ISSUE NO.
3 APRIL 2019
In this issue:
• DISCOVER why the US shale
bubble is about to burst
• LEARN why the Fed will be
forced to step in and prop up
the sector
• INVEST in the beaten-
down stock set to jump as
one corner of the market
breathes a huge sigh of relief
• PLUS – a review of the Power
& Profits portfolio
Dear Power
& Profits
subscriber,
The transition
from fossil fuels
to renewable
energy is
probably the biggest financial
trend of our lifetimes. It’s a
long-term process that will
change the world.
But in this issue I want to talk
to you about a rather more
short-term, urgent situation
shaping up in the oil markets
that is vital you understand.
It threatens to cause a sudden
spike in the price of oil – and
could turn the geopolitical
balance of power between
the US, Middle East and Opec
on its head.
Not only that, I believe this
unusual situation could lead to
another round of state-funded
bailouts, the scale of which
How to profit from the
impending bust of
SUBPRIME
OIL
James Allen, Editor
hasn’t been since the last
financial crisis a decade ago.
The key players of this story
are all found in the US.
They comprise the shale
oil firms that have laid
the shaky foundations for
President Donald Trump’s
much heralded “energy
dominance”.
They also comprise Trump
himself, who is taking
increasingly stronger
positions overseas because
he is no longer dependent
on imported oil, yet who is
also determined to keep oil
flowing and depress oil prices
to help him out domestically.
And they comprise, too, the
Federal Reserve, which will
be forced to act to prop up
the increasingly bad debt of
the shale firms themselves.
In short, it’s all about
subprime oil and how shale
is seeing a credit crunch that
is going to wreak havoc in the
oil business.
Importantly for you, I see a
major opportunity for private
investors to profit.
The rest of this issue is
dedicated to showing you
what’s happening – and what
you can do about it.
Let’s get started.
The exploding myth of
energy independence
Just before Christmas, the
USS John C. Stennis, an
American aircraft carrier,
sailed into the Persian Gulf.
Flanked by a flotilla of
accompanying ships, this
was the first such military
presence in the region in
eight months, the longest
carrier absence in the volatile
continued on next page
ISSUE NO. 3
region since at least the
September 11 terror attacks.
The deployment of a US
aircraft carrier strike group
was undeniably a show of
force against Iran.
After all, tensions between
Washington and Tehran had
been growing over renewed
Trump administration
sanctions on the country,
Iranian-backed groups in
Syria, Iraq, Lebanon and
Yemen and Iran’s latest
ballistic missile tests.
But the naval deployment,
above all, was about one
thing and one thing only.
Oil.
In the preceding days and
weeks of the John C. Stennis’s
arrival in the Gulf, Iranian
officials had started to ramp
up threats to close off the
Strait of Hormuz, the narrow
mouth of the Persian Gulf
through which a third of the
world’s seaborne oil passes.
Tehran was in turn
responding to efforts by the
US to strangle Iran’s economy
by halting its oil exports as
part of the US sanctions.
But for keen watchers
of energy politics, the
positioning of the airport
carrier seemed, on one level,
somewhat incongruous.
After all, wasn’t the US
now meant to be “energy
dominant” or, at the very
least, “energy independent”?
Powered by the recent
surge in domestic US oil
production, the US was fast
becoming the world’s biggest
oil producer – something
it actually achieved on
a monthly basis a few
months later in February,
leapfrogging over Russia and
Saudi Arabia in the process.
In fact, with the US already
a net exporter of coal and
natural gas, experts were
counting down the days until
the US became an overall net
energy exporter, something
it hadn’t been since 1953
and something that had
the potential to upend and
scramble geopolitics from
Russia to the Middle East into
China’s industrial landscape.
“An energy-dominant America
means a self-reliant and
secure nation, free from the
geopolitical turmoil of other
nations that seek to use energy
as an economic weapon,” said
US energy secretary Rick Perry
in June 2017.
Certainly, according to
deputy energy secretary Dan
Brouillette, the US oil boom
had already made it possible
for the Trump administration
to take stronger positions in
support of Israel, including
recognising its sovereignty
over the Golan Heights,
because it is no longer
dependent on imported oil.
You might think that
makes sense. After all, the
US’ increased energy self-
sufficiency means it should no
longer be beholden to Opec
as it was in 1973-74, when the
oil embargo imposed by Arab
members of the cartel during
the Arab-Israeli war sent fuel
prices soaring.
