Fracking Companies Innovate on Securitization by Tying Bonds to Specific Wells

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With oil prices remaining relatively low and funding drying up, US fracking companies are issuing bonds tied to production from specific wells.

The bonds sport a high coupon — nearly 6% on best-quality wells — and are drawing interest from yield-hungry investors despite the risks involved.

The evaporation of funding has hit hardest the small, independent firms responsible for the marginal production that has made the United States the world’s biggest oil producer. But Raisa Energy, a Denver-based independent company, floated the first well-specific bond in SeptemberOpens a new window , and others are lining up to do the same.

Oil prices are volatile as usual, but are staying below a ceiling of around $60 a barrel, which many in the industry question is sufficient for shale producers to make a profit. Most forecasters expect a continued oil glut next year in spite of factors such as the requirement for shipping to use low-sulfur diesel fuel starting January 1.

Declining production

The impact on the shale industry has been significant. The number of land rigs employed by the industry fell by 11% between the second and third quarters, making investors skittish about shale producers as well as hurting oilfield suppliers such as Schlumberger and Halliburton.

In addition, the young business of fracking is now old enough to have a track record, and it’s not encouraging. Many wells are tapering off without reaching the production forecastOpens a new window for them. It’s far from certain, in short, that any particular well can achieve the predicted output.

So the new bonds are getting close scrutiny. The securitization involved is similar to that for mortgages and auto loans, but these types of credit have a much longer history and predictions are more reliable. The oil well bonds are more like aircraft or railcar leasesOpens a new window , which have similar credit scores but coupons tend to be lower at a maximum of 4.5%.

Backing bonds with assets

Ownership of the wells is transferred to a special purpose entity that issues the bonds and repays them from the revenue generated by the wells. In the Raisa case, the company offered non-operating stakes in around 700 wells across the country.

Investors don’t take on the full risk of the company, which might not be investment grade, just the revenue-producing assetsOpens a new window , which do get an investment-grade rating and a higher yield than can be obtained from similarly-rated securities.

The new type of asset-backed security opens up a channel of financing for oil producers and an asset class for investors. Raisa chief financial officer Jeremy Cook highlights what he says is the innovative nature of the bond, a private placement that received an investment-grade rating.

Markets find a way

The oil well bonds didn’t catch the market by surprise. Given the difficult circumstances facing the industry in finding finance, participants felt it was a natural step.

Rating agency Opens a new window FitchOpens a new window predicted in FebruaryOpens a new window that securitization based on proven developed and producing wells would emerge some time this year and said it would adapt its rating parameters accordingly. Historically, oil producers took the form of master limited partnerships and relied on reserves-based lending for finance.

Only time will tell how permanent this new technique, born of adverse circumstances, will be. But markets have a history of finding new financing and investment channels as needed and keeping them open as long as they serve a purpose.