Wolf Richter: Toxic Mix for Fracking – Oil Price Collapse & Junk Bond Insanity

Yves here. As oil prices have collapsed, the fundamentals of fracking, which was overhyped given the short productive life of individual wells, now looks even more dubious at current energy price levels. And given how risky the sector has become, cheap debt, even in this time of ZIRP, is no longer freely available either.

By Wolf Richter, a San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience. Originally published at Wolf Street.

It’s now called a “collapse”: The US benchmark light sweet crude plunged 4.6% to settle at $81.84 a barrel on Tuesday, the lowest since June 2012. In London, Brent made a similar journey to $85.04, its lowest level since November 2010. Explanations abound why this is suddenly happening, after years of deceptive calm.

Is it some harebrained plot to punish Russia by destroying its economy? Signs of success are everywhere. The ruble is in free fall despite the central bank’s efforts to prop it up. Yield on Russia’s 10-year note is nearly 10%. The government’s budget, heavily dependent on oil revenues, is in trouble. And every unit of foreign currency that isn’t nailed down is fleeing the country.

Or is it a plot by Saudi Arabia to squash the US shale oil boom? In November last year, the Saudi Gazette published an editorial on the “successful, wise, and balanced OPEC strategy” that led to “unprecedented” stability of oil prices for the past few years of around $106 a barrel. But couched in words such as “skeptics are demanding,” it uttered the threat to raise OPEC production until the price would drop “below $70 a barrel” to “remove the shale oil from the world oil production map….”

Or is it the combination of surging production in the US and sagging demand around the world, particularly in China and Europe?

Demand for oil would inch up this year at the slowest rate since the terrible year of 2009, the IEA predicted. OPEC might not be willing or able to lower production, it said. Why? Because of the US shale boom. And so, “Further oil price drops would likely be needed for supply to take a hit – or for demand growth to get a lift.”

Whatever the reasons for the market chaos, we already know what it has accomplished in the US: Investors who were long when they sleepwalked into this new era that started in late June have had their heads handed to them. WTI gave up 21% in less than four months. Over the same period, the SPDR Oil & Gas Equipment & Services Fund (XES), a basket of the largest oil- and gas-related stocks, plummeted 33%. Shares of smaller oil and gas companies have gotten demolished.

Reason for this mayhem: the toxic mix of high debt and plunging oil price.

The oil and gas sector is capital intensive. Drillers have borrowed phenomenal amounts of money, which was nearly free and grew on trees, to acquire leases and drill wells and install processing equipment and infrastructure. Even as debt was piling up, the terrific decline rates of fracked wells forced drillers to drill new wells just keep up with dropping production from old wells, and drill even more wells to show some kind of growth. One heck of a treadmill. Funded in part by junk debt.

Junk bond issuance has been soaring as the Fed repressed interest rates and caused yield hungry investors to close their eyes and take on risks, any risks, just to get a teeny-weeny bit of extra yield. Demand for junk debt soared and pushed down yields further. And even within this rip-roaring market for junk bonds, according to Bloomberg, the proportion issued by oil and gas companies jumped from 9.7% at the end of 2007 to 15% now, an all-time record.

While the overall high-yield market is down 2.3% since the end of August, oil and gas junk debt has dropped 4.6%. But as Bloomberg reports, it hides the bloodletting beneath the surface.

Samson Investment, an oil and gas explorer headquartered in Tulsa, OK, owned by private equity firm KKR, extracted $2.25 billion of new money from gullible investors in July. In early August, these junk bonds still traded at 103.5 cents on the dollar. Then reality sank in, and that formerly low-risk paper plunged to 77.5 cents on the dollar.

Not just in fracking la-la land. Paragon Offshore, an offshore driller, completed its spinoff from Noble in early August. Its stock started trading at $17.50 a share and immediately plunged and is now down a cool 68% in the first 10 weeks as an independently traded company. In July, it also sold $580 million in 10-year junk bonds to your bond fund at 100 cents on the dollar. Now they trade for 77.3 cents on the dollar.

