Thoughts on the economic effects of the reduction in capex from the energy sector
The rout in the energy sector is complete now. Cuts in capital expenditure are everywhere you look, not just in shale oil. With oil stocks at a record high level, it is unlikely that a rebound in prices will happen in the near term. And that means continued capital expenditure cuts and downward estimates to GDP growth rates in North America. Some thoughts on economic effects follow below.
First, a lot of the data we are seeing today talks about whether oil companies can manage oil prices at $50 or $60 a barrel, under the assumption that prices can rise to those levels at some point in the next year. It bears noting, however, that those price levels are significantly below levels that were seen as having dire consequences just a few months ago. For example, in October, I quoted an $80-90 level as a threshold below which the IRR for many shale investments turned negative. In November, I mentioned an ITG Investment research study that said the average breakeven in the Anadarko formation in Texas and Oklahoma was $79, whereas it was $63-65 in Bakken and Permian basins, according to ITG. And we also know that wellhead prices in Bakken are well below WTI prices. In short, the prevailing price levels are absolutely catastrophic for the oil industry, particularly expensive oil in shale, deepwater and oil sands.
The question is what the economic effects will be. I want to look at three areas: capital expenditure in the energy sector, oil investment financing, and the general economy.
As I wrote in November, when prices were higher than they are today, “if we get well into 2015 with oil at these levels, there will be a slowing in production and well counts. That is a definite. The big unknown is how investors will react or overreact if oil prices stay depressed for longer. The potential for investors to stop funding new investment is clear.” Let’s focus first on capex.
Rig count is a good proxy for the present state of capital expenditure and the drop in rig count has been especially precipitous of late. Last week, US drillers pulled 94 rigs out of service, the largest drop ever in a single week. This brings US rig count down to a three-year low of 1223 according to Baker Hughes, a large oil services company. Just last month, the rig count was higher on a year-over-year basis. So, we are seeing a massive reduction in capital expenditure here. And the capex reduction is not just for shale, where in North Dakota rig counts were already at 4-year lows in January. It is everywhere in the energy space. For example, just today the Guardian said BP will announce massive capital expenditure and job cuts to match the ones recently announced by Shell. This follows ConocPhillips, Chevron, Total and a host of other major oil firms.
In North America, the reduction in oil capital expenditure will have a major impact on GDP growth going forward. Canada is more leveraged to natural resources than the United States and so the impact will be greater. Hence the recent cut in interest rates by the Bank of Canada. Mike Shedlock has noted that the Canadian yield curve has inverted, suggesting that more rate cuts are coming in the future due to persistent weakness in the Canadian economy. Combined with the decline in the Canadian dollar, this is a clear sign that markets anticipate very bad things for Canada over the medium-term. Yield curve inversion could also mean recession, according to Shedlock.
In the US, the reduction in capital expenditure will have a meaningful impact on GDP growth as well. I believe the 2.6% number for Q4 2014 was in large part due to a reduction in capex, much of it coming from oil. The drop in oil prices helped consumers to a 4.1% annualized gain in spending, but business spending was down an annualized 1.9%. I believe these GDP figures will be revised lower as the effects of capex reductions filter through into the numbers. I thought we would have risen to a 3%ish growth rate last quarter before revisions brought it back in line with my 2%ish baseline. But, the 4th quarter was so weak that 2014 US GDP came in at 2.4%, meaning we are still trending in the 2%ish level, even before the negative capex data comes online.
The Fed has not incorporated this downshift into its thinking yet according to the analysis Tim Duy recently put together on Fedspeak. A mid-year rate hike beginning as soon as June is still on the table. While a material weakness in GDP growth has to put the Fed hike off in my view, if employment numbers continue to show strength, we are going to need to see GDP growth drop into the 1’s for the Fed to alter its timetable. Though the Fed’s policy choices are data dependent, the bias is clearly on the tightening side. I think this would make the case for a yield curve inversion in the US as well. Watch jobless claims for the best real-time indicator of the jobs picture to get a read on where the Fed will be moving.
On the investment financing side, the sudden stop I feared is happening, at least in high yield. A Bloomberg report from this morning picks apart the details. Here are the salient points on high yield:
“Traditional, high-yield debt markets were not available” at reasonable prices, DeNezza said in a telephone interview. “The debt markets were closed to us.”
Shares of the State College, Pennsylvania-based driller have fallen by 77 percent since it raised $818 million in its initial public offering on June 20, when U.S. oil prices were $107 a barrel.
Small energy producers “are effectively shut out of the debt markets. They’re priced out. You can’t raise money at any reasonable terms,” Sean Sexton, who oversees oil and gas research at Fitch Ratings Ltd. in Chicago, said in an interview.
Research firm CreditSights Inc. projects the default rate for energy junk bonds will double to 8 percent this year. The costs to insure energy company debt against default has also soared — even for some of the biggest and healthiest conglomerates like Exxon Mobil Corp. and Chevron Corp., whose credit default prices have already doubled since September.
This is only a partial investment stop, however. The hedge funds and private equity companies that are still leveraged to the energy sector have stepped into the breach where bond markets have dried up. And many smaller or mid-sized energy names are getting credit or equity funding from these sources.
But the funding from private equity and hedge funds cannot last if prices stay at these levels, simply because these oil companies are not economically viable at these oil price levels. First, we know breakevens including exploration and all other costs put the IRR well above these price levels for much of the shale sector. Breakevens are somewhere between $60-90 for much of the shale sector. And the firms in North Dakota, at a minimum are receiving wellhead price $15 below WTI, meaning somewhere in the mid $30 range. How long can these companies hold out on the assumption that oil prices will rebound?We will find out as 2015 continues.
Second, these firms have to stay in business to finance their huge debt burdens until they get down to shut-in costs where operating costs are negative and this is as low as $15 a barrel. This essentially means that oil prices will remain under pressure because of supply on the market will still be heavy, despite the rig count reduction. The signs of oil surplus are everywhere. Crude stock levels are at record highs.
Third, oil demand growth is weakening. Look at the China slowdown, where the official PMI hit a two-year low below 50, meaning contraction. This means China’s economic growth is still decelerating. And the need for oil is decelerating as well. Global growth estimates are being cut, telling us that globally demand growth for fossil fuels is waning. These factors will also keep downward pressure on oil prices.
The bottom line: Capex is declining in the oil patch and more defaults are likely later in the year. I don’t think this will be enough to boost prices considerably. I have seen a lot of analyses predicting a slowdown in supply that causes prices to soar from today’s depressed levels. UBS is talking about $90 oil in 5 years. The OPEC chief is warning about $200 oil if cutbacks go too far. A lot of the hedge fund and PE investment in oil is predicated on oil rebounding. If oil prices do not rebound, however, there will be a massive number of defaults. And the carnage this causes plus the loss in capital investment will mean lower yields for safe assets in North America as the economic impact of the oil bust takes form.
In Europe, by contrast, negative yielding bonds are not very appealing. Any small increase in yield will savage a fixed income investor. The risk/return dynamics continue to favour English-speaking countries like Canada and the US, but also the UK, Australia and New Zealand, where bond yields are much higher relative to the eurozone.
In pure economic terms, the Asian exporters outside of Malaysia have the most to gain from the oil price dividend. Look for slight benefits to Indonesia, Taiwan, China, and the Phillipines and bigger benefits for India, South Korea, Thailand and Singapore.