US Monetary Policy, Junk Bonds and the Collapse of the Oil Price

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The twin technologies of directional drilling of wells and fracturing rock formations to stimulate recovery of oil and gas are widely known and have been utilized for decades in the industry. It is only relatively recently that these technologies have been applied to shale, rock formations which were previously thought to be devoid of recoverable natural resources. It is this marriage of known technology with untapped shale formations that has caused the rapid rise in oil and gas production in the USA over the past decade. (US oil production declined steadily from a 1985 peak of slightly under 9 million barrels per day until 2008 when production bottomed out at 5 million barrels a day.) [1]

ihrdc, oil and gas, US, Oil Price, junk bonds, unconventionals, shale oil, frackingRecovery of unconventional resources generally and oil from horizontal completions and hydraulic fracturing shale (“fracking”) in particular changed this picture dramatically.[2] From a low level in 2008, US oil production began rising year after year to just under 8.7 million barrels a day in 2014.[3] However, increased production brought with it the higher costs of unconventional recovery techniques. Although direct cost comparisons between conventional and fracked wells are hard to come by, a study of wells in the SE Oklahoma Woodford Shale concluded that fracked horizontally completed wells cost $5-6 million more than conventional wells.[4] (These numbers were originally published in 2007 and have no doubt been reduced by efficiencies achieved over time.)

Another characteristic of fracked wells (besides higher cost) is that deliverability tends to be high at initial production but tends to decline more rapidly than conventional wells over time.[5] The reason may be that fracked wells in shale only drain an area within the fracture zone whereas conventional wells in permeable formations tend to drain a larger area. The result of accelerated production decline is that more wells must be drilled at a fast pace to achieve and maintain plateau field production.[6] Drilling pace must also be maintained to continue making reserve additions that enhance the balance sheet and offset production well declines.

At this point in the story, chronology becomes important. Investment in drilling operations in 2007 and 2008 would produce the turnaround results in US oil production at the same time the country was about to experience the “financial meltdown” and enter into a prolonged recession. The root causes of the meltdown can be traced, in part, to cleverly designed security pools and bundled high – risk mortgages.[7] Investors and banks bought into these risky investments because a prolonged period of low interest rates had failed to yield higher returns in more risk free investments. (For example, money managers who only invest in conservative, low risk investments, will only earn very low returns. Such a conservative investment strategy cannot achieve their clients’ expectations of higher returns…at least better than inflation. This principle is illustrated in financial modeling as the “Risk/Reward Curve”. The higher up the risk curve, the more reward is expected.) Finally, the house of cards collapsed in the fall of 2008, culminating in the Lehman Brothers bankruptcy and the country spiraling down into recession.

However, at the same time, the oil industry thought they had finally found the key to unlock the elusive dream of US energy independence. All they needed was money to keep drilling and fracking shale as fast as possible…faster than declining production from depleting wells. To do this required an infusion of capital. Now, however, there was no money to loan from traditional sources because big banks and investment houses were in a survival mode.

ihrdc, oil and gas, US, Oil Price, junk bonds, unconventionals, shale oil, frackingThe unconventional companies became more resourceful. They formed new types of business entities, such as limited partnerships, to raise money; they sold shares; they approached  hedge funds; and, most importantly, they began to rely on a source of cash from the issuance of high risk / high yield bonds (sometimes referred to as “junk bonds”).

Meanwhile, the outgoing Bush administration and the incoming Obama administration searched for a solution to stimulate the moribund economy beyond a limited number of shovel ready public works projects. The ultimate solution adopted by the FED was “quantitative easing” (“QE”)[8], a dense term which simply means a policy of increasing the money supply and making it available to banks, essentially for free. The hope was that banks would begin lending anew at relatively low interest rates and the influx of borrowed money would stimulate the economy. The only real worry was that free money would lead to inflation. To the credit of the FED and the administration, QE worked. Over the next several years, money flowed into the consumer markets, the recession was reversed and inflation was kept in check. However, the new problem became that rates of return on low risk investments dropped to record low levels, pushing investors to seek higher yields in higher risk investments.…like the US oil and gas exploration business. The market for junk bonds increased dramatically. (Figure 1)[9]

ihrdc, oil and gas, US, Oil Price, junk bonds, unconventionals, shale oil, fracking