But sending a US aircraft
carrier strike group to the other
side of the world certainly
didn’t seem consistent with a
“self-reliant and secure nation,
free from the geopolitical
turmoil of other nations that
seek to use energy as an
economic weapon”.
2 continued on next page
APRIL 2019
The move seemed very much
like the US still had a keen
interest in keeping global oil
supplies flowing.
What’s more, this was by
no means the first time
the US’ apparent energy
independence had been
called into question.
Indeed, Trump’s barrage of
tweets both to and about oil
cartel Opec certainly hadn’t
given the impression that
the US oil boom meant the
country was now free from
its dependence on foreign
suppliers.
The most recent example
took place on 28 March when
he took to Twitter to press
Opec to stop driving prices
higher and start pumping
more oil.
Source: Twitter
This tweet – by no means
his first directed towards
Opec – came as the cartel
and a group of allies led by
Russia (Opec+)were cutting
production following a
collapse in oil prices at the
back end of 2018, output
curbs that have played a
major part in the rebound in
the oil market this year.
Of course, Trump knows
full well that any supply
disruption in the Gulf or
dictated by Opec+ will push
up oil and, in turn, gasoline
prices – something he doesn’t
want to countenance before
the next elections in 2020.
In a global market, increased
ISSUE NO. 3
US oil supply does not insulate
drivers from higher pump
prices because a supply
disruption anywhere leads to
a price increase everywhere –
regardless of whether the US
imports oil or not.
Both the position of the USS
John C. Stennis and Trump’s
tweet are clear reminders
that the US remains entirely
beholden to any nation or
group seeking to use energy
as an economic weapon.
The punchline is this: so-called
energy independence or energy
dominance is a myth. The US
is still very much vulnerable to
supply disruption and oil price
shocks.
What’s more, the whole
edifice is about to crumble
as the driving force behind
the huge growth in US oil
production is – left to its own
devices – about to come to a
grinding halt.
For investors who
understand what’s
happening, it could be a
fortune-making event.
Let me explain.
Is this big
turnaround real?
Of course, the US’ emergence
as one of the world’s biggest
oil producers is quite the story,
representing a quite staggering
switch for an industry that,
before 2009, had been in
decline since 1970.
But how things change.
That’s because US oil output
started to grow rapidly a
decade ago, when companies
started to master the use
of horizontal drilling and
hydraulic fracturing, to
release crude from previously
unyielding shale rocks.
US oil production has surged
In short, US drillers started
to frack. And then they
fracked a whole lot more.
In fact, the so-called shale
revolution has more than
doubled US oil production
over the last decade,
slashing US net import
dependence in the process.
Last year US production
exceeded its previous peak
of just over 10 million
barrels a day (b/d).
As a result, US net imports of
oil and petroleum products
have dropped from more
than 12 million b/d in 2004-
07 to just 2.3 million b/d last
year. The US’ own Energy
Information Administration
(EIA) expects that to
disappear completely next
year, as the country becomes
a net oil exporter.
The explosion in fracking
has led to robust claims
about American energy
wealth. Erik Norland,
executive director of
CME Group, a derivatives
marketplace, calls fracking
“one of the top five things
reshaping geopolitics.”
But is this big turnaround
real? What if it’s itself
based on a presumption
that US shale oil output will
3 continued on next page
APRIL 2019
continue indefinitely?
To rephrase the question
another way, what if the US’
rising shale oil production
was effectively built on one
giant Ponzi scheme that
could, if market forces do
their job, quickly go into
reverse any day now?
You see, unlike conventional
drilling, a shale gas well’s
production rate falls by about
70-90% in the first three
years, while fields see output
drop off by about 20-40% per
year without new drilling.
This means companies have
to constantly keep drilling
wells just to keep output flat
and stay operative. But the
industry is drilling at a higher
cost than it can charge for its
shale gas and oil.
At the same time, not every
shale well is the same. The
core areas, or “sweet spots”,
typically make up just 20%
of a given shale play. When
shale drillers move beyond
the core, they tend to post less
impressive production figures.
That’s a problem when
you consider the explosive
ramp up in production over
the past decade has mostly
occurred in these sweet spots,
a trend that was accentuated
during the market downturn
ISSUE NO. 3
Smoking gun
beginning in 2014.
Of course, improvements
in drilling technology and
techniques can compensate
for the depletion, but the fact
remains that major shale
plays in the US – such as in
the Bakken and Eagle Ford –
productivity improvements
have already started to flat-
line or decrease.
This means that any forecasts
suggesting at huge levels of
production for decades to
come are based on extremely
shaky assumptions, at the
very least.
