Why Some Hedge Funds Believe The Shale Boom Is Coming To An End (Again)

Tyler Durden's picture

Today's Baker Hughes report confirmed that the US shale miracle continues, as another 6 oil rigs were added bringing the total to 747, the highest since mid-2015, with domestic producers seemingly oblivious - or perfectly well hedged - to the ongoing decline in crude prices which is once again set to crippled the Saudi budget.

And as has been the case for the past year, virtually all of the increase in rigs came from the Pemian basin...

... and if Goldman is right, this is just the beginning of a shale cypercycle that will triple shale production over the next decade.

Today's rig data effectively confirmed what the EIA predicted earlier this month, namely that July will see a new all time high in US shale production,surpassing the march 2015 high of 5.46mmb/d. Permian production is expected to reach 2.47 mmbpd by July, a 330,000 bpd increase from the beginning of the year.

And while the future for shale appears bright, much to the chagrin of OPEC which tried valiantly to crush shale but yield-chasing and low rates helped it survive, storm clouds are gathering.

First, consider the following chart from Goldman, which shows that the most significant shale drilling ramp up in shale production (i.e., Permian) has come from public companies issuing junk bonds and from PE backed private companies. In other words, producers heavily reliant on the generosity of junk bond investors and PE firms.

Horizontal oil rig count changes from May 2016 by producers' sources of funding

That may be a problem, because as Reuters writes, as cash, people and equipment continue to pour into the prolific Permian basin in Texas as business booms in the largest U.S. oilfield, one group of investors is heading the other way - concerned that shale may become a victim of its own success.  Indeed, the speed of the recovery in shale in the past year has not only stunned OPEC which has been flailing like a headless chicken in the past 6 months, desperate to boost prices using and every gimmick, but more importantly surprised those oil investors who foiled OPEC's plans in the first place by providing much needed distressed capital to shale companies.

As a result, eight prominent hedge funds have reduced the size of their positions in ten of the top shale firms by over $400 million, concerned producers are pumping oil so fast they will undo the nascent recovery in the industry after OPEC and some non-OPEC producers agreed to cut supply in November.

Translation: contrary to what you may read elsewhere, not only is shale the marginal producer, but it is on its way to becoming the dominant  one as well. And that is making investors, who prefer to play "marginal" moves, nervous.

According to Reuters, the funds, with assets of $286 billion and substantial energy holdings, cut exposure to firms that are either pure-play Permian companies or that derive significant revenues from the region.  What are they so concerned about? Same thing that keeps the Saudis up at night: "going crazy"

"We'll have to see if these U.S. producers have the discipline to not go crazy and keep prices where they keep making money," said Gary Bradshaw, portfolio manager at Dallas-based investment firm Hodges Capital Management. Hodges Capital owns shares of Permian play firms including Diamondback, RSP Permian and Callon Petroleum. Bradshaw's firm has maintained its exposure to the Permian.

 

There is no sign that shale producers will restrain production. They redeployed rigs and personnel quickly since prices began strengthening in 2016 and made shale profitable again; rig counts have risen by 40 percent this year in the Permian, which accounts for about half of all U.S. onshore oil rigs.

As the pumping is accelerating, shale companies still have ample capital - especially those who restructured last year and eliminated any interest expense burdens - however, the market has clearly soured on their equities, with hedge funds pulling back in the first quarter and shale stocks have continued to struggle as oil prices have come under renewed pressure. The value of these funds' positions in the 10 Permian companies declined by 14% to $2.66 billion in the first quarter, the most recent data available, from $3.08 billion in the fourth quarter of 2016. Hedge funds have continued to reduce their exposure to energy stocks in the second quarter, according to Mark Connors, global head of risk advisory at Credit Suisse, though he could not provide figures specific to shale companies.

Curiously, while the equity decline has been acute, especially for some very levered hedge funds such as the Alphagen Elnath Fund which is down 44% YTD after surging 60% through this period last year, the junk bonds space in 2017 has been far more resilient, as Goldman pointed out last month, suggesting credit investors have more patience then equity guys, a flip of their roles in 2016.

That may also be changing.

In a note from RBC Dave Schulte, the energy strategist wrote today that “high yield E&P bonds tracked oil prices downward, hitting a succession of lower lows as the week progressed. Crude-focused beta credits (i.e. lower quality assets and/or high financial leverage) are weaker by as much as 6.5pts. Higher quality names (good assets in core plays with manageable capital structures) held up better, in part due to greater interest rate sensitivity, closing the week 2-3pts lower. Trading activity was very balanced until today; buyers now seem to be on hold, leaving sellers to push paper lower despite a modest uptick in crude."

But back to the Permian, where fund managers interviewed by Reuters expressed concern that volatile oil prices along with rising service costs and acreage prices are not reflected in overly optimistic projections for the Permian. The funds analyzed include Pointstate Capital, a $25 billion fund with 16% in energy shares, and Arosa Capital Management, a $2.1 billion fund with more than 90% of assets in energy stocks.

"Margins will continue to be squeezed by a 15 to 20% increase in service costs in the Permian basin," said Michael Roomberg, portfolio manager of the Miller/Howard Drill Bit to Burner Tip Fund. A Reuters analysis of 10 Permian producers, including several that almost exclusively operate in Texas, carry an average price-to-earnings ratio of about 35, compared with the overall energy sector's P/E ratio of about 17.8.

 

"These are not great returns, but the problem is the market is rewarding them," said an analyst at one of the hedge funds on condition of anonymity, because he was not authorized to speak to the press.

