The Small Hedge Funds That Won Big by Betting Against Shale
(Bloomberg Businessweek) -- When Billy Bailey first pitched betting against shale stocks to oil tycoon T. Boone Pickens, crude prices were above $70 a barrel and the fracking boom was in the first few years of its life. Bailey was sitting in a booth across from Pickens at R+D Kitchen in Dallas, asking his boss if he, at 28, could become sole manager of a “long-short” portfolio within Pickens’s now-shuttered hedge fund, BP Capital. Long-short portfolios mix conventional investments in equities with short positions—contracts that make money when a stock falls in value.
It was November 2014, one week before OPEC would surprise the market by failing to reach a deal to curb supply, exacerbating a downturn in oil prices that would last the next two years. Bailey got the job and tilted the portfolio more toward shorting shale producers.
Bailey went on to start his own hedge fund, Saltstone Capital, a small shop in Dallas that manages less than $10 million. His years of skepticism are starting to pay off in a big way: Saltstone was up 36% in the first quarter of the year, according to an investor letter seen by Bloomberg. A handful of other funds have done even better. Kalkriese Capital Partners LP, which manages $21 million from Dallas, gained 300%. Tulsa-based Exo Trading, with $5.7 million under management by the end of the quarter, was up nearly 500%. The SPDR S&P Oil and Gas Exploration and Production exchange-traded fund, meanwhile, fell 65%.
Their approaches differed, but all three investors have one thing in common: Even as shale stocks lagged the broader market for the better part of the last five years, they saw a greater reckoning coming. That reckoning may be here. Shale producers sprouted up around the U.S. when debt was cheap and oil prices were high enough to justify the relatively expensive process of extracting oil from rock. Now oil prices are crashing as demand withers across the global economy—the most commonly referenced U.S. futures contract actually fell to a negative price on April 20. Many highly leveraged companies are on the brink of bankruptcy.
“This is just ripping the Band-Aid off,” says Exo Trading’s Chris Bird, who also serves as president of Exponent Energy, a company that buys oil and gas assets. “It’s just getting the industry back to where it should be, which is actually finding a way for their projects to make money.”
Unlike Bailey, who went straight into finance after college, Bird got his start in the field as an engineer. “That’s where my total disdain for the business came,” he says. “The information arbitrage is huge in oil and gas, and for the last 10 years people have used that to enrich themselves at the expense of investors.” Generalist investors often didn’t understand the complex terminology of the oil and gas industry—and the new world of shale in particular. “It became something that was sellable,” says Bird, even if many of the wells didn’t make economic sense when oil got cheap.
As anyone who’s ever bet on the market knows, hindsight is 20/20. Before the pandemic, the world economy was booming, and this year was looking to some investors like a chance for independent oil and gas producers to prove themselves. A handful hiked dividends in the first few months of 2020. Others predicted they would generate free cash flow for the first time. Bailey, Bird, and David Mooney, who runs Kalkriese, weren’t convinced. “The market still does not comprehend the depth of decline in the sector’s financial position,” Kalkriese said of oil and gas pipeline companies in a February letter to investors.
Succeeding at a time when the rest of the world feels as if it’s ending can be tricky. All three firms are headquartered in cities with deep ties to the oil and gas industry. Bailey counts some executives in the sector he bets against as friends. Bird keeps in touch with engineering classmates who still work in the industry. “Even though it’s going in our way, it doesn’t necessarily mean it’s easy, because these are a lot of our good friends who are being affected,” Bailey says.
Layoffs and furloughs at oil companies have already been announced, and more seem certain. Veterans say the industry will re-emerge a better version of itself. Skeptics say there’s far more pain to be felt. Even though share prices are down, Bird says it’s almost impossible to find an independent shale driller that looks like a value when oil is in such a glut. “Shale works at a certain price,” says Bird. “For the most part, historically, that price was probably $75 a barrel.”
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