, and when they do, it will be with much more prudence. It will be of incremental help to the US, but it won’t make many investors rich.

The tens of thousands of wells drilled over the past years were driven by cheap credit and misguided optimism rather than any economic merit.

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