There are two fundamentals in the oil industry:
It is, has been, and will be volatile.
Its forecasts, predictions and assessments are almost always wrong.
It took some moxie, then, for Bethany McLean to write a book, “Saudi America: The Truth About Fracking and How It’s Changing the World,” predicting that the oil industry was going to sink and would take the global economy down with it. More specifically, she believes that the financial underpinnings of the fracking-based producers are shaky enough to trigger a financial crunch that would spread quickly throughout our system.
The oil business, though, has a longstanding tradition of being thinly financed at the entrepreneurial end of the discovery and production process. “Wildcat” drilling rigs fed entrepreneurs’ dreams of striking oil — tapping into a gusher and the riches that came with it. For the most part, the banks that lent money — usually on the physical equipment as collateral — were not fools waiting to be fleeced but lenders who understood the risks.
That tradition continues in the tar sands of the western Permian Basin, where startup companies are mining the sand so that producers can squeeze the oil out of it. There are probably too many of these mining operations for all to survive, but that, too, is a tradition in the oil business. In fact, it is a tradition in virtually all new and growing technology sectors.
It is not impossible for a bank to get snookered and overextended to wildcat energy startups. Those in our state who remember Seafirst Bank can recall how its ill-starred energy loans led to its downfall, its shotgun marriage to Bank of America and eventually its disappearance. And that is the typical experience with individual banks that are not managing their risk exposure well. The bank fails, not the global financial system.
The Federal Deposit Insurance Corporation is the one left holding the proverbial bag when a bank fails, so they have a keen interest in loan risks. They have been examining the ability of banks that make the bulk of the loans to fracking-based producers. Their report, published this summer, focused on the ability of these banks to survive oil price volatility.
Not surprisingly, the FDIC found that bank management was the key factor. If a bank recognized risk areas and established procedures to measure and control its risk, it would likely not encounter any undue stress from oil price volatility.
Much of the fracking-based oil and natural gas business is a high-risk proposition for either bank lending or investment, but many individual investors get caught up in the industry’s successes and the wildcatters’ dreams. If you have ever spent any time with an entrepreneur or a wildcatter, you know just how contagious these dreams can be.
Still, that is the nature of the free market for investment capital. A portion of it always goes to higher-risk operations. There is, for example, an active market for so-called “junk bonds,” bearing higher risk and paying a higher rate of interest. And that market is not limited to fracking entrepreneurs or even to the energy industry. There are all sorts of risks in our economy and those investors searching for higher returns will find them.
Fracking-based operations produce half of our oil and two-thirds of our natural gas, It isn’t wrong, then, for McLean to point out the financial weakness of much of the fracking industry or the risk aspects of fracking production businesses but equating it to the sub-prime mortgage debacle is questionable at best.
One of the issues she alludes to is ripe for research rather than conclusions at this point. Output from many fracking production sites declines very steeply after the first year. How much of this decline is inherent in the process or the result of other forces such as technology or geology is still unclear. Fracking is still very new from an engineering standpoint.
Production costs are a critical factor. The landscape of Southern California, for example, used to be dotted with old-fashioned, “walking beam” oil wells, and some may still be around, after half a century or more, still pumping a few barrels of crude oil each day. The operating costs of these wells, though, are low enough to justify the meager output, but whether fracking-based wells can be scaled down to produce oil at lower levels of output remains to be seen.
The fragility of the fracking-based energy sector seems to be a classic market invitation to consolidation rather than collapse. On the other hand, we are now as dependent on fracking as we once were on OPEC and other foreign producers. This would be a good time to develop an economic policy that took that seriously.
James McCusker is a Bothell economist, educator and consultant.
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