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Will Central Banks Derail The Shale Boom?

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The U.S. Federal Reserve has already increased interest rates several times, most recently in June, with promises to do much more. Rate hikes pose a problem for the oil industry, which has used debt to underpin a drilling boom across the U.S. shale patch. Higher rates could raise the cost of drilling.

But low oil prices, and few prospects for a strong rebound in the near-term – and possibly even the medium- and long-term – undercut the rationale for higher rates. After all, inflation is soft, and low commodity prices have a lot to do with that.

In fact, the decline of oil prices this year has led to even lower inflation than expected, not just in the U.S., but also in Europe. The Fed has insisted that weak inflation is “transitory,” but more people are starting to wonder if that is true. “There is now a much bigger chance that there will be an important disinflationary impact from lower oil prices,” Thierry Wizman, global interest rates and currencies strategist for Macquarie, told MarketWatch. With oil prices and broader inflation low, why raise rates?

Still, the Fed seems intent on moving forward. And the Bank for International Settlements (BIS), a group of central banks from around the world, urged central banks a few days ago to continue the “great unwinding.” That is, the extraordinary monetary stimulus stemming from the 2008-2009 financial crisis needs to be reined in. Fed chair Janet Yellen has warned about overpriced asset classes, a side effect of loose monetary policy. The hawkish Fed thinks that monetary policy needs to tighten in order to prevent overheating. Related: The Downturn Is Over, But U.S. Oil Companies Face A Huge Problem

They aren’t alone. The European Central Bank (EBC) has hinted that it could cut back on its policy of quantitative easing. “The time is approaching when the [Federal Reserve] will no longer be the only major central bank in tightening mode,” BNP Paribas SA wrote in a note to clients. In fact, the prospects of tighter conditions from the EBC led to a sharp selloff in bonds and strengthening of other currencies against the dollar.

What does this have to do with oil? A tightening of interest rates could pose problems for the shale industry. The shale boom was underwritten by cheap debt – low interest-rates allowed anyone and everyone to drill, with companies rolling over debt each year to keep the drilling frenzy going. According to May 2017 report from Columbia University’s Center on Global Energy Policy, the total debt of 63 shale companies in the U.S. rose fourfold between 2005 and 2015.

That wasn’t a problem when oil prices were high. The crash in oil prices pushed more than 100 companies into bankruptcy, mostly small and less efficient ones.

But even if the urge to raise interest rates from the central bank is controversial, it seems to be almost a foregone conclusion. So, the shale industry will face rising interest rates at a time when oil prices might be stuck wallowing below $50 per barrel.

This is a much more serious problem for smaller companies without the best credit ratings. The oil majors will take the rate hikes in stride, but for smaller drillers, the rate hikes could be a looming threat. Columbia University concludes that a 2 percent increase in the London Interbank Offer Rate (LIBOR) would cause interest expenses for companies with credit ratings between B and CCC- to skyrocket by 30 percent. Part of that has to do with the knock-on increase in credit spreads for these companies. Related: Can ‘Fire Ice’ Replace Shale?

An even grimmer scenario of interest rates rising to 5 percent would ultimately mean that small and medium-sized drillers might only be able to obtain unsecured debt at rates exceeding 10 to 12 percent, Columbia University argues.

The upshot is that higher interest expenses would wipe out much of the gains from cost reductions and efficiencies that these shale drillers achieved over the past three years.

On top of all of this, higher interest rates have a more obvious effect on oil prices. Higher rates will strengthen the dollar, and since oil is priced in dollars, demand will fall as oil becomes costlier. The result will be downward pressure on prices. The flip side of this, of course, is that monetary tightening from other central banks outside of the U.S. tends to have the opposite effect.

In short, the tightening from the Fed poses one more problem for the shale industry at a time when it is fighting hard to stage a rebound.

By Nick Cunningham of Oilprice.com

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