The US shale revolution has upended global oil markets and reshaped how OPEC does business. But Wall Street has different ideas for the revolution that could raise oil prices higher in 2018. In September, twelve major shareholders, portfolio managers and fund officials invested heavily in US shale oil and gas producing companies met in Manhattan to reiterate their position to shale executives that fracking companies via shale oil need to “make money for a change.”
Shale companies aren’t making return on investment or profits for their shareholders and investors. This caused the meeting’s participants to demand that shale executives change how they do business, which “could ripple through the global oil market.” The charts below detail shale’s “profit problem.”
The frustration for investors is that the shale-fracking boom has “made the U.S. the world’s largest oil-and-gas producer,” and a disruptive force keeping prices lower against OPEC’s wishes. For investors though, shares in US shale producers have fallen 31%, while the S&P 500 rose 80%; in that time energy companies have also spent $280 billion more than profits generated from shale investments according to Evercore ISI.
The Manhattan meeting had limitations to lower shale production, because speaking about specific companies or appearing to have an action plan would have invoked, “antitrust regulations and rules governing passive and activist investors.” The intent was there but the discussion evolved into “how to make frackers pump less and profit more.” Two participants in the meeting, Invesco Ltd., and Sailing Stone Capital Partners LLC all agreed that near existent shale profits “have become an existential issue for us.”
No one is certain the shale industry can change, yet determination is there to force operators to turn profits by changing executive compensation practices that reward CEOs for increasing production no matter the cost or outcome on investors returns. Todd Heltman, senior energy analyst at Neuberger Berman Group LLC said,
“Investors are tired of getting burned. Many are telling companies that unless this becomes a more discipline industry, they aren’t going to come back.”
But there are conflicting reports that firms like Mr. Heltman’s group can impose discipline on shale oil producers. The International Energy Agency (IEA) published a report in mid-December stating, “U.S. shale would grow so sharply that it would help bring back inventory builds in 2018.” But OPEC believes global balancing will take place and the supply glut will end in 2018.
The most interesting quote regarding these conflicting reports came from Ole Sloth Hansen, head of commodity strategy at Saxo Bank A/S when he said, “Both (OPEC & IAE) cannot be right. Whichever way the pendulum swings will have a significant impact on the market.”
Adding to the confusion about production discipline and higher investment returns was an article by Reuters stating:
“Financiers keep pouring cash into the shale oil sector, providing producers with a path to keep U.S. output rising through the middle of the next decade.”
Then add in the Trump administration’s pro-fossil fuel policies and Republican tax plan, which rewards energy companies and it’s a perfect storm of production upticks for 2018 that will have U.S. shale “surging.” The IAE reiterates this stance by estimating the United States will likely deliver, “80% of the world’s oil production gains through 2025, fueled by access to easy capital undermining OPEC and investors looking for profits over production. Through the third quarter of 2017, private equity firms have invested $20.26 billion into energy, 36% more than last year according to financial data provider Prequin.
Hedge funds and private equity seem to want higher profits but according to interviews Reuters conducted with more than a dozen financiers, advisors and executives that paints a different picture than what came out of the Manhattan meeting:
“Shale producers now have a range of new and traditional financial levers they can pull as needed to keep shale rigs drilling. Money continues to flows despite rising pressure from some investors for drillers to prioritize better profit margins over expanded production.”
This rising investment market for shale producers is a marked reversal from the 2014 oil price collapse that caused banks to abruptly taper lending to oil and gas producers. Shale has been tested before and “these firms have adapted to lower prices using new technologies and financing vehicles,” according to Charlie Leykum, founder of private equity fund CSL Capital Management LLC.
In 2018 the shrewd investor should look at shale investments on a case-by-case investment or use DrillCos (this finances new wells and control cash flow for a few years until double-digit rates of return are met), or use a combination of production hedging and contracts, as investment vehicles to lock in prices on future output. This type of hedging can act as insurance against price drops, geopolitical disruptions or market fluctuations seen by the Forties pipeline cracking.
Geopolitical disruptions though can overtake high-powered Manhattan meetings or billions in new shale investments; and need to be consistently monitored. From Israel drawing a “redline” over Iranian aggression in Syria to Saudi Arabia shooting down missiles aimed from Houthi fighters in Yemen targeting senior government officials in Riyadh – the Middle East continues experiencing geopolitical tensions. Moreover, according to a senior Trump administration official based off a new national security laid out by the President:
“Russia and China are attempting to revise the global status quo – Russia in Europe with its military incursions into Ukraine and Georgia, and China by its aggression in the South China Sea.“
Many are skeptical shale drillers can change their ways or habits, which means company boards may need to step in or seek counsel how to improve their industry’s lower return on investments and profit performance. The factors for where oil is moving in 2018 aren’t consistent with laying out a specific investment strategy unless hedges are used. One thing is certain – investors at the Manhattan meeting aren’t backing down – and that will cause oil prices to move significantly unless a geopolitical event materializes that no one is planning for at this time.
