As Risky Finances Alienate Investors, Fracking Companies Look to Retirement Funds for Cash

Jerri-Lynn here. Just the latest installment in DeSmogBlog’s ongoing coverage of fracking follies. The still unprofitable industry now turns to pension funds and private equity for capital. What could possibly go wrong?

By Sharon Kelly, an attorney and freelance writer based in Philadelphia. She has reported for The New York Times, The Guardian, The Nation, National Wildlife, Earth Island Journal, and a variety of other publications. Originally published at DeSmogBlog.

A year ago, Chesapeake Energy, at one time the nation’s largest natural gas producer, announced it was selling off its Ohio Utica shale drilling rights in a $2 billion deal with a little-known private company based in Houston, Texas, Encino Acquisition Partners.

For Chesapeake, the deal offered a way to pay off some of its debts, incurred as its former CEO, “Shale King“Aubrey McClendon, led Chesapeake on a disastrous shale drilling spree. Shares of Chesapeake Energy, which in the early days of the fracking boom traded in the $20 to $30 a share range, are now valued at a little more than $1.50.

Encino has marketed itself as a stable source of long-term returns (something the industry overall has struggled so far to create), attracting the managers of one of the world’s largest pension funds to drill and frack the land that Chesapeake sold off to repay its enormous debts from fracking nationwide.

A Unique Model’ for Shale Drillers

Chesapeake, of course, is not alone in discovering that shale drilling can be financially disastrous for investors. In 2018, the top 29 shale producers spent $6.69 billion more than they earned from operations, an April report by Reuters concluded — a spending record racked up two years after investors began pushing shale drillers to start turning a profit. In December 2017, the Wall Street Journal found that shale producers had spent $280 billion more than the oil and gas they sold was worth between 2007 and 2017, the first 10 years of the shale drilling rush.

“We lost the growth investors,” Pioneer Natural Resources CEO Scott Sheffield recently told the Journal. “Now we’ve got to attract a whole other set of investors.”

Encino, which bought up Chesapeake Energy’s 900,000 acres of drilling rights in Ohio’s Utica shale in that $2 billion deal, may have found its “other” investors: the Canada Pension Plan Investment Board (CPPIB), which manages retirement funds on behalf of the Canada Pension Plan.

“We’re not your typical private equity company in that the Canada pension plan is I think the third largest pension plan in the world,” Ray Walker, Encino’s chief operating officer, told attendees at last month’s DUG East shale industry conference in Pittsburgh. “They have a long-term view on capital and they don’t expect their funds to start declining — in other words more people [in Canada] are putting in today than will be taking out, and they don’t expect that to flip til 2050-plus.”

“So, it’s a unique model and it’s something I had not ever run across in the industry,” Walker, who served as chief operating officer for the gas drilling company Range Resources until early 2018, added. “It’s what really attracted me to come out of retirement, to do something different and a little bit more exciting and a long-term — really long-term view.”

“Patient money,” responded moderator Richard Mason.

“Yeah,” Walker replied with a laugh.

“Who’d have ever thought, right?” said Mason.

Long-Term Investments as the Climate Changes

The Canada Pension Plan — often compared to the U.S.Social Security system — is funded by mandatory contributions from workers’ wages that generally begin at age 18 and end at age 65. The CPPIBinvests that money on behalf of the plan.

Last May, Mark Machin, the chief executive officer of the CPPIB, pledged to start taking the risks associated with climate change more seriously.

“We’re going to make a huge push on it this year,” he told the Calgary Herald. “We want to do a much better job of being able to understand the risks that we’re taking on in each investment and the risks we have embedded in the portfolio, and make sure we’re being paid for them.”

As the impacts of climate change are increasingly felt around the globe, watchdog groups have pushed pension fund managers to keep in mind the ways that climate change will impact the global economy in the coming years and decades.

“Pension funds have legal obligations related to their fiduciary duties, to consider long and medium-term risks, such as those related to climate change that could have adverse effects on their investments,” the Global Initiative for Economic, Social, and Cultural Rights wrote in an April 17 report. “Such risks include physical impacts of climate change on pension fund assets and investments, but also the increasingly evident risk of stranded assets and the associated legal risks of failing to address the climate-related risks.”