In fact, according to a report
by The Post Carbon Institute,
the EIA is vastly overstating
the potential of US shale,
calling its projections “highly
to extremely optimistic, and
are therefore very unlikely to
be realised”.
Burning money
So the frackers, chasing fast
oil output, are on a treadmill.
With more oil wells front-
loaded to boost output, many
companies have to drill again
soon – and find new capital to
keep production up.
But the problem is that this
treadmill is not conducive to
making money.
“The industry has a very bad
history of money going into it
and never coming out,” says
the hedge fund manager Jim
Chanos, who founded one
of the world’s largest short-
selling hedge funds.
Indeed, free cash flow –
the cash generated from
operations (meaning the sale
of oil and related products)
minus capital expenditure
– continues to be wildly
negative for those companies
most deeply dependent on US
shale oil deposits.
In fact, despite ramping
output significantly, the top
oil and gas companies in the
US shale boom have lost tens
of billions of dollars over the
past decade.
Excluding the integrated
majors, explorers have
burned through around $200
billion over the last eight
years, according to data
compiled by Bloomberg.
As The New York Times
4 continued on next page
APRIL 2019
states,
Because the industry has
such a voracious need
for capital, and capital
costs money, fracking
could not have taken off
so dramatically were it
not for record low interest
rates after the 2008
financial crisis. In other
words, the Federal Reserve
is responsible for the
fracking boom.
In other words, the post-2008
era of super-low interest
rates is the real catalyst of the
shale revolution.
Saying that, the situation is
only getting worse.
According to a Reuters
analysis of top independent
producers, US shale
producers last year again
spent more money than they
collected, extending a years-
long streak of putting oil
output above cash flow and
investor returns.
All but seven of 29 of
these producers last year
spent more on drilling and
shareholder payouts than
they generated through
operations, according to
securities filings.
Total overspending by the
group was $6.69 billion
in 2018, according to
Morningstar data provided
to Reuters by the Sightline
Institute and the Institute
for Energy Economics and
Financial Analysis.
Hardly any producers
generated solid returns
last year, even as US crude
prices rose 28% in 2018 to
an average $65.06 a barrel.
In fact, stock prices of all
29 shale producers fell in
2018, while only one of the
29 traded higher at the end
ISSUE NO. 3
of 2018 than it did two years
earlier.
According to Reuters, an
investor who put $100
into the S&P 500 Oil & Gas
Exploration & Production
Index in 2013 would have
had $58.99 at the end of 2018.
By contrast, $100 in the S&P
500 grew to $150.33 over the
same period.
This year, while the major
oil companies’ stock
prices have all increased
significantly off their lows,
their shale counterparts
have continued a downward
trend. ExxonMobil, Chevron
and BP are heading back to
their highs made in October,
while shale oil drillers such
as Continental Resources,
Concho, Pioneer, Whiting,
Oasis and Callon are all
down considerably.
Wall Street stating to
back away
Up to now, unprofitable
drillers, being unable
to finance their drilling
programmes from their
operating cash flows, have
relied on a constant inflow of
capital to keep afloat.
Capital raising by US E&P companies
Source: U.S. Energy Information Administration
As The New York Times
states,
For a long time, the public
markets have been valuing
fracking companies not
based on a multiple of
profits, the standard way
of valuing a company,
but rather according to a
multiple of the acreage a
company owns. As long as
companies are able to sell
stock to the public or sell
themselves to companies
that are already public,
everyone in the chain, from
the private equity funders
to the executives, can
continue making money.
Much of this inflow of capital
has been raised from the
debt markets. In fact, US
shale oil exploration and
production companies have
raised about $300 billon
from bond issuance over the
past ten years.
Many shale oil firms have
simply rolled over their
debt with the help of Wall
Street investment banks
that have provided finance
despite production being
unprofitable. Up to now Wall
Street has managed to flog
off assets of unprofitable
5 continued on next page
APRIL 2019
fracking companies to
investors such as pension
funds, who know little of the
risks in shale production.
But investors are now
signalling they’ve had
enough. Wall Street, in short,
is backing away, depriving
the shale firms the finance
that has funded the last
decade of shale growth.
According to Dealogic,
companies in the sector have
not held a single bond sale
since the start of November.
As per the Financial Times
article:
Ken Monaghan, co-
head of high yield at
Amundi Pioneer, the fund
management group, said
the rise in exploration and
production companies’ debt
yields had put off potential
borrowers, with spreads
over US Treasury bonds
climbing from 3.9 to 7.5
percentage points at their
peak before settling back to
about 5.9 percentage points
this year.
