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There Will Be Blood - Part I
By Chris at www.CapitalistExploits.at
Humans are hardwired to take things to extremes.
Take junk food, for example; here is something that could be a nice treat every once in a while, and we go and scoff so much of it that we've turned diabetes into a national sport.
And then we have shampoo. I was asked to do some shopping for my wife the other day and you'd think buying shampoo would be easy but no. They've got shampoo for hair types I never knew existed: dry, grey, oily, brittle, thin, full bodied,... For goodness sakes, what about just plain shampoo for hair? Hair on a human's head? And full bodied? It's not wine, it's bloody hair!
Extremes are good and pretty much necessary. The pyramids of Egypt, the Great Wall of China, Roman roads - all built under extreme situations otherwise known as slave conditions. Since we pretty much decided that slave labour wasn't the only way to build amazing things we've moved up the humanitarian ladder and found that bubbles do an equally impressive job. And what's more, we get to have those who suffer most pay for it.
Take, for example, the dot-com boom of the 90's which was necessary for us today to all be enjoying cheap, fast, reliable communications from what is close to free fibre. Fibre optics has been around since the 1800's but it took insane amounts of money pouring into companies to allow for the laying of fibre across this ball of dirt. When the inevitable happened and the crash came, the market liquidated and companies ended up picking up what was incredibly expensive infrastructure for cents on the dollar.
Prices go up and prices go down and occasionally they go to extremes. The extremes interest me greatly as asymmetry lies at the extremes.
On that note, I recall it was December last year that my friend Harris Kupperman aka "Kuppy" began articulating the immense problems in the shale oil sector. A disconnect between cashflows and equity values is as red a flag as one is likely to find anywhere. Over the course of the week I'd like to share with you some letters written by Kuppy. I think you'll find them enlightening.
To provide some context about Harris: he first dipped his toes into investing back in college and was instantly hooked. Starting with some friends and family seed capital, he grew that pot of money more than tenfold by the time he finished college, all the while the markets were in turmoil after the burst of the dot-com bubble. Kuppy then started his own hedge fund in 2003 and over the next decade outperformed the market and most hedge fund indices.
Harris is also the founder and CEO of Mongolia Growth Group, a public company focused on leveraging the dynamic growth of the Mongolian economy through investing in real estate in the capital city of Ulaanbaatar.
Though this first letter was written late last year, it is important to provide the context for what is now unfolding.
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Date: 10 December 2014
Subject: There Will Be Blood - Part I
Last week, I had the great fortune to finish reading The Frackers by Gregory Zuckerman, which I highly recommend to anyone with even a cursory interest in the history of fracking in America. Essentially, it is the story of a handful of outcast wildcatters who were convinced that there was a way to extract oil and gas from shale that had previously been written off as unrecoverable by the mainstream oil industry. After many years of marginal returns, they finally cracked the code of horizontal drilling, multi-stage fracking and the correct mix of fracking proppants. The success was a combination of trial and error, along with plenty of dumb luck along the way. In the end, a whole new type of oil extraction was made viable by these visionaries.
At that point, the wildcatters were mostly pushed aside, and the finance guys took over. They instantly recognized that near worthless drilling rights were suddenly on the verge of becoming quite valuable. This ignited a land-grab of epic proportions. The land-men overtook the geologists in importance and newly formed shale companies recruited thousands of land-men to scour farmland and pasture trying to lock down drilling rights from flabbergasted farmers.
These companies successfully convinced Wall Street that they could ignore production, cash flow, reserves and other metrics related to the oil and gas industry. Instead, investors should focus on metrics like acreage and which "play" they were trying to consolidate - often ignoring if the "play" was even economically viable. It was a virtuous cycle: lease land for X, convince investors that it is worth a few times X, see your shares appreciate, raise more capital, buy more land from competitors to show that the value of the land was appreciating, raise more capital, rinse, repeat, make sure that Wall Street gets I-banking fees while receiving enough analyst upgrades to continue the charade.
In some ways, it was just as preposterous as the mad scramble for internet eyeballs. The only difference is that bankers were able to convince investors that there would eventually be cash flow; hence these drilling leases could be borrowed against. In the mid-2000's scramble for yield, investors were only too happy to buy these high-yield junk bonds backed by previously worthless lease rights. A truism in finance is that debt eventually needs cash flow to repay it. Ironically, in the shale space, much of the borrowed money wasn’t being spent to drill and produce cash flow. Instead, the shale companies were using debt to acquire more lease rights in the hope that they would continue to appreciate faster than the interest payments went out the door.
Any first year analyst could do a back-of-the-envelope analysis and realize that if even a small fraction of these wells were drilled simultaneously, there would be an epic glut of natural gas—which is precisely what happened, just as the great credit crisis of 2008 unfolded. At the nadir in 2009, many of these companies were shells of their former selves, barely able to raise enough capital to avoid default and completely unable to roll over their debt. If not for QE, which sparked a massive run back into the most questionable of junk bonds, many of these shale companies would have disappeared long ago.
