Dysfunction in Oil Markets Increases the Probability of a Deflationary Debt Spiral

November 16, 2015 Industrial organization

A deflationary debt spiral occurs when many entities simultaneously decide to sell assets to pay down debt. If the value of the assets is inferior to the debt owed, this can lead to defaults, decreased asset prices, and decreased borrowing which creates a sharp contraction in economic activity (see [6] for a view of the role of debt in economic cycles). For many years, Gail Tverberg has extensively associated unaffordable oil with deflationary debt spirals [19]. In this post we explain how the current mal-investment in oil production increases the probability of a deflationary debt spiral.

Briefly we can say that globally, debt has increased more than 30% since the collapse of Lehman Brothers in 2008 [9]. Weak or negative economic growth makes this debt more difficult to service. Mal-investment contracts economic activity thus increasing the probability of a negative debt spiral.

Throughout 2015, the production cost of 10 to 15% of world oil supply has been above oil's market price, in other words, 10 to 15% of world oil supply has been produced at a loss [10, Figure 5]. Never the less, oil production in 2015 will be roughly the same as oil production in 2014. The reason production has been maintained is dysfunction in the oil markets.

Low prices have put financial stress on oil producers. In response they have cut capital spending by about 20% this year. Financial stress leads to short term thinking [15]. Short term thinking in resource production is as follows: if prices are low I must produce as much as possible today to make enough money to pay my bills, capital spending cuts will sacrifice future production, 2018 and beyond, rather than 2015 production. This tactic is touted as making up for low prices through volume. Obviously longterm profits would be higher by halting investment in unprofitable production so that production falls enough to raise prices. Evidence of this short term thinking is that the number of producing wells brought on line in 2015 is similar to that of 2014 even though capital expenses have been slashed. So far $200 billion of planned investment by the oil industry has been either canceled or postponed. Over 200,000 workers have been laid off. The cuts have mostly been in large mega projects which require years of investment to bring on line [5]. Exploration budgets were cut drastically [14]. Expensive Light Tight Oil (LTO) production was maintained as were older projects in which money had already been sunk. If prices remain low, many more projects should be canceled, the consulting group Wood Mackenzie estimates that $1.5 trillion of planned oil development will not be profitable with oil at $50 per barrel or less [17].

In 2014 LTO, produced by hydraulic fracturing or "fracking", represented just over 5% of world oil production and about 20% of global investment in oil production. World oil production has increased by roughly the same amount since 2005. It is for this reason that Ben van Beurden CEO of Shell says 80% of investment in oil is just to prevent a decline in production [13]. Because of LTO's short investment cycle (on the order of 6 months) and high production cost, the International Energy Agency's Medium Term Oil Market Report 2015 published in February suggested that producers of LTO would become the new swing producer. Thus far, dysfunction in the oil markets has prevented them from playing this role. With West Texas Intermediate (WTI) less than $65 per barrel, LTO is not profitable [11,3,2]. In spite of this, financial markets have enabled LTO producers to bring almost as many producing wells on line in 2015 as in 2014, most of which will be loss making wells. This can be asserted because the high decline rate of LTO wells makes them extremely front loaded in terms of profitability. If they do not make a profit in the first two years of production, they will not make a profit. Financing loss making projects is not the goal of the financial sector of the economy hence we may speak of a dysfunction in oil markets. In part, the dysfunction was enabled by hedges that LTO producers bought. These hedges spread losses from LTO producers to the other party in the purchase of the option. Hedges can be useful protecting producers from volatility on financial markets, but in the case of LTO, they were a factor allowing companies to ignore clear market signals that production should fall by shifting the loss from producers to other parties. The other primary reason for this dysfunction is relentless marketing on the part of LTO producers enabling them to raise capital on debt and equity markets in yet another example worthy for inclusion in [1].

Even when oil prices where high, LTO producers rarely produced positive cash flow [12, Figure 02]. As of October 15'th, private equity firms had raised a record $61.5 billion for LTO producers in 2015 (the previous record was $53 billion in 2013) [4, Figure 6]. Today over 80% of LTO producers operating expenses consist of paying interest on debt [18]. The mal-investment has resulted in considerable losses for investors. Banks have thus far avoided losses by selling bad debt and equity to their clients as they did in the run up to the sub-prime crisis [16]. This may end as equity and debt markets have dried up for LTO producers. To enable LTO producers to continue operations banks have loosened their covenants and kept credit lines open [8].

From this point there are several possible scenarios of which we highlight three extreme cases:

  • The mal-investment in oil markets continues creating a negative debt spiral which leads to continued low commodity prices and a severe contraction of economic activity.

  • The mal-investment in oil markets is halted but is not replaced by investment in other sectors. This will lead to unemployment, relatively low commodity prices, and a contraction of economic activity.

  • The mal-investment is shifted to investment in profitable sectors of the economy and economic contraction is avoided.

All of these scenarios are good news for climate change as decreased investment in oil production will lead to lower fossil fuel production and thus lower greenhouse gas emissions. The third possibility could be very good for the climate if the profitable investment is directed towards transitioning to a fossil fuel free economy (fossil fuel prices would remain low). Bill Gates recently characterized the private sector as "inept" at developing new technology while his analysis of the public sector was that it was very good at developing targeted new technology [7]. We second his advocating a vast government program to develop our future energy technologies such as cheap electrical storage and airborne wind power. We also second Mark Carney's warning that vast amounts of "stranded assets" in fossil fuels could lose value if a +2°C carbon budget is adopted.



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Phishing for Phools: The Economics of Manipulation and Deception
Princeton University Press, 2015.

Art Berman. 
Only 1% of the Bakken play breaks even at current oil prices. Blog, 11 2015. 

Art Berman. The party is over for tight oil. Blog, 09 2015. 

Art Berman. The problem with oil prices is that they are not low enough. Blog, 10 2015. 

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How the Economic Machine Works
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http://bwater.com/Uploads/FileManager/research/how-the-economic-machine-works/ray_dalio__how_the_economic_machine_works__leveragings_and_deleveragings.pdf See also the video of the same name.



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We need an energy miracle. 
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US shale firms see smaller than expected cuts to their credit lines. 
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What to do about debt. 
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Is the red queen outrunning bakken LTO extraction? 
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Shell boss endorses warnings about fossil fuels and climate change. 
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Many oil companies "virtually abandoning" exploration. 
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$1.5 trillion in oil projects at risk says Wood Mackenzie. 
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Oops! low oil prices are related to a debt bubble, 2015.