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Shale Drillers About To Be "Zero Hedged" As Loss Protection Expires

Tyler Durden's picture




 

In many ways, the US shale industry is emblematic of why failing to normalize monetary policy after seven years of largesse can be extremely dangerous.

As discussed at length in these pages and then subsequently everywhere else, access to cheap cash via capital markets allows otherwise insolvent producers to keep drilling even as prices collapse, creating what are effectively zombie companies (to use Matt King’s words) on the way to delaying the Schumpeterian endgame and embedding an enormous amount of risk in HY credit by flooding the market with supply just as demand from investors (who are delirious from hunger after being starved of yield by the Fed) peaks and secondary market liquidity continues to dry up. 

This dynamic has served to create a supply glut in a number of industries and has suppressed commodity prices in a self-feeding deflationary loop.

Thanks to SEC rules on how drillers are required to value their reserves, producers are effectively forced to overstate the value of their O&G businesses by nearly two-thirds, which can lead unsophisticated investors who don’t bother to read the 10K fine print to believe that the businesses are healthier than they actually are.

Furthermore, the next round of revolver raids for the industry isn’t due until October, meaning investors may also believe the industry has easier access to liquidity than it actually does. As a reminder:

As if all of the above weren’t enough, there’s yet another reason why the shale default cascade has thus far been forestalled, giving many the impression that perhaps a “crude” awakening (pardon the terrible pun) has been averted: hedges.

Here’s Bloomberg with more on why some US shale drillers may soon be zero hedged (ahem):

The insurance protecting shale drillers against plummeting prices has become so crucial that for one company, SandRidge Energy Inc., payments from the hedges accounted for a stunning 64 percent of first-quarter revenue.

 

Now the safety net is going away.

 

The insurance that producers bought before the collapse in oil -- much of which guaranteed minimum prices of $90 a barrel or more -- is expiring. As they do, investors are left to wonder how these companies will make up the $3.7 billion the hedges earned them in the first quarter after crude sunk below $60 from a peak of $107 in mid-2014.

 

“A year ago, you could hedge at $85 to $90, and now it’s in the low $60s,” said Chris Lang, a senior vice president with Asset Risk Management, a hedging adviser for more than 100 exploration and production companies. “Next year it’s really going to come to a head.”

 

The hedges staved off an acute shortage of cash for shale companies and helped keep lenders from cutting credit lines, many of which are up for renewal in October. With drillers burdened by interest payments on $235 billion of debt, $89 billion of it high-yield, a U.S. regulator has warned banks to beware of the “emerging risk” of lending to energy companies.

 

Payments from hedges accounted for at least 15 percent of first-quarter revenue at 30 of the 62 oil and gas companies in the Bloomberg Intelligence North America Exploration and Production Index. Revenue, already down 37 percent in the last year, will fall further as drillers cash out contracts that paid $90 a barrel even when oil fell below $44.

 

For SandRidge and other drillers, the hedges, required by some lenders, gave them enough time to cut spending. Costs in shale fields have fallen by 20 to 30 percent and productivity has increased as producers moved rigs to the most prolific regions. Producers were able to raise about $44 billion in equity and debt in the first quarter, according to UBS AG.

 

“That postponed the day of reckoning,” said Carl Tricoli, co-founder of private-equity firm Denham Capital Management.

 

At Goodrich Petroleum Corp., hedges accounted for 35 percent of revenue in the first three months of 2015. Most of its insurance runs out at the end of the year, company records show.

In short, the last line of defense against terminal cash burn for the beleagured US shale complex is about to fall and when it does, it's going to take bank credit lines down with it.

This means October is the expiration date for heavily indebted US drillers and perhaps for HY credit as well, because once the defaults begin in earnest and HY spreads start to blow out, the BTFD-ing retail crowd will head for the exits, triggering a very non-diversifiable, unidirectional flow for bond fund managers who will then be forced to hold their noses and dive into the ever-thinner secondary corporate credit market.

It is precisely at that point when everyone's worst nightmares about shrinking dealer inventories and illiquid credit markets will suddenly be realized.

 

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Thu, 07/02/2015 - 20:48 | 6264436 angel_of_joy
angel_of_joy's picture

Not to worry. They'll make it up "in volume"...

Thu, 07/02/2015 - 21:22 | 6264534 813kml
813kml's picture

They just need to open a disaster theme park in Oklahoma, guaranteed earthquakes daily with high chance of twisters and/or dust storms.

Thu, 07/02/2015 - 21:29 | 6264567 Gromit
Gromit's picture

I wouldn't like to be on the other side of these hedges.....

