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

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.