Other large pension funds have concluded that the oil and gas industry carries too much economic risk to make for a sound long-term investment — even without taking climate change into account. This March, Norway’s $1 trillion Government Pension Fund Global announced that it would be divesting from oil and gas exploration firms, a move affecting $7.125 billion worth of its holdings.

“The objective is to reduce the vulnerability of our common wealth to a permanent oil price decline,”Norway’s finance minister, Siv Jensen, told The Guardian as the move was announced.

Outside observers have specifically warned that pension plans that invest in shale companies might wind up with regrets.

While the shale drilling industry’s financial instability may not be so large as to pose an overall risk to the financial system, “I think there’s risk to pension plans that are pouring their money into private equity firms, which in turn are pouring billions into shale companies,” Bethany McLean, author of the book Saudi America: The Truth about Fracking and How It’s Changing the World, told E&E News in a September 2018 interview. McLean is also widely credited as the first financial reporter to take a critical look at energy company Enron before its collapse.

In addition to the long-term risks that all fossil fuel companies face from the drive to keep oil, coal, and gas in the ground and prevent catastrophic climate change, shale drilling companies face some unique long-term risks.

Many shale drillers told investors that they plan to drill multiple wells — in some cases 20 or more wells — from the same well-pad. But the industry has discovered that those later wells, called “child” wells, often perform worse than the first well drilled, called a “parent” well.

“It’s something we’re all trying to synthesize,” Encino’s Walker said in Pittsburgh as he discussed parent-child well interference. “There’s still a whole lot of learning curve to go through. But I think the one thing that everybody is noticing, probably even more so in West Texas than up here, is that parent-child relationship is playing a huge role in the recoverable reserves. In other words, the second, third, fourth well are not anywhere near as good as the first well.”

A Gamble on Shale

The stock markets and banks have become increasing unfriendly places for shale drilling companies as the oil and gas industry has under-performed compared to other parts of the economy. This has left drilling companies hunting for capital to fund continued drilling — and they are increasingly turning to so-called private equity — a category covering both private investors like Warren Buffett and asset managers like pension funds.

Drilling companies plan to source 40 percent of their capital for 2019 from private equity funds, according to a recent survey by Haynes and Boone, compared to 26 percent from selling the oil and gas they produce, 21 percent borrowed from banks, and 12 percent in debt and equity from capital markets like Wall Street.

Privately held companies like Encino are more opaque than publicly traded oil and gas companies because they generally are not required to make their financial information public. That means there’s little publicly available information about how private shale drilling companies have performed over the past decade. And every shale drilling company has unique financial prospects, based on a broad array of factors that include the amount it spent to acquire drilling rights, its drilling and fracking costs, and the amount of oil, gas, and natural gas liquids it can tap.

Encino did not respond to questions sent by DeSmog. “Our assets generate strong cash flow, we have modest debt, and we support our development activities with a robust commodity hedging program,” the company says on its website.

A wellpad in Carroll County, Ohio. Credit: Ted Auch, FracTracker Alliance

Canada’s pension fund praised Encino’s acquisition of Chesapeake Energy’s acreage in Ohio when that deal was announced. “We are pleased to support EAP’s [Encino Acquisition Partners’] acquisition of these highly attractive Utica shale assets, which provides CPPIB with meaningful exposure to a leading North American natural gas play and aligns with the growing focus on energy transition,” said Avik Dey, managing director and head of energy and resources at the CPPIB.

Others saw the deal as carrying a significant degree of risk. Moody’s Investor Services rated debt associated with Encino’s Utica deal at B2. “A B2 rating is deep into junk status and means there’s a very significant chance you’ll end up in default,” Axios explains. Moody’s rated the overall probability of default one notch higher at B1.

For its part, Encino predicts that it can do better in the Utica than Chesapeake Energy could — not just in terms of individual well performance, but also in avoiding the boom-bust cycle for which the oil and gas industry is notorious.

“All of that is part of a longer-term strategy to run this as a normal business that needs to be profitable, less volatile, and therefore better for its shareholders, its employees, and the community,” Encino CEO Hardy Murchison told an Ohio newspaper after a talk at Kent State University in March.

