Letters From a Hedge Fund Manager – Part I

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.
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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.

Gregory Zuckerman The Frackers

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.

There Will Be Blood Poster

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
High Yield Energy Yield

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.
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Thanks for reading and make sure not to miss the next Kuppy’s letter on Friday.

– Chris

“A burst of drilling in shale and other long-overlooked rock formations had created the biggest phenomenon to hit the business world since the housing and technology booms. In some ways, the impact of the energy bonanza might be even more dramatic than the previous expansions, especially if shale drilling catches on around the globe. Surging oil and gas production likely will affect governments, companies, and individuals in remarkable ways for decades to come.” – Gregory Zuckerman

CapEx-Logo-Our-World-This-Week

This Post Has 4 Comments

  1. Marian

    Chris,
    very interesting piece which makes me wondering whether you share Kuppy’s point of view (bullish on price of oil due to demand related decline) or think he is missing here something (the expensive infrastructure has already been spent and will eventually be picked up by somebody for cents on the dollar)?

    My thoughts on this:
    In the short run (and in a competitive market) the price is set by the variable costs of producers or SRMC (short run marginal costs).
    In the long run producers have to earn total costs (SRMC + fixed costs). Hence if somebody picks up the infrastructure for cents on the dollar, his total costs are lower, as the fixed costs have already been written off by the guy who invested in the first place and went bust.
    SRMC will be probably remain the same.
    Therefore one should have a rather good idea about the SRMC of the relevant technology/driller if one is to predict where oil prices may be heading in the longer term.
    As long as there are shale companies drilling i would suspect oil prices are still above their SRMC (even though they might not be high enough to cover total costs of shale companies).
    Taking this into account I would not bet the farm on oil prices going up to levels we have seen several years ago because after the shakeout total costs of the shale industry will be lower.

    I’d be very excited to get your thoughts on this especially as this shale situation resembles very much the current situation in a different industry I am currently looking at and investing in – happy to discuss this with you as well.

    Best,
    Marian

  2. Chris

    Very perceptive 🙂 I wanted to write about this after providing Kuppy’s point of view. He’s a smart guy and I like a strong discourse as much as anyone.

    My view, which I’ll elaborate on in a report, is that I think we’re in for a flattening of the forward rate oil curve. So no, I”m not particularly bullish. By the way, my thinking has changed on this as I was much more buillish. Like I said, I’ll elaborate why I think I was wrong and why I think Kuppy may be wrong. Thanks for the rundown though.

  3. Marian

    Sorry then for the spoiler..
    Looking forward to the second part anyway!
    Interested in discussing a similar situation in a different part of the energy world?
    Drop me an email..
    Best,
    Marian

  4. Scott

    Marian,

    While you’re right about the assets being picked up for pennies, what exactly will they be picking up? Any well that’s over 2 years old will already have produced over half its oil and will be essentially a stripper well. It will still cost money to maintain and operate the well. Furthermore at the end of the wells useful life there’s an expensive abandonment and plugging process. It remains to be seen just how profitable these wells will be.

    As for lower costs of drilling and fracking, There have been some cost reduction but that will probably be off-set by the fact that the core areas of these plays are being rapidly drilled out and whats left is the marginal to poor acreage. I’ve worked in the fracking business and can’t see how they can cut costs very much. It’s a very costly business prone to equipment failure and accidents. I’ve never been on a site where there was less than 50 men and cutting costs and corners usually results in accidents which means injuries, lost time, and lost money.

    Also, consolidation in the fracking industry will sideline a lot of equipment and allow the survivors to defend their margins. When there’s work for that equipment again it will have been cannibalized for parts and in general disrepair, crews will need to be rehired and trained…you get the picture.

    More importantly… how high would oil need to go before you’d lend your money to a shale fracker. If they can’t make money on 5% money, how’re they gonna do it with 12% money.

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