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.”
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.