Opinion

Shale Plays Will Not Cause the Next Financial Crisis


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).

Figure 1. Markets have devalued oil prices by approximately 20% over the last year 2014-June 2017 comparative inventory yield curve indicated a mid-cycle price of $75. July 2017-2018 yield curve suggests a mid-cycle price of $60/barrel. Source: EIA and Labyrinth Consulting Services, Inc.

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).

Figure 2. The balance of risks to oil-price outlook for 2018 and 2019. Modified from Fattouh & Economou (2018) by Labyrinth Consulting Services, Inc.

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).

Figure 3. The current oil-price rally has stalled at $70 per barrel for now. Source: Quandl and Labyrinth Consulting Services, Inc.

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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