Ed Harrison: Zero Rates, Resource Misallocation, and Shale Oil

Yves here. Established Naked Capitalism readers may recall that Ed Harrison was a regular and much appreciated contributor to the site, particularly in 2009 when I was on partial book leave writing ECONNED. Ed now focuses more on writing premium content, as well as producing RT’s Boom and Bust. But he is now posting occasional pieces on his non-subscription site, and has graciously allowed us to post them from time to time.

This article is a more systematic work-up of something that we’ve discussed short form and Wolf Richter has also written up: that of the dependence of the shale oil boom on reasonably high oil prices as well as cheap financing. And as predicted, shale oil producers have shut marginal wells, and even majors are cutting back on oil production.

By Ed Harrison, founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. Originally published at Credit Writedowns

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 high yield energy 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.

The catalyst for many market 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.

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.

Putting this all together says that the huge investment in shale oil is in part an artefact of Fed policy because of the unique investing pre-conditions low interest rates, quantitative easing and forward guidance have created.

When oil gave way earlier this year, 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 some 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 some projects are already not profitable below the $80-90 level.

If these low prices last 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.

This article is an abbreviated excerpt of a post from 16 Oct from Credit Writedowns Pro

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  1. Greenbacker

    Sorry, but this stuff just isn’t connected like you think. Firstly, we have enough oil in the ground for oil prices roughly in the 60$ range. That is it. That is the total. If all phases are going in high production. Prices just aren’t whats being extracted, but what can be extracted in the future. So higher prices due to declining future wells of extraction cause the industry reach for new supply. This brings in money so you can hedge the future price down. There is so much wealth in interest, it drives down interest. When the wealthy have alot of savings, interest rates are low. When the wealthy are strapped for cash, interest rates are high.

    Your “subprime” is globally in oil related countries like always. Your looking at the wrong source and the wrong continent. Lets remember the 2008 “crash” as we found out was not a liquidity NOR solvency crisis. It was a mispricing crisis. The total funds were available to avoid the default, but because nobody could trust the others balance sheet, all credit lines collapsed and cash dried up. It started because of the surge in supply after the computer revolution topped out in the 90’s. All that excess supply with little to do caused demand for products like the AAA scam.

    1. Yves Smith Post author

      You are completely wrong about the 2008 crisis. It was a solvency crisis. Financial firms had written underpriced CDS on subprime exposures. They were grossly underpriced because (crudely) BBB- risk was sold at (largely) AA prices by packing them in CDOs. The CDS written amounted to 5+x actual real economy subprime risk. The parties exposed to these bad wagers (virtually all of these CDOs went to zero and never cam back) were levered and highly interconnected firms. I have detailed analysis in Chapter 9, with supporting data and extensive footnotes, of ECONNED.

      We would not have had to have massive bailouts and going on seven years of financial repression to goose asset prices and make them look solvent if there hadn’t been a solvency crisis. And the US banks got a SECOND monster bailout, that from chain of title liability, in the National Mortgage Settlement (49 state/Federal) of early 2012.

      The fact that you opine so confidently about the crisis when you don’t have your facts right calls your other views into serious doubt.

      1. susan the other

        The massive “bailout from chain of title liability”: this is one of Das’s derivatives in that the housing debacle was concocted because housing was fiated into a commodity of CDOs. But the “securitizers” forgot to acknowledge that people were the underlying commodity (evidence of this when Bush withdrew bankruptcy protection, etc.) So there are commodities and there are “underwriters” of commodities. We live in a virtual world. So – please forgive this ramble – real estate is a human confection. A fake commodity. Still the laws of basic resources applies. It can be mitigated by money manipulations because it is capitalism. But only because. When interest rates go up because resources are cheap and growth is nuts it logically follows that they go down and/or disappear when those resources disappear. In housing it was merely the disappearance of a chimera. In oil it is more concrete. Something tells me the “sweet spot” will disappear faster than a subdivision. And now I’ve lost my train of thought. Lucky for me.

    2. Moneta

      I’d love to know what % of the population thinks like this. It would explain why conservative investors keep on buying all these really bad risk-reward investments.