Chief operating officer Walker sounded a similar note at the DUG East conference this June.

“Pretty excited about what we’re seeing, the economics are very favorable,” Walker said at the industry conference. “So, Chesapeake did a great job of setting this up, but we’ve got a lot of running room going forward.”

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  1. timbers

    Another by product of the central banks of the world and their policy of ultra low/negative interest rates that benefit the rich and asset holders: unlimited funding for fossil fuels that destroy life on earth.

    If the Fed has a brain and could see further that it’s own nose, it would RAISE interest rates end of this July instead of cutting them. This might end a lot of the capital hogs that really don’t contribute to the economy other than to suck the life out of it.

    With Mr Market expecting more welfare from the Fed via an expect rate cut, this would turn the tables back towards normalization and send shock waves to the markets that their free lunch might be ending and help fell a lot of zombie corporations feeding off our own life savings and making life worse for man with the ultra low interest rates that steal our savings and transfer it to businesses that would not exist w/o that massive subsidy.

    1. Amfortas the hippie

      Mr Market is nowhere near West Texas, atm…just a cardboard image on a stick, so the junk bond salesmen can point to it on late nite tv.
      how anyone can call this “capitalism” is beyond me…except for inasmuch as they’re burning said Capital, with a will…presumably propping up the stock and bond markets in the process.
      My brothers in law work out there, and i’ve sent them this, and other things i come across, to shore up my warnings to sock away as much of the cash they’re currently carting off for the inevitable bust(that will shock everyone on bidnessteevee).
      numerous others in similar situations out this way apparently don’t have a suspicious curmudgeon in the family to yell in their ears….what i overhear is the Party Line(“New Saudi Arabia!!!!”).
      When the Bust comes, it will be a further blow to the local economy of this far place….first the peanut subsidy went away, then 9-11 ruined hunting, then the incredibly shrinking middle class further damaged hunting, and smothered the just born winery pretentiousness(discretionary income required for all that,lol)
      Boards for the windows on the Square will be a growth industry, I guess…

  2. whiteylockmandoubled

    Zzzzzzzzzzz. Another NC OMFG fracking is losing money!! article. How many of these are you going to publish until you actually do some research into who is behind the private equity funds?

    At least this one is pegged to the Canadian pension fund’s investment in Encino, so your writers are starting to look behind the publicly traded share prices. But let’s say it again, for those of you who are slow on the uptake: For tax-exempt US limited partners:


    Diversified endowments produce returns in other asset classes that generate Unrelated Business Income. Fracking partnerships generate losses that offset that income, reducing a tax exempt entity’s tax liability.

    Whether the investments themselves ultimately generate returns depends on the terms of the partnership agreement, when you can exit, and whether, how and under what terms your partnership shares have or have not been converted to publicly traded MLP shares.

    Oil and gas is a boom and bust industry to begin with. Bought legislators and regulators have allowed financial engineers to partner up with energy engineers to generate win-win, or at least win-hedge financing structures with built-in tax hedges for certain classes of investors.

    These articles get more and more cringeworthy as time goes by. Stop pretending that you’re going to cleverly talk this industry out of profitability, and trying to play the “we’ll use their own market logic against them” game. The shift away from carbon is not happening nearly fast enough to keep prices permanently depressed — yes, the author’s right, there is massive volatility, which means another boom is coming to set up the next bust. Investors know this and expect to cash in. If the argument is that we’ve reached the point at which domestic extraction has permanently collapsed, there’s a serious disconnect with reality.

    The only “risks” to oil and gas are supply and politics. For the “risks” that the author touts to be real enough to influence investment behavior, investors have to believe that governments are, within the life cycle of an investment, going to radically alter the regulatory landscape and force externalities to be internalized along the production cycle. Does anyone actually believe that’s imminent?

    Do I want it to be? Yes. Do I want us to stop extracting carbon tomorrow? Yes. Are we close yet? No, not really. If you want to stop oil and gas extraction, transportation, refinement and burning, it’s going to take brute political power, not fantasy-based attempts to spin what most investors already know, and for which efficient investors have reasonably credible plans. A lot of investors will get skinned in this industry in the coming decades. But then again, it is, in fact, a volatile industry, and that has always happened.

