Headlines abound about the massive surge in US shale oil production. The energy independence-cheering punditocracy hail this as a great victory. This includes President Trump.
And it would be if this surge in production was built on financially stable ground. But it isn’t. The fracking industry continues to bleed massive amounts of cash. As I pointed out in an article earlier this week, when accounting for this inconvenient truth much of the U.S’s return to dominance in the energy space is a lot of hot air.
Nick Cunningham’s article at Oilprice.com tells the tale.
Heading into 2019, the industry promised to stake out a renewed focus on capital discipline and shareholder returns. But that vow is now in danger of becoming yet another in a long line of unmet goals.
“Another quarter, another gusher of red ink,” the Institute for Energy Economics and Financial Analysis, along with the Sightline Institute, wrote in a joint report on the first quarter earnings of the shale industry.
The report studied 29 North American shale companies and found a combined $2.5 billion in negative free cash flow in the first quarter. That was a deterioration from the $2.1 billion in negative cash flow from the fourth quarter of 2018. “This dismal cash flow performance came despite a 16 percent quarter-over-quarter decline in capital expenditures,” the report’s authors concluded.
This lack of profitability is maintained solely through financial engineering and a continued bull market in structured credit in the US due to the needs of pension funds to make a 7.5% yield to maintain their defined benefit payouts.
They aren’t the only ones fueling this fracking boom but it is a major driver of both US equities and the commercial paper market. This is just another consequence of the Federal Reserve’s zero-bound interest rate policy.
So, why is this Trump’s foreign policy Achilles’ heel? Because with the global economy slowing down, US domestic production is already in massive oversupply. There is a glut of oil and gas so profound that it ensures the bottom lines of these companies will not improve, leaving them at the mercy of these creditors.
The good news for them, in the short run, is that they will likely be able to continue in their Ponzi-like ways, because the Fed will start cutting interest rates by September.
But from a foreign policy perspective Trump is betting on restricting the supply of oil from ‘competitors’ to make US oil more attractive. There are two problems with this.
First, other countries with lower costs of production can keep the market in relative equilibrium, living on small profits, but profits nonetheless.
Second, and more importantly, US shale oil has an upper limit on demand since it’s too light for most refineries and requires blending with heavier feedstock. This is why, for example, US imports of Russian oil are rising rapidly to feed Gulf coast refineries starved of Venezuelan oil thanks to Trump trying to take it off the market.
Countries like Venezuela and Iran can, and will, compete on price. They can and will find ways around Trump’s sanctions. Again Russia moves in to provide a market deficit, this time payment clearing services through already US sanctioned banks.
With each new tariff or sanction on a third-party Trump further alienates US producers from all industries from foreign markets.
And the Saudis are trapped in the middle. They now know they can’t expand production because demand is so poor. In fact, they cut production by 120,000 barrels in May. So much for their assurance to Trump that they will take up Iran’s losses.
Prices are falling because of inventory builds which imply slack demand not higher supply.
Moreover, OPEC wants to continue the production cuts, but Russia has signaled strongly that they are uninterested in joining them. Putin knows he has Saudi Arabia on price because Russia is budgeted for $40 per barrel while the Saudis need a multiple of that.
He will continue to drive a wedge between the Saudis and the US on oil market share. The Saudis cannot afford to lose any while Russia can ramp production or expand its oil-for-goods program with Iran to expand theirs.
What’s Trump going to do, sanction Russia further?
A contracting global economy is a recipe for low oil prices begetting bankruptcies across the shale space. This is why Trump is exhorting the Fed to cut rates, to allow the fracking Ponzi a little more time to bring Iran to heel.
This is the game of chicken Trump is playing with China, Russia and Iran. He’s betting on the short-term pain creating capitulation. They are playing the long game getting him to over-extend himself. There are always workarounds to mitigate that pain and eventually those workarounds become the new normal as people’s habits change.
President Putin understands Russia can make serious gains playing good cop to Trump’s bad cop.
Russia has made it clear to Secretary of State Mike Pompeo and Trump directly that it will not horse-trade Iran’s presence in Syria for a small concession on Europe, despite the conciliatory note struck diplomatically.
Moreover, Putin knows Trump can’t be trusted to keep or implement his word anyway, so no agreement is possible on the now myriad issues between them. So, Russia and China will support Iran as best as they can while pursuing their own paths to strengthen their relationship.
A stronger Chinese/Russian alliance creates new paths for capital to flow away from Trump’s prying and threats.