Zero rates, resource misallocation, and shale oil
This post has been a long time coming because it is very much in my wheelhouse and I haven’t connected the dots for you on this issue yet. The nexus of zero rates, resource misallocation, and risk on has favoured shale oil. But the drop in oil prices will call many of these projects into question precipitating a funding crisis and a panic dash for the exits. There will be carnage and the question will be whether this carnage causes contagion into other markets.
Right now, another global financial crisis seems to be brewing, with emerging markets plunging, European periphery sovereign bond yields soaring and volatility increasing prodigiously in US equity markets. The catalyst for these gyrations, as I predicted them in late September, is the global growth slowdown, especially in China. And the most important immediate result is a weakening oil price, which is why I want to concentrate on shale oil in the US. I think it is a big coincidence that I had been talking up the likelihood of another crisis just before we started to get these jitters because even I am surprised at how soon and how aggressively the market swoon has come. But now that we are in the midst of this volatility, we need to think about knock-on effects just as we were in November 2009 with the Dubai World collapse that triggered the European sovereign debt crisis. That again means shale.
Here’s the macro story as it concerns shale:
- The Fed lowered the fed funds rate to effectively zero percent in the wake of the subprime crisis. With the financial system still in disarray, the Fed began quantitative easing and forward guidance initiatives as a way to re-animate dislocated markets. Eventually, the Fed returned to these same two unconventional tools to aid economic growth and full employment when the private debt overhang in the US retarded growth.
- Lower interest rates and forward guidance signals of continued low rates shifts private portfolio preferences toward riskier projects and projects with longer payback periods because lower risk premia and lower discount rates make these projects more attractive in relative terms to other projects.
- The Fed’s low rates, QE, and forward guidance fomented risk appetite that saw the following markets soar: US equities, US high yield, US leveraged loans, US private equity, US auto loan asset backed-securities, subprime auto lending, pre-IPO technology companies, and shale oil exploration and production.
- Shale oil exploration and production fits the bill perfectly for the type of investment that easy money should favour: oil exploration and production is risky in general and fracking is considered even riskier. Moreover, low discount rates help because many of the shale oil companies are cash flow negative because the payback period on their investment is long. And finally, shale oil production is very capital intensive, requiring lots of debt financing because the scale of the investment cannot be financed with equity alone.
- But shale oil is not profitable at low oil prices, creating a tension for investors. If shale oil investment is successful, a lot of oil will flood onto the market, driving down prices. But if shale oil is unsuccessful, then the oil produced will not be enough to recoup high capital investments. Clearly then, the sweet spot for this market is one in which production costs drop over time, well depletion rates drop and oil production levels remain high enough for profits but low enough not to crater the market.
Most of the forgoing analysis is not particularly controversial. Putting it all together, however, says that the huge investment in shale oil is an artefact of Fed policy because of the unique investing pre-conditions low interest rates, quantitative easing and forward guidance have created. Indeed, when you look at the US Energy Information Agency’s reports on shale. All of the data start in 2008 because that’s when investment began en masse. According to the EIA, from 2008 to 2012, investment in shale plays in the US totaled $133.7 billion. Foreign investors invested more than $26 billion in tight oil plays in the U.S in that time.
This is where the Chinese rebalancing enters the picture. After last year’s third plenum, the Chinese became serious about moving from the export and infrastructure-led growth model they had followed to one in which domestic consumption mattered more. And to make this transition, it would mean a slowdown in commodities and energy consumption growth as the economy slowed during the rebalancing. Industrial commodities have been falling for months on the back of this transition. And the initial emerging markets crisis last January and February was a direct result of the dislocation brought on by these changes. But, somehow, oil resisted the downward pressure until the past two months.
When oil finally gave way, the world changed dramatically for shale oil exploration and production companies in three distinct ways.
First, the Japanese experience with zero rates and risk spreads told us that while safe assets were firmly anchored by the central bank’s actions, risk assets decoupled from safe assets in economic downturns. What we saw in 1997-98 and subsequent Japanese downturns was that the full force of market dislocation fell onto risk assets in the form of higher risk spreads without any yield relief because of the central bank’s inability to cut rates. For shale oil producers, this should mean a gapping up of rollover payment terms, presenting those companies with a brutally different funding environment.
Second, to the degree investors know the IRR of these companies based on previous funding rounds, companies could get locked out of funding markets altogether as the return on investment won’t exceed the interest rate on loans. This would be a sudden stop of debt financing to the shale market, which would either require more equity funding or it could usher in a crisis of epic proportions into the shale oil sector.
Third, unless companies can lower breakevens on exploration profitability, the $80 crude environment could be catastrophic to profitability of shale oil production because the lower revenue fundamentally changes the IRR on these investments. My understanding based on conversations with people familiar with this market is that many projects are not profitable below the $80-90 level.
As a result, what I am looking to see is how long this slump in prices last. And what I expect to happen is that if it lasts more than a few weeks, we are going to see liquidity in the shale oil funding market dry up and then the companies with the worst cash flow positions will run into trouble and default. I don’t think we are there yet. But the drop in price has been so abrupt and so extreme that it will have caught everyone off guard.
Now notice that QE is less potent here. It’s not as if the Fed could wave it’s magic QE wand and get risk spreads back down, especially if the real economy heads south. Without the interest rate lever then, the central bank has much less control over asset markets because they will be completely driven by term and risk premia instead of by interest rate cuts or hikes. This is where QE and forward guidance are much less useful than interest rate policy.
What we should be concerned about here is that, just as with subprime mortgages, this is not a particularly big market but one with interconnections to others. The leveraged loan and high yield market could be affected and other riskier US debt markets like student loans or auto ABS could be affected by sentiment. Right now, it is still early days. So the oil price might even recover. But the abundant liquidity of zero rates, resource misallocation and shale oil simply do not mix.