What U.S. Energy Investors Can Learn From A Defunct Burger Restaurant

by: The Heisenberg


Throwing good money after bad is generally a terrible investment strategy.

And yet nearly $7 billion went down the tubes last month.

The frackers are back. Are you ready to go along for the ride?

Greetings from a not-so-great seafood joint where I've only decided to park myself because I needed a place to sit while I pen this short missive on America's capital markets or, as I like to call them, zombie creation machines.

It's funny how stories just come together when your mind is completely unencumbered and your thought process isn't weighed down by obligations, deadlines, or other distractions like say, interpersonal relationships of any kind (how sad is that?).

This place (the seafood joint) wasn't here 10 years ago. There used to a mall on this lot and in what amounted to a mercy killing, a developer tore it down around a decade ago and replaced it with a few useful establishments (like a grocery store and a pretty decent gelato shop), and a few not so useful ones (like this seafood place).

The view is nice, though - the bar overlooks a scenic marsh that's home to more than a few smallish alligators and a few dozen turtle clans.

As usual, there's a market parallel here. Heisenberg vignettes always have a market parallel.

For at least 20 years (and probably longer), there was a fast casual chain burger restaurant on this same lot. In all the years I've been coming to this island it was never busy. Ever.

I know a few waitresses who worked there over the years, and by their accounts, it was a money pit. And yet management (perhaps due to corporate's deep pockets) continued to throw good money after bad, year after painful year. Finally, it closed. Now - and I can literally see the place from where I'm sitting as I write these lines - there's a locally owned Italian sub-shop in the same building and it's doing well.

The point is that throwing good money after bad never works. You can forestall the inevitable, but at some point, you have to face reality. Just ask the IMF, which is now right back in the same spot the fund was in a couple of years ago with Greece.

Those of you who follow Heisenberg religiously probably know where this is going.

As I was waiting in line to pay for some tomatoes at the little grocery across the way, I scrolled through some of the headlines on Bloomberg's website and happened upon this: "Wall Street's Love Affair With Energy Heats Up as Rigs Soar."

It was just 24 hours ago (give or take) when I showed you the following charts and explained (again) why wide open capital markets are creating a zombified US oil production complex:

(Charts: SocGen)

For those who might have missed it earlier this week, here are the five bullet points SocGen uses to support the idea that "shale is coming back, and it's coming back strong":

  • Rig counts are increasing at an accelerating pace, and given the technological advances of the past three years, this should translate into significant supply.
  • Decline rates for US shale wells are still steep, but typical production profiles have shifted upwards considerably. Going forward, higher initial production levels and production profiles (due to high-grading of well locations, technology improvements, and efficiency gains) mean stronger aggregate supply.
  • Preliminary US EIA estimates indicate that net new shale supply turned positive in December, the first time since March 2015. Net new supply recovered just seven months after rig counts bottomed out and began to increase.
  • The increase of drilling activity comes on the back of a large stock of drilled and uncompleted wells (DUCs). The industry is also vigorously adding to this stock, which demonstrates that the shale sector is recovering and expanding once again.
  • Evidence from the Bureau of Labor Statistics is showing the oil and gas labor market is stabilizing and reversing its declining trend.

Well, can you guess who's more than willing to finance this mad dash? That's right, Wall Street, and of course. Gullible investors who, like the corporate burger chain mentioned above, don't seem to understand that throwing good money after bad never ends well.

Here's Bloomberg (my highlights):

Wall Street is throwing the most money at U.S. energy companies since at least 2000 amid growing confidence that the industry is emerging from the worst downturn in a generation.

Energy firms raised $6.64 billion in 13 equity offerings in January, drawn in by a rich combination of oil prices consistently above $50 a barrel and a rush to drill that's doubled the rigs in use in the U.S. and Canada since May. The biggest change from last year: oilfield servicers that provide the rigs, fracking equipment and sand used by drillers.

In a sign of the times, a fracking company was the first US IPO in 2017, as Keane Group (NYSE:FRAC), a Houston-based provider, raised $508.4 million on January 20.

The ticker: FRAC. No, seriously:

"The public equity markets are looking to invest in pure-play completion companies with a footprint and a growth story," Keane's CEO James Stewart told Bloomberg in a phone interview after the IPO.

I mean, come on folks. Are people really this gullible? As I've said more times than I care to remember, this is a completely self-defeating dynamic.

Intuitively, there are only two ways this works: 1) operators stop outspending their cash flow and thus become viable, or 2) enough of them go out of business to balance supply and demand.

That's it. Those are the only two options.

Otherwise, this is just a deflationary circle. That is, this is how QE and easy monetary policy effectively create the opposite of what central banks are trying to create. When you force investors to hunt for yield, you effectively drive down the cost of capital for speculative corporates, allowing them to stay in business and produce more of whatever it is they produce (in this case oil). The more supply, the more deflationary the environment. It's incredible that central banks apparently didn't take this into consideration.

If you want more details on these companies' propensity to outspend I encourage you to read "Return Of The Living Dead."

Make no mistake, this isn't over by any stretch. Consider a few more passages from the Bloomberg piece linked above:

Services companies weren't alone in drawing investment. The Williams Companies, Inc., a pipeline owner, raised $2.17 billion while oil explorers Parsley Energy Inc. and Jagged Peak Energy Inc. raked in $885.5 million and $474 million, respectively.

There's no sign that companies are done raising money. Parsley dipped back into the market Tuesday to raise $1.12 billion from 36 million new shares that will help fund its $2.8 billion acquisition of drilling rights in the Permian.

So basically, existing investors get to sit around and get diluted while the companies they own go out and sow the seeds of their own destruction by digging up more oil (NYSEARCA:USO) and adding to an already oversupplied market thus offsetting OPEC production cuts in the process.

There you go. That paragraph right there is all you need to know about what's going on here.

Some observers are apparently willing to admit that this isn't exactly a sure bet. For instance, Trey Stolz, an analyst in New Orleans at Coker & Palmer Inc., told Bloomberg that investors shouldn't "go out in the street and dance quite yet."

No Trey, they probably shouldn't.

Mark my words: this will not end well.

Just ask the IMF.

Or the corporate burger chain I mentioned at the outset.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.