Figure 1

Investors bought energy junk bonds in increasing numbers. In 2007, the US energy business comprised about 5 % of the total high yield bond market; by 2014, this participation had risen to 15.4 %[10]. (Figure 2) The borrowing costs for junk bonds remained reasonably low due to the increased supply of credit through QE. (As more money flows into the high yield debt market, yields are held down and borrowing is relatively cheap.) However, when the oil price started to drop, the risk of these high yield bonds became immediately apparent, and the interest rate skyrocketed. (Figure 3)

ihrdc, oil and gas, US, Oil Price, junk bonds, unconventionals, shale oil, fracking

Figure 2: Junk Debt Yields by year for the domestic oil and gas industry (energy sector)

Notice the low and relatively stable interest rates from 2011 until the end of 2013.  Then, when oil prices begin to slide, risk increases dramatically and so does the cost of using junk bonds as a borrowing tool.[11]

ihrdc, oil and gas, US, Oil Price, junk bonds, unconventionals, shale oil, fracking

Figure 3

As an unintended result of QE, investors fled to the high yield bond market. It was there that energy producers found the cash they needed to expand drilling and production. US exploration companies had a total debt of $128 billion in 2010. By 2014, the debt load had climbed to $199 billion.[12] This extra debt was assumed by companies whose balance sheets looked strong because of reserve additions; but were fundamentally short on cash flow. In mid-2014, Bloomberg reported that the only shale producers making money were those subsidizing their US operations with profits from overseas.[13] When the oil price entered a prolong decline, companies operating solely in the USA were covering flat cash yields in 2014 with more borrowing.[14]

The conclusion is that the policy of QE at precisely the moment in the energy industry when money was needed to increase drilling and US production has indirectly and unintentionally produced a key element in the oil price slide by funneling bond investments into more drilling, which in turn has contributed to sustained production increases. However, since oil is in a global commodity market, monetary policy is by no means the only element in the oil price slide. Other factors contributing directly to the oil price collapse include:

  • Saudi Arabia’s non-intervention strategy
  • Declining GNP in China and India
  • Sluggish economies in OEDC countries

As an additional effect, the steep oil price decline (if it lasts) has made junk bonds, at high interest rates, an unsustainable source of funds for the US energy business. That leaves the important question: how will production from shale wells be sustained if the money becomes much more expensive or non-existent?

 

 

Research and graphics for this paper were done in cooperation with Andrew Maryan, MBA/JD candidate May 2015, the College of William and Mary (Business and Law).

[1] EIA Release 12/31/2014

[2] “Unconventional” is a term in wide use to include tar sands, heavy oil, tight formations and oil shale. A generic definition is: oil produced by any method other than extraction through a conventionally drilled (vertical) well.

[3] EIA, supra

[4] Fitzgerald, T. Frackonomics: Some Economics of Hydraulic Fracturing, 63 Case Western Reserve Law School 1337 at 1353 (2013).

[5] Likvern, Rune Is Shale Oil Production from the Bakken Headed for a Run with the “Red Queen”? The Oil Drum .com (Jan 2013). The literary allusion is to the Red Queen who Alice encountered in Lewis Carroll’s classic “Through the Looking Glass”. The Queen said, “It takes all the running you can do to keep in the same place.”

[6] Likvern, supra

[7] See The Economist (Sept. 2013)

[8] The way QE works is that the central bank (FED) purchases treasury bills. These purchases increase the money supply thereby lowering the interest rates to promote GDP growth. A by-product of the policy is to avoid currency deflation…at the risk of inflation. A second effect of the policy is that when it ends, interest rates for borrowing will rise which will tend to depress business lending, expansion and therefore stock prices.

[9] Maryan, A., data retrieved from: http://www.sifma.org/research/statistics.aspx. (2015) This graph shows the explosion of Junk Bond debt in USD following the Fed Interest Rate reduction policy in 2008. This huge increase in junk bond debt is due to investors moving to higher yield (riskier) avenues of income when interests rates are reduced to zero.

[10]  Martin, Collin, How are High Yield Bonds Hurt by Falling Oil Prices, October 24, 2014 (Charles Schwab).

[11]  Maryan, A. from statistics on Bloomberg Terminal, William & Mary Business School. (2015)

[12] WSJ,  January 7, 2015 (Excludes the Super Majors.)

[13] Loder, A. Trouble in “Shale” paradise , May 27, 2014 (Bloomberg)

[14] Oil & Gas Journal, August 4, 2014.

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Skip Maryan

Skip Maryan is a lawyer and consultant with a practice in International Energy. In 2009 he started his own consulting company.

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