“No one wanted to issue
debt unless they had to,”
Mr Monaghan said. “At
the peak, they would have
been looking at yields of
about 10.25 per cent. That’s
awfully expensive.”
But the bond markets have
been by no means the
only source of funding. In
fact, while US energy and
production (E&P) companies
have borrowed about $300
billion from bond sales over
the past decade, they have
raised $780 billion in bank
loans, and raised about $140
billion from share sales,
according to Dealogic.
Both these sources of funding
are under pressure, too.
ISSUE NO. 3
Shale companies are also now
finding it increasingly hard
to loan money, secured on oil
and gas reserves, from the
bank. Previously, they used
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.
But with the Fed signalling
its intention to keep raising
interest rates, the financial
conditions that have
protected the shale industry
have started to wear thin.
What’s more, the plunge in
E&P share prices has made
it harder to raise equity
finance, too.
What this means is that
investors are signalling that
they do not have unlimited
patience for sustaining those
capital inflows.
John Hess, chief executive of
shale firm Hess Corporation,
said shale producers were
now contending with a new
financial climate. “The investor
The rebound in US shale drilling
has been flagging
Source: U.S. Energy Information Administration
paradigm is changing.”
As per the Reuters article:
“This is a critical moment”
for shale producers, said
Clark Williams-Derry,
director of energy finance
at think tank Sightline
Institute. “They’ve lost the
confidence of the investors.”
As a recent report from
the Institute for Energy
Economics and Financial
Analysis (IEEFA) noted: “The
ranks of frustrated investors
are growing”.
According to an October 2018
report by Kallanish Energy
Consultants, “The quality
of debt issued by the North
American oil and gas industry
has changed substantially –
and not in a good way — over
the past two years”.
Kallanish quoted Paresh
Chari, a Moody’s vice
president-senior analyst, who
said: “The North American oil
and gas industry today faces
about $240 billion of debt
6 continued on next page
APRIL 2019
maturities through 2023, with
the amount increasing fairly
steadily apart from a modest
spike in 2022.”
Remember: this is maturing
debt, not total debt – which
will be higher.
According to some estimates,
just under 30% of shale
production in the US is used
just to pay debt interest.
Mike Shellman, a 40-year
oil industry veteran, told Oil
Change International that,
using the industry’s own
breakeven prices, the US shale
oil industry will ultimately
have to produce 9 billion
barrels of oil, “as much as it
has already produced in 10
years... just to pay its total
long term debt back.”
“Essentially the only chance
it has of doing that is if oil
prices go to $115-125 a
barrel, and stays there for
a very long time... Most
of this shale oil debt, in
my opinion, is going to be
virtually impossible to ever
pay back.”
But with long-term oil
demand under attack from
cheaper renewables and the
rise of the electric vehicles,
sustained prices around $115-
125 a barrel just won’t happen
– meaning the debts will never
be paid back by the drillers
themselves.
Production falls
on the cards
So with new capital
constrained and cash flows
squeezed by the drilling
treadmill, no wonder oil
production companies have
already started to rein in
their plans for drilling and
completing new wells.
In fact, the number of rigs
drilling oil wells in the US
has already dropped by
ISSUE NO. 3
about 8% since November to
889, according to S&P Global
Platts Analytics.
The data suggest that after
a record-breaking boom in
US oil output in 2018, growth
will be weaker this year.
Already, the EIA has forecast
that between December 2018
and December 2019, US crude
production will rise by about
500,000 barrels a day. That
would represent a sharp
slowdown from growth of 1.8
million b/d over the previous
12 months.
But what happens when the
music stops entirely?
After all, even cheap capital
can’t persuade investors or
lenders to keep on pouring
money indefinitely into a
bottomless pit, which is what
the shale sector has become.
If the money tap was
turned off, US production
would continue to see
sharp declines. And if that
happened, the price of oil
would soar.
But is a rising oil price really
what Trump wants?
After all, it’s clear that the
US has a strategic as well
as a financial interest in
not allowing production to
slump.
Trump’s problem, of course,
is that the rhetoric of “energy
independence” doesn’t match
reality. It certainly doesn’t
produce profits.
As The New York Times
states,
Remove US oil growth and the
global balance shifts
Source: U.S. Energy Information Administration
It’s all a bit reminiscent of
the dot-com bubble of the
late 1990s, when internet
companies were valued
on the number of eyeballs
they attracted, not on
the profits they were
likely to make. As long as
investors were willing to
believe that profits were
coming, it all worked —
until it didn’t.
