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Wall Street Is Pouring Money Back Into Shale

Wall Street

With oil prices seemingly on firm footing, Wall Street is pouring money back into the shale sector, expecting profits even at $50 per barrel.

The private equity industry raised an estimated $19.8 billion in funds for energy investment in the first quarter of this year, or about three times as much as the same period in 2016. The figures indicate a more aggressive approach from private equity in shale drilling, and rising expectations that the oil market is set to rebound. The data comes from Preqin, and was reported on by Reuters.

The optimism comes even as oil prices have languished in the $50 per barrel range since November, after briefly dipping into the $40s last month. The hopes of a stronger rebound by now have been dashed, and oil analysts have steadily revised their expectations, pushing out their projections for stronger price gains. The extraordinary gains in U.S. crude oil inventories in the first quarter caught the market – and OPEC – by surprise, killing off hopes of oil heading north of $60 per barrel.

But the new money from Wall Street need not depend on $60+ oil. Lenders are confident that their investments will turn out to be profitable even at the prevailing market price today. That is because shale drillers have dramatically cut their costs, pushing breakeven prices down. "Shale funders look at the economics today and see a lot of projects that work in the $40 to $55 range," Howard Newman, head of private equity fund Pine Brook Road Partners, told Reuters. His firm dumped $300 million in Permian driller Admiral Permian Resources LLC in March.

Related: Reeling From Low Oil Prices, Saudis Look To Freeze Megaprojects

Lenders are already doing much better than they expected. JPMorgan Chase, Wells Fargo and Citigroup announced that they have an additional $370 million from the first quarter to use at their disposal, a collective sum that had been set aside to be used for expected losses on their energy portfolios. The better-than-expected performance from the energy sector could entice the banks to increase lending. Bloomberg reports that the volume of leveraged loans – loans made to indebted companies – shot up by 86 percent in the first quarter, compared to 1Q2015.

A survey from Haynes & Boone of oil companies, banks and private equity found a high degree of confidence that the ongoing credit redetermination period – a twice-a-year review by lenders of their credit lines to drillers – will be favorable to the energy industry. Of the 163 people surveyed, roughly 76 percent said they expect credit lines to either remain unchanged or even increase. In other words, banks are not backing away from the shale industry, and in some cases, they are pouring more money in.

There are several reasons for optimism. New figures from China show that its economy grew faster than expected in the first quarter, a sign that oil demand will grow at a steady, if not blistering pace. Global oil inventories are falling. Some geopolitical events have knocked some supply offline. And OPEC is doing its best to keep prices afloat. All in all, there is a growing consensus that the market is tightening.

But higher oil prices are not a given. In fact, another downturn is not out of the question either. The most recent rebound in prices came in part because of an outage in Libya – more than 200,000 bpd recently knocked offline. But Libya’s National Oil Company recently reopened a shuttered oil field and has plans to restore output at another. Nobody can make solid projections about what will happen with Libya’s output, but the outage could be temporary. Meanwhile, shale output is surging and more rigs are being added back to the field every week – a development not unrelated to the wave of money coming from Wall Street.

Related: Could An OPEC Extension Normalize Inventories?

"All the signs of an ever-growing bull market are starting to fade away, (with) Libya and geo-political tensions easing, but also because the Texans are back and they are pumping like there's no tomorrow," Matt Stanley, a fuel broker at Freight Investor Services (FIS) in Dubai, told Reuters in an interview. "If I were OPEC, I'd be pretty worried."

Nevertheless, a few major investors say that another price downturn would not necessarily kill off their optimism. For example, Orion Energy Partners told Reuters that they would continue to lend to shale drillers even if WTI plunged as low as $40 per barrel. But many financiers believe that OPEC will extend its production cuts anyway, which will likely put a floor beneath prices, ensuring that their investments pay off.

Other investors apparently agree. Bullish bets continue to rebound in the oil futures market, with hedge funds and other money managers posting a second consecutive week of increases in net-long positions. Saudi Arabia is reportedly on board with an extension of the OPEC cuts, although Saudi officials say it is a bit early to make that call. In fact, OPEC appears to be targeting $60 per barrel. OPEC sources told the WSJ that officials from Saudi Arabia, Iraq and Kuwait are in agreement that they should aim for $60 per barrel, which would obviously require at least a six-month extension of the collective output reductions.

At $60 per barrel, OPEC thinks, oil-producing countries can take in more revenue while prices will be low enough to prevent a dramatic resurgence in U.S. shale. But they may be wrong about that last point.

By Nick Cunningham of Oilprice.com

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