US shale fluffing its feathers in mating dance with banks
Cash-addicted producers are making greater use of hedging to attract loans
The second shale revolution is well under way, and banks are primed to join the party. In mid-April, JP Morgan, Wells Fargo and Citigroup – three of the largest US exploration and production lenders – announced in their first-quarter earnings that they had reduced provisions for bad loans by a combined $370 million. It’s led to speculation that the banks will use some of that cash to lend to shale producers.
Buddy Clark, partner at Houston-based law firm Haynes and Boone, says banks are partly attracted by greater hedging sophistication among energy firms: “We are seeing banks becoming more interested in lending to shale producers.” He says an upswing in hedging, the presence of sophisticated financial engineers in the form of private equity-backed management teams and strong production opportunities are enticing banks back to the shale patch.
US energy firms have been getting their hedging arrangements in place. According to a recent report by Wood Mackenzie, 33 of the largest upstream companies with active hedging programmes added 648,000 barrels per day of new oil hedges in the final quarter of 2016. That’s an increase of 33% on the previous quarter. And many shale producers are in it for the long haul, rather than rushing to hedge purely as a result of high crude prices. Pioneer, one of US shale’s most established companies, says it will “continue to use derivatives to mitigate commodity price exposure in order to ensure funding for development programmes and to maintain a strong financial position”. Similarly, Devon Energy says it “will continue to further build out its hedging position in the future”. Risk management at its finest.
It’s a trend that has been growing, says Andy Brogan, who works in EY’s global oil and gas transaction advisory services. Oil hedging, driven by shale producers, has increased “by roughly a factor of 20 over the course of the last 20 years”.
Oil hedging, driven by shale producers, has increased ‘by roughly a factor of 20 over the course of the last 20 years’
Since 2009 – when banks started to exit commodity trading – private equity teams have brought a financial intelligence to shale that wasn’t there when they arrived, says one head of an oil and gas-focused private equity firm, who asked not to be named. A former analyst at a US oil trader who has spent time at a major shale producer, also requesting anonymity, agrees private equity brought a “substantial portfolio of financial tools”.
In the first quarter of 2017 alone, private equity funds raised $19.8 billion for US energy ventures, according to financial data provider Preqin – nearly three times the total for the same period last year. That marries with the increase in hedging activity by US energy producers, and optimism in the industry that has got banks keen to lend again.
Of the new hedges added in the first quarter of the year, 41% were swaps, 21% traditional two-way collars and 22% were three-way collars – in which a producer sells an additional out-of-the-money put, known as the ‘subfloor’.
“This signals a shifting preference for collars,” says Roy Martin, corporate analyst at Wood Mackenzie. Analysts suggest this is down to a cash-constrained shale industry, knowing it may struggle to meet potential margin calls on swaps, but aware it has equity and production that can be used to sell covered calls while buying puts.
In most reserve-based lending contracts with energy producers, a covenant is placed imposing a strict hedging policy on the borrowers during the period of the loan. It stipulates minimum hedging volumes against an agreed portion of production, and gives reason for shale producers to get creative on how they hedge.
The process of extracting oil from shale rock formations requires far greater, more consistent investment than traditional vertical drilling. Capital expenditure for 44 US onshore oil production companies increased by $4.9 billion between the fourth quarter 2015 and the fourth quarter 2016, according to the Energy Information Administration. That’s the largest year-on-year increase in investment since at least the first quarter of 2012. And the industry lives off debt. As of the end of last year, five of the largest publicly traded oil companies had a combined debt of $297 billion.
So a perfect romance may be on the horizon: with crude prices about 70% higher than this time last year, market risk has abated for shale producers for now. Cash-strapped, debt-ridden and needing to produce now, companies increasingly employ hedging strategies to secure reserve-based loans. Banks, keen to put some cash to good use, look only too keen to help out.
Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.
To access these options, along with all other subscription benefits, please contact info@risk.net or view our subscription options here: http://subscriptions.risk.net/subscribe
You are currently unable to print this content. Please contact info@risk.net to find out more.
You are currently unable to copy this content. Please contact info@risk.net to find out more.
Copyright Infopro Digital Limited. All rights reserved.
As outlined in our terms and conditions, https://www.infopro-digital.com/terms-and-conditions/subscriptions/ (point 2.4), printing is limited to a single copy.
If you would like to purchase additional rights please email info@risk.net
Copyright Infopro Digital Limited. All rights reserved.
You may share this content using our article tools. As outlined in our terms and conditions, https://www.infopro-digital.com/terms-and-conditions/subscriptions/ (clause 2.4), an Authorised User may only make one copy of the materials for their own personal use. You must also comply with the restrictions in clause 2.5.
If you would like to purchase additional rights please email info@risk.net
More on Our take
Talking Heads 2024: All eyes on US equities
How the tech-driven S&P 500 surge has impacted thinking at five market participants
Beware the macro elephant that could stomp on stocks
Macro risks have the potential to shake equities more than investors might be anticipating
Podcast: Piterbarg and Nowaczyk on running better backtests
Quants discuss new way to extract independent samples from correlated datasets
Should trend followers lower their horizons?
August’s volatility blip benefited hedge funds that use short-term trend signals
Low FX vol regime fuels exotics expansion
Interest is growing in the products as a way to squeeze juice out of a flat market
Can pod shops channel ‘organisational alpha’?
The tension between a firm and its managers can drag on returns. So far, there’s no perfect fix
CDS market revamp aims to fix the (de)faults
Proposed makeover for determinations committees tackles concerns over conflicts of interest
BofA quants propose new model for when to hold, when to sell
Closed-form formula helps market-makers optimise exit strategies