As the article states, most
things that are economically
unsustainable, from money-
losing dot-coms to subprime
mortgages, eventually come
to a bitter end.
Fracking is no different.
We’re now facing the very
real risks of a Crude Credit
Crunch.
Tim Morgan, a contributor
to Power & Profits, has some
startling conclusions about
what comes next, which
you can read about on these
pages below.
7 continued on next page
APRIL 2019
He says the US’ debt-based
fracking boom is comparable
to the mortgage-backed
securities crisis before 2008,
and not just in the causes of
cheap money and spiralling
debt but also because of the
inevitability in what comes
next.
His conclusions, based on his
surplus energy economics
model, are startling: the
Fed, which in some ways
caused the fracking boom,
will be forced to step in and
prop up the sector. This will
have enormous implications
for the shale sector and,
specifically, for one beaten-
down sector of the market
that is set to directly benefit
as a result.
What’s more, we have
identified the perfect way to
profit.
Read below to get the full
details.
ISSUE NO. 3
Money, energy and the
impending collision
The US will be the first of many countries forced to print money to subsidise energy supply,
When the world financial
system almost borrowed
itself into oblivion back in
2008, the authorities’ only
possible response was to
create enough new money to
pull off a rescue.
Please be clear that this
was, and is, economically
dangerous.
But the only alternative was
worse.
If we hadn’t slashed interest
rates to keep over-burdened
borrowers afloat – and
created enough new money
to plug the worst gaps in
banks’ balance sheets – we
faced a complete seizure in
the banking system. As you
probably know, Britain’s ATM
network was within hours of
ceasing to function.
We’re going to have to do
the same thing now to keep
energy flowing. Again, this
is dangerous – but letting
energy supply slump would
be even worse.
You need to understand why
this is going to happen, and
what its implications are.
Quite simply, the need to
subsidise energy supply
has become urgent. Shale
production, which has
always been profoundly loss-
making, is fast running out of
investors generous enough
to fund its losses. The cost of
conventional energy supply
is moving above commercial
says Dr Tim Morgan.
viability thresholds. A
renewables “breakthrough”
isn’t going to happen without
subsidy.
Let’s be clear that this doesn’t
mean handing taxpayers’
money to energy companies.
Governments couldn’t
afford to do this, and voters
wouldn’t let them.
But the world is already
awash with subsidies, and
most of them don’t come
from the taxpayer.
They come from newly-
created money.
We’re at the point now where
we need to do for energy
supply what we’ve already
done for reckless borrowers
and irresponsible lenders.
This is bad news for the value
of cash.
What’s more. the injection of
subsidy isn’t going to make
energy suppliers profitable.
But it is great news if,
as a supplier of services
and equipment to energy
producers, your business
model is being crippled by
your customers’ worsening
losses.
Actually, providing subsidies
for the energy sector isn’t
without precedent. In the US,
the production of shale liquids
has been a transformational
success – in purely volume
terms – but a commercial
8 continued on next page
APRIL 2019
failure, continuing solely
thanks to subsidy. Production
from individual shale wells
declines so rapidly that
producers are on a “drilling
treadmill”, needing a constant
stream of new wells even
to maintain their output, let
alone to increase it.
If drilling ever stopped,
output would slump. But cash
flow from production has
never covered these drilling
costs, so the industry’s free
cash flow has always been
negative.
Two things have alone kept
shales in business. One is
debt, and other is investors’
willingness to pour in capital.
One pre-condition makes this
possible – the abundance of
ultra-cheap capital put into
the system by central banks.
The subsidy of cheap money
has been with us ever since
the 2008 global financial
crisis (GFC I). The financial
system can no longer
function without it – any
more than it could function
without energy.
I’m sure you’ve heard that
creating new money (through
quantitative easing) isn’t
dangerous, and hasn’t caused
inflation. Neither assurance
is wholly true.
So subsidising energy would
increase the risk to fiat
currencies – and the only
reason we’d do it would be
ISSUE NO. 3
if the alternative was even
worse.
Start lines
Here are two fundamental
points to keep in mind.
The first is that the cost of
supplying energy keeps
rising. Though the cost
of solar and wind power
is coming down, these
renewables are less than 4%
of world energy use.
Oil, gas and coal – which
provide 80% of all primary
energy supply – are becoming
ever costlier, mainly because
of depletion. Quite rationally,
we started with the most
attractive fields and, as these
are exhausted, the ones
that remain are ever more
expensive to produce.
