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There has been a lot of speculation about how deeply and how quickly U.S. shale production would contract in the low price environment. The industry has proven resilient, with rig counts having fallen by more than half since October 2014 but actual production not exhibiting a corresponding precipitous decline.

That could soon change. Shale companies drastically cut spending and drilling programs following the collapse in oil prices. For example, Continental Resources, a prominent producer in the Bakken, slashed capital expenditures for 2015 from $5.2 billion to $2.7 billion. Whiting Petroleum, another Bakken producer, gutted its capex by half. The list goes on.

To be sure, exploration companies are achieving a lot of efficiency gains in their drilling operations. After years of pursuing a drill-anywhere strategy, many are now approaching the shale patch with more forethought and cost-saving technologies. Oil field service companies are also dropping their rates, allowing for drilling costs to decline. That will allow U.S. companies to squeeze more oil out of shale while spending less.

However, the improved productivity could be temporary. Much of the cost reductions have come in the form of layoffs rather than fundamental gains in the cost of operations. If drilling activity picks up in earnest, costs could rise again as workers will need to be rehired. The tumbling “breakeven” costs for producing a barrel of oil could be a bit of a mirage.

If oil prices remain relatively weak, or even drop further in the second half of the year, the problems could start to mount. Shale wells suffer from steep decline rates after an initial rush of output. That means that unless enough new wells are drilled to offset natural decline, overall output could drop precipitously. Add to that the fact that the companies are bringing in 40 percent less per barrel than they were last year because of lower oil prices, and falling revenues start to become a problem for weaker companies.

If prices do not rebound as expected, some operators may complete wells out of desperation, ultimately realizing lower revenues than they had hoped.

Moreover, drillers have left a backlog of wells that have been drilled but not completed (nicknamed the “fracklog”) to sit on the sidelines as they await higher prices, deferring income. If prices do not rebound as expected, some operators may complete wells out of desperation, ultimately realizing lower revenues than they had hoped. If a company is shrinking its footprint—spending less and earning less—interest payments on debt will account for a larger share of the company’s income. As that happens, it becomes more likely that the most indebted companies default on their payments.

With global markets still oversupplied, fundamentals suggest that prices are unlikely to rebound soon.

Of course, all this will change if something on the global landscape puts upward pressure under oil prices. But with global markets still oversupplied, fundamentals suggest that prices are unlikely to rebound soon. Oil companies will continue to produce as much as possible to make up for lower prices, which only pushes off the day of reckoning. A much larger shakeout needs to occur across the industry before prices will rebound, with the weakest producers forced out of the market.

Shale debt

The shakeout could already be well on its way. An estimated 27 out of 62 companies that Bloomberg tracks in an index of independent drillers are devoting more than 10 percent of their revenues to interest payments, more than twice the number last year. With oil prices still so low, they are burning through cash faster than they are taking it in. The companies averaged $4.15 in expenses for every dollar they earned in the first quarter of 2015.

More than three quarters of the companies that Bloomberg tracks have credit ratings in “junk” territory.

Debt levels among the 62 companies in the Bloomberg index rose to $235 billion in the first quarter, 16 percent higher than the same period in 2014. As credit lines become tapped out, some companies are turning to equity markets. An astounding $10 billion in fresh equity was issued in the first quarter of 2015 to small and medium-sized U.S. oil companies, a record high.

A worsening outlook

A May 2015 report from Moody’s predicts that 7.4 percent of U.S. oil companies could default within the next year unless oil prices rebound, up from a previous estimate of just 2.7 percent.

Things could get much worse. A May 2015 report from Moody’s predicts that 7.4 percent of U.S. oil companies could default within the next year unless oil prices rebound, up from a previous estimate of just 2.7 percent. The credit ratings service thinks that the defaults could increase in the fourth quarter of 2015.

Distressed drillers, with credit ratings of B3 or lower, actually make up nearly 15 percent of firms Moody’s tracks with the worst credit ratings, the highest share of any other industry.

There are two reasons why the financial position of U.S. shale companies could darken in the months ahead. First, many oil companies hedged their production ahead of the price downturn, locking in prices for their product that insulated them through the early months of the price collapse. Those positions will begin to expire this year and as they are unwound many firms are becoming more exposed to low prices—companies that have been protected up until now will start feeling the pain.

A second reason that is another round of credit redeterminations will hit the industry. Twice a year, in April and October, lenders assess the financial health of drillers, and offer lines of credit. If the value of a company’s assets decline–for example, because of lower oil prices–credit lines are severed. More banks could cut off their borrowers this fall, potentially forcing some drillers into a liquidity crisis.

The Fed’s oil boom

The drilling boom was built on cheap credit.

The drilling boom was built on cheap credit. Successive rounds of quantitative easing since the financial crisis in 2008-2009 led to a half decade of near-zero interest rates. The era of easy money inflated U.S. shale. Banks, hunting for yield, loaned out money to increasingly marginal shale players, who loaded up on debt to drill as much as possible. This allowed for drilling to take place to such a degree that it papered over their problems. Many companies spent more than they took in, but still, they were given credit by accommodating lenders, all the while increasing oil production. In this sense, the Federal Reserve has its fingerprints on the “shale revolution.”

But the punch bowl may eventually get taken away. Nobody expects the Fed to slam on the breaks and hike up interest rates over a short period of time, but after years of keeping the pedal to the metal, the central bank is expected to finally increase its interest rate target later this year. Higher interest rates could ripple through the U.S. oil industry, and indebted drillers would likely be forced to pay higher interest rates on new debt as it becomes more difficult to attract lenders.

Oil prices

In the end, it all comes down to oil prices. A swift rebound, although unlikely, could cure a lot of the problems across the industry. Increasing global demand could soak up some of the extra crude.

But there are no shortage of downside risks. Rising OPEC production, including a potential rush of Iranian oil awaiting the finalization of a nuclear deal, means the world will be well-supplied throughout this year. Iraq continues increasing production, while a slowing Chinese economy poses further risks.

Nobody knows what oil will do next and projections are all over the map. For U.S. companies mired in debt, their survival hangs in the balance.