Thu, 07/02/2015 - 21:32 | 6264577 Publicus
Publicus's picture

Why not? You just get the money from the Fed for free. Big bonus continues for the CEO.

Thu, 07/02/2015 - 21:34 | 6264583 Save_America1st
Save_America1st's picture

Well...in the immortal words of Admiral Ackbar...

 

It's a trap!!!

Thu, 07/02/2015 - 21:46 | 6264626 Joe Davola
Joe Davola's picture

They just need to hold on until the LNG terminals are fully operational.

So they can pump tankers full and anchor them in international waters.

Thu, 07/02/2015 - 21:55 | 6264660 angel_of_joy
angel_of_joy's picture

Now that would make for some spectacular fireworks...

Thu, 07/02/2015 - 23:36 | 6264975 Paveway IV
Paveway IV's picture

Why doesn't Puerto Rico backstop drillers with PR revenue bonds? They need to put the PR revenue cash cow to WORK for them. It's a win-win.

Thu, 07/02/2015 - 23:25 | 6264938 Anunnaki
Anunnaki's picture

They are gonna keep fuckingaround in the midwest and rhat New Madrid fault is gonna make San Andreas look like a butterfly fart

Thu, 07/02/2015 - 20:51 | 6264443 SillySalesmanQu...
SillySalesmanQuestion's picture

I wondered how the shale drilling companies had forestalled declining price and red ink for this long. Thanks for a enlightening post to how the hedges actually work.

Thu, 07/02/2015 - 20:53 | 6264451 Salah
Salah's picture

Fracking's not like std. reservoir management.  In that case you pump or somebody else does ("milkshake straw") downline.  In fracking you can stop, leave it in the ground, and come back to it anytime.

Thu, 07/02/2015 - 21:00 | 6264475 angel_of_joy
angel_of_joy's picture

Sure dude, that's why all frackers are pumping like crazy right now, as the price of oil goes down...

Thu, 07/02/2015 - 22:02 | 6264675 aVileRat
aVileRat's picture

While you may be correct that after stimulating a reservior a well can be shut in, shut in resource does not generate cash flow. Also, suspended resource no longer can be attributed as proven production. So given VWAP financings done in March are well underwater at the moment, there is little hope of bailout for most of the weakest players. The only solution is that general credit facilities which were extended beyond 3x (5x) debt ratio covenants will need to be expanded upwards to 7x, or new junior tranches of financing will need to be cooked up. Prefs, or firesales is the last stage.

For players who do not own their infrastructure and book line time, having shut in production forces you to buy production off the market and this can be a real pain should you already be 5 million from entropy death (what its called). 

On a related note, a large degree of NAFTA basin hedging happened a few weeks ago around 62. Feel free to estimate which corporates are still pricing in 80/bbl. Gas is not oil.

 

 

Sun, 07/26/2015 - 17:58 | 6356778 sun tzu
sun tzu's picture

Leaving it in the ground doesn't pay the bills.

Thu, 07/02/2015 - 20:56 | 6264461 Chad_the_short_...
Chad_the_short_seller's picture

CLR's wonderful ceo harold hamm sold all their oil hedges when oil was $80 LOL

Thu, 07/02/2015 - 22:12 | 6264714 WillyGroper
WillyGroper's picture

Calling him wonderful is permitted.

Sun, 07/26/2015 - 18:00 | 6356788 sun tzu
sun tzu's picture

When oil ran back up to $60, he refused to hedge, borrow more money, or issue more shares to raise money. Their LOC will be tapped this fall just as the junk debt markets freeze. 

Thu, 07/02/2015 - 21:00 | 6264474 ajkreider
ajkreider's picture

$89 billion is going to wreck the bond market? Even if it all goes to zero, which it won't, there's little chance of catastrophe.

Sun, 07/26/2015 - 20:38 | 6357206 sun tzu
sun tzu's picture

How many insurance policies were taken out on those bonds?

 

$89 billion x 10 = $890 billion

Thu, 07/02/2015 - 21:00 | 6264476 Never One Roach
Never One Roach's picture
Ford recalling 433,000 cars for engines that don't shut off

 

http://www.msn.com/en-us/autos/news/ford-recalling-433k-cars-for-engines...

 

Winning !

Thu, 07/02/2015 - 21:09 | 6264505 all-priced-in
all-priced-in's picture

Over 90% of all Fords sold since 2005 are still on the road today

 

 

 

 

 

 

 

The other 10% made it all the way home before they broke down.

