Fracking Needs a Shakeout, Not a Bailout

By Liam Denning | Bloomberg  March 12, 2020 at 12:42 p.m. CDT  washingtonpost.com

Calls for the Trump administration to provide financial aid for frackers have drawn denunciations of socialism. If anything, with oil trading around just $31 a barrel, the critics don’t go far enough. Because directing state resources into producing yet more of a thing manifestly not in demand isn’t just socialism; it’s the Soviet-grade, tractor-quota good stuff.

There is nothing wrong per se with government stepping in as a last resort when crisis threatens a vital segment of the economy. But you need a clear understanding of what the crisis is, what’s vital and what the objectives are.

In the case of the U.S. exploration and production business, to say the current predicament is the fault of Saudi Arabia or a virus is to cite catalysts rather than the underlying pathology.

Consider Continental Resources Inc.: Founder and majority shareholder Harold Hamm told Bloomberg TV on Wednesday he had “reached out” to the Trump administration and wants it to take action to prevent cheap Russian and Saudi Arabian barrels flooding the U.S. to the detriment of the domestic industry. Yet Continental should look to itself. Its guidance — which envisages growing production in a market that was oversupplied even before coronavirus struck — implies free cash flow going to zero this year if oil averages about $48. As of now, 2020 swaps trade around $34. Only last summer, the company was buying back shares at an average price of about $34 apiece. They are now below $9.

The shale oil boom of the past decade (and natural gas before that) has come with a hefty dose of moral hazard built on various assumed market puts.

One was OPEC’s willingness to keep its own barrels offline to prop up prices. It’s worth remembering that in 2016, when Hamm was then-candidate Donald Trump’s energy adviser, he openly called on Russia and Saudi Arabia to boost oil prices by cutting supply. This striking call for cartel behavior at the expense of American consumers came almost two years after Continental had imprudently cashed out its hedges in the belief the oil crash would reverse quickly. Clearly, that lesson wasn’t learned by too many.

Another put was the capital markets’ willingness to fund drilling budgets come what may. This worked out in 2016, when investors’ Pavlovian expectation enabled E&P companies to sell a ton of new stock. By 2019, though, investors were wising up to the sector’s peculiar capital-management skills. Then coronavirus showed up.

Now the puts are gone and the model has hit a wall. Beyond the losses inflicted on investors, there will be layoffs, bankruptcies and rationalization. Absent a sudden change in circumstance, U.S. oil production will start falling later this year.

Oil and gas production clearly is a vital sector. But that doesn’t make every marginal barrel or molecule vital. Commodity prices, along with dismal equity multiples and credit spreads, were telling us that even before this week. Much of the industry engaged in a decade-long, WeWork-like expansion in global oil, aided by third-party money and rewarding many executives handsomely. In doing so, they flattened oil and gas prices and return on capital.

So it is almost comical to now hear Hamm decry Saudi Arabia’s sudden grab for market share as “illegal” when his own bit of the oil industry has been doing that for years — and helped by Saudi Arabia’s prior restraint, to boot. As an aside, how do you prove a producer with operating costs of less than $10 a barrel is dumping oil when the market price is still three times that?

I cannot count the number of times I’ve heard about the Darwinian imperative that infuses shale, spurring deeper wells, faster fracks and an energy revolution. Yet now the talk is of trade barriers or even direct Federal aid, a bailout that would turn the industry’s dead men walking into the walking dead.

There is a long tail of producers lacking scale and duplicating corporate costs that is ripe for consolidation. And there are companies out there with the strategy and resources to hunker down and ultimately lead it. Capex budgets and (for some) dividend commitments can take some of the strain, and some companies have been quick to adjust. If that means less production, well, that’s kind of the point. If it means angering shareholders, they’re not happy anyway (or just AWOL). This would result in a more resilient, self-sufficient industry.

Too often, entrenched management convinced their stock is undervalued and corporate balance sheets larded with debt have been obstacles to making deals. Government aid would stymie this again at an opportune moment, keeping marginal wells pumping oil and gas into a market that doesn’t need it. Along the lines of this recent column by my colleague Joe Nocera, if coronavirus aid is coming, then target workers and consumers. It makes little sense to pump more capital directly or indirectly into a broken business model that ultimately has the wherewithal to fix itself.

That doesn’t mean it won’t happen, of course. Oil and gas producers enjoy a range of existing subsidies already, from the Texas Railroad Commission’s casual tolerance of gas flaring to society’s broader unwillingness to comprehensively price carbon emissions.

There was nothing in Wednesday evening’s presidential address to help, though; new travel restrictions on Europe and the lack of reassurance in the broader financial markets actually inflict further pain on the E&P sector. Indeed, one of the best things the White House could do for all parts of the economy, including oil and gas, would be to signal a comprehensive understanding of the threat and a set of concrete measures to help prevent further panic.

Still, watching the end of the 11-year bull market in stocks, President Trump has even more reason to try to provide succor to friendly constituencies. Hamm, whose stake in Continental has dropped by $7.3 billion this year, cited risks to jobs in comments made to the Washington Post on Tuesday, notably mentioning Pennsylvania.

Above all, “energy dominance” is a prominent part of the broader MAGA trope — and one whose worship of sheer quantity is both inherently deflationary and aligns perfectly with the old shale model. Overt government efforts to keep wells pumping regardless of price signals would lay bare the fallacy of this, regardless of whether you’re a wildcatter or a president.

Liam Denning is a Bloomberg Opinion columnist covering energy, mining and commodities. He previously was editor of the Wall Street Journal’s Heard on the Street column and wrote for the Financial Times’ Lex column. He was also an investment banker.