Many think that debt and negative cash flow by U.S. shale companies will crash the global financial system. I believe the opposite is more likely, that a developing financial crisis may crash oil prices and test the survival of shale plays.
In The Next Financial Crisis Lurks Underground, Bethany McLean argues that the U.S. energy boom is on shaky ground because of excessive debt and failure to show profits after a decade of drilling. This thoughtful op-ed raises concerns that many have expressed since the advent of tight oil production.
The problem with her thesis is that debt from the U.S. oil sector is just not big enough to crash the global financial system. Losses and bankruptcies in that sector in 2015-16 were substantial and yet, did not threaten the stability of world financial markets. In the improbable worst case scenario, the U.S. government would step in as it did for the auto industry in 2009.
Higher oil prices are inevitable at some time sooner than later because of under-investment over the last several years of low prices. This is compounded by lack of big discoveries and ever-present geopolitical supply interruptions and outages.
Ms. McClean correctly identifies the link between near-zero interest rates and the rise of tight oil financing. She fails, however, to acknowledge the 2004-2008 plateau of world production at the same time that demand from China greatly increased. This pushed oil prices to more than $100/barrel–the main factor that made tight oil development feasible. Because that price trend continued for 4 years, supply overshoot led to the oil-price collapse of late 2014.
The two price cycles since then are shown in Figure 1 as a cross plot of oil price vs comparative inventory (current oil + product stock levels minus the 5-year average of those stock levels).
(Click to enlarge)
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