- September 4, 2018
- Posted by: Art Berman
- Category: The Petroleum Truth Report
Many think that debt and negative cash flow by U.S. shale companies will crash the global financial system. I believe the opposite is more likely, that a developing financial crisis may crash oil prices and test the survival of shale plays.
In The Next Financial Crisis Lurks Underground, Bethany McLean argues that the U.S. energy boom is on shaky ground because of excessive debt and failure to show profits after a decade of drilling. This thoughtful op-ed raises concerns that many have expressed since the advent of tight oil production.
The problem with her thesis is that debt from the U.S. oil sector is just not big enough to crash the global financial system. Losses and bankruptcies in that sector in 2015-16 were substantial and yet, did not threaten the stability of world financial markets. In the improbable worst case scenario, the U.S. government would step in as it did for the auto industry in 2009.
Higher oil prices are inevitable at some time sooner than later because of under-investment over the last several years of low prices. This is compounded by lack of big discoveries and ever-present geopolitical supply interruptions and outages.
Ms. McClean correctly identifies the link between near-zero interest rates and the rise of tight oil financing. She fails, however, to acknowledge the 2004-2008 plateau of world production at the same time that demand from China greatly increased. This pushed oil prices to more than $100/barrel–the main factor that made tight oil development feasible. Because that price trend continued for 4 years, supply overshoot led to the oil-price collapse of late 2014.
The two price cycles since then are shown in Figure 1 as a cross plot of oil price vs comparative inventory (current oil + product stock levels minus the 5-year average of those stock levels).
The data is connected by an interpreted yield curve. It is similar to a bond yield curve except in place of interest rates vs maturity dates, it shows oil price vs comparative inventory.
The point at which the yield curve intersects the y-axis represents the 5-year average or “mid-cycle price.” It is the value of the marginal unit of production needed to maintain adequate supply over the duration of that particular price cycle.
The mid-cycle price from 2014 to June 2017 was approximately $75/barrel. The mid-cycle price from June 2017 to the present is about $60/barrel. In other words, markets have devalued oil by at least 20% over the last year.
A C.I. minimum was reached in May 2017 at $71.25/barrel. Since then, C.I. has been trending back toward the 5-year average along the yield curve. The fact that oil prices are once again approaching $70 at a lower C.I. than in May suggests that price is being supported more by sentiment than by fundamentals of supply and demand.
That sentiment is concern about medium-term supply. It is moving prices higher and must be taken seriously. At the same time, C.I. suggests that lower prices are as likely as higher prices in the near term.
WTI at $70 and Brent near $80/barrel make “demand destruction” or weakened consumption a possibility. Prices averaged only $47/barrel in 2016 and 2017. Today’s price is 70% higher and may cause lower consumption and, therefore, lower oil prices.
Adding to that, emerging-market economies are in trouble. A credit bust in Argentina, Turkey, and South Africa may spread to Brazil, India, and China. Lower consumer demand in those regions would put downward pressure on oil prices. Trade wars and tariffs increase the cost of goods and services. Higher oil prices and interest rates add to that burden.
The global economy is more fragile than ever as debt continues to grow and has not been successfully “inflated away.” A recession in emerging economies may move a delicate oil price-consumption balance toward over-supply. Combined IEA, OPEC and EIA market balance forecasts suggest this by mid-2019 or sooner.
Slowing global economic growth in fact is probably the main downside factor for oil demand and price going forward. A recent report by The Oxford Institute for Energy Studies concluded that global growth risks far outweigh geopolitical and U.S. shale growth as risks to the downside for oil prices through 2019 (Figure 2).
Concern about future oil supply has moved prices higher since mid-August but the current price rally has stalled at $70/barrel…for now(Figure 3).
Before that, markets were confident enough of adequate supply for the near term that WTI prices fell from $74 to $65/barrel from early July to mid-August. Nothing has materially changed since then except for market sentiment.
Prices are more likely to remain in the current $65-$70 range than to move much higher. The world has ample supply for now but tighter supply seems probable before year-end in a business-as-usual world. If the global economy weakens, it’s anyone’s guess where oil prices may go.
What is certain is that tight oil plays are here to stay. High debt load and failure to demonstrate sustained positive cash flow are nothing new in the oil business, and are not unique to shale plays. The plays survived the dark days of 2016 without crashing global financial markets.
The return of much lower oil prices would test them again. Today, however, half of U.S. production is from tight oil and it is difficult to imagine that investors or the federal government would allow the suppliers of our master resource to fail.
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For a more detailed explanation of comparative inventory, please see Oil Price Crossroad and $60 – $65 Emerging Mid-Cycle Price For WTI.
Art,
I read the opinion piece. I’m not sure exactly what Bethany was saying. The headline and the article say two different things. In fact, outside of the headline she never mentions a future financial crisis again. However, one can make the case that the end of easy money will be the end of cheap oil.