Hercules Offshore, a Houston-based drilling company with the appropriate ticker HERO, saw its shares plunge 81% since July last year to $1.47. In March, it had the temerity to sell – or rather investors had the Fed-induced idiocy to buy – for 100 cents on the dollar $300 million in junk bonds that now trade at 66 cents.

This is what happens at the tail end of a credit bubble. Investors still lust for high-risk debt because it offers a little more yield in the era of ZIRP, but that yield did not compensate investors for the risks they were taking on. Companies and Wall Street did what the Fed had wanted them to do: issue junk and push it into retirement portfolios where it can quietly decompose. And bamboozled investors – thinking that the Fed was the best thing since sliced bread – took this debt with a desperate smile.

Now that the bottom is falling out, it is getting more expensive for these companies to borrow. Newly awakened investors are demanding to be compensated at least a little for the risk, and that risk has now been exacerbated by the collapse of the price of oil. That’s the toxic mix. If the money stops growing on trees, the jig is up for many of these companies, and the American fracking boom may well do what other oil booms have done before, and what OPEC would like it to do: grind to a halt. And investors would lose their oil-stained shirts.

The broader market has, let’s say, some issues: “Too many poorly understood structural changes have created unstable markets. Now comes the dismount.” Read… Why the Market Swoon May Become “Disorderly on a scale not seen since the crash of 1987

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  1. John

    It can be safe to say oil prices were propped up on a bubble — many speculating in long positions, not to take delivery but to game the market. Sellers outnumber buyers.

    Typical of global capitalism, in all honesty, few benefited from the so called oil boom. Oil made it to only a handful of people rich.

    Not all is doom. The West can do a lot to reduce their need for oil so as to mitigate disaster. As for those countries that are totally reliant on oil production like Iran, could make them more open to negotiations. Perhaps the same with Russia.

  2. Dino Reno

    I’m making the Big Call right here, right now: Peak Oil…consumption, not production. Oil used for transportation and power generation will now begin its long slow decline due to several factors including conservation and renewables. Consumption figures are now dropping in every country on earth that has a pulse. Experts are pointing to the end of subsidies or slowing economies. True, but there is a much larger secular trend that changes everything on how we use and price oil. I give more credit to sustainable technology and oil price gouging for the change than to the higher calling of climate change that will benefit from the shift. However you slice it, oil consumption will now decline a half a percent a year from here on out to the end of time. Peak Oil Consumption has arrived.
    Memo to all those now enrolled in school to become oil geologists: Have you considered the rewards of becoming an English Major.

      1. Code Name D

        But he isn’t the only one who has been thinking along these lines.

        The industries problem is its model of perpetual growth. It simply can not come to grips with the idea that there may be a contracting demand for oil as we work to make things more efficient and sustainable.

        1. NOMAS

          The ongoing pauperization of the people of the working class (say “middle class” if it comes out easier for you) of the developed counties is having the largest effect. Its one of the most fundamental contradictions of capitalism – you cant have your cake and eat it to.

  3. cnchal

    Investors who were long when they sleepwalked into this new era that started in late June have had their heads handed to them.

    Respectfully calling them investors is like calling an idiot a genius. Very few people are “investors” today, not even Fortune 500 companies.

    It is irrational to base the value of a piece of paper on the price the last person bought it at. It is only worth what the next person buys it at, when you sell, which can be vastly different than the price this second.

    The word “investor” is so abused it is often substituted with “speculator” and “gambler”.

    “Gamblers who were long when they sleepwalked into this new era that started in late June have had their heads handed to them”. Now they are headless zombie gamblers and more accurately describes what is happening.

    Samson Investment, an oil and gas explorer headquartered in Tulsa, OK, owned by private equity firm KKR, extracted $2.25 billion of new money from gullible investors gamblers in July.

    Of course KKR will sell shit to gamblers. When one deals with PE, you are the mark. Hasn’t everyone learned that yet?

    1. McMike

      Problem is, the pension fund and 401k account holder had no idea they were gambling. They thought they were saving.

