oil OPEC

Behold! The Shale Oil “Deflationary Cycle” Flow Chart

We’ve written exhaustively about the deflationary dynamic that grips crude markets.

Indeed, what you’re seeing from US producers is effectively what happens when QE and central banks inadvertently create deflation as opposed to inflation.

It’s very simple, really. The central bank-inspired hunt for yield drives investors down the quality ladder, creating artificial demand for HY debt and equity follow-ons. This relentless appetite for anything that offers investors some semblance of yield allowed otherwise insolvent US production to remain online as operators tapped capital markets to plug funding gaps. Here’s how Citi put it way back in 2015:

Easy access to capital was the essential “fuel” of the shale revolution. But too much capital led to too much oil production, and prices crashed.  The shale sector is now being financially stress-tested, exposing shale’s dirty secret: many shale producers depend on capital market injections to fund ongoing activity because they have thus far greatly outspent cash flow.

Capital markets remained open to many of these operators during the OPEC-engineered price downturn, allowing US production to effectively go into hibernation (as opposed to going clean out of business) until prices rose again. Now, they’re back pumping, sowing the seeds of their own demise by offsetting the very OPEC production cuts that allowed them to start pumping again in the first place. This is a circular, deflationary dynamic that can only be short-circuited by capital markets finally slamming shut on US operators and as we saw with the $6.64 billion US energy companies raised in 13 equity offerings in January, that doesn’t look like it’s imminent. 

Well, speaking of oil and circular, deflationary deathtraps, Goldman is out Tuesday with an expansive new piece on crude and more specifically on OPEC. We’ll get to the details later, but for now, consider Goldman’s take on how shale has “transformed the cost curve” creating a “structural deflationary cycle.”

Via Goldman

Short-cycle shale has transformed the cost curve

Shale’s short time to market and ongoing productivity improvements have provided an efficient answer to the industry’s decade-long search for incremental hydrocarbon resources in technically challenging, high cost areas and has kicked off a competition amongst oil producing countries to offer attractive enough contracts and tax terms to attract incremental capital. This is instigating a structural deflationary change in the oil cost curve, as shown in Exhibit 2. This shift has driven low cost OPEC producers to respond by focusing on market share, ramping up production where possible, using their own domestic resources or incentivizing higher activity from the international oil companies through more attractive contract structures and tax regimes. In the rest of the world, projects and countries have to compete for capital, trying to drive costs down to become competitive through deflation, FX and potentially lower tax rates.



6 comments on “Behold! The Shale Oil “Deflationary Cycle” Flow Chart

  1. Hello therealheisenberg,

    You wrote:”what you’re seeing from US producers is effectively what happens when QE and central banks inadvertently create deflation as opposed to inflation….The central bank-inspired hunt for yield drives investors down the quality ladder, creating artificial demand for HY debt and equity follow-ons.”

    If I understand your point correctly, you are arguing that it is the central bank of the United States, the Federal Reserve Bank (FRB), which is causing interest rates to decrease and as a result, investors have to push out into higher risk investments to find adequate return.

    I believe that you are incorrect.

    Normally, central banks seek to ease credit market conditions by lowering interest rates, an “Interest Easing Policy” (IEP). Since the overnight interest rates on bank reserves were already effectively at zero in November 2008 lowering those same interest rates was was largely pointless, IEP would not work (the “Zero Bound Problem”). QEP, increasing the *quantity* of money for leading, was hoped to provide additional *easing* to credit market, thus helping un-restrain business borrowing.

    Additionally, QEP, particularly the “Operation Twist” / “QE2” component [1], had the additional goal of lowering interest rates on longer term forms of credit. By purchasing longer term United States Treasury (UST) bonds rather than shorter term bills or notes it was believed that the credit market for longer term instruments would ease through IEP.

    QEP was also thought to be a monetary stimulus (which works through “wealth effect”) to increase aggregate demand, and to stimulate inflationary pressures to counter the intense deflationary pressures present in the economy. Certainly a very large increase in the supply of money, which occurred as a result of QEP did indeed create inflationary pressures.

    The point that you raise is how effective was QEP. As an anti-deflationary policy, it seems to have been quite effective. The velocity of money was falling significantly following the Crash of 2008 and there was evidence for the danger of falling prices. QEP was largely effective at stimulating some amount of inflation. It was below the unofficial target of 2% but it was above zero.

    However in terms of lower long term interest rates, QEP was probably not effective. While long term interest rates did indeed decline following the adoption of QEP, those same interest rates had been declining since for 30 years. The Federal Reserve Bank (FRB) itself conducted a study on this topic. They determined that the long term UST bond rates fell by 15 basis points which really not very significant [2].

    Rates of investment are not driven by interest rates. If interest rates drove investment, there ought to be an inverse / negative relationship between capital formation and interest rates. More investment ought to occur when interest rates are low and decline when interest rates are high. Generally there is a positive relationship, as businesses expand, they demand more credit[3]. If the supply of credit is stable while demand increases, then the price of credit rises, i.e. interest rates go up. It is generally a demand driven market. Interest rates do not drive investment, investment drives interest rates.

    If one examine the petroleum industry in particular, one of the few which has shown growth since 2008, there is in fact no relationship at all between interest rates and growth. Consider this graph, it shows the Value of Manufacturers’ New Orders for Durable Goods Industries: Machinery: Mining, Oil Field, and Gas Field Machinery which we can take as measure of capital formation in the petroleum industry. This is plotted against time. Also plotted is the Effective Federal Funds Rate. As can be seen, there is no correlation between the two [4].

    Investment is not driven by interest rates rather it is interest rates which are driven by investment. When businesses expand, they borrow money. As money is withdrawn from the credit market, the balance of supply to demand changes, driving up interest rates[5].

    So it is unlikely that any change in monetary policy as they impact interest rates have had little impact on investment rates investment in tight oil produciton.

    [1] http://www.frbsf.org/economic-research/publications/economic-letter/2011/april/operation-twist-effect-large-scale-asset-purchases/

    [2] http://www.frbsf.org/economic-research/publications/economic-letter/2011/april/operation-twist-effect-large-scale-asset-purchases/

    [3] http://bit.ly/1PKBcZa

    [4] http://bit.ly/1O7yQmN

    [5] http://bit.ly/1pIzPbQ

    David de los Ángeles Buendía

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