    1. whiteylockmandoubled

      Also, the narrative framing “look to pension funds and private equity….”, as if pension fund and private equity investment is somehow a sudden new source of capital for fracking is flat-out false and a disservice to NC readers. Been there all the time.

    2. timbers

      I agree with Clive in that if fracking on it’s own is not profitable, there is likely mis-allocation of capital whatever the reason…in this case probably in part due to tax laws, and ultra low interest rates that steal interest from savers and non asset holders so the it can be “mis allocated” to fracking, Netflix, Elon Musk, hedge fund managers, and other areas.

      The Fed needs to raise rates to a level that no longer promotes capital mis allocation – like the incredible amount of capital flowing to Netflix, Elon Musk, fracking, and others. If it puts the U.S. in a technical recession by slaying some corporate zombies, IMO that would be a good thing.

    3. ptb

      “If you want to stop oil and gas extraction, transportation, refinement and burning, it’s going to take brute political power”

      Correct. And that is how it’s done, except without much public awareness (let alone debate), and usually motivated in extremely large part by political favors for a rival industry.

    4. Badbisco


      I have worked with institutional tax-exempt US LPs and the idea that they would willingly make commitments to private investment vehicles that will lose money to offset UBTI gains from other investments isn’t true based on my experience. In general, they try to avoid UBTI.

      – They evaluate potential investments based on the expected return/volatility and expected correlations with other assets while picking up a liquidity premium. These private energy funds are pitched as seeking good returns with lower correlations to equity & bonds. As Yves has extensively gone through here at NC, multiple aspects of that decision making process and the private investment vehicle structure/terms themselves could be questioned depending on your own opinions.

      – UBTI typically is generated by investments that utilize leverage or borrowing and as a result, it is typically only generated by hedge funds and private equity/real estate/energy. The standard or “non-alternative” portions of their portfolio, equities and bonds, will not generate UBTI. The hedge funds are also usually invested in using an offshore vehicle that blocks UBTI. As a result, UBTI is typically only from private investments. It ends up being rather small and is usually seen as more of an administrative headache rather than a significant impact on their after-tax total return.

      – A lot of private equity funds also offer offshore feeder vehicles that eliminate/reduce the impact of UBTI. These vehicles typically have higher expenses and the returns may be impacted by corporate tax rates instead but the impact hits the vehicle rather than the end LP investor having to submit tax docs. Many LPs choose these vehicles to reduce the UBTI administrative work.

  3. whiteylockmandoubled

    And yes, fracking is bad, polluting and harming local communities. Yes, natural gas extraction in the US produces more methane emissions than EPA has heretofore been willing to admit, and yes, each successive IPCC evaluation ups the estimated greenhouse effects of methane, increasing the urgency of dealing with fracking.

    But this hooey about the industry’s finances obscures rather than clarifies.

    1. Clive

      Capital allocation is made with the intention of generating a profit. If you’re not going to turn a profit, it’s capital misallocation, plain and simple.

      If there’s no capital allocation to the fracking sector, there’ll be no fracking. This isn’t some mysterious chicken-and-egg situation. We know the chicken (capital investment) came first, then the (rotten) egg — fracking.

      It’s not even as if the private and alternative (plus even retail) investment industry / finance is oblivious to the risks inherent in fracking as an asset class. Take Europe:

      Jason Hollands, managing director of financial adviser Bestinvest, says: “Fracking is the big story in energy at the moment — and it’s already had a major impact in the U.S. Undoubtedly, it could become a real growth area in the UK, and that will whet the appetites of investors who like to take risks.”

      However, the collapse of shale gas prospects in Poland shows how unstable the industry can be. Wells were drilled and gas flowed, but the fractures in the rock quickly closed, causing gas flow to reduce to a trickle and calling a halt to operations.

      Without a doubt, investing in fracking at this stage is far from safe.

      (emphasis mine).