      1. cnchal

        The pension business, and the financial business have a vested interest in fooling gamblers into believing they are investors.

        How can one call buying shares of companies with before tax income saving, when the banks can lend money to each other and “invest” in the stock market right along side your hard earned but not yet taxed dollar? The banks can sell in a heartbeat. No one else is quicker, except HFT which is illegal but ignored by the cops. Like a lot of other things that were ignored.

        The money was corralled in the stock market yard and has been led to the slaughterhouse.

        NC can lead to interesting reading, and a while ago this caught my eye.

        Ken Jones, July 22, 2014 23:02

        Price is what you pay and value is what you get”. If you think that’s true, Alan (and no one with a brain could disagree) – how can you write this nonsense?
        Shares are a long term instrument analogous to a variable coupon 50-60 year bond. Central Bank cash-splash in the short term makes no difference to the VALUE of a share today. But their operations (all this “whatever it takes” puff) have created the recent illusion that they have the power to refashion reality as they choose, in a long term sense. This is “new normal” nonsense. Buyers think they’re sagely buying VALUE. They’re just paying today’s price, and that price is currently based on belief in the permanent effect of an unsustainable external interference.
        Anyway – we can’t all be bulls. Like the “money entering the market” talk, this is rubbish. Like every dollar put in by one trader leaves with another, for every one of these bulls buying there’s a bear who’s happy to get out. When we hear from 65% of the commentariat, like now, and including you – “The only way is up!” that is a screaming sell signal. Optimism, like pessimism is very infectious, and sense goes out the window. As Buffet said – “A market with a concept between its teeth makes lemmings look like individualists”. Like in NYC the man said that all the traders he met were contrarians (impossible) we all know we’ll be the smart ones who’ll be fearful when others are greedy. Well – we can’t all be, and they’re certainly not todays buyers!

        What is the average holding time for stock market shares?

    2. susan the other

      So maybe all those derivatives were taking bets on the direction of oil. That begins to make sense. As Code Name D says above, we don’t know how to cope with a changing model of growth. I like to think that growth and survival have more to do with cleverness and tenacity than oil. Instead of a petro dollar we need science dollars. There is a world of endless growth out there.

  4. damian

    “oil price gouging” ?

    $100 / Bbl. for oil and $7 / MCF for gas is not “gouging” – it is called the forecasted model price for a lot of people to take a “risk” on step out of known fields no less new areas.

    The USA in many areas is the marginal producer given the decline curve of shale is so dramatic – these guys need north of $75 consistently and $4 MCF for gas isn’t fun either – doesn’t work.

    So the bonds don’t get paid and drilling winds down – Russia et al have cheaper costs: drilling / operating / reserve life – especially for gas – so the USA is the odd man out – Shell in Alaska Beaufort Sea ? risk and cost don’t work at $70

    so game winds down and the biggest driver of US Economics / Employment from the Williston to Houston is over for awhile – once again – In 86′ – $9.62 / Bbl. June 20, 1986 – bottom – everyone went BK including the law firms after the windup.

    what will Obama do to replace this economic activity?

    try taking the risk personally before you use the term: “gouging” and see if its the right characterization.

  5. wbgonne

    “what will Obama do to replace this economic activity?”

    Nothing. Obama’s imagination ends with asset bubbles and carbon fuel. When those collapse, as they appear to be, the Obama economic plan collapses too. Watch for Obama approval ratings in the low 30s very soon. Before he leaves, Obama will begin to be recognized as what he is: the worst president in American history. A cowardly, craven deceiver serving the plutocracy and nothing else.

    1. RUKidding

      Agree in part. Vis the “worst president” thing for Obama: please awaken me when the majority (even if only 51%) really “gets” what’s going on. Obama’s still rather large-ish fan-base will forevermore keep him on a pedestal, and the rightwing haters of Obama all hate him for stupid reasons mainly having to do with his melanin-content and/or bc he’s not waging enough WAR in tougher ways (not kidding; just read several letters to the editor stating it pretty much that way).

