Oil, Interest Rates and Debt
At first glance it is hard to see how oil, interest rates and debt are connected. Two of them are human constructs while oil (fossil sunlight), a gift from Mother Nature, took tens of millions of years to process. Oil is an endowment extracted from a confined underground stock and is now the most dense and versatile energy source known to man.Both lines are SIGNALS, and most likely plan their future based on only one of them.
The 10 Year Treasury (or similar) rate is the reference used for amongst other things to set interest rate for mortgages. Most now, aware of it or not, base their future plans on the expectations to developments of the 10 Year Treasury.
What is now playing out in the oil market may be described as below;
Low interest rates [stimulates debt growth] => Pulls demand forward => Oversupply => Deflation
How will the interest rate develop in the future?
This is important as the present huge global debt overhang weighs heavily in the consumers’ balance sheets and their affordability for costlier oil. It is also important for oil companies’ long term planning to bring costlier oil to the market.
A lasting, low rate makes higher debt loads manageable. Interest rates works both sides of the demand/supply equation.
A higher interest rate will have serious implications for highly leveraged consumers and oil companies.
The dynamics may be described as below:
Higher interest rate => lowers demand => downward pressure on price [deflation] => makes it harder for [highly leveraged] consumers/oil companies to service their debt overhang => lowers investments to develop costlier supplies
At some point in time the present oil supply overhang will come to an end. This will become reflected in a higher price.
The timing of these events creates uncertainties and the agile and financial strong oil companies will sweat out a lasting low oil price.
Few are aware of that the costs of accessing our real capital (like oil) that runs our economies are rapidly increasing.
What is different this time is that the oil price may remain lower for longer than the estimated full cycle break even costs for new developments.
The suggested path for costs is believed in the near term to come down as oil service companies have reduced their prices to shoulder the burden from the recent price collapse. Over time, the capacities of the service companies will become aligned with the demand for their services and products. At some point, as the oil price recovers and investments pick up, the market mechanisms will bring the prices from the service companies up as the service companies also need to make a profit to stay in business.
In figures 4 and 5 are shown how the combination of lower interest rates and a lasting, high oil price encouraged the oil companies to rapidly take on more debt to develop costlier oil on the expectations that consumers had remaining ability to take on more debt/credit to pay for this, thus allowing the oil companies to retire their debts.
The oil companies’ behavior in the recent decade is reminiscent of group think. Few expected the oil price to collapse, though the oil industry itself repeatedly point out the cyclical nature of the oil price.
The aggregate of developments (primarily driven by an amazing growth in the extraction of light tight oil [LTO]) gradually resulted in a supply overhang that made the oil price collapse.
The costs of extracting real capital, like oil, has been rapidly increasing, yet we are making decisions for the future as if it were decreasing, based on the price of capital (money). This is a short term phenomenon that will last until supply and demand become balanced.
The present situation with an apparent oil glut and low prices is a temporary false signal.
This may also be the case with the low interest rates.
The near future will reveal how the competition for available funds to service a still growing huge global debt overhang fare towards the need to fund developments of costlier oil.
Can an increasingly leveraged global economy handle both higher oil prices and interest rates and still remain on its growth trajectory?
Some energy basics and food for thought
One of the items in figure 2 is very special, and it is not the rose colored glasses.
One barrel of crude oil (159 liters) contains about 5.7 Giga Joules (GJ) energy or about 1,640 kilowatt hours (kWh) of available energy/work. (Conversions as proposed in the BP Statistical Review for 2016.)
A human doing hard manual labor produces 0.07 – 0.08 kW. For a workday of 8 hours this amounts to about 0.6 kWh.
One barrel of crude oil has the potential to substitute for about 22,000 hours of hard manual labor. Some refer to fossil energy as our fossil energy slaves that are available 24/7 and which never complains, strikes, takes sick leaves, etc. In recent years, these slaves have been asking for wage increases and are destined to continue to do so.
Mother Nature took tens of millions of years to process fossil sunlight into crude oil and we humans gradually figured out ways both how to locate and wrestle it from the deep underground and to use it to improve our living standards.