The second is that consumers
are getting poorer. This has
been masked by the spending
of borrowed money, but is
none the less real for that. The
authorities, who will admit to
nothing worse than economic
“secular stagnation”, have
nevertheless tried financial
fixes.
They started with making
debt available abundantly,
and relatively cheaply,
‘without too many questions
asked’. This is a process that
I call “credit adventurism”,
and led directly to GFC I in
2008.
Since then, they’ve turned
to “monetary adventurism”,
slashing the cost of credit to
levels lower than the rate
of inflation. That’s what’s
going to cause the next crisis
(“GFC II”).
When “real” (ex-inflation)
rates are negative, people
are paid to borrow. That’s
a subsidy, not just to
borrowers, but also to those
who’ve lent recklessly to
them in the past. You might
think that, if one group (in
this case, borrowers) are
subsidised, others must be
losing out, and they are.
Losers include savers, and
young people priced out of
housing. In the long run,
though, the reckless creation
of money reduces its value,
making us all losers.
If you don’t think that money
creation is inflationary,
please think again. To be
sure, retail prices haven’t
taken off – but the prices of
assets, such as stocks, bonds
and property, have soared,
a process of asset price
inflation induced directly by
the tide of cheap capital.
The other thing that has
helped contain inflation
has been monetary velocity,
which means the speed at
which individual dollars,
pounds or euros change
hands. During and after
2008, velocity slumped
as people became more
cautious. But we can’t rely
on velocity remaining low,
as it would surge at the first
sign of a spike in inflation.
What we have, then, is pent-
up inflation, held down
by consumer caution and
the outlet of asset price
escalation.
The big question
What happens when energy
prices are at once too high for
consumers to afford, but too
low for suppliers to earn a
return on capital?
That’s the situation now with
petroleum, but it’s likely to
apply across the gamut of
energy supply as economic
trends unfold. On the one
9 continued on next page
APRIL 2019
hand, prosperity has turned
down, undermining what
consumers can afford to
spend on energy. On the
other, the real cost of energy –
the trend energy cost of energy
(ECoE) – continues to rise.
In any other industry, these
conditions would point to
contraction – the amount sold
would fall. But the supply
of energy isn’t “any other
industry”, any more than it’s
“just another input”. Energy
is the basis of all economic
activity – if the supply of
energy ceases, economic
activity grinds to a halt. (If
you take a moment to think
through what would happen
if all energy supply to an
economy were cut off, you’ll
see why this is.)
Without continuity of energy,
literally everything stops.
But that’s exactly what
would happen if the energy
industries were left to the
mercies of rising supply costs
and dwindling customer
resources.
This leads us to a conclusion
which is as stark as it is (at
first sight) surprising – we’re
going to have to subsidise the
supply of energy.
Essential premises –
leverage and subsidy
Apart from the complete
inability of the economy to
function without energy, two
other critical considerations
point emphatically in this
direction.
The first is the vast leverage
contained in the energy
equation. The value of a
unit of energy is hugely
greater than the price which
consumers pay (or ever could
pay) to buy it. The energy in
a barrel of oil is equivalent
ISSUE NO. 3
to 22,360 hours of human
physical labour. Whatever
hourly wage rate you attach
to that, the result comes out
drastically higher than any
conceivable oil price.
Why, then, does oil trade at
such a huge discount to its
broader value?
The answer lies in that word
“broad”.
Energy does vastly more for
us than power our cars and
heat our homes, even though
that’s where we pay directly
for it. How much we can
afford to spend on petrol and
home electricity is limited by
how much we have to spend
on other things, which are
themselves other forms of
energy purchase.
When you’ve already paid
for the energy in your food,
the energy which supplies
your water, and the energy
embodied into literally
everything else that you buy,
you’re not left with enough
money to pay high prices just
to fuel your car or heat your
home.
This means that there’s
an overriding collective
interest in continuing the
supply of energy – even if
this cannot be done at levels
of purchaser prices which
make commercial sense for
suppliers.
The second is that we already
live in an “age of subsidy”.
Ever since we decided,
in 2008, to save reckless
borrowers and reckless
lenders from the devastating
consequences of their folly,
we’ve turned subsidy from
anomaly into normality.
The subsidy in question isn’t
a hand-out from taxpayers.
Rather, supplying money
at negative real interest
rates subsidises borrowers,
subsidises lenders and
supports asset prices at levels
that bear no resemblance
to what “reality” would be
under normal, cost-positive
monetary conditions.
