Fracking: The Alchemy of Turning High-Yield Bonds into Low-Inflation Growth

  • New discoveries increase the future available supply. If you own oil today, and you expect more fields to be discovered next year, you want to pump immediately.
  • On the other hand, some resource owners have a higher discount rate, so they have an incentive to pump faster. For example, if you’re tenuously in control of an unstable country, you might pump as much oil as possible and keep a gassed-up Cessna on hand at all times to fly you to Switzerland in the event of a coup.
  • And on the other-other hand, if you’re a supplier, you might think that volatility encourages buyers to switch to other resources. If oil is more volatile than coal, a coal power plant with a lower absolute return than an oil-based plant might generate a superior risk-adjusted return. So large suppliers have an incentive to raise and lower production to manipulate prices towards a more stable equilibrium.
  • Rockefeller monopolized refining in the 19th century, and sometimes used above- or below-market crude purchases to control volatility.
  • The “Seven Sisters” had a lock on oil, and agreed to quotas starting in 1928.
  • Texas Railroad Commission (call them OPEC: the Organization of Petroleum Exportin’ Cowboys) suppressed US extraction activity in the 50s and 60s, before finally giving in and allowing unrestricted production in 1972, two years after US production peaked.
  • OPEC generally controlled production thereafter, but by the late 2000s they had little excess capacity.[2]

Fracking: What Kind of Engineering Miracle?

In 1997, the equation for American hydrocarbon production changed when George Mitchell successfully fracked a gas well. The old approach was high-risk exploration, after which a field would have fairly low breakevens for a long, long time. Now, the durations are shorter, and there’s more certainty, at the cost of lower margins. In traditional investing terms, the math switched from venture capital-like returns (power law distribution of results, with a few winners dominating many losers) to private equity-style (more certainty, with lower returns on assets from winners, juiced by higher leverage).

The Microeconomics of Fracking: Supply Elasticity and Credit Spreads

Prices are the point at which supply meets demand. Historically, both supply and demand have been prone to shocks. On the supply side, shocks tend to be immediate: a new field gets discovered, or an existing field gets disrupted for political reasons. On the demand side, shocks are more prospective: the reason prices plummeted in 2015 was that investors have previously extrapolated forward higher rates of developing-world growth. In 2014, markets outside the North America and Europe were 64% of consumption but 106% of the last ten years’ consumption growth, so a lower growth rate compounded over several years produces a meaningfully lower current price.

Oil prices still respond to supply more than supply responds to oil, but the relationship isn’t as perversely negative as it used to be.

The Macroeconomics of Fracking: Monetary Flexibility (Unless You Really Need It)

Oil plays an outsize role in economic policy: it’s consumed everywhere, but not produced everywhere, and the price is volatile, so big swings in oil prices tend to affect currencies and central bank policies. We saw this most vividly in 2008, when the Fed refused to cut rates the day after Lehman failed, on the grounds that high oil prices presaged more general inflation. Traditionally a country is viewed as economically independent if its debts are denominated in its own currency, because it can inflate them away. But an oil-dependent oil importer has a large debt denominated in oil, which is more volatile than any major currency.

  1. Housing prices were highly responsive to incremental capital flowing into mortgages.
  2. Capital from oil exporters flowed into mortgages (and also into other forms of less-than-riskless debt, such as the debt underpinning large leveraged buyouts).
  3. US consumers were, in the aggregate, willing to smooth consumption by monetizing their home equity — the wealth effect from real estate appreciation offset the spending drag from gas prices — so
  4. Higher oil prices didn’t slow consumption — they just lowered credit spreads and thus raised leverage, and the resulting gusher of liquidity actually raised consumption.[3]
  1. Low credit spreads lower the duration of oil investments in the US, increasing the elasticity with respect to price
  2. So higher oil demand quickly matches supply, keeping economic growth stable
  3. Stable economic growth leads to more willingness to take risks, increasing investors’ willingness to buy high-yield debt
  4. The combination of US production offsetting consumption, and higher demand for USD-denominated corporate debt, puts upward pressure on the dollar, giving the Fed more flexibility
  • Current low oil prices could persist, causing more frackers to go out of business
  • Low oil prices could also slow the rate of improvement in fracking ROI, making investors less willing to front frackers the money
  • Inflation ex-energy could lead to higher rates, reducing the relative attractiveness of high-yield debt[4]
  • We could see a faster decline in the performance of fracked wells. An oil services company recently pointed out that the Permian Basin, the main source of fracking supply growth, is seeing declining performance per well:

