North American shale oil and gas companies have proven that they can adapt their business model through the lower crude oil prices cycle. Now, the new challenge for shale producers is how to adjust their financial strategy when the Federal Reserve (Fed) raises interest rates.
Since the 2007 financial crisis, the Fed interest rate has declined from 5 to 1.25 percent, having hit the record low of 0.25 percent in December 2008, just four months after the Lehman Brothers bankruptcy that triggered a domino effect across the financial sector.
The Fed’s actions weren’t enough to stabilize the American economy, but thanks to U.S. Congress approval of the American Recovery and Reinvestment Act of 2009, business activities began to re-emerge due to the nation’s economic stimulus package supported by tax breaks, quantitative easing (QE), and government spending.
At last, those recovery measures and the Fed’s rate cut helped stabilize the financial markets following the financial crisis. But most important for the Fed, it led to lower unemployment rates, which dropped 4.4 percent lower in August 2017.
For these reasons, the Fed has struggled with ‘rate normalization’ (returning rates to pre-crisis levels), having seen market participants become highly reliant on its record-low interest rates and improved access to finances with QE.
QE has also played a key role in capital allocation decisions by forcing investors out of the bond markets and into the riskier stocks/equities markets by suppressing bond yields with the purchase of billions in government debt since late 2008.
The Fed has watched crude oil price closely since the crisis, because when oil prices fall they tend to pull down inflation with them. However, once they begin to stabilize—at whatever level—their impact on inflation dissipates over time. Since the beginning of 2017, not only have crude oil prices stabilized, but they’ve also increased, but the impact on U.S. inflation remained weak throughout this time. Related: Can Oil Prices Hit $60 In 2018?
In a stabilized economy, a Fed interest rate hike would strengthen the U.S. dollar, making crude oil more expensive due to the commodity’s dollar denomination. Therefore, this would reduce demand for the black gold, although this effect takes time. Oil prices are at such an affordable level that demand, from this point of view, won’t be significantly impacted.
U.S. shale oil production has increased from an average of 600 thousand barrels per day (bpd) in 2009 to 4.54 million bpd in 2017. The rapid growth in nonconventional production methods (fracking) bloated soon after U.S. interest rates tumbled to record lows—making money very cheap and readily available to be pumped into any projects returning figures higher than the depressed cost of borrowing, even with oil prices trading below $60 per barrel since July 2015.
Between February 2009 and April 2011, crude oil prices rose from $34.62 to $113.93 per barrel, a move that also coincided with stronger equity markets and a recovering U.S dollar index resulting from the impact of QE. Through this period, high oil prices, coupled with historically low-interest rates, bolstered the growth of U.S. shale oil production at a much faster rate than observed in the conventional/traditional oil production sector.
U.S Exploration and Production companies (E&Ps) had easy access to low-cost funding that helped finance their negative cash flow amidst the low revenues generated from sales. In 2005 the cumulated U.S. E&Ps debt was around $50 billion, and by 2011 their financial debts almost tripled to $140 billion thanks to the ‘free money’ era.
Other cash flow indicators used, such as EBITDA, also reflected the growth of easy financing sources, with shale-oil producers increasing their debt from $90 billion to $130 billion between 2005-2011, meaning that while borrowing grew by 280 percent, U.S. E&Ps saw their EBITDA only move higher to 144 percent—allowing room for further debt accumulation in the near future.
From June 2014 to February 2016, crude oil prices dramatically decreased from $106.79 to $29.44 a barrel, reacting to the growth of U.S. shale oil production ignited by low Fed interest rates. Through this period, E&Ps had to adjust their internal cost structure via reduced capital expenditures, and optimize on their operating cost to remain competitive in the new ‘lower-for-longer’ oil environment. However, E&Ps that weren’t able to achieve significant cost reductions, eliminate slack, and become more efficient with their productions went bankrupt, as oil revenues plummeted alongside the price of crude.
Even with interest rates remaining so low since the financial crisis, banks and other financial players have slowly become wary of extending new credit lines to oil producers, pulling out $400 million in positions from 10 big shale oil and gas companies active in the Permian Basin—despite operational costs being reduced by up to 50 percent at some basins because, according to Reuters, “frackers learn by doing”.
While oil sector investment has struggled to recover to pre-crisis levels, money flowing into the more efficient onshore U.S production projects has encouraged targeted funding of “short-cycle” resources (shale oil) over conventional oil projects or “long-cycle” projects, a point highlighted by the Organization of the Petroleum Exporting (OPEC) Secretary General Mohammed Sanusi Barkindo.
Conventional analysis will determine that within OPEC, low production break-even points can be found among many of its member states. Saudi Arabia’s average cost per barrel is around $10, however, when the cost of balancing the Kingdom’s domestic budgets is taken into account, this cost surges almost five-fold to around $98 per barrel, based on Royal Bank of Canada research.
In its desperate attempt to push out the unwelcome U.S shale oil incursion back in 2014, OPEC chose measures aimed at the supply side of the economic equation, allowing crude oil prices to decline by around 80 percent between mid-2014 and early 2016, in order to stave off U.S shale producers by denying healthy profit margins and high revenue levels.
Ironically, OPEC’s approach to reclaiming its lost market share from nonconventional U.S producers (i.e. choking off competitors) was met by robustly resilient shale producers who restructured their finances to accommodate the new lower-for-longer oil price environment.
In fact, actions taken by the world’s oil cartel adversely influenced the required investment for those conventional long-cycle projects—like deepwater fields and Canadian oil sands—in favor of on-shore short-cycle shale projects.
Since commencing its series of rate hikes aimed to bolster confidence around the U.S. economic recovery, the Fed’s interest rate hikes have shifted debt financing across America’s shale oil regions, trimming production levels.
Notably, the cost of crude oil increased to average prices of $47 per barrel in 2017, due to historical OPEC and Non-OPEC agreements made to cut production and stem prices. Alongside the increased Fed interest rates, which had a negative impact on the borrowing cost for the shale region, the rate change influenced two parameters determinant of oil prices: The cost of purchasing crude (dollar strength), and increased scrutiny over investment decisions (risk aversion) into the shale oil sector.
What this all means is the better-graded E&P companies with the lowest risk or cost of production were still able to tap into the debt markets, while others moved toward selling equity in order to help raise the needed finance.
With a move on interest rates alone, the Fed has gradually flushed out the less efficient shale oil players from the market. This is a feat the world’s oil cartel has struggled to sustainably achieve, due to their counterpart’s ability to hastily return to producing once prices ticked high enough to allow profitable hedging of future production.
Since the Fed began its move on interest rates, U.S shale oil players have moved toward equity sales, achieving twice the amount of needed funding in 2016 ($30 billion), compared to the $15 billion via equity sales achieved in 2015.
Going forward, the Fed remains a key player in setting oil prices. Not necessarily by inflating the cost of purchasing through a stronger U.S dollar index, but by reducing the number of shale oil players.
The cost of doing business is poised to rise along with the Fed’s inevitable campaign toward ‘rate normalization’ in the world’s largest economy, as it continues to show signs of growth following its rising inflation figures.
Where the oil cartel failed, the Fed looks set to prosper. The cycle of high and low crude oil prices attracts shale producers to the sector, and then squeezes them out. In spite of this, sustainable interest rates should bring about viable changes to the dynamics of the crude market by starving unconventional producers of the much-needed cash required to resume production through coming periods of higher-trading crude oil markets.
As the Fed continues on its rate increase path, if E&P companies want to survive, they should continue to improve their operating cost and EBITDA, and reduce debt holding.
By Luis Colasante and Serge Mazodila for Oilprice.com
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