If you borrowed the money to drill your wells in the first place, you need cash flow to service your debt. So you might keep pumping even if you only break even or run a small loss. That seems to be what many small US producers are doing. The alternative is to default on their bank loans or high-yield bonds.
Indeed, the high-yield bond market seems to have calculated that more defaults are coming. Bond prices have collapsed as low oil prices make it hard to stay current on debt payments.
What will be the endgame here? If companies default and go into bankruptcy, courts will sell their assets to the highest bidder. Bondholders will push for quick liquidations.
If the assets consist of oil in the ground that can’t be profitably extracted, who will buy those assets?
I don’t really know. I’ve been told the major multinational producers are biding their time, hoping to buy those reserves on the cheap. I also know for a fact that drilling rigs and ancillary production items are going for ten or twenty cents on the dollar at auction. The cost of drilling new wells is going to be down in the next cycle. The unanswered question is whether the currently producing wells will actually stop pumping during this shake-down process, and if they do, for how long. Producers face quite a dilemma.
Third-Order Effects
I believe much of the recent market volatility really results from the second- and third-order effects of lower commodity prices. The sovereign wealth funds of oil-producing nations are liquidating non-energy assets or at least not buying them. Changes in oil import/export patterns are affecting currency flows. Stung by energy losses, portfolio managers are reducing risk elsewhere.
Why is anyone surprised? And that brings us to another key question. Conventional economic wisdom tells us that lower fuel prices ought to spur consumer spending. It seems not to be happening this time. Why not?
Here is my theory: this price decline is different because it’s affecting domestic oil and gas producers.
In previous oil downturns, more of the pain was felt overseas because we imported more of our oil. New domestic shale production changed that. So the defaults, lost jobs, and negative wealth effects are hitting closer to home this time. They are specifically hitting in Texas, Oklahoma, and North Dakota.