Thursday, March 24, 2016

Picking up the pieces from the latest oil bubble - history repeats itself!

Haven't we seen this before,
From 2004 to 2013, annual capital spending by 18 of the world’s largest oil companies almost quadrupled, from $90bn to $356bn, according to Bloomberg data. The assumptions used to justify that borrowing were fuelled by a textbook example of disruptive technological innovation: the advances in hydraulic fracturing and horizontal drilling that made it possible to produce oil and gas from previously unyielding shales. The success of those techniques added more than 4m barrels a day to US crude production between 2010 and 2015, creating a glut in world markets that has sent prices down 65 per cent since the summer of 2014. The expectations of sustained high prices have vanished: crude for 2020 delivery is $52 a barrel. Oil is now back to where it was in 2004, but most of the debt that was taken on in the boom years is still there.
The extraordinary monetary accommodation by central banks pushed investors in search for yields into oil and gas companies. Now, the signatures of the wreck caused by the boom and bust are seen across the market, 
From 2006 to 2014, the global oil and gas industry’s debts almost tripled, from about $1.1tn to $3tn, according to the Bank for International Settlements. The smaller and midsized companies that led the US shale boom and large state-controlled groups in emerging economies were particularly enthusiastic about taking on additional debt... Since the decline in oil prices began in mid-2014, activity in the Eagle Ford, one of the heartlands of the shale revolution, has slowed sharply. The number of rigs drilling for oil has dropped from a peak of 214 to 37... Since crude prices began to fall in the summer of 2014, investors in oil and gas companies have lost more than $150bn in the value of their bonds, and more than $2tn in the value of their equities, according to FT calculations... The decline in the industry’s cash flows has prompted huge cuts in investment, with about $380bn worth of projects delayed or cancelled according to Wood Mackenzie, the consultancy. 
Three observations

1. All rapid sectoral growth episodes will, more likely than not, end up in tears. Industry analysts, especially the cheerleaders of US shale boom, who gloated over the spectacular technological breakthroughs generally suffer from cognitive biases which nudged them into overlooking historical evidence and flashing warning signals. Who will hold up the mirror to infuse a dose of realism among all stakeholders during such booms?

2. No matter how rigorous regulatory restrictions are, euphoric times will always be accompanied by over-optimistic investments and reckless lending, and are almost always backed by governments. Financial markets simply lose their disciplining powers as the "irrational exuberance" takes hold. Someone has to "take away the punchbowl when the party gets going".

3. Commodity exploration lenders should eschew mark-to-market valuation of the borrowers commodity reserves, and resultant borrowing limits. In good times, when prices balloon, it encourages excessive lending, whereas during troughs, it engenders liquidity squeezes and insolvencies. A more prudent strategy may be to value them at a ten-year rolling average or a long-term trend price.  

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