Shale, Shale and Rage!

The exploitation of oil and shale gas has opened considerable possibilities in regard to the size of the available reserves. This exploitation has allowed the U.S. to attain energy independence, notwithstanding at an enormous cost, which has yet to be evaluated at an ecological level. This aspect was treated on Dec. 30 by the liberalization of U.S. legislation concerning the export of petroleum products. The expansion of shale oil and gas mainly explains — doubtless more than 50 percent — the American growth since 2011 because the exploitation of the reserves gave a considerable kickstart to the industry. Besides, the environmental cost urged a number of states to implement norms that become more constraining every time.*

The exploitation of shale products also had geopolitical consequences. It was often said that shale derivatives could give the U.S. the upper hand against OPEC country members, but also against Russia. This question is of salient importance because it is at the crossing between ecology, economy, finance and geopolitics. The financial dimension of this exploitation is certainly the most ignored. Nevertheless, and in the case of all emerging economies, the industry of shale hydrocarbons was assisted by the financial sector and has generated a considerable speculative “bubble” around it. This situation is the result of the almost nonexistent initial capitalization — a normal situation for an emerging industry — but also the financialization, which governs the U.S. economy today. This “bubble” is therefore the result of a paradigm shift from a “pseudo-validation” of the engaged values to a “pre-validation,” according to the study depicted in Cédric Durand’s book, “Le Capital Fictif.”

The drillings seems to be profitable, for the latter ones, at just above $80 a barrel. The oldest drillings had a lower break-even point — at around $50 to $60 — but the exhaustion of these drilling sites has forced the companies to utilize more expensive techniques. What follows is a thorough examination of the economic logic behind shale oil.

A Sane Base and a Speculative Wayward Trend

The exploitation of shale oil is based on the drilling of wells, first vertically and then horizontally, and the injection of chemical components whose purpose is to crack the bedrock and separate the oil with components low in hydrogen. Moreover, an external heat input is needed.** These components are generally mixed with water, and one of the first problems of this industry was its water consumption and the contamination of neighboring groundwater tables.*** The drilling yield dropped considerably as soon as the first year. It can be assumed that many drilling sites, in view of the operating costs, ceased to be profitable in the fourth year. The break-even point, initially set at around $30 per barrel,**** is currently around $60-$70 per barrel — that is, solely for direct costs.

Nonetheless, the good thing is that initial production is high and investment costs are relatively low. A small company can therefore obtain a franchise — permit of five to 10 years — and start quickly to exploit the dealership. With a high price of oil, the initial yield is important. It allows the owner to either reimburse its starting loans or sell the franchise to another company, which is less experienced than the former. In the case of a significant drop in production in the first year, it is clearly a scam. The first company makes a large profit, and the second must then deal with rapidly plummeting yields. In fact, this situation gives the shale oil industry a Ponzi scheme dimension, a term used in finance to describe financial pyramids where the first comers are remunerated by the following wave of comers. Indeed, the investments are largely based on credits, sometimes to 100 percent of equity assets. It is imperative that the company sell the dealership really quickly if it does not want to be penalized by interest rates. Here rests the importance of producing shale oil in great quantity and quickly, but in detriment of future yields, in order to sell a dealership that seems, from the outside, a very profitable business. This also explains the rapid increase of shale oil volume produce, which contributed to unbalancing the market.

The Financialization of Shale Oil Production

We talked about loans. In reality, it is the entire exploitation cycle that is largely financialized. First, the dealership and the initial equity assets are financed through loans, and the company actually advances very little money. It is easily understandable in view of the initial high risks of this activity. These loans are given by small, local American banks. Nevertheless, the latter quickly securitized these loans, which can all be found in the American banking sector. The interest rates add to the exploitation and drilling costs. It appears, notwithstanding the lack of systematic studies, that the break-even point is beyond $80 — some analysts evaluated that the actual price was around $100 — per barrel.

Companies have also subscribed to insurance — technically called “risk hedging” — in the case of price devaluation. Here again, we do not know to what level. Nonetheless, the duration of these insurance contracts is rarely more than six months to one year. No such contracts seem to have been made since September 2014 because since the brutal drop in oil prices, the price of these contracts has become exorbitant. Most of the companies that are currently covered are therefore only covered until June 2015. These insurance contracts have been securitized following the Credit-Default Swap model that played a major role in the subprime crisis. The securitization of loans and insurance has been a considerable factor in the development of the U.S. financial sector. Nevertheless, this securitization also ended by spreading the risk as soon as the shale oil industry ceased to be profitable, which is the case today.