The Financial Theory of Oil

It doesn’t make sense to talk about oil price without talking about volatility as well. I recommend Crude Volatility for a great historical overview, coupled with some theory.

  • Higher oil prices imply more economic uncertainty, raising their cost of capital.
  • The cost of capital further ratchets up because of the correlation between price and volatility; high oil prices are less stable than low, and lenders care more about downside than upside.
  • Geopolitical uncertainty also raises the cost of capital, albeit less in the US than in other markets. This effect is mixed. If risk-seeking capital is especially averse to the risk of war, then war means that capital flows towards the US. But total investor risk aversion will be higher at a time of conflict. If the impact on overall risk-seeking is greater than the impact within the pool of risk-hungry investors, the net effect is less available capital for risky endeavors.
  • As prices rise, the energy cost component of extraction will be increasingly dominant. The prices for other inputs will rise as well, which hurts lower-margin players the most.
  • A high-price world is also a world where more low-hanging fruit has been picked, raising their risk and their energy cost — so both the operating-cost problem and the financing-cost problem compound.

There is no Status Quo

The two sins in economic analysis are blind faith in extrapolation and blind faith in mean reversion. Either one can work for a while, but reality eventually prevails. Technological progress and natural resource depletion both represent non mean-reverting changes to fundamental drivers behind economic trends.

Further Reading

  • The Boom is a good overview of the industry. Saudi America was kind of disappointing; fairly brief, poorly-edited, not a ton of new information, but it does articulate the financial engineering thesis of fracking.
  • For more on petrodollar recycling and its effects on risk premia, I recommend either a) reading this, b) scrounging up some macro research from the mid-2000s (I’ve come across a couple great long-form pieces on petrodollar flows, but nothing publicly shareable), or c) just looking at this chart:
As long as housing was rising, an increase in oil meant a mortgage subsidy that more than offset the consumption tax.
  • BP produces a nice annual Energy outlook with consumption forecasts by energy type, and also a useful (and much more detailed) Statistical Review of World Energy. Some other organizations do the same.
  • Oil 101 was published just before fracking got big, so reviewers are divided on whether it’s out-of-date or timeless. I found it helpful as a quick primer on the industry.
  • The Prize is a very fun history of the oil industry, full of fascinating stories. If you haven’t read it, you owe it to yourself: you’ll completely rethink the twentieth-century. World War Two, the Cold War, and the first Gulf War only make sense in light of oil. (Blaming Gulf War Two on oil is just fighting the last war, but for not-wanting-to-fight-wars. One way you know it’s wrong: when there’s a war motivated by oil, at least one side wins.)
  • I read Crude Volatility after I wrote most of this, and was delighted to see that the author shares some of my theses. It’s a great look at the oil industry from the perspective of alternating periods of stability and extreme instability: the biggest players tend to band together to reduce price swings, but that gives free riders superior economics. Eventually, the bigger players are producing at capacity and can’t control prices any more, and then there’s a Minksy Moment where the cartel collapses and prices — and their volatility — explode higher.
  • Oil is a bit outside my bailiwick, so if there’s some further reading you’d recommend, or if you’d like to follow up, email me.

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Byrne Hobart

Byrne Hobart

I write about technology (more logos than techne) and economics. Newsletter: https://diff.substack.com/