Why higher rates could raise oil prices
The shale revolution has been built on cheap credit. So what happens when rates rise?
Just as enthusiasm for oil prices was taking off, they have crashed, falling from over US$80 a barrel about two months ago to well under US$60 today.
A large part of the fall can be explained by the tremendous success of shale producers in the US who have responded to higher prices by lifting production.
Onshore shale output is now almost 8 million barrels of oil per day (mmbpd) and total US production has rocketed to over 11mmbpd.
These are staggering numbers. America - once slavishly reliant on imported oil with production having peaked in the 1970s - is now the world's top producer.
All of that growth has come from shale. The shale revolution has been well documented, and the sources of growth are well understood: a large onshore infrastructure base, supportive regulation and the availability of support services have all played a part in the shale boom.
Yet there is one important factor in driving the shale boom that doesn't get so much credit (if you'll excuse the pun): sustained low interest rates.
Thanks the Fed
Frackers have been known to thank God for their endowment of oil; they ought to thank the Fed in equal measure.
Shale production is characterised by high initial flow rates followed by sharp declines which means that companies need to keep drilling to maintain output. This is different from conventional oil projects which demand high upfront capital expenditure but then enjoy decades of high margin cash flow.
Unlike conventional oil, shale production demands constant capital, which has been supplied enthusiastically by swooning debt and equity markets. It is no coincidence that the shale boom coincided with record low interest rates. One has followed the other.
Shale producers have done well to lower production costs but, even so, operating cash flows don't come close to covering the costs of sustaining production. The enormous production growth has been financed by external capital and asset sales.
Providers of external capital have stumped up cash for an enticing narrative. Shale is often portrayed as a disruptive force, crowding out expensive lumbering conventional projects. To an extent, this is true.
Show me the free cash flow
Yet few - if any - shale producers have ever generated free cash flows. Every dollar that is extracted from shale production is needed to sustain that output and more cash is needed to grow it. That is true regardless of quality.
Even BHP, which owned some of the best quality Permian acres, had to subsidise its shale production to the tune of about US$2bn a year. Indeed, that was a big reason BHP got out of the shale business. It was, in effect, being subsidised by its other operations. This is in marked contrast to conventional oil projects which generate big free cash flows and support generous dividends.
As shale production enjoys another boost, it's worth asking: if shale production is reliant on external capital, what happens to production as interest rates rise and liquidity dries up?
Will shale attract the capital needed to keep current production rates humming?
In the midst of the exuberance, these questions aren't being asked. My guess is that higher interest rates will make it harder for shale producers to sustain the enormous production base built up over a period of cheap, easy credit. Oil prices may well follow interest rates higher.
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