What Will Cause the Next Big Market Drop?
Quick – what was the second-worst U.S. stock market drop since the 1930s? What caused it? It wasn’t the pricking of the tech bubble in the early 2000s. It was the bursting of the oil bubble in 1973. Fossil fuels have been the life blood of economic growth for the entire time that economies have been growing – almost 200 years – and they have been responsible for many of their ups and downs.
Could the bursting of an oil bubble devastate the economy again?
After the Organization of Arab Petroleum Exporting Countries (OPEC) imposed an embargo on the export of oil to countries that supported Israel during the Yom Kippur War in 1973, oil prices shot up by a factor of four. This caused the U.S. stock market to decline more than 45% over the 21 months from January 1973 to September 1974.
Before the oil bubble burst in 1973, the U.S. had become used to cheap oil. Sales of automobiles were booming. Cars used gasoline extremely inefficiently, as if oil were as cheap as water. The fourfold increase in the price of oil, followed by another threefold increase in 1979-80, wreaked enduring havoc on the U.S. economy – particularly its automobile manufacturing and related sectors – initiating the rust-belt phenomenon that has continued to eat away at the U.S. economy and psyche to the present day.
U.S. automobile manufacturing failed to respond in an agile manner to the increase in oil prices. It assumed – as an expensive marketing study performed for General Motors concluded at the time – that “the American male will never give up his big car.” As a result, more fuel-efficient – and more reliable – small Japanese cars made inroads into the U.S. market and now dominate it. Meanwhile, GM and Chrysler received a bailout, approved by President Bush in 2008, that – according to Time magazine – cost U.S. taxpayers $11.2 billion.
The 1970s oil bust had, arguably, even more far-reaching negative economic consequences in the U.S. than the Global Financial Crisis of 2007-2009, and certainly more than the consequences of the tech bubble and bust of the late 1990s and early 2000s, which may even have been positive. It drove a decade of high inflation, ending with interest rates nearing 20%. It prompted President Carter to deliver a pessimistic speech in July, 1979, often referred to as the “malaise” speech. Carter’s pessimism gave way to the election of an optimistic President Reagan, who promised an exhausted electorate “It’s morning in America!”
But the long-lasting effects had not ended – far from it.
Bethany McLean’s warning
Bethany McLean has a good record of analysis of financial problems. She was one of the first to point to Enron’s shaky financial situation in a 2001 article in Fortune magazine. She later co-authored with Peter Elkind The Smartest Guys in the Room, a book about the Enron debacle that was made into a popular movie of the same name. One of the best books about the financial crisis, All the Devils Are Here, published in 2010, was co-authored by McLean and Joe Nocera, at the time a New York Times columnist.
Last month, on September 1, Bethany McLean published an opinion piece in The New York Times titled “The Next Financial Crisis Lurks Underground.” In that article, McLean argued that the oil and gas fracking boom that has produced such huge quantities of those fuels in the U.S. in the last few years is on shaky financial ground.
McLean’s article was so startling that I read not only her new book, Saudi America: The Truth About Fracking and How It’s Changing the World, but also another, more in-depth history of the fracking industry by Gregory Zuckerman, The Frackers: The Outrageous Inside Story of the New Billionaire Wildcatters. (Unfortunately, the latter book’s account ends in 2014.)
The fracking industry, McLean argues, uses Enron-like financial shenanigans to produce the appearance of profits. “The attitude is invest-and-flip,” she says, “not buy-and-hold.”
“I view it as a greater fool business model,” one private equity executive told McLean, “But it’s one that has worked for a long time.”
A capital-intensive industry with highly volatile and uncertain returns on capital
The problem is that fracking is extremely capital-intensive, requiring massive amounts of capital before any oil or gas can begin to flow. The payback on that capital is highly speculative and variable.
Fracking would never have come into being at all, were it not for government-funding of its development, and a low interest rate environment that enabled borrowing to fund it.
The first thing that a fracking company needs to do when it suspects that a geographic region will produce substantial oil or gas is to quietly amass as many leases to oil and gas rights in the region as possible.
At one point, in 2008, the fracking company Chesapeake Energy deployed over four thousand “landmen” in the field every day buying new leases, often from family farmers and other small landholders. They had to be circumspect about what they were doing lest other oil and gas companies notice and begin to compete for leases, driving the price up and reducing the amount of leases that one company could purchase.
Once land rights are purchased, the land has to be drilled and the rock beneath it fracked. The keys to the success of the new technologies in producing oil and gas are horizontal drilling, fracking and the successive sealing off of zones of a wellbore so that fracking can be concentrated successively in different zones. (Fracking is the process of injecting, at high pressure, massive quantities of water laced with specialized sands and chemicals that crack open the rock and let the oil or gas flow out.)