Another thing spooking hedge funds are rising land prices: values for Permian acreage have increased 30 percent from two years ago, according to Detring Energy Advisors in Houston.

But perhaps the biggest threat facing producers is the decling of hedging. A Reuters analysis shows many shale companies reduced hedges in the first quarter, leaving them vulnerable to falling oil prices. Still, the good news is that the Permian still has the lowest break-even costs. And by 2020, Goldman predicts that technological innovation will push breakevens even lower...

... to the point where the Permian may become competitive with the Gulf states.

"In terms of the time horizon, the economics of the Permian are so good they’re going to keep on drilling," said Colin Davies, senior analyst at oil services company AB Bernstein.

So is the current shale euphoria a harbinger of the next shale downfall, as investors - voting with their money - suggest, or will Goldman be right and will shale face a golden age stretching over the next decade, as OPEC vanishes into irrelevance? The is the question that will determine if oil drops back under $40 next, or surges.

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
AlexCharting's picture

Some industries die slowly, while others face a violent death. I think solar soon will cause the latter for fossil... those high IQ Chinese are investing bigly in solar. 

Mr 9x19's picture

those betting on focus for fossil industries are the fossils themselves, scared of the change, because they have no time line, no direction, it is blind navigation, trump acts this way, european countries also. huge mistake.

EROI says all by itself, nothing to understand, nothing more simpler, many idiots believers of the past periods.

it is plain simple as that : oil era is over.

tmosley's picture

Hahaha, every time the shale era ends it creates the conditions for its re-emergence months or weeks later.

Any higher price will bring more production, end of story.

fx's picture

The boom and the peak of US shale will perfectly mirror a decline and an ultimate low in realized oil sales prices. 10 years from now, oil will be back at 80$/bbl or , more likely, well above $100 but shale reservoirs will mostly be emptied by then. Well, done America; selling boatloads of oil at throwaway prices (barely break-even, all-in-costs).
But yeah, we were the marginal swing producer for a while. LOL!

AllOfGood's picture

I'm making over $7k a month working part time. I kept hearing other people tell me how much money they can make online so I decided to look into it. Well, it was all true and has totally changed my life. This is what I do... http://bit.ly/2jdTzrM

Balanced Integer's picture

"oil era is over."

Said no one with an IQ over 5, ever.

Balanced Integer's picture

Solar is garbage for serveral reasons:

Clouds.

Darkness of night.

No batteries for power storage through the night. And clouds.

Subsidized by the taxpayer up the wazoo.

More expensive to purchase solar-generated electricity than electricity generated by fossil fuels.

Face it. Solar ain't ready for prime time, and it won't ever be until it can generate electricity cheaper than natural gas and/or coal.

Teja's picture

More expensive to purchase solar-generated electricity than electricity generated by fossil fuels.

In many regions, this ain't true anymore. Especially in rural regions in the south - fuel driven generators are much more expensive than solar these days. And batteries getting cheaper rapidly, with new technologies in the pipeline.

Some googling, found a very detailed article regarding costs here:

https://www.vox.com/2016/8/24/12620920/us-solar-power-costs-falling

Figure 13 most intriguing - US installation costs more than double that of other major countries.

FredGSanford.'s picture

So peak oil was a myth? Happy motoring will continue ?
Dang.

FredGSanford.'s picture

Lots of good, cheap oil for years to come!!

knotjammin2's picture

Not just oil but natural gas too.  Decades of it not including untapped known reserves.  

Pasadena Phil's picture

This is Big Oil (aka the real OPEC) making one last Hail Mary pass desperately trying to shut down the new swing producer. US shale means US energy independence and national soveriegnty. Big Oil means AGW and global government. This is what is called "cutting to the chase". All masks have been dropped.

JuliaS's picture

When pro-shale sponsored articles begin showing up on ZH, you know they've run out of greater fools.

Normalcy Bias's picture

Yep, those dumbasses that run Big Oil just love losing money, which is of course why they became Big Oil in the first place.

jmack's picture

There is absolutely no difference between these firms who are lightening up thier permian basin dispositions and those that lightened up their fang dispositions this past 8 days.

 

    But note the difference in tone and treatment by the Tylers......

ali-ali-al-qomfri's picture

they're rigging the rigging of the rigs.

TGDavis's picture

This is known as the market searching for equilibrium. All these articles assume that there is some permanent price or "right" price for oil. The world is awash in oil and will be for the next 1500 years. The boys in the shale fields have brains, hence, they will drive the breakeven price down and down.

Cutter's picture

Goldman projects 3 to 10 percent "productivity gains" that will lower the breakeven point further. From where? Fracking has been known since the 1950s, it was simply uneconomic to do until prices hit 100 per barrel. The technology is very mature at this point.

Goldman puff piece meant to stimulate buyers in some Goldman investment product.

VangelV's picture

""In terms of the time horizon, the economics of the Permian are so good they’re going to keep on drilling," said Colin Davies, senior analyst at oil services company AB Bernstein."

 

Before the Permian became hot, Bakken was the place to be.  But things have not worked out too well for the producers in that area.  Over the last two years, the well count has gone up by 17.4% while average output has fallen by 24%.  Note that during that period some wells were shut off because they were not productive enough to make economic sense while the new wells produced at very high rate.  And still the math works against the naive optimists who believe that a miracle can occur even as the shale producers destroy capital.  

This is a game for fools.  Reasonable and rational investors might want to pick up the shares of conventional players that can ride out the storm and come out much stronger on the other side.