Rising Debt Levels Are Strangling the Domestic Oil Boom

Shale oil drillers are increasingly relying on debt to fund growth. Rice Energy and Parsley, on this basis, look like they should be avoided.

Jun 22, 2014 at 8:08AM

The U.S. shale oil revolution has completed changed the country. The rise of the shale oil industry has created thousands of jobs and billions of dollars in wealth. Not to mention the fact that the U.S. has been able to reduce its dependence on foreign oil.

But some analysts are now starting to doubt the sustainability of the U.S. oil boom. This creeping doubt is based on the fact that drillers are now spending much more on increasing production growth than they are generating in free cash -- not a sustainable way of running a business.

As a result, the number of domestic oil companies reporting financial stress is rising.

Rising stress
According to Bloomberg, the amount of debt on shale drillers' books has doubled during the past four years. The survey looked at a broad selection of 61 drillers. Over the same period, the study found that revenue has only increased 5.6%. Additionally, a higher percentage of the companies surveyed were spending around 10% of revenue on interest costs.

This year it is expected that producers will spend $1.50 on drilling for every $1 in return. According to the International Energy Agency, based on falling output rates at mature wells, producers are having to drill 2,500 new wells per year just to maintain current levels of output.

And the value of shale assets are also falling, according to the Oxford Institute for Energy Studies. Fifteen of the shale industry's main operators have written off $35 billion in assets since the shale boom started.

Saddled with debt
Rice Energy (NYSE:RICE) recently tapped the market for $900 million. It seems as if investors' appetite for this debt is insatiable as the company managed to raise $150 million more than it originally planned.

But Rice is not a company Foolish investors should be lending to. The company has lost money for three years in a row and has drilled less than 50 wells. The company will spend $4.09 for every $1 in earns this year. Nevertheless, having only come to the market in January, Rice is flush with cash, reporting a cash balance of $230 million at the end of the third quarter; net debt was close to $60 million. 

Factor in the recent $900 million debt issuance and it would appear that Rice is set to obliterate shareholder equity, which stood at $1.2 billion at the end of the first quarter.

Poor outlook
Parsley Energy (NYSE:PE) is another risky driller borrowing to stay alive. Like Rice, Parsley has only just hit the market, but based on first quarter accounts the company currently has a debt-to-equity ratio of around 500%. Actually, the company doesn't even have a positive current ratio.

Parsley's total debt pre-IPO amounted to more than $500 million. However, the company received around $740 million from the IPO, which it planned to pay down debt with.

These figures imply that the company now has a cash balance of $240 million, although this isn't likely to last long as management is planning acquisitions and an aggressive exploration program.

With the average well cost in the Midland basin averaging $10 million, Parsley only has enough cash to drill 24 wells, assuming no other costs. This cash won't last long.

Foolish summary
So in conclusion, shale oil debt is rising as companies struggle to ramp up output. In the long term this will be a problem as, with 2,500 wells per annum needing to be drilled, companies that can't afford costs could get stuck in a debt spiral.

The best way to protect yourself is to stay away from drillers with high, and rising, levels of debt. Rice Energy and Parsley on this basis look like they should be avoided.

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Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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