“Bloomberg – A pipeline shortage that’s leaving gas trapped in West Texas’ Permian Basin means prices for the fuel there are the lowest of any major U.S. hub, wresting that distinction from Appalachia’s Marcellus Shale. Prices for Permian gas, produced alongside oil in the play, have tumbled 32 percent from a year ago, while output rose to a record. And the pipeline crunch is also pummeling the region’s oil market.”
Energy production has always been a highly capital-intensive business. The dirty little secret of the U.S. shale boom is that fracing (not fracking, that’s how they can tell who the Yankees are) is not cheap, no matter what it costs to fill your car up at the pump. The costs of equipment, surveying, labor, licensing, water, sand and waste handling will run into the millions before a single well even comes online. So what did the industry do to juice their returns and ease the burden on their end consumers? Everyone, say it with me now: they levered up! It’s no coincidence the U.S. shale boom coincided with the post-crisis era of cheap money. The ability to voraciously borrow money from investors looking for anything resembling a decent yield fueled the fracing boom, as well as its eventual demise.
I spent a few years in Houston at an energy-focused PE shop, so this is a topic that’s near and dear to my heart. The U.S. energy markets have been in disarray since the end of Q2 2014. Throughout the shale boom, the strategy for oil companies was to lever up or issue equity to fund acreage development, then turn around and sell the company or specific assets to a strategic buyer to pay down debt and cash out their investors. The playbook was similar for infrastructure sponsors, except they used the capital raised to fund new pipeline assets that they would drop down into MLP subsidiaries that would be brought public. They’d use the IPO proceeds, and any dividend payments from MLP shares they retained, to fund even more pipeline construction. It was financialization at its finest. Oil companies would then pay fixed rates on long-term contracts to the MLPs in order to have their crude or gas shipped around the country to refineries. This was all well and good until 2014, when the energy complex collapsed in on itself under the weight of debt and over-production.
This brings us to today (and to this Bloomberg piece). The MLP model still hasn’t recovered and I’m not positive it ever will. The big retail pitch for owning MLPs in a portfolio was that it was yield-generating energy exposure without the commodity risk (which was true, until it wasn’t). While the MLPs didn’t have direct commodity price exposure, they had indirect capital markets exposure, and that would be their death knell. Once oil producers started defaulting on their debt due to tanking commodity prices, the MLPs were shut out of debt and equity markets as well – a little guilt by association. Without access to fresh capital, the infrastructure sponsors were unable to fund new pipeline construction and sell the assets into their publicly-traded MLP subsidiaries. Now, with massive debt loads and capex commitments to unfinished pipeline projects, the infrastructure sponsors went into survival mode: cutting dividend payments, selling assets and operating strictly out of cash flow. That last part is important – operating out of cash flow meant using huge chunks of FCF to service debt instead of building pipelines, which is why the Permian is in the odd position of having inaccessible, near-worthless gas assets. That oil and gas isn’t worth shit without the infrastructure needed to sell it into markets, no matter how prolific your acreage is.
What a conundrum. All this PE capital flooded into the Permian in 2016 looking for bargain basement acreage deals – and they got them. Now that the PE firms are all there drilling, there is too much production coming online and too little pipeline to ship the stuff. This is ironic because oil and gas acreage assets are valued by what’s in the ground, not by what comes out and makes it to market. The new problem that will (inevitably) come to the forefront is that PE firms never pay for these assets with 100% equity capital, rather they almost always issue debt or take on a revolver and collateralize it with the asset alongside some equity to fuel the drilling capex. That leads me to wonder, if pipelines aren’t built quickly enough for these PE-sponsored DrillCos to ship and sell product, will funds run into cash flow issues and be forced to start liquidating at a loss or, even worse, engage their lenders for a little restructuring? Should either of those scenarios play out, it would have a ripple effect on acreage prices throughout the Lower 48, likely kicking off a deja vu of late 2014. Round and round we go.