Junk Bonds, Debt Spreads: There Will Be Blood!! by Harris Kupperman, AdventuresInCapitalism
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 Spread Over Treasury
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.