Beijing may have popped the Fed’s oil bubble, and everyone’s getting splattered.
- By Edward HarrisonEdward Harrison is the founder of the Credit Writedowns and a former career diplomat and investment banker. Follow him on Twitter: @edwardnh.
Who doesn’t love falling oil prices? They can be a big boost to the American economy. Because the United States is a net importer of oil, the pickup in disposable income for consumers should more than offset any losses to American oil producers. But this simple math may get a lot more complicated because of the nexus between interest rates and high-cost production from deepwater, shale, and oil sands.
Here’s how the story began.
In December 2008, the Federal Reserve lowered the fed funds rate to effectively zero 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. As the economy stalled, the Fed returned to these same two unconventional tools to aid economic growth when the overhang of private-sector debt was dragging it down.
Quantitative easing and the Fed’s forward guidance were signals to the markets that low rates would remain in place for an extended period. These signals also shifted private portfolio preferences toward riskier projects and those with longer payback periods, because the lower risk premiums and lower discount rates associated with the Fed’s policy made these projects more attractive in relative terms.
As a result, many of the riskier investment markets soared: stocks, high-yield bonds, leveraged loans, private equity, auto loan asset backed-securities, subprime auto lending, pre-IPO technology, and, last but not least, shale oil exploration and production.
Low discount rates helped oil exploration even more, too, because many of the shale oil companies needed loans to finance their big capital expenditures.
So far, so good. Then the bottom fell out of the oil market, thanks in large part to China.
This past year, in the wake of the Chinese Communist Party’s third plenum, the Chinese became serious about moving from the export and infrastructure-led growth model they had followed to one where domestic consumption mattered more. This transition has meant a slowdown in demand for commodities and energy consumption growth. Prices of industrial commodities have been falling for months on the back of this transition. Indeed, 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 three months, when the large net long position in oil futures began to be cut, resulting in a 25 percent fall in oil prices.
The big drop in oil prices is killing margins for producers with high production costs. EOG Resources has said it can survive at $40 based on its drilling costs at the Eagle Ford shale formation, but it may be the exception to the rule. According to ITG Investment Research, Cana Woodford producers in Oklahoma need $100 to break even, and the Anadarko formation in Texas and Oklahoma requires around $79 a barrel. ITG says Bakken and Permian producers can make it at $14-16 less.
But oil is already at price levels that bite, and the capital investment implications are mounting. Recently, Transocean, a deepwater driller, warned of a “cyclical downturn” — not just a blip in the market. It has written off $2.79 billion in goodwill and warned of more writedowns to come. Transocean said that both rig count and rig prices have declined. So capital investment is already worsening for one part of the industry.
Then there are the oil sands in Canada, from where oil is flowing into the United States via the Keystone pipeline. According to data from IHS, a global information company, Canadian producers must rely on short-term borrowing, having spent an average of 167 percent of their incoming cash since 2009. Their profitability has been the worst in the world in that time, with profits averaging under $6 per barrel of oil equivalent, less than half the global average. Peter Howard, president and chief executive of the Canadian Energy Research Institute has said that “if you drop below $80, you would actually start affecting developments, they would get pushed off and maybe cancelled.” And that is where we are right now.
The outlook is downright scary for global financial markets. Because energy was considered a relatively safe sector for investment, energy bonds are almost 16 percent of the $1.3 trillion high-yield bond market, up from just over 4 percent a decade ago, according to Barclays. This means virtually every major high-yield bond manager in the world has exposure to this sector. But if oil prices fall further from here, the most cash-strapped and indebted companies might be forced into bankruptcy or restructuring. And the wave of defaults would see outflows from the high-yield sector as bond managers sell other bonds to balance their portfolios, creating contagion beyond the energy sector.
The interconnections here suggest that the fall in oil prices will significantly impact capital investment in the energy sector and beyond. And, to the degree that funding costs for capital investment rise, so will the price levels oil companies need to break even. We could even reach a tipping point where this process causes a further rise in the cost of borrowing, creating yet higher break-even prices for drillers.
These spiraling increases present the alarming possibility that many of the oil companies that have boosted employment and supported the U.S. economic recovery could suddenly become unprofitable. In fact, a collapse in the sector could overwhelm the benefits of the oil price decline on consumer disposable income. Look toward $75-80 as a sort of tipping point, below which ugly scenarios take form quite rapidly in high-yield energy funding markets. If prices fall below that range, the spillover into the broader high-yield market, with even bigger repercussions in global financial markets, seems a certainty.
The lesson here is that interest rate policy has a tremendous effect on capital investment. The shale oil boom is not just the result of high oil prices; it’s also the result of low interest rates. Even if rates stay low, the industry is incredibly vulnerable to changes in prices. If rates rise, watch out.
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