Oil, Gas, Inflation, and Cheap Money

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-Boom_Town_ballyhoo-_-_sponsored_by_the_A&R_Department_-_at_the_Post_Gym_LCCN98513372.tifToday’s Mises Daily article covered the impact of government subsidies and infrastructure on the fracking boom. But there is another big player in the oil and gas boom that is routinely ignored by “energy independence” enthusiasts who claim the sky is the limit for fracking: cheap money from the central bank.

Energy companies are employing massive debt schemes to finance exploration and initiation of extraction plans. According to Bloomberg

Quicksilver acknowledges the company is over-leveraged, said David Erdman, a spokesman for Quicksilver. The company’s interest expense equaled almost 45 percent of revenue in the first quarter. “We have taken concrete measures to reduce debt,” he said.

Drillers are caught in a bind. They must keep borrowing to pay for exploration needed to offset the steep production declines typical of shale wells.

“Interest expenses are rising,” said Virendra Chauhan, an oil analyst with Energy Aspects in London. “The risk for shale producers is that because of the production decline rates, you constantly have elevated capital expenditures.”

Chauhan wrote a report last year titled “The Other Tale of Shale” that showed interest expenses are gobbling up a growing share of revenue at 35 companies he studied. Interest expense for the 61 companies examined by Bloomberg totalled almost $2 billion in the first quarter, 4.1 percent of revenue, up from 2.3 percent four years ago.

Yes, “interest rates are rising,” but they’re still extremely low in the big scheme of things, thanks to the unending new money flowing from central banks. Even with rising rates, however, fracking operations, in order to remain viable, will need to keep borrowing since, as it turns out,  fracking is extremely expensive. Bloomberg explains:

The path toward U.S. energy independence, made possible by a boom in shale oil, will be much harder than it seems.

Just a few of the roadblocks: Independent producers will spend $1.50 drilling this year for every dollar they get back. Shale output drops faster than production from conventional methods. It will take 2,500 new wells a year just to sustain output of 1 million barrels a day in North Dakota’s Bakken shale, according to the Paris-based International Energy Agency. Iraq could do the same with 60.

Consider Sanchez Energy Corp. The Houston-based company plans to spend as much as $600 million this year, almost double its estimated 2013 revenue, on the Eagle Ford shale formation in south Texas, which along with North Dakota is one of the hotbeds of a drilling frenzy that’s pushed U.S. crude output to the highest in almost 26 years. Its Sante North 1H oil well pumped five times more water than crude, Sanchez Energy said in a Feb. 17 regulatory filing.Shares sank 7 percent.

The U.S. oil industry must sprint simply to stay in place. U.S. drillers are expected to spend more than $2.8 trillion by 2035 even though production will peak a decade earlier, the IEA said. The Middle East will spend less than a third of that for three times more crude.

So, if we read through the lines just a tiny bit, we can see that the fracking boom towns, like those that dot Noth Dakota, Wyoming, and Colorado, are resting on a shaky foundation of cheap money. If interest rates move into more normal territory, then the funds for fracking will dry up even before the wells do (which is pretty fast).

You can’t blame the fracking frenzy on just some parochial search for profit, though. Energy policy is always of great interest in DC. On the foreign policy front, of course, “energy independence” is always of importance because it allows the American state a free-er hand to meddle in oil-producing countries without wild fluctuations in domestic oil prices. The fact that it’s largely illegal to export American oil means that more domestic production means more control over domestic supplies without having to worry about OPEC turning off the spigot.

There are more mundane domestic concerns as well. Energy prices, including oil and gas for heating homes, and also gasoline, are a big part of the consumer price index. If domestic energy prices can be kept under control by turning up the volume on fracking operations, then it’s easier to push the idea that inflation is low by pointing to the CPI.

Bloomberg again: 

Energy prices have become disinflationary in the U.S. as America comes closer to attaining energy independence, which has been bolstered by the proliferation of hydraulic fracturing, or fracking, of the nation’s shale deposits.

While a Labor Department report last week showed that fuel helped lift consumer prices 0.3 percent in December, the most in six months, energy expenses for all of 2013 still decreased.

And on top of all of this is the fact that the states, which can collect huge tax revenues from fracking operations, love it, and it can create booms for local economies.

For example, last week’s state-by-state GDP map shows some interesting growth patterns:

gdpmapWe can see that the highest growth is, for the most part, concentrated in the interior West.

Some conservative web sites rather simplistically tried to make the case that this proves the triumph of Red State Republicanism.  While it is likely true that conditions for economic growth are in fact better in places like Texas and Nebraska than they are in New York and Pennsylvania, why are the red states of the east, such as Tennessee and Alabama showing such lackluster growth?

The answer: This map shows that GDP growth is especially strong in oil and gas producing states (Wyoming and Colorado), and in states with close ties to the industry, such as Texas.

Nowhere is this connection to recent economic growth more obvious than in North Dakota which registers a whopping change of 9.7 percent (year over year). The Bakken shale formation up there has created boom conditions for that economy.

Thus, we can see that the politicos will favor cheap and easy fracking as long as possible. If the party needs to kept going by more tax breaks, or subsidies, or more easy money, then the friends of the oil and gas companies in DC will make sure that the favors keep flowing. Of course, when inflation becomes undeniable, and as cheap money becomes not-so-cheap, the party will be over.

11:54 am on June 19, 2014