Eclectications

Short takes on science, business, health, agriculture and possibly the kitchen sink

Robert Wise   email  
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Funding a Miracle
The Shale Revolution and Related Wonders

Two weeks ago, my wife Kae received a check in the mail for the residual "fair value" of a major investment. Ten years ago, she had bought a limited partnership in a new company drilling for natural gas in one of new shale plays, using the much-hyped fracking technology.

The partnership was bankrupt and was now being liquidated. It had yielded a big tax writeoff in the purchase year and great distributions for two years, but then the annual returns dropped below five per cent and continued to decline (graph below.) She had invested $90,000; the remaining value was about $1500.

It was as if Kae had made a no-interest loan of $90,000, and the borrower defaulted after paying back $54,000- a net loss of $36,000. This was no default, of course; it was all legal- just a risk she took when buying a limited partnership.


The graph of returns on her investment has the same shape as depletion graphs for fracked shale gas or oil wells. It's not surprising that the returns from an extraction operation should tail off at a rate similar to a well's depletion.

Which was what I feared after the first couple of years, as I learned more about fracking. We had invested in the energy sector for years and made good profits. Given the constant need for energy in every human activity, it seemed like the most secure sector for long term investment. But that was before the fracking miracle.

Our investment advisor had looked at dozens of possible energy investments, including a number of fracking operations. This company seemed to be the soundest of all. Natural gas was cheap at the time, but they had bought hedges on the price which made up for their temporary (we hoped) shortfall.

Three years on, as the returns dwindled, our advisor set up a phone conference with one of the principals. He emphasized how much of Kae's original investment had already been paid back; they always reported this figure with their monthly, later quarterly, distributions. I asked how fast their wells were depleting, and was told I didn't understand the meaning of "depletion." That meant capping wells, shutting down, he said - no depletion here! I asked one or two other questions which he did not answer.

I don't know if the man was consciously obfuscating. He may have had a sort of prospector mentality: his mission in life was to find backers, drill wells and produce gas or oil. Little items like "return on investment" were just numbers for the accountant to play with.

This would have been a good time for Kae to sell out, but she could only sell her interest back to the management, and they weren't buying. It wasn't a good time to sell, they cautioned- always looking out for her interest. Wait for a better time, when they would offer buybacks.

As I learned about the environmental hazards of fracking- the secret chemical mixtures injected, the immunity from EPA regulation- our advisor queried the management about their operations. Very clean and safe, he was told. In fact, their operation was so clean, they contracted to provide safety/environmental training for other fracking firms. Much later in the game, he learned that hydrochloric acid was a major component of fracking fluids.

Kae's loss is not unusual in the energy investment world. It's a commonplace that the shale fracking industry as a whole has never made money, even when oil prices spiked over $100 a barrel. During 2007-2017, though some companies made money in some years, shale operators as a group spent $280 billion more than they earned. Those losses represent bankruptcies, defaults and added debt.

"..shale has been a lousy bet for most investors," according to a 2017 Wall Street Journal article. Since 2007, an index of U.S. producers had fallen by 31%.

When oil prices dropped suddenly in 2014, more than 100 shale producers went bankrupt, defaulting on $70 billion in debt. During 2015-2016, over 1,000 U.S. oil and gas companies (shale drillers and others) filed for bankruptcy.

The shale industry as a whole may show a profit in 2018- the first year ever. And none too soon, because the industry is carrying close to a trillion dollars in debt, half of which will mature by the end of 2019.

A prime example is Anadarko Petroleum, which lost $456 million in 2017. If it had not paid $932 million in interest on its debt, it would have made a half billion in profit. If a company can't afford the interest on its outstanding debt, what happens when the principal comes due?

We won't be investing in limited partnerships again, nor in anything related to shale plays or fracking. As everyone lauds the fracking "miracle", I hope they remember the financial miracles that made it possible- funded by the life savings of thousands like Kae.

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References

America's Shale Firms Don't Give a Frack About Financial Returns
The Economist

Wall Street's Fracking Frenzy Runs Dry as Profits Fail to Materialize
Wall Street Journal

IS Fracking Industry in Trouble; Investors Losing Faith
SRS Rocco Report

Top US Shale Producers Exploding Debt Guts Profits
SRS Rocco Report

Higher Prices to Help Oil Companies Refinance
OilPrice.com

Profitability is Finally Within Reach for US Shale
OilPrice.com

Investment Analysis: The Journey of US Light Tight Oil Production Towards a Financially Sustainable Business
International Energy Agency

Energy Secto Bankruptcies: A review of bankruptcy activity in the energy sector: 2015-2016
BankruptcyData, New Generation Research, Inc.

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