The operation of the laws
of the market – laws which
state that mistakes are
penalised – were suspended
by the authorities in 2008,
when it was decided to save
reckless borrowers and
irresponsible lenders from
the consequences of their
actions.
Despite government bank
rescues, the main instrument
of intervention was the
supply of cheap, newly-
created money. This drug
has become addictive,
so it’s not surprising that
policies described as
being “temporary” and
“emergency” in nature
have now been with us for
ten years – and counting.
The Federal Reserve has
been trying to inch towards
monetary normality, but we
can take it for granted that
these efforts will be thrown
overboard at the first sign of
squalls.
My conclusion, then, is
simply stated.
Energy is utterly essential to
the economy. As costs rise,
but prices are held down by
consumer hardship, unaided
commercial enterprise will
no longer be enough to keep
supplies flowing.
In the future, the authorities
are going to have to do for
energy suppliers what they
already do for borrowers and
lenders – use “cheap money”
to sustain an activity which is
vital, but which market forces
alone cannot support.
10
APRIL 2019
Actually, this is a much easier
operation than you might
suppose. The process would
involve the Fed buying shale
operators’ bonds on the
open market, and acting as
a “willing buyer”, and thus
as an underwriter, of future
debt issuance.
Reasoning from
the basics
To understand why subsidy
is the “least worst choice”
in these circumstances, it’s
necessary to recognise that
the economy is an energy
system (and not a financial
one), with money acting
simply as a claim on output
which is itself made possible
only by the availability
of energy. Money has no
intrinsic worth, but has
“value” only in relation to
the things for which it can
be exchanged – and all of
those things rely entirely on
energy.
To be a bit more specific, all
economic output (other than
the supply of energy itself)
is the product of surplus
energy – whenever energy
is accessed, some energy
is always consumed in the
access process, and surplus
energy is what remains after
ECoE has been deducted from
the total (or “gross”) amount
that is accessed.
From this perspective, the
distinguishing feature of
the world economy over the
last two decades has been
the relentless rise in ECoE.
This process necessarily
undermines prosperity,
because it erodes the
available quantity of surplus
energy.
We’re already seeing this
happen – Western prosperity
growth has gone into reverse,
and progress in emerging
continued on next page
ISSUE NO. 3
market (EM) economies is
petering out. Global average
prosperity has already turned
down.
From this simple
understanding, much else
follows. Our financial
problems – recent, current
and looming – are caused
by a collision between (a)
a financial system wholly
predicated on perpetual
growth in prosperity, and
(b) an energy dynamic that
has already started putting
prosperity growth into
reverse. Likewise, political
changes are likely to result
from the failure of incumbent
governments to understand
the worsening circumstances
of the governed.
Prosperity in decline
– turning-points
and differentials
As we’ve noted, once ECoE
passes a certain point, the
remaining energy surplus
becomes insufficient to grow
prosperity, or even to sustain
it. This point has now been
reached or passed in almost
all Western economies, so
prosperity in those countries
has turned down.
Efforts to use financial
adventurism to counter this
effect have done no more
than mask (since they cannot
change) the processes that are
undercutting prosperity, but
have, in the process, created
huge and compounding
financial risks.
In EM economies, prosperity
continues to improve, but no
longer at rates sufficient to
offset Western decline. Global
prosperity per person has now
turned downwards from an
extremely protracted plateau,
meaning that the world has
now started getting poorer.
Comparative properity and ECoE
Amongst many other things,
this means that a financial
system predicated on the
false assumption of infinite
growth is heading for some
form of invalidation. It also
poses political and social
challenges to which existing
systems are incapable of
adaption.
How, though, does the
energy-prosperity equation
work – and what can this
tell us about the outlook for
energy itself?
According to my model,
global prosperity stopped
growing when trend ECoE
hit 5.4%. It might, at first
sight, seem surprising that
subsequent deterioration
has been very gradual, even
though ECoE has carried
on rising relentlessly, now
standing at 8.0%.
This apparent contradiction
is really all about the
changing geographical
mix involved. Essentially,
EM economies – which are
steadily becoming a larger
part of the global mix – are
capable of continuing to grow
their prosperity at levels of
ECoE a lot higher than those
which kill prosperity growth
in Western countries.
11
APRIL 2019
These charts show prosperity
per capita (at constant
2018 values) on the vertical
axis, and trend ECoE on
the horizontal axis. For
comparison with the US, the
China chart shows prosperity
in dollars, converted at
market exchange rates
(in red) and on the more
meaningful PPP basis of
conversion (blue). For
reference, ECoE at 6% is
shown as a vertical line on
both charts.
