Financial co-dependency: How Wall Street has kept shale gas alive
On October 21, 2012, the New York Times published an article delving in depth into the relationships between large Wall Street investment banks and shale gas operators. The article is outstanding but so much more needs to be said.
For nearly a year I have been giving presentations on this phenomenon which I refer to as financial co-dependency. A dysfunctional relationship, yes, but one which has been very lucrative for certain elite players, most particularly the investment banks and a few top oil and gas executives.
There is no doubt that the investment banking community has been the driving force behind shale production since the economic downturn. Shale should have unravelled long before now. But Wall Street saw an opportunity to generate massive fees and so shale was taken to new heights. Or perhaps some would say new depths. In August of 2011, Neal Anderson of Wood Mackenzie had this to say about the investment community and shale exploration:
“It seems the equity analyst community has played a key role in helping to fuel the shale gas M&A market, acting as chief cheerleaders for shale gas plays”.
It is important to understand how perceptions are manipulated by such “cheerleaders” in an attempt to effect changes in market direction that could be favorable to certain players.
After the economic downturn, shale operators continued to drill in spite of falling prices. Traditionally, when prices declined, oil and gas operators would shut wells in to stabilize the market. That, however, did not happen in 2008-2009. One look at the balance sheets of various shale gas companies explained why. They were exceptionally laden with debt and had no cash to speak of.
Oil and gas companies have traditionally been cash cows but not shale operators. They were highly leveraged and it seemed apparent that the only way they could continue to meet debt service was to engage in a frenzy of drilling due to shale wells steep depletions. It is extremely difficult to maintain a production plateau in shales without resort to continuous and prolific drilling. In fact, it has proven impossible.
Early in the game, Wall Street had been only too happy to provide funding to the shale operators. Many of these operators quickly became addicted to the cash. Shale production turned into more of a land grab than a legitimate oil and gas venture. In fact, I have referred to shale activities as “drilling for dollars in the capital markets”. And large Wall Street investment banks were only too willing to help…for a fee.
Investment banking has changed over the past few decades. There was a time when a bank was there to provide services to its clients in a partnership type relationship. Then a subtle shift occurred and investment bankers realized that fees could be maximized by employing a different mindset. In short, it no longer mattered whether the client was succeeding because the banks could make money on the way up or on the way down with a “client”. I use this term loosely for a reason.
Somewhere along the way, investment banks became predators of the very “clients” they were supposed to be helping. This is now a systemic problem in the financial markets worldwide and one which needs to be addressed. As long as such a predatory relationship is allowed free rein, we will continue to see bubble after bubble and bust after bust on an accelerated scale. Why? Because it is in the banks interest to create just such booms and busts. They will make money on the way up or on the way down. It is simply a matter of creating business.
In the early days of shales, the investment community provided massive funding for shale exploration. Wall Street loves a sexy story and shale provides just that with its incredible horizontal drilling techniques and Hollywood style pyrotechnics. The banks often used their sell side equity analysts to promote the stocks of shale companies rating them a buy and frothing the average investor into a buying frenzy by touting the perceived merits of shale.
It was difficult to verify in the beginning whether shale production was truly performing as advertised because the technology was new and investors simply had to take the operator’s word for it that the wells would really perform as promised. This turned out to be very convenient for both the operators and some of the banks. The oil and gas industry dutifully played their part by engaging in a public relations exercise of disproportionate scale to the actual performance of the wells. But why not? The monies were pouring in, literally. It was as though a drunken binge had taken hold of everybody. Operators claimed shale to be a game changer, a revolution and when they really got inebriated, they wrapped themselves in a red, white and blue flag and proclaimed energy independence for all. Share prices and natural gas prices soared as analysts touted the “shale revolution”. In 2008, natural gas prices hit record highs as speculators rushed in to take part in the self-proclaimed revolution. And yes, investment banks were making money in myriad ways off this so called game changer. Anything could be effected…for a fee.
Then the mortgage backed securities bubble burst. Another bubble, another story.
Global financial markets plunged into the abyss. It was only thanks to the extraordinary measures assumed by central banks around the globe that saved the average investor and even national economies from literally disintegrating on the rocks at the bottom of that investment bank abyss. Unfortunately, fees became a bit harder to come by for a while. Another vehicle was needed and needed quickly. Shale gas at least still seemed sexy in spite of the fact that natural gas prices plunged with everything else. Not to worry. Remember, banks make money on the way down as well. It is all a matter of perception. And spin.
Analysts rated shales a raging buy.
The operators, however, were beginning to suffer difficulties. The wells had not performed according to original projections. Not even close. Debt levels were extraordinarily high. Drilling had to continue just to meet debt service and hold leases.
Under such strain, the bankers began suggesting creative financing techniques and machinations…for a fee, of course. Extensive financing moved off balance sheet at some of the companies so it was becoming harder for the average investor to get a good picture of what the company’s balance sheet really looked like. The SEC changed the rules for oil and gas and made things easier for the companies to claim high reserve estimates. The SEC no longer required that they be independently verified. By claiming massive reserves the companies could access the capital markets for even more monies. Bankers encouraged the use of off balance sheet volumetric production payments. In some cases, they assumed shale assets for their own accounts and imposed production targets on the operators which have raised red flags because many think the wells have been overproduced which can damage a formation and may cause royalty owners to potentially lose out.
If the object of this exercise, for an investment bank, is to maximize profits at any cost, then it makes good business sense at this point to apply pressure to the operators to maintain production targets or face a downgrade of their stock. Operators would not be able to brook such a downgrade because it would mean less access to the capital markets and more difficulty in meeting debt service and production targets.
Production targets, however, added even more financial strain and much more gas to already burgeoning supply capacity driving prices to record lows.
A downward spiral had clearly begun. Production was now out of control and the market glutting. I am of the opinion that there is no way that the bankers did not recognize this and perhaps, in my most cynical moments, even encourage it. After all, Financial Markets 101 teaches that too much supply always drives down prices. One cannot claim that there could have been another alternative.
And here is where it gets interesting!
Prices plunge to record lows but the banks are still rating these companies as buys, still heavily promoting them as the bridge to the future. But that, of course, is just public rhetoric meant to sway the masses. Behind the scenes, they are crafting deals to spin the shale companies into the arms of the Majors…for a fee. And the dance continues.
The Majors have been the wall flowers at this dance up to now. They are feeling a bit unattractive and insecure. They haven’t been able to grow reserves for over a decade. They have been engaging in massive share repurchasing programs to make their stock appear more attractive. Natural gas prices are indexed to crude in most of the world so natural gas assets would seem to make sense. And the bankers can provide them with just the right dance partner…for a fee.
Ralph Eads of Jefferies, one of Chesapeake Energy’s primary investment banks, was quoted from an email in the above mentioned New York Times story. He admitted to talking up prices and even had a laugh at the Major’s expense:
“Typically we represent sellers, so I want to persuade buyers that gas prices are going to be as high as possible…the buyers are big boys – they are giant companies with thousands of economists who know way more than I know. Caveat emptor.”
Buyer beware, indeed!
According to KPMG, shale gas accounted for $46.5 billion in deals just in the US in 2011. That produces a significant amount of money…for a fee.
Read the full New York Times story here.