It was a wake-up call that many energy investors should have heeded as the shale plays moved from land-grab to production….
In Part II, we'll look at what the current downdraft means to the financial system and why shale plays are uniquely unfit for junk bond funding. Could debt tied to oil and gas become the new subprime crisis? What if I told you that the amounts involved are LARGER than all of subprime? Scared? I'll leave you with a teaser; debt spreads are blowing out and that's never good for anyone - especially in a QE inspired low interest rate environment.
High Yield Energy Yield
As a side note, I remain very bullish on the price of oil over the longer term and believe that the current price decline is demand related. This shakeout will bankrupt many marginal players and force the cancellation of high cost projects, leading to the next leg up in oil.
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Thanks for reading and make sure not to miss the next Kuppy's letter on Friday.
- Chris
"A burst of drilling in shale and other long-overlooked rock formations had created the biggest phenomenon to hit the business world since the housing and technology booms. In some ways, the impact of the energy bonanza might be even more dramatic than the previous expansions, especially if shale drilling catches on around the globe. Surging oil and gas production likely will affect governments, companies, and individuals in remarkable ways for decades to come." - Gregory Zuckerman
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- advertisements -
AC/DC: "If You Want Blood"
https://www.youtube.com/watch?v=gqwuGTOs1jo
"It's animal
Livin' in a human zoo
Animal
The shit that they toss to you
Feeling like a Christian
Locked in a cage
Thrown to the lions
On the second page."
So why are we still getting any oil from the Middle East? Isn't it time to shut down that pipeline?
I think oil/NG is going to be very inefficient from an EROI standpoint relative to alt energy tech advances inside of 10 yrs.
Pink Floyd - Wish You Were Here
https://www.youtube.com/watch?v=IXdNnw99-Ic
I think all them Tesla's and Priuses causing oil demand to drop.
Sarc
"...and Humpty Dumpty couldn't be put back together again."
The End
there is already blood in the streets,
the desert and the country side, never mind
the race track and the college campus.
who is sucking at the end of that straw?
you?
never mind .....
.
Cops & Robbers - Steve Ferguson - Mama U-Seapa
https://www.youtube.com/watch?v=rzCZtFFMMuE
.
a key component of globalization is financialising
energy usage payments. the "developed" or psychologically
globalized world is converting from petroleum oil based
heating to natural gas systems at a steady and accelerating
rate for 20 plus years. the banksters and hangers on
have this right in their sniper cross hairs, man. it is
the money system, stupid.
.
"...round and round and round she goes
and where its gonna stop, there ain't nobody knows. ..
cops and robber, all i see
and its really, really, really got a hold on me.
and you ain't seen nothin' yet
this is only the beginning. ohhhh whoa ..
cops and robbers is all i see
and its really, really got a hold on me
and the worst is yet to come
but there ain't no body winning. ...yeah
. yeah ,
and there ain't but one way out
and everybody knows what i'm talkin' about
but you don't wana hear it so
i just better keep it light
and shut my mouth" s.f.
Chris,
I like your final conclusion, that eventually oil will go up in price, long term.
Frackers really upset the current oil markets during the past 5 years. The improvements in Fracting really drove down natural gas prices.
Fracking itself has been going on for decades, but improvements in computer technology the last 10 years has really gotten better.
As to the current markets, oil included, maybe this is just an average bear market? Or is it worse. That is what I ask myself on a regular basis.
But long term, it is hard not to see oil going up.
"Could debt tied to oil and gas become the new subprime crisis? What if I told you that the amounts involved are LARGER than all of subprime? Scared?"
Why is nobody commenting on this line? This debt is obviously going south.
And when it goes south, the majors will step up in, buy up leases at pennies on the dollar and have a much lower base price for the oil they produce.
Oil is not going up much for a long time.
I drink your milkshake!
(nuttin to see here)
What if it were determined that after a small capital investment, and upkeep, energy could be produced without fossil or nuclear fuel?
http://youtu.be/0gVLv5eg4Xg
That's a great link - for anybody who actually wants to use up 3 hours listening to Joe Rogan & co.
I am still amazed that the original template for all this debt origination and all the fees collected with it, was started by Drexel, Burnham & Lambert years ago.
I am sure Michael Milliken never envisioned it growing to the complexity it is today, but the premise remains the same, issuing high yield junk bonds to finance rather dubious and risky business ventures, that could not obtain financing anywhere else.
A rather good game of hot potato with a live hand grenade...last one holding it goes BOOM, then bust...
We're all gonna get Fracked!
I'm feeling like we're fracked already...
;-D
Optimists are NEVER pleasantly surprised....