Some shale drillers feast on junk debt to stay on spending treadmillApril 30, 2014
“There’s a lot of Kool-Aid that’s being drunk now by investors,” one investment manager says. “People … stop doing the accounting. They’re just dreaming the dream, and that’s what’s happening with the shale boom.” Shown, a rig drills for natural gas at a hydraulic fracturing site owned by EQT atop the Marcellus shale rock formation in Washington Township, Penn., in 2013. Bloomberg News photo by Ty Wright).
(c) 2014, Bloomberg News.
Rice Energy, a natural gas producer with risky credit, raised $900 million in three days this month, $150 million more than it originally sought.
Not bad for the Canonsburg, Pennsylvania-based company's first bond issue after going public in January. Especially since it has lost money three years in a row, has drilled fewer than 50 wells — most named after superheroes and monster trucks — and said it will spend $4.09 for every $1 it earns in 2014.
The U.S. drive for energy independence is backed by a surge in junk-rated borrowing that's been as vital as the technological breakthroughs that enabled the drilling spree. While the high-yield debt market has doubled in size since the end of 2004, the amount issued by exploration and production companies has grown nine-fold, according to Barclays Plc. That's what keeps the shale revolution going even as companies spend money faster than they make it.
"There's a lot of Kool-Aid that's being drunk now by investors," Tim Gramatovich, who helps manage more than $800 million as chief investment officer of Santa Barbara, California-based Peritus Asset Management. "People lose their discipline. They stop doing the math. They stop doing the accounting. They're just dreaming the dream, and that's what's happening with the shale boom."
Rice Energy was able to borrow so easily because of the quality of its assets, which are in some of the best areas of the Marcellus, a shale formation beneath western Pennsylvania and West Virginia, and the company's drilling success there, said Gray Lisenby, Rice's chief financial officer. Demand was so high, in fact, that earlier this month Rice halted a planned four-city road show intended to entice lenders. Interest from investors after the first three stops overwhelmed expectations, Lisenby said.
Companies with a lot of debt relative to earnings use junk bonds to raise cash. Investors get higher returns because of the increased odds of not getting paid back. The debt is in demand because the Federal Reserve has held interest rates near zero for more than five years, shrinking returns on safer bets. The popularity has pushed down borrowing costs for companies trying to unlock oil and natural gas trapped in deep underground layers of rock like the Bakken shale in North Dakota or the Eagle Ford in Texas.
Rice Energy's bond offering this month was rated CCC+ by Standard & Poor's, seven steps below investment grade, or the level above which some institutional investors, such as pension funds and insurance companies, are allowed to buy. S&P says debt rated in the CCC range is "currently vulnerable to nonpayment" and, in adverse conditions, bonds with that grade aren't likely to be repaid. Even so, Rice Energy was able to borrow at 6.25 percent. That compares with 9.5 percent for other bonds with similar ratings, according to Bank of America Merrill Lynch index data.
Some companies have been able to drill themselves to better credit ratings. In December, Oklahoma City-based Continental Resources Inc., the most active driller in the Bakken, had its rating boosted from junk to Baa3, the lowest tier of investment grade, by Moody's Investors Service. Others, such as Chesapeake Energy Corp., have made changes that improved their standing with credit-rating companies. Chesapeake, based in Oklahoma City, has sold off $16 billion in assets in the past two years, cut spending and refinanced debt, and S&P said it's considering a higher rating for the company.
By contrast, Forest Oil Corp.'s recent battering shows how the borrow-drill-repeat strategy can backfire. Forest sold $1.3 billion in assets in 2013 to help finance its drilling. Then in February the Denver-based oil and gas producer reported disappointing well results from its marquee assets in the Eagle Ford. Forest didn't have enough money coming in to keep from running afoul of its debt agreements. Both S&P and Moody's cut the company's credit outlook to negative.
Forest's bonds plunged. Its $577.9 million of outstanding 7.25 percent notes due in 2019 traded at 88 cents on the dollar on April 22, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority, a drop from this year's peak of 98.4 cents on Feb. 24. The notes are now yielding 10.31 percent, up from 7.6 percent. Larry Busnardo, head of investor relations for Forest Oil, didn't return calls seeking comment.
"This is a melting ice cube business," said Mike Kelly, an energy analyst at Global Hunter Securities in Houston. "If you're not growing production, you're dying."
Of the 97 energy exploration and production companies rated by S&P, more than half are below investment grade, according to an April 21 report from the credit-rating company. The average yield for energy exploration and production companies rated junk has declined to 5.4 percent from 8.1 percent at the end of 2009, compared with a drop to 5.21 percent from 9.06 percent for all companies rated below investment grade, according to Barclays.
Cheap debt, along with advances in horizontal drilling and hydraulic fracturing, or fracking, have propelled U.S. oil output to a 26-year high. Last year, the country produced 87 percent of its own energy, putting it closer to independence from foreign sources than it has been since 1985, according to the Energy Information Administration.
It's an expensive boom. About $156 billion will be spent on exploration and production in the U.S. this year, according to a December report by Barclays analysts led by James West. That's 8.5 percent more than last year and outpaces this year's expected 6.1 percent growth in global expenditures, the analysts said.
"Who can, or will want to, fund the drilling of millions of acres and hundreds of thousands of wells at an ongoing loss?" Ivan Sandrea, a research associate at the Oxford Institute for Energy Studies in England, wrote in a report last month. "The benevolence of the U.S. capital markets cannot last forever."
The spending never stops, said Virendra Chauhan, an oil analyst with Energy Aspects in London. Since output from shale wells drops sharply in the first year, producers have to keep drilling more and more wells to maintain production. That means selling off assets and borrowing more money.
"The whole boom in shale is really a treadmill of capital spending and debt," Chauhan said.
Access to the high-yield bond market has enabled shale drillers to spend more money than they bring in. Junk-rated exploration and production companies spent $2.11 for every $1 earned last year, according to a Barclays analysis of 37 firms.
Rice Energy will outspend its cash flow through 2015, according to Moody's. Rice said it plans to invest $1.23 billion this year building pipelines, buying acreage and drilling in the Marcellus region, where the company already has wells with names like Hulk, Captain Planet and Mojo, as well as in the nearby Utica formation in Ohio. Its first well in the Utica failed, resulting in an $8.1 million write-off last year, company records show. Its second attempt is under way.
Stock analysts say they like Rice's growth potential. Sterne, Agee & Leach Inc., a Birmingham, Alabama-based brokerage, rated the company a "buy" in February, shortly after the initial public offering. Howard Weil, a division of Toronto-based Bank of Nova Scotia, said Rice's stock would do better than others in the same line of business. Shares have climbed 42 percent since the IPO.
Exploration and production companies that have wells in sweet spots "are able to raise debt because they have significant collateral value and thus are not viewed as high risk by investors," Lisenby, Rice's CFO, said in an e-mail.
"Asset quality and operational success drive returns and value creation for debt and equity holders," he said. "Investors are pretty smart in recognizing this in companies and reward the companies that have those qualities."
Still, the U.S. central bank has kept borrowing rates near zero since December 2008. An increase, expected in 2015, could cause investors to flee shale-drilling debt in search of safer returns.
"It's a perfect set-up for investors to lose a lot of money," Gramatovich said. "The model is unsustainable."
— With assistance from Bradley Olson in Houston and Lisa Abramowicz and Richard Bravo in New York.