Oil Price Plunge Drags Independents Below Crush Depth

The depth to which submarines can dive and survive are called depth ratings. Similarly, independent oil companies have various limits at which they can survive a dive in oil prices. 

In submarines, the test depth is the maximum depth a vessel is permitted to go during peacetime operations. Wikipedia suggests that's about 2/3rd of the nominal design depth, or the limit projected by engineer's mathematical calculations. 

With respect to onshore and shale-focused North American independent oil development and production companies, we blew through the "safe peacetime" test depth when WTI breached $70. Below this price, given service costs at the time, we know that it's not economically profitable to expand investment.

Now service costs have plummeted, so the safe test depth may now be lower, but clearly, we left the realm of safety and profitability in 2014.

We blew through the "safe peacetime" test depth when WTI breached $70

Continuing with the analogy, we then blew through the maximum operational depth (aka "Never Exceed Depth") of "risky wartime" when we broke $50. Conveniently, the SEC reserve calculation math for year-end 2015 will come in around this number, which should make for interesting conversations with any reserve-based creditors. 

Yes, many companies are struggling to survive. They hear the deep creaking of hull being compressed by the enormous pressure of the seawater, which we can only compare to the sounds coming from conference rooms full of creditors. 

We breached the "Never Exceed Depth"when oil prices broke $50

Growing up, there was a family at the end of the street whose pool all the kids in the neighborhood used to swim in during the summer. This, of course, was before litigation, political correctness and really, just plain-old-common sense really set in.

So all the kids of various ages, from first grade through high school, would just gather at this pool (it was the only one around) and take turns jumping in, or throwing each other in, or jumping on each other. There was no lifeguard, just someone's older sister, and no semblance of adult supervision.

Generally, the younger kids would dominate the mornings, and the teenagers would start aggregating after lunch until they reached critical mass, at which point they would do anything necessary to kick us out. The older kids would sometimes smoke, and I distinctly remember a game that involved them trying to "get us" with the hot end of the cigarette.

It sounds horrible repeating that, but at the time it seemed perfectly normal, and actually quite fun - running for your life and jumping in the cold pool if you happened to catch an ember. It was paradise for a seven year old.

The only reason I mention this background, is my association of the sound of a creaking submarine hull with that pool. You see, I remember coming home one day after swimming, and I asked my mom why the lady, whose pool it was, never seemed to come out of the house and yell at us. I think on that day I had wanted her to come out and yell at someone who was showing my face what the bottom of the pool looked like.

The woman had older kids, but they were away, presumably at college. She would bring us lemonade from time to time, you know, the fake sugary kind from the 1970's super market. She was always friendly, but she would never discipline or even supervise us.

Mom said her husband died in a submarine accident. I didn't quite know how to grapple with that, but I do remember we all payed our own tribute to the cognitive dissonance of mixing death with the joys of a swimming pool by playing our own version of submarine. We would each take turns being the sub, swimming underwater the width of the pool, while everyone would try and sink us by cannonballing from the edges and diving board.

Looking back it was not an ideal way of dealing with the long aftermath of the sinking of USS Thresher (SSN-593), but to this day I think sub and I think immediately of that pool. 

Returning to our original analogy, and falling oil prices, $40 was the design depth rating - the theoretical limit below which the independent shale-focused oil industry would experience catastrophic failure. The good news is like "design depth", the actual crush depth, where the external pressure on the hull breaches and implodes the structure, is somewhere below $40. 

Like submarines, oil and oil service companies each have an idiosyncratic crush depth. The individual welds and pipe fittings, environmental and experiential variables all come together to yield a point at which there's no return. So too do credit covenants, hedging, marketing, operational efficiency and capital structure, not to mention the heterogeneous physical attributes of the underlying reservoirs themselves.  So breaching $40, or $35, or perhaps even $30 may or may not cause any specific company to implode. 

Like submarines, oil and oil service companies each have an idiosyncratic crush depth

We are way below Never-Exceed depth. We are below design depth.

Every non-integrated oil and oil service company in North America hears the horrible sounds the hull is making. Anyone with debt financing of any kind has additionally sprung a leak, with seawater rushing in through cracked joints, and weak seams. 

It's only a matter of time now - either we slowly drown, or we suddenly perish in an implosion of twisted metal, bubbles and seawater. 

But an end to any given vessel, any given company, is by no means a prognosis on the outcome of the war. For the pain felt by the independents is also felt by OPEC governments, and strategic non-OPEC players including Russia. As the real target of Saudi manipulation, should one of these implode, or just give-in, the whole world could change in an instant. 

Meanwhile, hundreds of billions of investment have been cancelled or deferred. People are being forced out of the industry, and ultimately, long term productive capacity is being destroyed. To anyone that thinks this is the end of a supercycle, note that this is not a demand-driven price decline. Moreover, with Saudi and Iraq running more or less flat out, there's no systemic overcapacity burdening the system, as was the case with OPEC from 1982-1990. 

I like longer-term volatility (i.e. paying premium to buy long dated options, especially out-of-the-money options), which I'd pay for with short-term vol and perhaps a selection of high-yield oil credit opportunities. I am getting interested in deploying capital, again selectively. 

Don't rush - this bottom may be six months in the making. Its also never sound to fight the downward trend of a highly-leveraged commodity. But now that we've breached $35 WTI, it's time to start paying attention.

If you need help, please give me a shout. 

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(C) 2015 Matt Epstein | www.aremet.com | @OilArb (feel free to redistribute with attribution)

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