These fossil energy slaves are endowments from the distant geological past, by many referred to as our real capital.
ENERGY is hard to distinguish from MAGIC, as energy cannot be seen, only the effects of its workings are observable.
Energy should not be confused with technology!
We are conditioned to look upon the monetary/financial system as what runs our world.
Every product and service in our economies require an energy input, which makes energy the real power that runs our complex societies.
- Energy is THE invisible hand of our complex economies.
Money is a claim on energy.
Development in our energy consumption
The Industrial Revolution was in reality a Fossil Fuel revolution which started in the 1800’s as coal increasingly was introduced into the energy mix. This likely reversed the trend of using wood as primary fuel and slowed deforestation. Meaningful growth in the use of oil and natural gas started after World War 2. The chart also illustrates that as new energy sources were introduced in the energy mix some substitution took place, but globally the new sources were added to growth from the existing ones.
As from the 1980’s increasingly more debt was used both to grow energy consumption and for the extraction of fossil fuels and in the recent years, technological improvements allowed to add more repeatable methods for energy harvesting, like solar and wind.
Oil companies’ growth in debtFigure 4 has been lifted from the speech “Credit, commodities and currencies” of February 2016.
Since 2006 the oil companies increasingly turned to external funding by primarily debt as the oil price moved above $60/bo (ref also figure 5) in a bid to grow supplies.Higher oil price allowed to use oil reserves as collateral and allowed to rapidly take on more debt in a bet that oil prices would remain high. Figure 5 illustrates that the oil companies apparently based their future on sustained oil price around $100/bo.
The energy sector in both US and EMEs grew their outstanding bonds by a factor of 5 from early 2006 to early 2015.
That is an average compounded annual growth (CAG) of close to 20%.
Oil companies regularly underlines the cyclical nature of the oil price which begs the question why did they rapidly grow their debt levels on the expectations that an oil price of $100/bo was sustainable which would ensure orderly retirements of their debts?
This happened while total global debt grew strongly.
Debt funded growth works if the financial income grows fast enough.
The collapse of and sustained low oil price has forced many companies into restructuring their balance sheets due to the debt overhang.
As figure 5 illustrates some deleveraging has recently taken place. Most of this deleveraging is now driven by bankruptcies [bankruptcy is one way to deleverage], a process which now has picked up speed as this recent presentation from HaynesBoone illustrates.
Figure 6 illustrates that growth in inorganic CAPital EXpenditures (by growth in debt) has had small effects on production and this during a period where most of the time the oil price was high.
This is worrisome because with a lasting, low oil price (below $60/bo) debt management has now moved to the top of management’s agenda and dictate how future income becomes allocated between new developments, debt services and dividends.
A combination of lasting, low oil price and declining production makes it harder to access more and/or roll over debt.
With a lasting, low oil price the oil companies have become entangled in a CATCH 22 dynamics; More debt is required to grow their production, but as production declines (due to reserves depletion) so does their debt carrying capacities and the resulting deleveraging will reinforce the downward trend in production as CAPEX is cut.
This will challenge the existing business models (based on financial growth with high debt leverage) of the oil companies and may prompt them to reinvent themselves. Proceeds from asset sales used for debt retirement is one way to deleverage as described in this article.During the last year US total petroleum stocks have grown at an annualized average rate of about 0.3 Mb/d. This is one of the fundamental metrics I follow as it gives valuable feedback about the petroleum supply situation and thus one of the fundamentals that affects the oil price.
This article has also been about how the oil companies responded to a higher oil price and how their growth in debt (stimulated by the decline in interest rates) was used to grow CAPEX in a bid to grow supplies of costlier oil for an expected growth in consumption that could sustain a high oil price.
The other side of the equation is the demand (consumption) as lower interest rates also allowed consumers to expand their balance sheets (take on more debt) to afford higher oil prices and grow consumption.
The recent lower oil price predictably stimulates more consumption, but as more consumers will continue to struggle with their balance sheets, they are now more sensitive to considerable increases in the oil price.
This creates for an interesting situation; the price a growing number of consumers find affordable may be lower than what the oil companies need to go after the costlier oil and retire their debts in an orderly way.