Horizontal drilling involves drilling a well as much as one or two miles under the surface of the earth, then turning the drill so that it drills horizontally as much as two miles or more in a plane parallel to the surface.
These are obviously highly capital-intensive processes, and they are not at all certain to work. Furthermore, once they start to produce oil, it is uncertain how long they can produce. One of the most productive shale oil fields is the Bakken field, centered in South Dakota. McLean reports that, “According to an analysis by the Kansas City Federal Reserve, the average well in the Bakken declines 69% in its first year and more than 85% in its first three years, while a conventional well might decline by 10% a year.”
This decline means that in order to keep oil and revenue flowing to pay returns on the capital invested to fund their activities, fracking companies need to keep expanding beyond their producing wells – sending more and more landmen out to acquire leases, drilling more and more expensive wells, and raising ever more money to fund these activities.
The financial returns on these wells, in the meantime, is subject to very high levels of volatility. Global prices of oil fluctuate wildly, frequently dipping below levels that enable fracked oil to be profitable. The prices are strongly affected by the success of the fracking industry itself, dipping and even diving when fracking has been particularly successful, thus causing an oversupply, or when the economy suffers a downturn.
Because of the successes of fracking-related technologies and the hype surrounding it, and because of historically low interest rates and Wall Street’s zeal for the enormous fees it earns by raising and moving capital, raising money for the fracking industry has been very easy. It has even been easy to profit by selling fracking concerns to other energy companies or to private equity funds, which themselves find it easy to sell their investments to pension funds that engage in wishful thinking about future returns in order to justify their unrealistically low unfunded liability estimates.
McLean and other commentators, such as the short-seller Jim Chanos, think this is an unstable edifice that could collapse given the wrong stimulus. McLean uncovered evidence that shale-drillers exaggerate the quantities of oil in the fields to which they have drilling rights, often reporting much lower amounts to the SEC than to investors.
The legendary Aubrey McClendon, a flamboyant kingpin of the fracking industry and the co-founder and former CEO of Chesapeake Energy, was worth several billion dollars at one point. But after he was killed in a mysterious accident in March, 2016, he and Chesapeake had so much debt it was not even clear if his, or Chesapeake’s, net worth was positive.
Like in real estate – which the fracking industry resembles in financial terms – valuations depend on rough estimates of future profit potential, the price at which the property can be flipped, and the level of belief in the marketplace in those two estimates. Liabilities are typically of the same order of magnitude as assets, or closer, so that fluctuations in asset values can quickly flip net value from positive to negative and back.
Valuations in the fracking industry have been high, because flows of gas and oil have been much better than expected only a few years ago, because costs have come down, and because expectations for future production are high.
But what if something happens to prove those expectations wrong? There is no way to be certain how much oil and gas is recoverable with known technology.
A reading of Zuckerman’s book shows how much the experience and expectations of fracking returns have fluctuated. Saudi Arabia almost killed the fracking boom in late 2014 when it refused to lower production to keep oil prices high – prices plunged low enough that fracked oil couldn’t profitably be produced.
Is it possible that an energy shock could cause a financial crisis? That is what McLean is suggesting. Nobody thought that the default of subprime mortgages could produce the crisis that it did. This cause is at least as likely as that one.
Oil and gas
That said, the danger lies more in fracked oil than in fracked gas. Fracked gas flows more easily from its hiding places when the rock is fracked. Production from fracked gas wells falls off much less steeply over time than production from fracked oil.
Fracked gas in the United States has gotten so cheap that it has effectively killed off the U.S. coal industry because it is now cheaper to burn in electric power plants than coal. It is even cheaper than continuing to operate some nuclear power plants, which has caused nuclear plant shutdowns. And in February 2016, the U.S. started to export fracked gas in the form of LNG (liquefied natural gas) to other countries, where gas prices are much higher.
Still, we don’t know how long the shale gas boom can last, and as yet, gas is not substituting appreciably for oil in one of the U.S.’s main uses of energy, transportation. The current administration is trying to encourage more profligate use of oil by loosening the requirements for energy efficiency in automobiles, among other measures.
How soon we forget. If you think the energy-efficient cars from Japan were attractive in the 1970s, wait until you see the ones that China and India will send us. As it has in the past, our lust for oil could do us in again.
Economist and mathematician Michael Edesess is adjunct associate professor and visiting faculty at the Hong Kong University of Science and Technology, chief investment strategist of Compendium Finance, adviser to mobile financial planning software company Plynty, and a research associate of the Edhec-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, was published by Berrett-Koehler in June 2014.