By Harris Kupperman
What is the senior debt on a shale play that needs $100 oil to be profitable worth? With oil at $51, it’s worth roughly zero. What is the equity worth? Even less. What is the junk debt worth? Somewhere in the middle. The first epiphany in the shale patch will soon be that it doesn’t matter where you are in the capital structure of an uneconomic shale play. If that play needs $100 oil to work, you’re screwed. There is minimal salvage value there. At least the original subprime loan was worth what you could sell the underlying home for, minus the frictional costs along the way. The loss severity on these shale plays will be much higher. It is CDOs squared all over again.
Over the past few weeks, I’ve heard people articulate that there is something approaching $200 billion of junk debt tied to the shale space. For some reason, people seem to speculate that we may see a default rate in the teens. That sounds like $20 or $30 billion of total losses—as in, large but meaningless. Unfortunately, it’s probably better to use the CDO squared theory of finance.
If you recall in the prior two pieces, for the past decade, the game in shale has been to lock up land, borrow money and get oil & gas out of the ground. Since the decline curves are so steep, after only a few years, you basically have fully depleted land and likely less money back than was originally spent—hence you have to borrow even more money to drill more land and hope that no one notices that the returns are negative. Without new money going into the ground, the whole hamster wheel stops. You are left with depleted land and untapped land that suddenly is cut off from future debt funding. At that point, we learn the real cost of producing this oil and see who can self-fund, and who cannot.
What if almost ALL of the debt tied to the shale sector turns out to be largely worthless? Now we’re talking big money, as in hundreds of billions.
(For the rest of this horror story, click the link.)