Best,
HS
HS,
I suspect that NYT editors chose the title to get reader attention. Higher interest rates may reduce capital available to tight oil. At the same time, I’ve expected that before for other reasons and it never happened. Companies are resourceful & smart investors understand that peak oil is real despite ignorant, end-of-history opinions that it’s not.
All the best,
Art
Interesting take on this, but if prices tank and shale players falter, Wall Street is still hooked on fees and will go right back to the housing sector and pump money in like mad. And if shale players do slow, I don’t see how we keep pump prices from skyrocketing which will have a major impact upon the economy. This balancing act can falter, like 1979 – 1986…
Terrel,
Last time around, Wall Street got its fees by selling tight oil & shale gas assets and arranging M&A. Pump prices are another story. Higher gasoline prices are already reducing consumption. If prices go even higher, that will get worse.
All the best,
Art
Hi Art
I read the following paper this morning https://www.scribd.com/document/375780747/Forecast-for-US-Oil-and-Gas-Production-Laherrere-Hall-2018. Now suppose that LTO growth halts and the market comes aware of the too optimistic prognosis, the narrative will end and oil prices could surge in anticipation of gradual less LTO production.
In that scenario rising oil prices could kill world growth.
GV,
I have also read Jean’s recent paper. I have long believed that high oil prices will crash the world economy. That danger is amplified by the synthetic nature and attendant fragility of that economy in the post-2008 world of increased debt and low interest rates.
All the best,
Art
Art,
That doesn’t make you wrong. We haven’t even seen positive real interest rates yet using government inflation statistics. That being said, what you have here is a situation where the market (both public and private) has built such a large bubble around acreage valuation that it is damn near impossible for players to generate enough of a return by drilling to “carry” the values implied in their acreage. When you look at one of these companies (like Pioneer) with such a large implied acreage value, you have to ask yourself not what kind of oil price will make you a decent return on drilling capital (as most people seem to think), but also what kind of oil price will generate enough return on both drilling capital and the implied untapped acreage value (that generates no return). When you look at it this way, you realize that every decision to issue equity and plow the capital into drilling makes perfect logical sense. But I wouldn’t hold my breath for a crash because there is a certain circularity to the whole thing. If acreage prices fall and/or oil price rise, everyone wants to buy acreage causing oil price to fall and so on an so forth…right up until we become resource constrained. When that is, I don’t think anyone really knows, but oil price will be a whole lot higher then.
HS,
Excellent discussion–thanks. I understand why companies are drilling even though it doesn’t always seem to make sense from macro level. Once they opened the barn door, they have to go after the horses, so to speak.
I tried to make the point rather strongly in my post that I don’t see a crash coming for tight oil companies either.
All the best,
Art
Based on fundamentals , shale oil economics are way too small an issue to cause financial system meltdown .
However , are credit default swap contracts taken out by financial institutions with no actual exposure to oil companies or prices for the sole purpose of speculation large enough to cause a problem ?
An oil company going into administration with for example $20 billion of unpayable liabilities may generate $200 billion of CDS claims depending on how much those totally unregulated financial houses in Wall Street , Chicago and London have leveraged up and how dumb their counterparties are .
The precedent which was set in 2008 with betting on bundled junk mortgages was that the U.S. taxpayer ensured the winners survived by bailing out the counterparties . An irony is that the counterparties frequently claimed to be insurance companies and on several counts synthetic CDS would be considered blatent fraud in an insurance context .
In order to build new energy infrastructure (especially renewables) and upgrade existing infrastructure to be more efficient e.g. domestic accomodation insulation , the world needs a surplus of energy beyond that required to maintain the status quo .
It seems we have that luxury at the moment but it won’t last forever .
Simon,
I agree that CDS greatly expands the effect of failure. I maintain my statement, however, that oil and gas is a relatively small sector compared with the universe of CDS and the larger components of that universe.
That said, it is a potential house of cards. I suggest that the continued flow of capital to the O&G companies is the more critical factor than surplus energy (not to diminish the importance of surplus energy!).
All the best,
Art
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Art,
The Oxford Institute analysis premises risk based upon their baseline forecast. However, I am unable to define the assumptions which were incorporated regarding the risk associated with natural decline of world production. At roughly 3Mbpd/annum, this component of the supply equation is rarely addressed when discussing growth risk. Your insight would be much appreciated.
Ken
Ken,
The details of the Oxford methodology are found in an earlier paper on the same topic
I am not defending their method but it is based on a sophisticated model:
“The strategy is to project the growth of global demand for the remainder of 2018 and 2019 by feeding the structural moving-average representation of the VAR model of global oil demand with the sequences of oil price shocks obtained by our baseline forecasting model of the global oil market for the same period. Although, oil prices are not the only factor affecting oil demand, our analysis explicitly focuses on the price responsiveness of global demand for oil.”
All the best,
Art
[…] the U.S. government would step in as it did for the auto industry in 2009.—Art Berman, “Shale Plays Will Not Cause the Next Financial Crisis.” The Petroleum Truth Report, […]