Background: The 'shale patch' revolution driven by fracking and other unconventional drilling techniques may be headed in an unexpected direction: toward a shakeout.
This article discusses recent reporting on this topic and its implications.
Introduction: I recently updated my persistently and continuing bullishness on the (primarily) railcar manufacturer and lessor Trinity Industries (NYSE:TRN) in a Seeking Alpha article titled Trinity Industries: Another Beat and Raise; Is It Nearing a Top?. In this article, I explained why I raised that question. It had nothing to do with any intrinsic problems with Trinity, a very well-run and lightly-publicized company. (I reviewed TRN in Why There May Be 50% Upside From This Capital Goods Company's Stock last October.) The reason for the recent caution was an article from Bloomberg News that appeared just as I was writing the Trinity article, and it tempered my bullishness. That article, from April 30, was titled Shale Drillers Feast on Junk Debt to Stay on Treadmill. Those readers who are familiar with Trinity are well aware that its dominant business is the manufacture and leasing of rail cars, a business that has been energized in good measure because of the advances in shale drilling.
The Bloomberg [BBG] article was disconcerting, given the experience with junk debt economics I've seen in mid-late stage economic cycles in 35 years of investing.
Now a follow-up article has appeared, also on BBG. Once is happenstance and twice is coincidence, as Goldfinger said to James Bond the second time Bond outwitted him. As an investor, I don't want to wait for #3, namely enemy action. This follow-up article is discussed now.
Frackers getting squeezed: The article is titled Shakeout Threatens Shale Patch as Frackers Go for Broke.
The title's language has gotten stronger since the first article, which merely talked about a treadmill. This one uses the term "broke." BBG may be sending a subtle message here. This may the type of message I received in or around May, 2005. Then, a representative from the Office of the Comptroller of the Currency came on CNBC to warn that certain mortgage lenders were using unsound practices. Housing stocks peaked 2-3 months later, and the national housing market peaked within a year.
Here are some excerpts from the latest cautionary BBG article. Readers are invited to either read my most recent article on Trinity for extensive excerpts from the earlier BBG article, or to review it directly (both are linked to above):
The U.S. shale patch is facing a shakeout as drillers struggle to keep pace with the relentless spending needed to get oil and gas out of the ground.
Shale debt has almost doubled over the last four years while revenue has gained just 5.6 percent, according to a Bloomberg News analysis of 61 shale drillers. A dozen of those wildcatters are spending at least 10 percent of their sales on interest compared with Exxon Mobil Corp.'s 0.1 percent.
"The list of companies that are financially stressed is considerable," said Benjamin Dell, managing partner of Kimmeridge Energy, a New York-based alternative asset manager focused on energy. "Not everyone is going to survive. We've seen it before."
Some investors are already bailing out....
Drillers are caught in a bind. They must keep borrowing to pay for exploration needed to offset the steep production declines typical of shale wells. At the same time, investors have been pushing companies to cut back. Spending tumbled at 26 of the 61 firms examined. For companies that can't afford to keep drilling, less oil coming out means less money coming in, accelerating the financial tailspin.
"Interest expenses are rising," said Virendra Chauhan, an oil analyst with Energy Aspects in London. "The risk for shale producers is that because of the production decline rates, you constantly have elevated capital expenditures."
Chauhan wrote a report last year titled "The Other Tale of Shale" that showed interest expenses are gobbling up a growing share of revenue at 35 companies he studied. Interest expense for the 61 companies examined by Bloomberg totalled almost $2 billion in the first quarter, 4.1 percent of revenue, up from 2.3 percent four years ago.
The earlier BBG article gave as an example of what's happening these days, a very small, money-losing company drilling in the Marcellus Shale. It shortened its road show to raise money because investors were throwing so much money at it.
What hot stuff was Rice Energy (NYSE:RICE) selling?
Bonds rated CCC+.
We certainly have come a long way from 2009, when pictures of Depression-era food lines graced the covers of newsweeklies. That was market bottom psychology. This is boom-time stuff, where money (or credit) flows freely to speculative enterprises.
Investment implications of this phenomenon: My bias is to believe that BBG is on to something. Two feature stories close in time to each other may reflect their knowledge that things in shale land are "breaking bad," perhaps very badly.
The "Bloomberg News analysis of 61 shale drillers" shows that BBG is not just relying on third party info. I'm thus going to assume that these two articles are not mere coincidence, and that there really may be a "there" there, and that investors should prepare for a shakeout.
If exploration and production are not really economic at current levels of drilling, then either less drilling must occur and/or prices must rise. Assuming that natural gas prices are now too low to maintain current and projected production rates, then the resurgent chemical industry may face higher input costs, costing it a key competitive advantage. Railcar manufacturers such as Trinity, Greenbrier (NYSE:GBX) and American Railcar (NASDAQ:ARII) may suffer a double whammy, as shale oil and chemicals are each important contributors to the increased demand they have been seeing from railroads.
Treasuries would, on the one hand, benefit if credit ceased flowing to speculative-grade borrowers, but rising hydrocarbon prices would stoke general price inflation, so bonds might not be big winners. Perhaps bigger winners from a stock market standpoint would be market sectors that are unaffected by hydrocarbon prices, such as medical stocks of various types.
Macro thoughts: Overinvestment via extensive junk bond financing may be another instance in which "free" money provided by the government via the Federal Reserve has allowed overly permissive financing conditions. Beyond the question of what influence junk bond financing of money-losing speculative oil drilling enterprises will, or may, have on the price of energy is a larger question: What does this phenomenon of loose lending practices in the shale patch imply?
As we all know, loose lending practices are once again pervasive in the United States. Covenant-lite loans are surging. Auto lenders are getting aggressive. Federally-guaranteed student loans could lead to significant macroeconomic headwinds, if current trends continue.
A government may try to assist economic activity, but sometimes it goes beyond its core competencies, no matter how well-intentioned its goals.
A problem with unsound lending practices is that when they become a large enough fraction of all economic activity, when the tide turns, recession appears out of nowhere.
Perhaps "Mr. Bond" has rallied this year, to general disbelief, for similar reasons as in 2006?
Conclusions: A good deal of speculative money has been financing oil and gas exploration and production in the shale patch. Retrenchment is underway. The price of natural gas in the United States may now be too low to allow production to rise, and given rapid depletion rates from fracked formations, gas production may drop off sooner than anticipated at current prices. A reversal of the boom in unconventional drilling may lead to a downturn in the chemical industry and others. Railroads and their suppliers, such as rail car manufacturers, would then suffer loss of business that would not likely be immediately replaced by other business (all else being equal).
More broadly, the Federal government and all Americans are facing the wind-down of the extraordinary efforts pursuant to the economic problems that were both caused by, and revealed by, the events attendant to the Great Recession. These efforts may well have led to their own dislocations, such as overinvestment in shale drilling, but also including potential financially unsound lending practices regarding education and elsewhere in the economy.
Now that the second derivative of both Federal Reserve policy and Federal fiscal policy point toward taking the punch bowl away, it would appear that downside risks to the parts of the economy dependent on junk-rated borrowing and lending practices have increased.
I have therefore adjusted our stock portfolio in case these fracking stories have "legs," have greatly pared our holdings in TRN, and am watching carefully to see where all the new money and credit the Fed has created and encouraged to be created continues to go. I have not, however, lowered our overall allocation to stocks versus cash or bonds; I've merely adjusted the composition.
Disclosure: I am long TRN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.