Oil Price Drop Root Cause Analysis
The crash in oil prices over the past year is yet another clear-cut example of misallocation of resources caused by low-interest rates imposed by central banks, but to determine the solution to these misallocations we must determine, not just the cause, but the root cause.
As with tech companies in the ‘90’s, and housing in the 2000’s, oil exploration and production deserves investment. It is the markets job to take in all available information and signals to determine the level of that investment. When rates are artificially held too low these signals are distorted and the market cannot properly allocate capital. Investors who might normally invest in a safer asset with a reasonable rate of return are forced to look to alternatives when the Federal Reserve holds rates down with ZIRP and or QE. Those alternative investments may be a questionable tech company, condo’s in Las Vegas, or bonds in a fly by night shale drilling company.
No matter what the condition of the underlying asset, when the money starts to flow toward a certain class of investment the price will rise. This rise in prices feeds on people’s greed and the cards are set for a speculative bubble. As in the late 90’s when tech companies and dot.com’s were popping up by the hundred, or the obvious over building of housing in the early to mid-2000’s, the capital inflow to the oilfield caused real product to come to market. This over supply resulted in, surprise surprise, a drop in the price of the underlying asset, oil. The drop in price results in what is becoming the all too familiar bust, not just for the main industry but for all of the supporting industries that sprung up around it. In the housing bubble those were realtors, drywall and lumber companies, and for the oil bust those are oil service companies like Schlumberger, and Halliburton, as well as restaurants, shops, and lodging in oil field boom towns.
This story has played out over and over and I’m sure I am not telling my readers anything they don’t already know. That said the cause of these booms and busts is often attributed to the Federal Reserve holding rates too low for too long, and while this is true it is not the root cause.
I actually work in the oil field and when something goes wrong including equipment breakdowns, injuries or spills, we do something called a root cause analysis. Finding the root cause is the only real way to find a solution to prevent it from happening again. I would like to apply this analysis technique to the boom and bust cycle and it involves a lot of the question Why?
Result: Oil Price dropped by more than 50%
There was an oversupply of oil.
There were more wells flowing more oil?
There was an over-investment in the oil sector?
Yield starved investors were reacting to generally lower interest rates and were compensating by investing in riskier assets including shale and other oil plays.
The Federal Reserve had lowered their overnight rates to zero lowering the short end of the yield curve, and various quantitative easing programs lowering the long end of the curve.
This is where many of the alternative economic commentators stop and thus find a root cause of the boom and bust to be central banks lowering interest rates and quantitative easing programs. But this should not be the end of the root cause analysis. You must ask the next question. Why did the central banks lower short-term rates to near or below zero and facilitate the numerous QE programs? And so the chain continues.
They lowered the rates because they feared not doing so would result in a total and catastrophic failure in the financial system.
Because if the central bank did not lower interest rates and provide liquidity through QE, borrowers would not be able to service the debt they had taken on resulting in an uncontrolled chain of defaults which would likely destroy the financial system as we know it.
Because total credit market debt had risen to a point where it was no longer serviceable under the original terms. Market participants, considering the loss of equity in the underlying assets, and the general income levels would make the natural decision to default.
It is a feature of a debt based monetary system where both debt and money must grow in a near exponential function, but with debt growing at a faster rate. The divergence between the amount of debt and money in the economy eventually causes the debts to become unserviceable without lower rates, large-scale defaults/debt jubilee, or massive debt monetization.
So now we have reached the real root cause of the bust in not only oil, but in housing and the technology sector before that. All of these deserved investment, but it was simply a feature of our flawed monetary system that caused over-investment and the destructive busts. The solution resides in correcting the monetary system not changing the Federal Reserve’s reaction to its natural tendency.
There is also no doubt that this additional oil production spurred on by malinvestment outlined above has met with retaliation from OPEC to preserve market share, but again this is a reaction to the above chain, not the root cause.
As far as the oil market goes, I don’t see it being permanently hindered like the housing market. The housing market is still on fed life support. One of the main reasons for this is most of the over production in housing is still standing and usable. The over production in oil on the other hand will eventually be consumed spurred on by lower prices, notwithstanding an economic break affecting demand of course. The fact that the currently producing wells, particularly shale wells, will continue to pump as fast as possible is true. That said shale wells deplete very quickly and there will be a quick drop in this production at the margin supporting prices in the 18 to 36 month time frame.
Unfortunately for those betting on low oil price from here on out, investment that will supply future production not only in the shale plays, but in deep-water, and conventional plays, has all but dried up. This severe cut back in investment in the future could cause an upward price shock few are prepared for. As I type they are literally scrapping drilling rigs, on shore and off, that haven’t reached half their designed lifespan.
Companies in the oil sector have truly been spooked by this sudden drop in oil price and will not jump back in with both feet when the price rises. Investment will be slow and reluctant and future production will suffer.
As mentioned, I may be bias; I work right at the tip of oil industry cap ex. This being the case I am lucky to have a job, but have suffered a 15% pay cut.