All industrial revolutions need two things: technology and finance. The US shale revolution was made possible by the advances in horizontal drilling and hydraulic fracturing that allowed oil and gas to be released from previously unyielding rocks. But the industry’s financing was equally important in turning those innovations into a production boom that has shaken the world.
The financial model that has dominated the industry has been a highly competitive group of exploration and production companies using debt raised from bond markets and bank loans secured on oil and gas reserves. Often they use derivatives to hedge some or all of their revenues, giving lenders confidence in their ability to make interest payments if oil and gas prices fall. For most of the shale boom, that financial infrastructure has been underpinned by the low-interest rates and quantitative easing that followed the financial crisis. The surge in US oil production has been a result of the monetary stimulus, just as much as the tech start-up boom and the rise in the S&P 500 have been.
As its output has grown, the US E&P industry has been unable to finance its drilling programmes from its operating cash flows, and a constant inflow of capital has been essential for keeping it afloat. With stock markets and oil prices falling, and while the Federal Reserve is still signaling its intention to keep raising interest rates, the financial conditions that have protected the shale industry like a warm blanket may next year start to wear thin. One issue that has been highlighted by Philip Verleger, an energy economist, is the outlook for the hedging used by E&P companies to protect their revenues and reassure their lenders.
Strategies vary, but the standard practice is for companies to put a floor under the effective price of some or all of their production by buying put options. Mr Verleger argues that those options have been an important factor in the collapse of oil prices to a 15-month low since October. The investment banks and others that sold those put options have to hedge their own positions, typically by selling oil in the futures market. The more likely it is that the options will be exercised, the more oil the finance companies have to sell, in a practice known as “delta hedging”. That creates a positive feedback loop: as prices fall, financial companies that have sold puts need to sell more oil, which drives the price down further.