With a very significant drop in the price of oil, it is clear that the industry is losing money. The same can be said of the corresponding Canadian shale industry — Alberta. As soon as the insurance companies cease to cover the loss — for the covered companies — a great number of foreclosures will be ineluctable. The fall of dealership sales and the rapid drop in production of new exploitation sites is a sure sign that the entire shell industry is already stepping in a crisis. This will create a dual problem that U.S. and Canadian authorities have to address:

– First, an industrial problem: Indeed, a great number of small companies exploiting dealerships will go bankrupt in the ensuing months. It will entail a production stoppage, and the volume of oil produced in the U.S. will plummet spectacularly in the second quarter of 2015. Moreover, the massive employee layoffs will ripple through the services sector. The U.S. will then face “an industrial crisis,” admittedly localized, but of great magnitude as soon as the summer of 2015.

– Second, a financial problem: These bankruptcies will convert a great portion of “securitized” loans in the U.S. banks into “bad debts.”

The Geopolitics of the Crisis of the ‘Nonconventional Oil’ Industry

The consequences will be almost certainly economic — and financial — but also geopolitical. It is clear that the U.S. government counted on the shale industry to lessen its dependence on oil imports. It is clear that at first, the U.S. instrumentalized the drop in oil prices in order to weaken Russia, and also, Venezuela. Nonetheless, if oil prices remain as low through summer 2015, it will face, in turn, a severe double crisis — i.e. industrial and financial. The shell oil “baby,” on whom so much hope was bestowed, will be converted into a big, shitty baby.

It would therefore be logical that prices go back up again starting March 2015. Nevertheless, markets are not driven like fighter jets. If it is clear that prices will go back up by the second quarter this year, nobody can tell whether it will be sufficient to prevent the crisis and at what level. In fact, the best strategy for Russia would be to postpone this rebound. If price fluctuation ends in the establishment of the aforementioned dual crisis, we will have:

– A brutal drop in production, which would entail price increases capping at $90, and why not $100, per barrel — but if they go up as soon as the end of the first quarter, prices would stabilize around $75 per barrel.

– A weakening of the U.S. position, in view of the industrial and financial crisis, that would be visible as soon as fall 2015.

– This aforementioned weakening will appear as a relative drop in the value of the U.S. currency and a corresponding increase in the euro, which, combined with an increase in the price of oil, will jeopardize the limited growth hoped for in Europe — and particularly in France.

Hence, the question is to know whether Russia and the OPEC member states can wait until fall 2015. For Russia, it seems certain. Nonetheless, it seems to be a lot less certain for the OPEC member states. Besides, big U.S. companies could also have an interest in the crisis; the latter would allow them to buy back hundreds of dealerships for a miserable price. The hopes created by shale oil might turn into a nightmare in the next six months, and in particular for U.S. authorities.

References

* “Chapter 4. Effects of Shale Oil Technologies”. Proposed Shale Oil and Tar Sands Resource Management Plan Amendments to Address Land Use Allocations in Colorado, Utah and Wyoming, and Final Programmatic Environmental Impact Statement. http://ostseis.anl.gov/documents/fpeis/vol1/OSTS_FPEIS_Vol1_Ch4.pdf.

Bureau of Land Management. September 2008. Pp. 4-3.

** Burnham, Alan K. and James R. McConaghy (2006-10-16). “Comparison of the acceptability of

various shale oil processes.” https://e-reports-ext.llnl.gov/pdf/341283.pdf. 26th Shale Oil symposium. Lawrence Livermore National Laboratory (Golden, Colorado): 2; 17. UCRL-CONF-226717.

Smith, M.W.; Shadle, L.J.; Hill, D. (2007). “Shale Oil Development from the Perspective of NETL’s Unconventional Oil Resource Repository.” http://www.osti.gov/scitech/biblio/915351. United States Department of Energy. DOE/NETL-IR-2007-022.

*** World Energy Outlook 2010. Paris: OECD. pp. 165–169. Tuvikene, Arvo; Huuskonen, Sirpa; Koponen, Kari; Ritola, Ossi; Mauer, Ülle; Lindström-Seppä, Pirjo (1999). “Oil

Shale Processing as a Source of Aquatic Pollution: Monitoring of the Biologic Effects in Caged and Feral Freshwater Fish.” https://www.ncbi.nlm.nih.gov/pmc/articles/PMC1566439. Environmental Health Perspectives (National Institute of Environmental Health Sciences) 107 (9): 745–752.

**** “Fact Sheet: U.S. Shale Oil Economics.”

http://web.archive.org/web/20120108161835/http://www.evi.ee/lib/Security.pdf. DOE. Office of Petroleum Reserves.