OPEC FACE DOWN SHALE

This is no time for OPEC+ to cut production and if I were in charge I would maintain production levels as they currently stand.

The main beneficiary of any OPEC cut would be shale. According to Moody’s investor service  60% of the $86b debt issued by Shale producers  maturing in the next four years has  junk bond status. Junk bonds are typically rated  'Ba' or lower by Moody's which means they are of a lower credit quality and more likely to default. Investors have become increasingly impatient with an industry that has prioritised production over free cashflow and dividends. US producers reportedly absorbed over $400 b in the decade from 2008 -18 with scant return for investors. The financial future for shale is by no means secure.

Yet shale production has increased to reach record levels making the US the worlds largest producer and now a key exporter, all at the expense of OPEC.  In  2014 OPEC under the leadership of Saudi Arabia, initiated an abortive price war with the objective of expelling the higher cost shale production  from the market. The plan was simple or so it seemed at the time. It was considered that shale production needed $50 a barrel as a break even.  After 2 years of mutual destruction and low oil prices it ultimately ended in failure. Shale survived due to a combination of factors. It was able to increase efficiency using new drilling techniques, it had abundant prolific  tier 1 acreage to drill wells, and it had sustained access to cheap money from Wall Street and acquiesant capital markets.

Since 2016 shale production has increased by 50% from about 8.5 million bpd to 12.2 million bpd, increasing output by 1.2 million bpd last year.  US Shale production was expected to rise by 9% to about 13.2m bpd in 2020. The Shale boom is a zero sum equation  to the direct detriment of OPEC production. Where OPEC have cut production shale has stepped in and seized marketshare. The continued viability of shales existence is premised on OPEC continued willingness to cut production in the face of global demand destruction or oversupply.

Shale is now at its most vulnerable, it requires continual capital investment at a time there is significant investor antipathy. The tier 1 acreage that provided bountiful output for frackers has shrunk and experimental drilling program results have been dissapointing.  The nature of shale production and its  steep declines necessitates constant drilling to offset the loss of production and maintain output levels. Such output levels provide a constant supply of cashflow, a reduction in drilling will diminish future cashflows. Energy stocks have tumbled and a slew of bankruptcies have further  dented investor appetite. The collapse of oil benchmark mean that the likelihood of default events and chapter 11 episode seem destined to increase. Refinancing using reserve base lending approaches are also restricted when crude oil prices slump.

Unlike in 2014 OPEC will need to stay the course which will mean such a decision must be sustained until Shale production decreases. It may take a couple of years. This is easier said than done as OPEC members have contrasting and sometimes contradictory  policy objectives. It begs the question, is it now  OPEC's response to any 'Black Swan' to further cut production in order to ensure the price of crude is sufficient to enable its great rival to increase its marketshare?