Pavan Sukhdev

"We still have a lot to learn about the nature of value and the value of nature"

Of Markets and Failures

Will the next “Too-big-to-fail” be in Oil & Gas?

Way back in January 2009, in his inaugural address, President Obama waxed eloquent about his vision of harnessing  “the sun and the winds and the soil to fuel our cars and run our factories”. Achieving energy independence for the US through alternative fuel was indeed a noble goal, both for national security and for biospheric survival.  But of course, little was heard about that goal for the next several years, and when we did finally hear, the vision had morphed beyond recognition.

It was no longer about renewables, but about more fossil fuels. And the unlikely hero was fracking natural gas. Investments poured in from those who would benefit the most: the oil & gas industry, backed by their bankers.

Break-even levels for fracking in the US had been estimated (by the oil industry) at around USD 75-80 per barrel of crude[i], and of course, oil prices since 2010 had been comfortably above USD 100 most of the time, so oil & gas and their bankers eagerly placed their bets.

Does this sound familiar?  Heard of the housing bubble?

Housing prices had been rising for most of the millennial decade when, in 2007, mortgage originators structured CDO’s out of their Sub-prime and Alt-A assets which were tranched and rated by agency analysts – with senior tranches even being rated AAA. However, underlying all these ratings were many assumptions, not least based on modelled housing market scenarios with further rising housing prices. The rest is history.

For the same reason, fracking is probably also history, including in the US. History repeats itself – and many lessons are often re-learnt. However, history does not repeat price trends. Forecasters who project a reassuring return to USD 100+ may just be wishful thinkers, for a couple of reasons.

Saudi Arabia and OPEC’s overt strategy seems to be to put big shale out of business, and their targets are clear: they are producing enough crude to keep prices below USD 75-80/bbl. They seem eminently comfortable with the idea of doing so because their production costs are closer to USD 5/bbl. Furthermore, some analysts find evidence for a strategic view amongst Saudi officials that their oil revenues are better tapped up-front to transform their country to a broader, more diverse, more lasting economy. If they are right, Saudi production has another more strategic reason to stay high.

But even if the Saudis were to relent, in response to political pressure from the US and OPEC partners, what is the assurance that global demand picks up? Thanks largely to worldwide improvements in energy efficiency, and low economic growth rates, global oil demand has only inched up from around 85 to around 90 million barrels per day over five years (2009-2014) and does not show signs of surging. With slow demand growth and strong production, why should prices go back?

 The Saudi’s strategic bet has serious ramifications: it calls into question how long other OPEC nations (not least Iran, Russia, Venezuela) can sustain low oil prices in an era of budgetary stress. What this means in terms of political instability is anybody’s guess, and it could be a macabre ending to low oil prices if one of these oil producer countries could not stand the budgetary strain anymore and erupted in chaos.

Large national oil producers and the oil & gas majors will need to re-think all their high-cost investments, especially in new offshore sites and in shale. However it is not only “Big Oil” that is at risk. In the US, shale production is traditionally led by so-called wildcatters or independent companies, and only around 30% is with Big Oil. How secure are the futures of these smaller firms?

The collapse in oil prices will hurt oil and gas shale producers, particularly so-called “wet” shale gas producers reliant on shale liquid by-products (indexed to oil prices) to bankroll drilling operations. Shale formations offer full production for short periods, and significantly deplete thereafter. Therefore typically these US shale plays operate on 9-18 month credit lines and require frequent capital injections to drill and generate free cash flow. Such regular need for capital and land for drilling puts them in a very different position compared to conventional producers, which can invest and maintain production from a single asset for 10-30 years. Without a positive profit outlook short term, refinancing for shale could dry up, and bankruptcies may become more norm than exception.

All of the above is reasonably clear and needs no genius to forecast. But what we don’t know is: how much public money will the US & other governments waste by shoring up economic failure yet again, this time because they think that oil & gas is also “too big to fail”?

Time and time again, governments when confronted with economic crisis caused by bad thinking and worse investment have thrown away the neo-classical economics textbook that they swear by, i.e., the one which tells us that markets are there to punish the mis-allocation of capital.  They have instead thrown public resources (read: your taxes and mine) at failed banks (most recently in the 2008 financial crisis), failed insurance companies (eg: AIG), failed car companies (eg: General Motors), etc.  So why not failed Oil & Gas companies?

So far, large oil explorers and producers are very well capitalized through a few decades of profitable high-margin operations based on low-cost drilling concessions, effective exploration, and high oil prices. However, neither feature holds true anymore, so my guess is that the US and other governments will have to make a hard decision: earn the wrath of society by doing what they have always done, bailing out their friends in business, or admit that they got energy policy completely wrong and jump tracks. They would not be the first to do so.

With oil prices low, the setting is right to finally introduce meaningful fuel taxes and reduce income taxes, to fund fresh infrastructure and promote renewables instead of funding production & price subsidies for fossil fuels. Indonesia and India are seizing the opportunity to push through long-overdue subsidy reform – efforts that should help stabilize public budgets and effectively allocate resources. Low oil prices helped Indonesia’s President Jokowi to deliver on his election promise to redirect oil subsidy funds in record time, and India is using the low price environment to whittle away its substantial subsidies for natural gas & kerosene. Whether the USA also uses low prices to engender a change in taxation is an open question.

The right vision for the “Anthropocene”, an era where we humans have become the dominant geological force, was indeed that of President Obama circa 2008-9.

The right strategy was investment in alternative fuels, and not more fossil fuel investment.

The right policy would have been to reduce and gradually eliminate the estimated USD 1 Trillion of price and production subsidies given to fossil fuels ( this number rises to USD 2 Trillion if, like the IMF, you include emissions’ third-party economic costs or negative externalities).

Instead, as far as energy is concerned, we are collectively entering 2015 with clouded vision, wrong strategy, confused policies and bad investments.

I have a simple request for Governments in 2015. Please do not rescue those who make bad economic decisions yet again, just allow them to fail. It will be good for the economy and jobs, and even better for our safe planetary existence.


[i] Wood Mackenzie estimated that most US shale production breaks even at $75 – i.e. levels unlikely in 2015

 Natural Gas Intelligence (NGI)’s “Shale Daily” said as early as Oct 2014

“If anything, then, this tight oil shift should insulate U.S. E&Ps from oil price concerns. No longer are U.S. E&Ps the marginal producer. In fact, our analysis suggests that the average break-even for our E&P coverage is $70/bbl, well below our $90/bbl marginal cost and below today’s $80/bbl WTI oil price.”

 Below $80.00/bbl oil prices, the leverage on the balance sheet is high enough that some producers “will begin to lay rigs down,” Pursell said. “And it’s no surprise…that the large caps will have more ability to sustain lower oil prices, but the smaller caps will be a bit more sensitive to leverage…” In any case, “our view is below $80 is not sustainable for any period of time.”


An abridged version of this blog was first published in Guardian Sustainable Business on 3 February 2015

January 5th, 2015 Posted by | no comments