Fracking: Technological Miracle or Cheap Money Malinvestment?

Now that the fracking boom seems to be faltering, it is probably time to start thinking about why the boom happened in the first place and what consequences might flow from it. I suspect, mostly based on the degree of denial that the boom is ending, that oil prices are set to fall further. The Saudis may be aiming for $60 but I think there is a good chance they’ll hit something well south of that. Like say $40 or even less. At that price it is going to be very difficult to justify any investment in wells that require fracking. I don’t know of any shale area that is profitable at a price below $50.

The reason I think we’ll see prices keep falling is pretty simple – the shale companies are not going to stop drilling new wells until they are convinced that prices are going to stay down. Right now, everyone seems to believe that prices can’t fall much further but it is their very optimism, their hope for higher prices, that will drive it lower.

We’ve already got a supply/demand imbalance of anywhere from 500k to 1 million barrels a day depending on who you believe. Unless someone stops drilling and pumping, the price is going lower. Given that many of the OPEC countries have no choice but to keep drilling – they have budgets to meet and if the price drops they will probably just pump more – the only relief valve is the US shale industry.

So what happens if the shale industry shuts down? I think people are underestimating the economic impact of a shale bust. This boom is bigger, at least by geography, than the boom that came out of the 70s oil spike. When oil went bust in the mid 80s it really just hit a few states, most prominently Texas.

This boom, on the other hand, stretches from Pennsylvania to Kansas and North Dakota to Utah. A lot more states will suffer if the shale boom busts. A significant portion of the economic recovery has come from fracking and it isn’t just directly in the oil and gas industry. The housing boom in North Dakota did not happen because people suddenly discovered they liked cold winters.

(editors note:  Since the December 2007 peak, the five big shale states have generated 1.36 million new jobs. The rest of the US lost 426k).

Most importantly, roughly a third of capital spending over the last 5 years has come from the oil and gas industry. If oil and gas capex goes back to its historical norm of 15% of the total – and if prices keep falling it will probably overshoot to the downside –  GDP is going to take a hit. And if that happens, no amount of cutting by OPEC will offset the drop in demand; heck $20 might not be out of the question.

But the supply/demand equation is only part of the story. The bigger one is US dollar and monetary policy which is where the shale boom was born. Oil prices – indeed most commodities – rose in the last decade because a weak dollar and easy monetary policy pushed capital into emerging markets producing a boom from China to Brazil. Part of the rise was due to rising demand from those countries – a result of capital inflows – and part of it was pure money illusion for a commodity priced in dollars. Now with the dollar rising, the emerging markets are no longer booming, capital flows are reversing and the money illusion is being revealed.

The dollar index fell from 120 to 71 from 2002 to 2008 and oil rose from $17 to $145. Recently the dollar index rose from roughly 80 to its current 89, about a 10% rise. If that rise in the dollar was sufficient to push oil down from $110 to $65 what do you think will happen if the dollar index continues to rise to say 100?

The point is that it was monetary policy that created this boom and it is monetary policy that is killing it. Believe what you want but the rise in the dollar is pretty good evidence that merely ending QE is being interpreted as a tightening of US monetary policy, at least relative to the rest of the world. There are many people who believe that it is the technology of fracking that drove the boom but I don’t buy it. They may have improved the technique in recent years but it certainly isn’t new; fracking goes back to the 70s. The main reason we had a boom in oil production is the same reason we had one in the 70s and early 80s – a weak dollar drove up the price of oil sufficiently to incentivize exploration and drilling activity in areas that were previously unprofitable. And after that boom ended, when the dollar index soared on the back of Reagan’s optimism, we discovered that we had merely wasted a bunch of capital drilling holes, literally burying capital in the ground. Most every big bank in Texas that provided that capital to the oil industry went bust. And if the dollar keeps rising it will happen again, this time with wider implications.

I’m no Austrian but the concept of malinvestment would seem to apply to shale oil and gas if it applies to anything. It was produced by money illusion, faulty monetary policy and it will end as all booms do – in bust. The implications of that are greater than most people believe. Just as they thought sub-prime real estate loans would be contained so they believe that the fallout from the shale bust will be confined to the oil industry. I have serious doubts about that and you should too.

     

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