    3. Ishmael

      In the early 1980’s I met with many a wildcater to discuss that it was costing them $50 a barrel to find oil (just including the price of successful wells and not the cost of dry holes) and selling it for $35 just did not make sense. In the late 70’s and early 80’s I was very involved with the oil and gas industry on several continents including Canadian oil sands and outside of North Africa I saw few oilfields being found where oil was being found for less than $50 a barrel and that was 35 years ago. Most fields are experiencing secondary and tertiary recovery now. I can assure you that $60 cost on current reserves is ridiculous.

      With that said there remains a large amount of reserves to be produced. The problem is the cohesiveness of the sands and getting the liquids to loss that cohesiveness to the sands is a challenge. I talked to a chemical engineer (heading up this department for a major oil company) at an oil symposium and had a new start up which had a product which could reduce the cohesiveness. This could result in significant future production since most of the oil is still locked into these reservoirs. Of course talk is cheap.

      Most independent oil and gas companies will have a tough time cutting back production. These companies are loaded up with debt which needs to be serviced. Also shutting in wells usually damages them and will damage future production.

      Oil looks like it could go to $40 a barrel. That will do a lot of damage to the oil industry. I expect a repeat of the 80’s and 90’s for a while where the industry just languished.

    4. Rosario

      I’m confused, oil in the 60 dollar range? This being a substance that is equivalent to (easily) hundreds of human labor hours per gallon? We have always priced oil incorrectly and we continue to do so. If we had any sense we would be hoarding the stuff like the priceless commodity it is. This is the problem with “markets”. They are dictated by our reason, and often it is lacking. Until we find a way to create another miracle liquid fuel I’d advise either researching advanced battery technology or finding a way to live without long distance transit.

    5. Rosairo

      I’m confused, oil in the 60 dollar range? This being a substance that is equivalent to (easily) hundreds of human labor hours per gallon? We have always priced oil incorrectly and we continue to do so. If we had any sense we would be hoarding the stuff like the priceless commodity it is. This is the problem with “markets”. They are dictated by our reason, and often it is lacking. Until we find a way to create another miracle liquid fuel I’d advise either researching advanced battery technology or finding a way to live without long distance transit.

      1. Moneta

        The number of gas stations in prime locations that just get paved over as parking is astounding. Companies do not want to pay for the clean up… huge companies with lots of cash flow… externalities are not priced in and many keep on arguing.

  2. frances

    Apart from the investment risk discussion, will default see the companies walk away from the environmental assault they have wrought? Rhetorical question. Irreversible damage, no matter how much money could be thrown at ‘clean-up.’

    1. James

      Good point, and one that will no doubt get lost in the ensuing meltdown. Looks like another round of socialized losses headed our way, regardless of the economic fallout.

  3. not_me

    Interest, interest interest! We are a usury-soaked nation and world! Have people totally forgotten that usury, for good reason, was condemned in the past and still is in some parts of the world? Central banking is an attempt to eliminate high interest rates in fiat but it does so by subsidizing private credit creation for the sake of the banks and the so-called creditworthy, which always includes the rich.

    Why should we care about high interest rates in fiat for the private sector IF other forms of private money creation were allowed? Indeed, high interest rates in fiat could be a BLESSING since they might encourage businesses to SHARE wealth and power by issuing new common stock (shares in equity) rather than stealthily steal the purchasing power of the population via government-suppressed interest rates.

    But IF high interest rates in fiat are considered a problem, then let the proper monetary sovereign (eg. the US Federal Government) equally distribute new fiat into existence to meet the demand for it. That way, losses in interest income by those who need it would be at least partially compensated for by the new fiat – more so if the fiat distribution were means tested.

    But let’s get away from usury-based money by moving to shared-equity based money – IF we are wise enough to realize that usury and/or government-privileged private credit creation are not the basis for a healthy society.

    1. curlydan

      “let the proper monetary sovereign (eg. the US Federal Government) equally distribute new fiat into existence to meet the demand for it”. Can you give a concrete example of how this might work for the poor? I think it’s a good idea, but I’ve struggled about how it could be done operationally.

  4. proximity1

    ” Make the ..(?) . look solvent….”

