Wolf here: occasionally I highlight a comment that adds a different flavor or an illustration or more depth to an article published on WOLF STREET. This is a comment by “MC” on my article,This Is Just the Beginning of the Great American Oil Bust
I think financial markets have become so detached from fundamentals not even an invasion staged by little green men from Mars could stop them from climbing higher and higher. The only thing that could kill them stone dead is an interest rate hike – even a modest one – but that’s not going to happen anytime soon. Or, who knows, it may happen next week. Interpreting central bankers is as an obscure and arcane of an art as predicting the future from the flight of birds.
Having said that, I strongly suspect Prince al-Walid bin Talal of Saudi Arabia is fundamentally correct in his assessment: nobody knows what the true breakeven for fracking and shale is, not even the companies physically pumping the stuff from the ground.
The reason for this is very simple: most of them are so heavily leveraged even a seemingly modest hike in interest they pay on their debt could easily add $10-15/barrel to their breakeven overnight. The present figures daily trotted out by Wall Street are based on the assumption interest rates will stay stable through all of 2015 and beyond… and that foreign oil won’t become so cheap as to become more tempting for refineries than it already is. Saudi Arabia has already sent signals in that direction by lowering crude prices for the European market.
A combination of oil prices in the $65-75/barrel ballpark midterm and slightly higher interest rates could cause far more damage than the present burst because most small and middle sized fracking and shale companies were bred and raised in an environment of very high oil prices and very low interest rates. They lack the experience and leadership of Exxon and Chevron for dealing with different situations.
A year ago, I mused if there ever was to be a burst of the fracking and shale industries, it would have ended in tears and a bailout. Now I only see the tears.
Exxon, Chevron and large foreign companies such as BP, Talisman and Shell cannot only weather the storm but profit from it mid to long term: somebody will have to buy the assets of all those small oil companies that will inevitably go burst. They aren’t robot traders buying the dip: they can wait for prices to go down a long way and States such as North Dakota and Texas to become really desperate. They have the political clout to keep at bay demands by politicians to “buy now” to save their districts from financial ruins. Most of all, they are financially solid enough to not only weather, but profit (though not at present levels) from reasonably priced oil.
In a way, this could end up a bit like the Zaitech Burst in Japan. The three largest and most solid keiretsu (Mitsui, Sumitomo, and Mitsubishi) ended up being strengthened by being able to scoop up assets from the other Big Three and the plethora of smaller conglomerates at rock bottom prices. By “MC” in response to This Is Just the Beginning of the Great American Oil Bust
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I’ve started alerting my fellow Texans of the coming economic crash in Texas. None of them have heard of it. Responses I get are ‘high-end real estate will be fine’, ‘it’s just Dallas and Houston’, and ‘it’s a diverse economy now’. Personally, I don’t mind a little steam let out of the overheated real estate market because, presently, properties don’t stay listed long enough for me to snap them up.
The fracking and shale model is, technically speaking, financially sustainable only in exceptional conditions like we had in the past five years or so. If those conditions were here to stay long term, the boom could go on for a pretty long time.
But… when the new normal is for companies to outspend their cash flows by 110-120% with oil at $80-90/barrel, it cannot last forever. Interest rates cannot go lower than this. Debt burden can only go up (not just to put up new rigs but to pay for dividends and service older debt as well), while oil… behaves very much like any other commodity, going up and down, soaring and falling.
Something will have to give here. If we could see clearly in future, we would know how it will go down and make a lot money out of it. But we cannot, nobody can: some may be luckier than the rest and get it right, but that’s about it.
In my opinion, most shale and fracking outfits can weather a brief and sharp drop in prices, but they cannot weather oil in the $65-75/barrel ballpark mid to long term. It would probably be more companies dropping dead by the roadside one by one than a slaughter. However, should interest rates go up, even in baby steps, the situation could become highly dramatic. Not only debt would become far more expensive to service (given the volume, even 1-2% more could be devastating), but their junk bonds would become far less palatable as more conservative investors would shift in mass to safer assets. Hence higher bond yields should be offered to reflect the higher risk… call it the cascade effect if you will.
Suddenly those two year Ukrainian bonds at 29% look rather tempting…