This article was published by The McAlvany Intelligence Advisor on Friday, July 21, 2017:
It's no wonder that investors owning bonds of companies in the energy business are getting nervous. They purchased high-yield bonds issued by them, seeking income when there was little to be had elsewhere. Last year they were rewarded with 38 percent gains in their holdings as the industry rebounded.
But in June Bloomberg reported that those same bondholders saw their values drop by two percent. This is on top of energy stocks that have tanked 16 percent so far this year.
It's the vicious circle facing frackers.
For instance, Continental Resources paid $77 million to service its debt in 2011. Last year its debt service was $321 million. Pioneer Resources' debt service in 2011 was $31 million. Last year it was $207 million. For Whiting Petroleum, they paid $46 million in debt service in 2011 and a breathtaking $558 million last year.
All told, adding the debt owed by oil and gas producers and their service providers, $110 billion in debt will have to be paid off, or renewed, by 2021.
The vicious circle works like this: energy producers have to produce to generate enough cash flow to cover their variable expenses and interest costs. They hope to generate more than that, of course, to pay down their debts significantly. The problem is that, as they produce, they flood the world with cheaper and cheaper oil and gas, which means that they must produce even more to service their debts. But as the debts grow – for leases, land purchases, and wellhead development – so do interest costs. The more they produce, the lower those prices tend to go. The end point of this unhappy scenario is that the companies (especially the smaller ones, with weaker balance sheets and smaller reserves) can't even generate enough to cover their variable costs and interest. It's no wonder that bondholders are getting nervous.
The circle spins more rapidly when bankers start reviewing the value of the reserves these companies are using as collateral for their loans. When loans are up for renewal, banks often will ask for more collateral, or higher interest, or, even worse, they might call the loans.
This is what OPEC hoped for, but were unable to accomplish on their own. First, they flooded the market, hoping marginal american producers would be forced to close. It worked, a little: 89 energy producers went out of business last year. Then they cut production, hoping demand would drive oil higher. But that didn't work. So they decided to extend the agreement into next year.
But with frackers increasingly running faster in order to stay in place, OPEC isn't likely to extend that agreement when it ends. Instead it might see that the goal it sought on its own might be within reach, thanks to nervous American bondholders and bankers.
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