Not so long ago the US economy had some bright spots that seemed to justify a general sense of optimism. The fracking revolution had turned the country into the world’s largest oil producer with, apparently, a lot more to come. And the growing number of tech “unicorns” – private companies with valuations exceeding $1 billion – promised a steady parade of flashy IPOs for as far as the eye could see.
This year both were exposed as frauds.
Iconic unicorns Uber, Lyft, Peloton and SmileDirect went public and then dropped rather than soared. And now WeWork, the real estate “tech” company that in 2018 was worth $47 billion, has imploded. The founder/CEO has been tossed out a high-rise window and a major investor has stepped in with a bailout that values the company at a paltry $8 billion – which still looks rich for a start-up whose losses exceed its revenues. See the video in this article that explains WeWork’s business model and why it was always doomed to failure.
Now on to fracking, the process of pumping immense amounts of water dosed with a cocktail of industrial chemicals into the ground to force out heretofore inaccessible oil and gas. Turns out that it only works for a few years on each well, putting drillers on a treadmill of ever higher debt (mostly via junk bonds) and soaring rig counts while producing zero profits.
Not surprisingly, traditional financing has dried up as once-burned banks and junk bond buyers balk at second helpings. So frackers are turning to … wait for it … asset backed securities similar to the subprime mortgage bonds of the 2000s:
(Wall Street Journal) – Desperate for cash, shale companies are trying to court investors with a new and potentially risky financial instrument that resembles mortgage bonds.
The companies are floating a type of asset-backed security that involves existing oil and gas wells. Producers transfer ownership interests in the wells to special entities that then issue bonds to be paid off by the output from the wells over time.
Raisa Energy LLC, a Denver-based oil-and-gas company backed by private equity firm EnCap Investments LP, closed the first such offering in September and several others are planned before the end of the year, said people familiar with the transactions. The bonds will pay nearly 6% interest on the best quality wells, the people said, with higher rates on riskier assets.
The investments are drawing attention from insurance companies, large money managers and other traditional investors of asset-backed securities. They represent a new avenue for shale companies as the industry’s traditional investors sour on the sector following years of disappointing returns.
While similar in structure to securities backed by mortgages and auto loans, the securities pose potential risks because projecting the long-term output from shale wells remains an inexact science. Shale drilling only became a widespread method of extracting oil and gas in the past two decades. Modelling future production has proven difficult because of the complex geology of shale basins and large variability from one well to the next, engineers say.
Thousands of shale wells drilled in the past five years are pumping less oil and gas than their owners forecast to investors, The Wall Street Journal previously reported.
Investors will have to rely on companies’ estimates to model potential returns, said Harrison Williams, managing principal at Core Energy Advisors, which advises producers on asset sales.
“The pitfalls are in the underwriting: Is the oil and gas there and will it come out?” Mr. Williams said. “Sometimes predicting reserves has a large component of art as well as science.”
Securitizing wells may be one of the few sources of new money available to producers, said Jonathan Ayre, a partner at law firm Orrick Herrington & Sutcliffe LLP. It The firm is working with Guggenheim Securities, which also structured Raisa’s offering, on a similar securitization.
“The appetite is definitely out there,” Mr. Ayre said. “For oil and gas companies looking to monetize their investments, there are not a ton of good options.”
For two such high-profile sector stories to become object lessons in credulity is of course bad for those companies’ investors. But the impact won’t stop there. Fracking and tech IPOs were major reasons for positive animal spirits generally. Take them away and the question becomes: if these guys can’t make money and enrich their investors, who can? At some point the answer becomes “no one” and risk-off becomes the new normal.