How monetary policy and commodity markets collide

Its been widely acclaimed as being a product of the unique combination of geological, technological and commercial factors that are present in the US. One that has evolved into making US shale producers the short-cycle supplier of the energy market.

What is rarely mentioned in relation to the apparent success of shale is the extent to which it is a product of monetary policy. The U.S. shale oil and gas industry uses expensive drilling methods to extract oil and gas from rock formations. Frackers typically rely much more on debt than big, integrated oil companies. It can be argued that US shale economics are just not viable without a monetary policy regime that created a chase for yield environment. Is it any coincidence that the ‘shale’ revolution coincided with monetary madness of QE followed by more and more QE? Monetary policy created an environment of massive misallocation of capital which funds uneconomical shale producers in the US.

The risk to investors is now being highlighted by investor Jim Chanos. He looked at about three dozen drillers and found that their capital spending would eat up almost all of their earnings, minus certain expenses, this year. That leaves them with little cash to service their debt. Drillers have reduced the amount of capital they need to produce the same amount of oil, but not enough to make many of them profitable.

Capital spending creates a vicious cycle. As drilling activity picks up, so do service costs. Those expenses get capitalized, or spread out over the life of the asset. According to Chanos, capitalising expenses in other businesses can be acceptable, but it is a problem in the oil and gas industry because frackers have to constantly reinvest in new wells to replace cash flow from depleted wells.

“The way to think about it is that unlike other businesses, your assets literally get burned up,”

So whats the end game for shale producers? Well, as US monetary policy starts to normalise the cost of capital for US shale producers should start to become more expensive, making it more difficult for drillers to service their debts. While this could provoke another round of cost cutting and asset burn to fund the additional debt costs, there is no way that this can go on indefinitely.

The shale oil industry and the price of oil as well as other commodity markets are built on narratives. Cuts to Chinese capacity, reflation, etc, etc. But the real narrative is monetary policy and at the moment investors in financial as well as physical markets are undervaluing the risk of that narrative changing.

This shouldn’t just be a worry for financial markets. Expectations of relatively low and stable energy prices continuing long into the future has encouraged massive amounts of investment into petrochemical and other manufacturing and industrial capacity, built on the premise that ‘new economy’ commodity markets will continue.

Related article: Narrative economics

My new book Crude Forecasts: Predictions, Pundits and Profits in the Commodity Casino is now available to pre-order as an e-book on Amazon, Kobo, Apple and Google Play. The book will be launched and available to download on Monday 25th September. The paperback version should be available on or about the same day while the audio version should be coming later in the autumn.

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