    RE: “We would not have had to have massive bailouts and going on seven years of financial repression to goose asset prices and make the __[banks (?) ]_ look solvent if there hadn’t been a solvency crisis.”

  5. Yata

    Investors losing their fortunes in the oil field isn’t a relatively new phenomena. There comes a point when you get numb to the idea of the dumb money being fleeced (less the victims of institutional investors who have relatively little choice) in the market. If you’re stupid enough to hand someone your money on some vague promise, you get what you deserve. Think of it as a form of socio-economic Darwinism.

    But as things go it will be the little guy taking the loss. Here I can only speculate that the smart money and profits have been off-shored in any soon-to-be-bankrupt shale oil ventures. There will be just enough money left behind for a rear guard action of legal defense and campaign contributions.

    Reuters has a special report in today’s headlines: Special Report: For these oil and gas bets, the odds favor the house which argues for the current trend in investing.
    If I were dense enough to hand them my money, my bet would be with the O&G firms who have retained the best O&G contract lawyers, and or, securities lawyers.

  6. chey

    Yves. The final barb in your response to Greenbacker could easily be leveled against Harrison. Some fact-checking, or just logic, is in order
    1- Shale production is not riskier than regular E&P, at least not from a dry hole standpoint. The degree of confidence about the resource in the ground is very high. When was the last time you heard of a U.S. independent drilling a duster?
    2- The payback period on wells is NOT long. Shale wells have extremely high initial production rates, and most of the overall resource is produced within a handful of quarters. Of course that ratio fluctuates with the cmdty price, but as a general rule his statement betrays a lack of basic understanding
    3- These companies are not cash flow negative b/c of payback periods. They could easily tailor their drilling plans to live within cash flow. The reason they are cash flow negative is grounded in the economic decision to maximize NPV. If your wells are 30+% IRR, what makes more sense economically? To drill 50 wells in Year 1 or over the course of 10 years? Again, this is very basic stuff that Harrison seems to miss.
    4- Listen to 3Q earnings calls and see if you can keep count of OFS co’s complaining about their deteriorating pricing, and E&P’s discussing their increasing efficiencies and their pushback on costs, so I guess that plays well to the “sweet spot” that Harrison mentions
    5- Apparently Harrison is not aware that there are virtually zero high yield maturity dates for E&P that take place in the next 4 years, while revolvers contain high amounts of availability
    6- Are reserve based lenders managing those secured revolvers going to abandon optimistic thinking and begin running backwardation price decks, thus shrinking their loans? Please…
    So bravo to Harrison for pointing out that producers will suffer in a lower commodity price environment. Thanks for that epiphany, but can we please take pause before predicting a “crisis of epic proportions”?

  7. Dikaios Logos

    Very randomly on two occasions in the past month in my 1%-ish mid-Atlantic neighborhood I’ve crossed paths with young men, no more than mid-thirties, who referred to North Dakota in their recent pasts. This is something I have not seen ever before and I didn’t follow up, but I’d guess some folks are done with the shale ‘boom’, FWIW.

  8. Luke The Debtor

    I don’t buy the “it’s the low interest rates” thing. The price has to be there as well. As far as “misallocation”, that’s up to the consumer. Economist blabber about how oil price drops are like a tax cut (yet the Keynesians never blabber about actual tax cuts). They say it’s good for the consumer and good for the economy. But it’s just money taken out of someone else’s pocket.

  9. Rosario

    Screw the economics, look at the politics. Refiners (Exxon, BP, Shell, etc.) push petroleum, through wild cat producers or Halliburton contracts (they sideline risk/cost), to push oil products which are required by a society that was built via politics and necessity on they same. Shale oil extraction is an obvious example of, simultaneously, the desperation present in the petroleum industry and the immense profitability (despite the absurd costs) because of beneficial policy (Halliburton/wild-cat producer blows it, government shakes a silly finger) and investment conditions. Why bother with analyzing costs/economics when the rules of the game are so floppy? Native Albertans (and those living in shale mining watersheds) will be dealing with the “costs” of this BS industry for hundreds of years. Just imagine the value of that same land in terms of water resources, CO2 sequestration, O2 production, other externalities. Same goes for fracking in the USA.

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