      And this is from the investment management industry. This ain’t no dippy-hippie internet-save-the-whale tree huggers. If they’re urging caution and saying, in investor-speak “prepare to lose your shirts”, why do you think pension funds, annuities, insurance floats and so on — who need capital preservation because it is beneficiaries’ funds at risk and either policy holders or government is on the hook to make good losses — should be in this game? Haven’t we had enough of privatisation of any (scant, vague, implausible) gains and socialisation of the (much more likely) losses?

      I have some sympathy for fund managers (even the drekky lot at CalPERS, for example) who are desperate for yield. But everyone knows hungry people make for poor shoppers. Bad investment decisions are bad investment decisions, regardless of the drivers behind them.

      And you think that somehow Naked Capitalism should hold its tongue on this subject? Maybe you’d be happier at MSNBC.

      1. drumlin woodchuckles

        I am an absolute layman on this subject. So I cannot support your view or Whitney’s locked and loaded view or any other view, because I don’t have the knowledge to do so.

        But I can wonder, in line with your view that the proper allocation of capital is to get a return or a profit on it . . . . if the tax-deductible loss earned by investing in fracking can create a bigger “default-profit” when applied against a profit elsewhere than if all the money had been invested into that “elsewhere” to begin with . . . then wouldn’t working the tax-loss fracking-rackets create greater overall profit within the capital allocator’s total allocation menu than if the capital allocator had avoided the tax-loss fracking rackets and only invested the whole total in entirely profit-making other places?

        If seems to me that knowledgeable and intelliigent people could run the relevant numbers through various different theoretical allocation models and see if more final net-default-profit is left by only investing in profit makers or by investing in some best combination of profit makers and tax-deductible money losers.

        I think the question deserves to be studied in those terms.

  4. Lakeshore

    I think the loophole that allowed endowments to offset their ‘unrelated business income’ with losses from fracking partnerships may have been closed last year. According to the law firm McGuireWoods:

    “Beginning with income earned in 2018, EOs (exempt organizations) must calculate their net UBTI (unrelated business taxable income) from each unrelated business activity separately. Post-2017 losses from one activity can no longer be used to offset taxable income from another activity.”

    Also regarding this post’s quote that “Pension funds have legal obligations related to their fiduciary duties, to consider long and medium-term risks”, I think private equity can get an ERISA exemption from some of their fiduciary responsibilities to pension plans. According to another law firm McDermott Will & Emery:

    “If a private equity fund holds plan assets, fund managers will be plan fiduciaries unless one of ERISA’s exceptions applies. The two most common exceptions are the insignificant participation exception and the operating company exception.”

    “The insignificant participation exception states that, if plan assets are less than 25 per cent of any class of equity of a fund, the fund will not be deemed to hold plan assets….the entity must have at least 50 per cent of its assets invested in operating companies that provide it with “sufficient” management rights in those companies”


    “a venture capital operating company (VCOC) will not be deemed to hold plan assets.….the entity must have at least 50 per cent of its assets invested in operating companies that provide it with “sufficient” management rights in those companies….management rights can include rights to appoint directors or officers to an operating company’s board, the right to examine its records”

    1. Yves Smith

      Public pension funds are not subject to ERISA. Only private sector pension plans are. Public pensions do have a fiduciary duty to members and states often adopt language that is similar to ERISA for how public plans are to operate.

      Private equity funds most assuredly do have a fiduciary duty to their investors, but the investors have astonishingly allowed them to contract out of it. As we’ve described at length, private equity limited partnership agreements allow the private equity fund manager to consider other interests, including its own interest (when a fiduciary is required to put the interest of his principal above all others). They also include sweeping indemnifications of liability, including for Bain, criminal liability.

  5. Valdarno

    Thank you for this information
    I will check my pension fund to make sure they’re not investing in shower oil companies
    Open shift where I invest there to something else if they do have some in an equity fund

  6. JBird4049

    So no duty to even protect the initial investment and never you mind making a profit with complete indemnification from everything. Can anyone make a reasonable argument that this is not carte blanch to invest it in crack, meth, and Floridian real estate?

    I can easily see the Nowheresville Pension Fund or some chump investing the family’s college fund in this.

    It seems like most of the “growth” and “profits” in the economy is of the slash, pillage, and burn model. Most of it “legal” for certain values of legal; why worry though when you steal, destroy, or murder enough people for profit it’s all good.

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