Having staged a dramatic reversal at the end of 2016, when the world’s formerly most bearish hedge fund – it was net short over 100% in late 2016, which in turn led to a -24% return last year…
… rerisked, turning flat in just a few months, Horseman Global – now short developed markets and long emerging markets, and having lost 8.31% through the end of June – is once again dipping its toes in shorting stocks in general, and shale producers in particular. And, in Russell Clark’s latest letter, the Horseman CIO explains why.
From Horseman Capital Management’s July Monthly Newsleter
Your fund made 85bps net last month. Gains came from FX book and long book.
The big returns in fund management for me always come from finding some perceived wisdom, in which the market so completely believes that its fundamentals are never questioned. Theoretically this should not happen that often, but in my experience, it’s a constant feature of the market. Once you have built a business around an economic proposition you have no financial incentive to question it.
The Japan bubble was built on the view that Japanese corporate culture was inherently superior. The Asian financial crisis had its genesis in the view that Asian corporates borrowing in US dollars was risk free. The dot com bubble in the view that all tech stocks would prosper. The financial crisis was built on the view that US house prices could never see a nationwide fall. The European crisis was built on the assumption that all European government bonds were of equal value. And the recent commodity crash was built on the assumption that Chinese consumption and low interest rates made commodities safe.
Having grown up, and spent my entire investing career in periods of bubble inflation and deflation, I am constantly minded to look for where the market is deceiving itself, and then positioning the fund to benefit from the process of realisation. Many years ago, I could see that the commodity bubble was ending, and Chinese growth was peaking. This meant that commodities would be weaker and inflation lower, making a short commodities, long bond position very effective. It was a great strategy, but its effectiveness ended early last year.
The good news is that new market delusion is now apparent to me. When I moved long emerging markets, and short developed markets, the one commodity I could not give detailed bullish reasons for was oil. Unlike most other commodities, the oil industry, in the form of US shale drillers has continued to receive investment flows throughout the entire downturn.
I had shorted shale producers and the related MLP stocks before, and I knew there was something wrong with the industry, but I failed to find the trigger for the US shale industry to fail. And like most other investors I was continually swayed by the statements from the US shale drillers that they have managed to cut breakeven prices even further. However, I have taken a closer look at the data from EIA and from the company presentations. The rising decline rates of major US shale basins, and the increasing incidents of frac hits (also a cause of rising decline rates) have convinced me that US shale producers are not only losing competitiveness against other oil drillers, but they will find it hard to make money. If US rates continue to stay low, then it is possible that the high yield markets may continue to supply these drillers with capital, but I think that this is unlikely. More likely is that at some point debt investors start to worry that they will not get their capital back and cut lending to the industry. Even a small reduction in capital, would likely lead to a steep fall in US oil production. If new drilling stopped today, daily US oil production would fall by 350 thousand barrels a day over the
next month (Source: EIA).
What I also find extraordinary, is that it seems to me shale drilling is a very unprofitable industry, and becoming more so. And yet, many businesses in the US have expended large amounts of capital on the basis that US oil will always be cheap and plentiful. I am thinking of pipelines, refineries, LNG exporters, chemical plants to name the most obvious. Even more amazing is that other oil sources have become more cost competitive but have been starved of resources. If US oil production declines, the rest of the world will struggle to increase output. An oil squeeze looks more likely to me. A broader commodity squeeze also looks likely to me.
In the latest letter’s sector allocation, Clark also added the following section providing a more detailed explanation why he has boosted his shale short to 15.5%:
We are negative on the US shale sector, during the month we increased the short exposure to oil exploration and MLPs to about 15.5%. Conventional oil wells typically produce in 3 stages: the start-up rising production stage lasts 2 to 3 years, it is followed by a plateau stage which lasts another 2-3 years and a long declining stage, during which production declines at rates of 1% to 10% per year. These wells generally produce over 15 to 30 years (Source: Planete energies).
In contrast, production from unconventional / shale wells peaks within a few months after it starts and decreases by about 75% after one year and by about 85% after two years (Source Permian basin, Goldman Sachs). This means that, in order to keep producing, shale producers need to constantly drill new wells.
Shale drilling is characterised by drilling horizontally into the layers of rock where hydrocarbons lie. Then hydraulic fracturing which consists of pumping a mixture of water, proppant (sand) and chemicals into the rock at high pressure, allows hydrocarbons to be extracted out to the head of the well.
Since 2016, as oil prices rallied, the number of rigs in the Permian basin, which is currently the most sought after drilling area in the US, rose from about 150 to almost 400. Furthermore, operations have moved into a high intensity phase as wells are drilled closer together, average lateral lengths increased over 80% from 2,687 ft in early 2012 to 4,875 ft in 2016 and the average volume of proppant per lateral foot more has than doubled (Source: Stratas Advisors).
Intensive drilling is causing a problem called ‘frac-hits’, which are cross-well interferences. These happen when fracking pressure is accidently transferred to adjacent wells that have less pressure integrity. As a result a failure of pressure control occurs, which reduces production flow. In the worst cases, pressure losses can result in a total loss of production that never returns. According to a senior reservoir engineer at CNOOC Nexen, frac-hits have now become a top concern, they can affect several wells on a pad along with those on nearby pads (Sources: Journal of Petroleum Technology).
A former engineer for Southwestern Energy said that frac-hits are very difficult to predict, the best way to respond is with trial and error and experimenting with well spacing and frac sizes to find the optimal combination.
In May Range Resources reported that it was forced to shut wells in order to minimise the impact of frac-hits. This month Abbraxas Petroleum said it will be shutting in several high-volume wells for about a month (Source: Upstream).
In the Permian basin new well production per rig continued to decline in June, from 617 barrels per day down to 602. In the meantime, legacy oil production, which is a function of the number of wells, depletion rates and production outages such as frac hits, is continuing to rise. (Source: EIA)
In light of the above growing short bet on shale, this is how Clark is positioned:
The analysis leads me to be potentially bearish on bonds, bearish on US shale drillers, but bullish on commodities. Over the month, we have added to US shale shorts, while also selling our US housebuilder longs. We continue to build our US consumer shorts, where the combination of higher oil prices and higher interest rates should devastate an industry already dealing with oversupply and the entry of Amazon into ever more areas. The combination of long mining and short shale drillers has the nice effect of reducing volatility, but ultimately offering high returns. The combination of portfolio changes has taken us back to a net short of over 40%. I find market action is supporting my thesis, and the research and analysis is compelling. Your fund remains short developed markets, long emerging markets.
While we will have more to say on this, Clark may be on to something: as the following chart from Goldman shows, the number of horizontal rigs funded by public junk bond issuance has not changed in the past 3 months. Is the funding market about to cool dramatically on US shale, and if so, just how high will oil surge?