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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.


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

  1. MASTERMIND on Fri, 16th Jun 2017 9:06 pm 

    Shale oil is a retirement party. How can anyone think shale oil is of any use if it take 2500 shale oil wells to do what 60 conventional wells do? And those 2500 shale well will deplete in 3 to 5 years while the conventional well produces for decades. It is a no brainer.

    They’re suckering gullible investors with promises that new and innovative technology will turn the shale patch profitable, truly laughable at this point especially given the numbers cited. Either Fed asset purchases decline and they die or they cannabilize themselves by spending the majority of their cash flow servicing debt and paying shareholders, take your pick.

  2. rockman on Fri, 16th Jun 2017 10:40 pm 

    Master – You’re certainly correct about the short lived production of individual shale wells. That’s the nature of fracture production that’s been true for 80+ years and it isn’t about to change today.

    OTOH: “How can anyone think shale oil is of any use if it take 2500 shale oil wells to do what 60 conventional wells do?” And that’s not at all true. Regardless of how many wells it takes the US refinery industry is totally dependent on the condensate/light oil produced from the shale trends. It’s critical to blend with our domestic and heavy oil imports. Without that domestic light oil production we would be even more dependent on imported oil since we we have to resort to importing large volumes of the light oil as we had in the past.

    Additionally the Canadians are also very dependent on US condensate/light oil to blend with its very heavy oil sands production. The would not be able to export almost 40% of that production without US light oils. But that only increases the gravity of the dilbit to about 23° API. Once in the US even more condensate/light oil has to be added to bring it up to the 32° API our refineries require.

  3. Davy on Sat, 17th Jun 2017 5:45 am 

    Great point rock and why it takes an expert sometimes to wade through the agendas of zealots. The board is replete with zealots with agendas and stories without substance. On the other hand debt is a shale issue. Low rates have created a monster.

  4. Davy on Sat, 17th Jun 2017 5:48 am 

    I post this article to remind some here who continue to be optimistic on the economy that compounding works both ways. Debt compounding is a serious force over time. Low rates are penalizing both by tying central banks hands with monetary policy but also creating structural debt traps. Rates go up and governments and business are driven to default. Rates stay low and debt continues to build and compound because of the nature of finance and low rates. Debt is being taken on as malinvestment of bubbles and poor productive returns because real cost are not expressed by the cost of money. Price discovery is neutered.

    “Bond Yields – “You Ain’t Seen Nothin’ Yet”

    “Velocity and inflation will continue to fall as long as debt compounds faster than GDP growth.”

    “The US economic return on additional debt has fallen to about 20 cents on the dollar. That means 80 cents is servicing existing debt, which has been borrowed for the purpose of supporting. The diminishing return of each new unit of debt is making it harder and harder for governments and corporations alike to juice their growth and returns. With debt levels so high, the service costs become punishing. To avoid a default, interest rates must remain structurally lower for longer just to support the present debt. Furthermore, the debt has to grow just to service the exisitng debt. Think about that for a second?”

    “It would only take a 20% backup in interest rates before the debt service becomes problematic (depending on duration and the amount of outstanding debt). The 10-year Treasury yield nearly doubled from the summer 2016 low, which suggests the US economy is about to slow down, rather sooner than later.”

    “The economy is slowing, and yet with these debt levels across the world, the growth rate required to get out from under them is essentially mathematically impossible to achieve.”

  5. MASTERMIND on Sat, 17th Jun 2017 7:21 am 

    US Shale oil the biggest joke ever

  6. MASTERMIND on Sat, 17th Jun 2017 9:15 am 

    Collapse of Global Civilization by 2020-Irrefutable Evidence

  7. rockman on Sat, 17th Jun 2017 9:46 am 

    Master – Congrats…you’ve found an appropriate thread!

    “US Shale oil the biggest joke ever.” Now if you can be more specific we might have an adult conversation. LOL.

  8. rockman on Sat, 17th Jun 2017 9:55 am 

    So some of the hedge funds that that couldn’t buy into the shale plays fast enough that then lost $billions when oil prices collapsed now worry about the future of the shale plays. We’ll have to wait to see if their timing is incorrect again. LOL.

  9. joe on Sat, 17th Jun 2017 10:07 am 

    At risk of upsetting Rockman even more I had to post this.

    Cloggie, comments….

  10. joe on Sat, 17th Jun 2017 10:09 am 

    I did mention that the sanctions would be ignored, but I did not think the Germans would publicly denounce them. Might as well have told the entire US ‘resistence’ to go fuck itself.

  11. rockman on Sat, 17th Jun 2017 2:10 pm 

    Joe – “At risk of upsetting Rockman even more I had to post this.” I’m confused: why would the Russian sanctions upset me? The Rockman and 99% of the global oil patch is thrilled at the prospect of inhibiting Russian fossil fuel development and export. We are competitors with them…right? I just hope our govt doesn’t buckle under to those krauts.

    Now if the US govt would just impose sanctions against those Canadian bastards!

  12. joe on Sat, 17th Jun 2017 4:03 pm 

    It was a bit off topic. U.S. sanctions against Russia are becoming sanctions against Germany. Germany has taken control of as much of the pipeline as they could. That’s a serious investment in political capital. Now the U.S. has simply told both the Germans and the proEU Ukrainians they died for nothing cause they are not allowed to exercise any power. The U.S. also effectively told Germany to accept gas from much more expensive sources too. Not gonna happen. This is not 1945 the power balance has changed.

  13. rockman on Sun, 18th Jun 2017 12:51 pm 

    Thanks for the clarification Joe.

    This touches ever so lightly on another silly acronym I coined: the MADOR concept. Similar to the MAD concept of the nuclear tipped Cold War. MADOR: Mutually Assured Distribution Of Resources. IOW those govts with the political strength (China, USA, Russia, et al) are not going to engage each other militarily to control petroleum commodities. They are going to use their political and economic capital to take resources previously utilized by the weaker countries.

    Take the European countries (excluding Germany and a few others). And I’m not saying that President Trump, President Obama et al were this foresighted but consider: any policies that can keep more Russian oil in the ground means more oil in the future for those economies that can afford it. Take an example today: Greece. Few people realize that the #1 export of Greece is petroleum refinery products: 40% of total. But crude oil is also its #1 import: 25% of total. As bad as the Greek economy is today imagine if it were being out bid for the oil it imports and lost most of that export revenue…and all those refinery jobs.

    Just like all that Iranian oil that hasn’t been produced the last few years. And not that the US would necessarily be a future major importer of Iranian oil. But if the Chinese are that makes them less of a competitor with the US for the rest of the global oil supply.

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