The Oil Shale Revolution Is A Double-Edged Sword

Back in the old days falling energy prices were a clear incremental tailwind for the U.S. economy. Some economists even went as far as to argue that low gasoline prices were the equivalent of a tax cut for consumers, but that line of thinking never made sense to me. After all, a tax cut implies that you have more money in your pocket, but when gas prices go down you have the same amount of money. You are simply able to reallocate some of it away from gas and into other things, as your total spending stayed the same.

Then the shale revolution came to the U.S. and technological advances resulted in states like Colorado, Ohio, Pennsylvania, and North Dakota having large slices of their regional economies linked to oil production. The tide shifted and the U.S. economy now was tied to oil production as opposed to simply consuming oil imports from Canada and the Mideast. When oil prices were high that was a good thing, but now that oil has cratered from $100 per barrel to below $30 we can clearly see the other side of the double-edged sword.

To understand why the stock market is reacting so much lately to falling oil prices, we simply have to think about the ripple effects now that we have so many more domestic oil producers. Most of these shale firms are relatively new companies that borrowed billions of dollars to acquire land and start drilling. Their business models were predicated, in most cases, on oil prices of $75-$100 per barrel. Once prices dropped below $50 certain companies no longer could produce oil profitably. As prices have continued to fall, more and more companies fall into that category. Very, very few can make money sub-$30 per barrel.

So what happens in this scenario? Frankly, many smaller oil companies will not survive. Without profits they will not be able to pay the interest on their debt (let alone the principal), which causes multiple problems. Most importantly for investors and financial markets, as debts go unpaid lenders will lose a lot of money. The energy sector owes tens of billions to banks and investors who hold their corporate bonds. Much of that debt is held in mutual and exchange traded funds, so the losses will accrue from the biggest banks all the way down to small investors. And without knowing how low oil prices will fall, and for how long it will stay there, there is no way to know exactly how many companies will survive and how much debt will go into default. That uncertainty is impacting financial markets today, this month especially.

The other issue worth mentioning is why exactly oil prices have not been able to stabilize after so many months of decline. The problem of excess supply is not self-correcting as quickly as many might have thought (the cycle looks like this: high prices result in too much drilling, prices fall due to oversupply, production is curtailed due to unprofitable prices, supply comes down to balance the market, low prices spur demand, prices stabilize and rebound).

For these shale companies want to hang on as long as they can, they simply need to keep paying the interest on their debt. If their debt does not come due for another 2-3 years, the companies can continue to sell oil at prices above their cost, so long as they have a little runway left on their bank credit lines and they can generate enough cash to cover interest payments. The reason we have not seen many oil-related bankruptcies yet is simply because very little of the debt has come due. But that time will come, and as long as oil prices remain low the banks and other lenders will not shell out any more money. Only then will companies stop producing, which will start to bring the supply/demand picture back into balance.

Coming back the stock market specifically, it is important to note that the non-energy sector is doing just fine (S&P 500 companies actually grew earnings in 2015 if you exclude the energy sector). Lenders will take some losses on their energy loans, but the size of that market is small relative to the rest of the economy. For that reason, it is fair to say that the current stock market correction is sector-specific and not indicative of a widespread, systemic problem (unlike in 2008 when banks were in danger of closing, this time they will simply take losses on a part of their loan book).

For comparison purposes, today’s situation reminds me very much of the dot-com bubble that peaked in early 2000. As was the case with oil in recent years, back then there was a bubble in one sector of the domestic economy (tech and telecommunications). While it caused a recession in the U.S. the problem was contained to that one area, which allowed for a relatively swift recovery. In fact, S&P 500 corporate profits peaked in 2000 at $56 before falling by 30% to $39 in 2001. Earnings began to rebound in 2002, got back to even in 2003, and hit a new all-time record of $67 in 2004.

The goods news is that this time around things should turn out considerably better because the energy sector peaked at 15% of the S&P 500 index in 2014, whereas the tech and telecom sectors comprised 30% of the S&P 500 in 1999. Therefore, energy should have only about half of the impact compared with the technology sector 15 years ago. Even as oil prices collapsed in 2015, S&P 500 profits only fell by 6% from their peak. While that number could certainly get a bit worse if oil stays at current prices for the duration of 2016, there is a floor in sight; in terms of market value the energy sector today only represents 6% of the S&P 500.