Letters from a Hedge Fund Manager
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.
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