The winding down of extraordinary measures taken by the U.S. Federal Reserve to ameliorate the effects of the financial crisis could reverberate through energy markets.
The Fed has kept short-term interest rates near zero for several years, a target that the institution hoped would spur lending and kick start the moribund economy in 2009. With job growth anemic for half a decade after the crash, the Fed has maintained its monetary stimulus right up until today.
But with the economy on more solid footing, the Fed is preparing to wind down its stimulus, known as “quantitative easing.” And although details are murky, the Fed will likely decide to raise interest rates sometime in 2015.
So what does this have to do with energy?
The oil and gas industry is extremely capital intensive, with billions of dollars required in some cases to pull hydrocarbons from the ground. That means that companies need to sell a lot of debt to financial markets, and use the cash to bring projects online.
But if interest rates rise, it will significantly raise borrowing costs for oil and gas operators. And the repercussions will amount to a double whammy.
First, increasing interest rates should strengthen the U.S. dollar relative to other currencies. Higher interest rates makes holding dollars more attractive, which increases demand for the currency. Why does that matter? Oil is priced in dollars, so a stronger dollar pushes down oil prices, along with other commodities priced in dollars. Lower oil prices mean lower revenues for oil companies.
Second, higher interest rates will make debt more expensive. Yields on corporate debt will rise as the Fed targets higher interest rates, making it more expensive to take out a loan to drill an oil well.
The effects act in concert. And the higher interest rates rise, the worse the scenario becomes for the U.S. oil and gas industry. “This might work out for a single producer in the Eagle Ford or the Bakken, but for an industry as a whole, this is not very sustainable,” Vivendra Chauhan, an analyst with Energy Aspects, told The Houston Chronicle in June. “This becomes a 2015, 2016 story about what happens when interest rates do rise. If they stop lending, you'll get a pullback in production growth.”
Moreover, the problem becomes worse still because so much of the oil growth in recent years has come from shale, which has rapid decline rates after initial production. Companies have to keep borrowing to drill new wells, but will run into trouble if the cost of debt rises too fast.
In short, tighter money will have a chilling effect on oil production.
To be sure, no one truly knows what the Fed is specifically going to do – it is a notoriously cryptic institution. However, it has provided some clues. On Sept. 17, the Fed revised upwards its estimate for the federal funds rate – the rate at which it lends to the most creditworthy institutions, and the benchmark that affects all other interest rates. By the end of next year, the rate could reach 1.375 percent, higher than the 1.125 percent that the Fed predicted three months earlier. When it announced the revision, the dollar rose and oil prices dropped.
Fed Chair Janet Yellen has not rushed to raise interest rates, and has expressed concern about the pace of job growth. In the Sept. 17 announcement, the Fed said that interest rates would remain low for a “considerable time.” Nevertheless, she has tried to warn the markets that rates could rise quicker than expected if the economy continues to improve. So far, the markets don’t seem to be listening.
At some point in 2015, the era of easy money will begin to end. That will raise costs on oil and gas companies, and the pain will be felt most acutely by companies that have high levels of spending.
Oil prices could rise, making up for higher borrowing costs with higher revenue. But if they don’t, many players in the industry will need to pare back production. In other words, over the next year or so, the Fed could begin to choke off America’s oil and gas boom.
By Nick Cunningham of Oilprice.com
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