      It would be great if USians awakened to the reality of what’s really happening, whether the US Pres is wearing a D-Team or an R-Team jacket, but I’m not holding my breath.

      1. wbgonne

        There won’t be an awakening before Obama leaves office. Tbe Right will continue to hate him, as you say, for all the wrong reasons. And African-Americans and braindead Democrat partisans will stick with him to the bitter end, just like W’s dead-enders did. But Obama’s support among independents, the largest political group in America, is sinking. Obama is down to 33% approval with independents and he is a stock-market correction away from 20%. Once the collapse begins, Obama has nothing to sustain him. He has betrayed and abandoned the Left, the Right despises him, and the neoliberals will move on to HerTurn the second she announces. I guess you’re suggesting that Obama’s belated comeuppence won’t do the country any good or change the inevitability of the successor president being more of the same. Unfortunately, I agree. In fact, one of the many pernicious aspects of Obama’s horrid presidency is that he has paved the way within the Democratic Party (neutering the black caucus for one thing) for HerTurn to run openly as the neolibcon she has always been.

        1. James Levy

          The nonsense I read at other sites about Obama (I responded to a “Kenya/radical leftist” post here at NC yesterday) is extraordinary. He’s an awful president but not yet a Buchanan or a Dubya. That said, he has the listlessness Dubya showed in his second term. But the whole owning/governing class internationally strikes me as listless, exhausted, and clueless. Obama is not alone. He quite nicely represents the blindness and weakness of the Power Elite as a class. This is why I am so worried that we are sleepwalking into a disaster.

          1. wbgonne

            Worse than W. Not that it really matters anymore. But when one considers the moment in history and the level of deceit, Obama stands alone, IMO. Bush was what everyone expected: a Right Wing boob. Obama is a living lie and, therefore, far more damaging. Add all that to his institutionalizing Right Wing policies across the board, his utter failure to address AGW (in fact setting us and the world on a course of certain disaster), and his demoralizing and confounding the nascent post-W progressive renaissance. Obama has a hot place in hell reserved. Yesterday, I heard James Risen on the radio talking about Obama’s attack on the free press, to the point of asking SCOTUS to declare there is no reporter shield at all in criminal cases. That alone makes Obama a monster.

          2. different clue

            With the very greatest of all due respect, I humbly beg to differ.

            Obama is far worse than Bush. Obama took CheneyBush’s boldly experimental experiments in anti-constitutional governance and made them permanentized and routinified. He conspired with Boehner, McConnell and the willing Democrats to make the sequester permanent and to make the Bush Tax Cuts permanent. He deliberately appointed with malice aforethought the Simpson-Bowles Catfood Commission to destroy Social Security by stealth where Bush could not destroy it by open frontal attack. He and his Administration colluded with BP to mix millions of gallons of corexit into the deep ocean water column where the oil was emerging to “dissolve” the oil to hide it from view. This has hidden it into the food chain for decades to come . . . Obama’s little gift which keeps on giving. He has taken the official persecution of dissidents and whistleblowers to Brezhnevian lows. He has carefully engineered a future of immunity and impunity for the FIRE sector perpetrators.

            Obama . . . worse than Bush.
            Obama. . . . the more effective evil.

        2. different clue

          I wonder how many of the “Obama haters” are really false-flag psy-oppers tasked with keeping up the sympathy-vote support levels for Obama. Remember some of the Racist Symbolism during the Town Meetings runup to Obamacare? Didn’t a lot of it seem awfully pat, tired, trite, and cliched?

  6. McMike

    People seem mystified by the price drop. But if you set aside the question of “how,” the “why” fills in rather nicely.

    The “why” is because this is simply part of the fleecing cycle set up by the elite to wring every little bit of wealth out of everyone else.

    (1) Inflate bubble
    (2) Entice dumb money in
    (3) Make money doing so
    (4) Pop bubble
    (5) Make money doing so
    (6) Slither in and buy up the prime assets at distressed prices
    (7) Enjoy last man standing profit margins

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