Thu, 07/02/2015 - 21:28 | 6264564 disabledvet
disabledvet's picture

Yeah I saw that one too.

You know it's bad when you can't even turn your car off.

Magnum Hunter hit so much natural gas in one day they pretty much went bankrupt the very next actually.

Wonder how "Bandar Bush" is gonna spin that one...

Thu, 07/02/2015 - 23:15 | 6264905 Anunnaki
Anunnaki's picture

Ford - Found on Road Dead

Fri, 07/03/2015 - 00:45 | 6265112 Abbie Normal
Abbie Normal's picture

Or as one redneck told me:  First On Race Day

Fri, 07/03/2015 - 09:01 | 6265749 Normalcy Bias
Normalcy Bias's picture

A good 'ole boy told me it was Fixed Or Repaired Daily.

...But that was 20 years ago. To be fair, Ford has improved drastically since.

Thu, 07/02/2015 - 21:05 | 6264486 WTFUD
WTFUD's picture

It's all rattling down like a yarn of wool.
Just like the subprime, JPM & Lloyd would testify to CONgress that they never envisaged in a trillion years falling prices when 35 billion is off balance sheet in the next quarter with more on the way as they can't get out of a trade.
An executive of JPM stated ( covered by Z/H ) that it's nigh on impossible to make a buck in today's markit. Choked i am!
Even with 0% fill yer boots they can't make ends meet.

The END is NIGH!

Thu, 07/02/2015 - 21:31 | 6264576 disabledvet
disabledvet's picture

WE'RE SO RICH WE'RE BANKRUPT!

Thu, 07/02/2015 - 21:07 | 6264493 Squid Viscous
Squid Viscous's picture

Goldman will drink it all up for pennies on the nickel...rest assured

Thu, 07/02/2015 - 21:34 | 6264586 disabledvet
disabledvet's picture

Nothing scarier to those clowns than solvency..

Worse still an ouright production boom..

Thu, 07/02/2015 - 21:08 | 6264504 847328_3527
847328_3527's picture

" It's contained.... "

Thu, 07/02/2015 - 21:10 | 6264512 Chad_the_short_...
Chad_the_short_seller's picture

OAS is one that's still $14-15 that has cheap january puts on it. That's my BK pick with a stock price that high. CLR is probably the best short though. That pig is going to get creamed.

Thu, 07/02/2015 - 21:10 | 6264514 Yen Cross
Yen Cross's picture

 The numbers don't add up.

Thu, 07/02/2015 - 21:23 | 6264551 813kml
813kml's picture

They don't subtract up either.

Thu, 07/02/2015 - 21:29 | 6264566 Farmer Joe in B...
Farmer Joe in Brooklyn's picture

Waiting until the Chinese stock market takes the really deep plunge...

Chinese demand for commodities, which is already severely waning, will go right with it. 

We are going to see massive deflation, followed by a loud "pop" (that moment faith in central banks collapses and the real fun starts)...then the hyperinflation will begin...

Thu, 07/02/2015 - 21:40 | 6264604 disabledvet
disabledvet's picture

China produces a lot of commodities too actually...

Thu, 07/02/2015 - 21:59 | 6264670 Jumbotron
Jumbotron's picture

Yeah....our manufacturing numbers show that. 

Thu, 07/02/2015 - 21:33 | 6264581 q99x2
q99x2's picture

Bomb the bearded drag queen's castle.

Thu, 07/02/2015 - 22:20 | 6264740 The Shape
Thu, 07/02/2015 - 23:09 | 6264885 Anunnaki
Anunnaki's picture

Just another broken promise from Obama.

Piss money for renewables. Put everything into his Oil of the Above energy policy

Bubble, bubble toil and trouble

How many more days til this nightmare is over

Thu, 07/02/2015 - 23:58 | 6265029 damicol
damicol's picture

If I was Putin I would be planning an early Christmas sale.

 Starting in September, 30% off all Russian crude until Christmas. Saudi sure to follow

Watch the hedges collapse then and the fuckers  on Wall St scream in pain.

 

Fri, 07/03/2015 - 01:52 | 6265218 katchum
katchum's picture

Don't forget the debt ceiling in October.

Fri, 07/03/2015 - 09:56 | 6265902 Arnold
Arnold's picture

Eight Ball says: FUTURE IS CLOUDY.

I'll shake it again tomorrow.

Mine has negitive vibes i am sure.

Fri, 07/03/2015 - 12:59 | 6266439 still kicking
still kicking's picture

Yeah my shitty company made the article.  SD is a disaster.

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