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Inside the Market U.S. shale oil boom goes bust as investors balk at unrestrained production

The energy bust that clobbered Canada’s oil patch has spread south of the border.

For years, the U.S. oil and gas industry remained resilient even as its Canadian counterpart fell out of favour with investors and global energy giants fled the country. But now, high fliers in the U.S. oil industry have succumbed to a bear-market playbook well known in Canada.

Market sentiment has turned against the sector, bankruptcies have jumped, drilling is in sharp decline and exploration and production (E&P) stocks have crumbled, all despite a 20-per-cent rise in U.S. crude prices so far this year.

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The U.S. shale revolution is in turmoil. Investors have grown intolerant of unrestrained production by companies that favour growth over profitability, fuelled by a constant influx of capital.

In a world awash in oil supply, investors are increasingly demanding something else of U.S. energy companies – rising profit margins, shareholder payouts and cautious growth.

“Investing in oil and gas companies has historically been driven by growth in production. All of a sudden, investors are saying, ‘I’ll give you money, but I want a dividend and I want near-term returns,' " said Peter Tertzakian, director of the ARC Energy Research Institute.

Over the past five years, the Canadian oil patch has slashed costs and remade itself in accordance with those principles, although you can’t tell that from their stock prices, which remain historically depressed. Canadian producers continue to grapple with a powerful confluence of negative forces, including environmental concerns around carbon emissions, competition from alternative energy sources and pipeline constraints.

The shift in global oil markets from scarcity to abundance in recent years can be largely traced back to the U.S. shale oil boom.

The use of hydraulic fracturing to extract oil from shale deposits has transformed the energy market over the past decade and made the U.S. the largest oil and gas producer in the world.

Surging shale production was the primary contributor behind the global oil glut that emerged in 2014, sending U.S. crude prices from more than US$100 a barrel down to a low of US$26.

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Canadian energy never really recovered. The group of E&P stocks in the S&P/TSX Composite Index is trading nearly 70 per cent below its 2014 peak.

The latest example of oil patch hardship came last week when Obsidian Energy Ltd., formerly called Penn West Petroleum Ltd., said it’s exploring “strategic alternatives” after a failed asset sale. Once one of Canada’s largest producers, Obsidian’s market capitalization has fallen from more than $12-billion in 2011 to less than $100-million today.

U.S. oil and gas stocks were also hammered by the 2014-15 oil sell-off, but shale production subsequently rebounded.

Last year, U.S. crude output grew by 17 per cent over the prior year, hitting an average of nearly 11 million barrels a day. And shale production grew at a quicker pace last year than in the boom period of 2011-14, according to the International Energy Agency.

“They've been able to do these things as they haven't had the same sort of political pipeline risk as Canada,” said Patrick O’Rourke, an energy equity analyst at Altacorp Capital Inc.

Despite dismal equity performance, in an era of easy money, shale companies have largely been able to access the capital they need to drill at will.

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Critics have long maintained that the shale boom, financed by heavy borrowing with little regard for profitability, is unsustainable.

Last year, only seven out of 29 U.S. shale producers made more money than they spent on drilling and payouts to shareholders, according to Thomson Reuters.

This year, however, the U.S. shale oil industry seems to have hit a wall.

Highly leveraged companies are struggling to service their debt while the costs of refinancing have spiked, contributing to a rash of bankruptcy filings.

As of July, high-yield energy bond issuance had fallen by 40 per cent over the prior year, according to Fitch ratings.

Several shale companies are cutting budgets and staff, while scaling back on drilling plans. The U.S. now has 898 working rigs, which is down by 17 per cent from the start of the year, according to energy-services company Baker Hughes. In Texas, home to much of the Permian Basin – the heart of the U.S. shale boom – there were almost four times more rigs drilling at the end of 2018 than there are now.

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And over the past year, the average valuation on independent E&Ps within the S&P 500 index has fallen by half.

“Investors have been burned for quite some time, and they’re calling for free cash flow and returning capital to shareholders,” said Morgan Kwan, vice-president at RS Energy Group in Calgary.

Canadian producers have responded to a similar call on this side of the border. Since the collapse of oil prices started in 2014, the industry has consolidated, paid down debt, pared back costs and deferred growth plans.

“The Canadian industry has become very good at bringing this stuff out of the ground at much lower cost than back in 2014,” Mr. Tertzakian said.

“Many of these companies have higher cash flow today than they did with $100-per-barrel oil.”

West Texas Intermediate currently trades at about US$55 a barrel.

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Most producers are currently restricted by mandatory production cuts, which were put in place by the Alberta government in 2018 to help address the pipeline-capacity shortage and reduce the discount on Alberta crude. In August, curtailment was extended to the end of 2020.

Over the past two weeks or so, Canadian energy stocks have received a bit of support, with E&Ps rising by about 15 per cent. That barely puts a dent in the losses realized over the past five years, but could be an early sign of investors recognizing value in the oil patch, Mr. O’Rourke said.

Although a solution to the sector’s transportation problems is nowhere in sight, aside from increasing the capacity to ship oil by rail, there is still U.S. demand for oil sands exports, Mr. Tertzakian said.

U.S. sanctions against Venezuela's national oil company have left U.S. Gulf Coast refiners without a key supplier of heavy crude.

But even a pipeline is no silver bullet. After years of underperformance, the industry needs to regain the faith of investors by demonstrating it can abide by this new paradigm of profitability over growth, Mr. Tertzakian said.

“Show me you can do it over and over again without any problems."

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