Published in 'The Ecologist', 17th December 2014, under the title, "With sub-$60 oil, fracking and tar sands losses threaten the whole financial system"
Brought about by the recent fall in oil prices, investors are beginning to review the economics of unconventional oil and gas. For the last few years there have been a number of damning reports about the economics of unconventional fossil fuels. Now it seems those long-ignored observations are being taken seriously by the money-lenders of Wall Street.
John Maynard Keynes was one of the most significant economists of the Twentieth Century, whose observations still draw the ire of pundits and politicians today. One of his lesser-known economic statements was, "If you owe your bank a hundred pounds, you have a problem. But if you owe a million, the bank has". Sound advice, but what if you owe hundreds of billions? Then it becomes a problem for the whole economic system, not just the bank.
During the early 2000s a lot of Wall Street's 'funny money', based around complex investment schemes, flowed into unconventional oil and gas developments. It was seen as the new 'revolution' in America's energy system, and a new, politically approved path to energy independence. When that funding stream collapsed, after the 2007/8 financial crisis, the number of drilling rigs operating in America collapsed too.
In the wake of the crisis the US and other governments instituted quantitative easing (QE) – in effect conjuring 'free money' from governments, given at near zero rates of interest to the major banks and finance institutions. Problem was, in the wake of the crisis, there was little to invest all that 'new funny money' in. Throwing free money after bad, the US fracking industry mopped up a large wad of QE cash, and shortly after the number of drilling rigs in the US took off again.
Looking for a fast return, sections of the finance industry specialise in 'high risk' or 'junk' investments – which in America is reckoned to be worth $1,300 billion. Over the last ten to fifteen years the global finance system has loaned the American unconventional oil and gas industry hundreds of billions of dollars. Today somewhere between $150 and $550 billion of those loans are considered to be 'junk'. Now, as oil prices fall, the precarious, Ponzi scheme nature of these investments is being exposed – although the basic facts were made public by the New York Times over three years ago.
There's a whole lot of reasons why many have seen 'fracking' as an economic train wreck waiting to happen. What's triggered today's reality-check is the large and fast fall in oil prices, and recent studies which have exposed the flaws in the investment models which underpin the industry. Now the 'shale boom' appears to be over, and the spin and hype which drove that revolution are finally being exposed. And, as Keynes suggests, if this triggers a wider crisis in the bond market it has the potential to cause problems way beyond the parochial issue of "fracking".
The problem with unconventional oil and gas is that it takes a lot of engineering to produce a small return of product. Some studies, such as one carried out by the Oxford Institute of Energy Studies in early 2014, reckoned that half of all unconventional wells were losing money – and the industry as a whole had written-off assets worth up to $35 billion. To put that into perspective that's more than J.P Morgan's post-crash bank bailout, and a bit less than Citigroup's – but unlike the bailouts that $35 billion would never be paid back!
Across America there are a large number of small oil producers – ranging from a few thousand to just four or five barrels of oil per day. These are the people at the bottom of the industry who exist largely on historic land rights and loaned capital. As oil prices fall, lacking the economic power of the major companies, these are the people who see the biggest impact on their earnings. As a consequence they are more likely to shut down and default on their loans.
There are obvious parallels here with the US sub-prime mortgage crisis. As these many small loans go bad the effects compound up the 'food chain' of finance. One measures of this is the bond yield, the earnings from energy investments – which have been sliding all year. Fearful that the 'shale revolution' might implode, some vocal free market pundits are calling for assistance to be given to the US shale industry.
More significantly, in terms of the potential losses, it's the biggest players in the US shale industry who are practising the most egregious tactics to keep on the "drilling treadmill" – continuously keeping new wells coming on stream in order to make up for the low returns and short productive life of the ones drilled previously.
At the national level some of the larger unconventional oil and gas companies have been playing the market to massage their credit ratings – to keep the investment dollars flowing in. Locally some are receiving back-door subsidies as US states overlook unpaid taxes, or pick up the bill for plugging old abandoned wells. In Florida, they proposed to front-load the high exploration costs for shale onto consumer's utility bills. Meanwhile some companies under-pay royalties to landowners, or under-pay their workers, in order to save money and make their balance sheets look better.
That was before December 2014...
The real fracking financial earthquake began in the first week of December, when oil prices fell below $70/barrel – the point at which most unconventional production becomes barely economic. Lower prices were already hitting the Canadian tar-sands industry too, where the break-even price for new projects is estimated at $115/barrel.
The week before OPEC had unexpectedly decided to keep oil production unchanged – guaranteeing a further fall in prices as traders off-loaded their increasingly loss-making futures contracts. Then sections of the financial media began to express concern about the viability of the unconventional oil and gas sector.
By the second week of December, when prices dropped to $65/barrel, there were reports that the 'bubble' in shale investments might be a serious problem for bond investors – potentially risking another market crash. As a result the value of many US, UK and Australian unconventional oil and gas companies fell further – to the point where Australian analysts suggested they would make ideal speculative take-over targets, and Canadian dealers start to short-sell tar sands debt in anticipation of a further fall in value.
At the beginning of this week, the third week of December, as oil prices hit $60/barrel, the off-loading of bonds began as investors tried to limit their exposure to the risk of a crash. As in 2008, companies started to decommission drilling rigs once again. The shale industry may have written off $35 billion in the last 10 to 15 years – but right now bond holders are staring down up to almost $12 billion of losses in the last few weeks.
OK – shale is going bust, isn't that a good thing? Looked at narrowly it is, but there are two problems this gives rise to.
Most importantly, where the industry has taken hold (the USA, Canada and Australia) widespread bankruptcy would allow the industry to walk away from the liabilities for the pollution they have created. This potentially dumps billions in clean-up costs on to state and national governments.
The second problem is the collapse of 'political capital', as politicians seek to distract attention from one failure by jumping on another bandwagon. In the short-term we might see the nuclear industry strutting around saying "I told you so"; and the green energy lobby has also been panicked by recent price falls.
In fact the long-term fundamentals of energy supply have not changed – the current trends have everything to do with the geopolitics of oil and little to do with what will happen to oil prices in five or ten years time. Those realities are likely to be drowned out as industry and lobby groups noisily queue at the government's door to sell yet more 'production' technologies to gullible politicians, and an incredulous public.
What we need instead is long-term thinking. The difficulty is, in the fall-out from the failure of shale, the more fundamental arguments about the relationship between energy and the economy will be missed.
The greater argument we should be having is about growth and ecological limits, and whether growth has reached its limit in the most developed nations. This isn't just an issue of climate change, or the depletion of national resources. The founders of modern economics – Adam Smith, John Stuart Mill, Thomas Malthus – all believed that the economy would grow to a certain point and then stop. That's not just an issue of material consumption; it's about the finite nature of the world. For example, how many hours of TV can you watch a week, or how many ready meals can you consume, before all your available free time/space is saturated?
What the 'fracking bubble' demonstrates in not simply the bankruptcy of extreme fossil fuels – it's the economic model itself which is bankrupt. Even students studying economics at universities around the world understand that point, and are lobbying for change.
Politicians are not necessarily stupid; they're goaded into it by well-connected economists who tell them that they have a fool-proof model for how the world works. The problem is that model is broke – and fracking, or futile carbon trading, or never-ending austerity are simply manifestations of a failure to accept that it's time to change our model of the political-economy.