As you can see, American
prosperity had already
turned down well before
ECoE reached 6%. Chinese
prosperity has carried on
growing even though ECoE is
now well above the 6% level.
How is it that China can carry
on getting more prosperous
at levels of ECoE at which
prosperity has already
turned down, not just in the
US but in almost every other
advanced economy?
The answer is that prosperity
isn’t exactly the same thing in
a Western or an EM economy
– put colloquially, how
prosperous you feel depends
on where you live, and where
you started from.
Economies like those of
continued on next page
ISSUE NO. 3
the US, Japan and western
Europe are more complex
than those of countries
like China and India. That
complexity enriches our
lives, but it comes at a cost
– complex economies need
more surplus energy than
simpler ones, which means
they need ECoE to be lower.
In the US, my model shows
that prosperity per person
peaked in 2005 at $48,660
per person (at 2018 values),
and had fallen to $44,830
(-7.9%) by 2018. Over the
same period, prosperity per
person in China rose by an
impressive 84% – but was
still only $9,670 per person
last year. Even that number
is based on PPP conversion
to dollars – converted into
dollars at market exchange
rates, prosperity per person
in China last year was just
$5,130.
So Chinese people feel (and
are) more prosperous than
they used to be, even at
levels of prosperity that
would amount to extreme
impoverishment in the US.
Before anyone says that “the
US is a more expensive place
to live”, conversion at PPP
rates is supposed to take
account of cost differentials
– and, even in PPP terms, the
average Chinese citizen is
78% poorer than his or her
American equivalent.
So there’s no “one size fits
all” answer to the question
of, “Where does ECoE kill
growth?” Just as prosperity
means different things in
different types of economy.
It should also be noted that
China’s ability to keep on
growing prosperity at quite
high levels of ECoE is not
necessarily a good guide to
the future. As things stand,
China’s economy, driven as
it by extraordinary levels of
borrowing, is looking ever
more like a Ponzi scheme
facing a denouement.
The situation so far –
and can we escape?
Given how much ground
we’ve covered, let’s take stock
briefly of where we are.
We’ve observed, first, that
the rise in trend ECoEs is in
the process of undermining
prosperity. Much of this has
already happened – prosperity
in most Western economies
has now been deteriorating
for at least a decade, whilst
continued progress in less
complex EM economies is no
longer enough to keep the
global average stable.
As ECoEs continue to rise,
what happens next is that
EM prosperity itself turns
down, a process which will
accelerate the rate at which
global prosperity declines.
My model already identifies
one major EM economy
(other than China) where
strong growth in prosperity
will soon go into reverse.
Second, a world financial
system predicated entirely
on perpetual “growth” in
prosperity has become
dangerously over-extended.
Again, this observation
isn’t something new. The
inauguration, more than
ten years ago, of mass
subsidy for borrowers and
lenders surely tells us that
we’ve entered a new “age
of abnormality”, in which
subsidy is normal, and
where historic principles
(such as positive returns on
capital) no longer apply.
If you stir energy leverage
into this equation, an
inescapable conclusion
12
APRIL 2019
emerges. It is that we’re going
to have to extend our current
acceptance of “financial
adventurism” to the point
where energy supply, just
like borrowers and lenders,
becomes supported by
monetary subsidy.
The only way in which this
might not happen would be
if we could somehow escape
from the implications of
rising ECoE. Some believe
that renewables will enable
us to do this – after all, just
as trend ECoEs for oil, gas
and coal keep rising, those of
wind and solar continue to
move downwards.
There are three main reasons
why it would be folly to
assume that renewables will,
like the 7th Cavalry, “ride to
the rescue in the final reel”.
1. The first reason is “the
fallacy of extrapolation”. This
is a natural human – but
often mistaken –tendency to
assume that what happens
in the future will be an
indefinite continuation of
the recent past. Because
the cost of renewables has
fallen by X% over the last
Y number of years, it’s easy
to assume that it will fall by
another X% over the next Y
years. But the reality is much
likelier to be that technical
progress in renewables
(including batteries) will
slow when it starts to collide
with the limits imposed by
physics.
2. The second fallacy is that
projections for cost reduction
ignore the derivative nature
of renewables. Building, say,
a solar panel, a wind turbine
or an electrical distribution
system requires inputs
currently only available
courtesy of the use of fossil
fuels. In this specialised
sense, solar and wind are
continued on next page
ISSUE NO. 3
not so much “primary
renewables” as “secondary
applications of primary fossil
input”.
We may reach the point
where these technologies
become “truly renewable”,
in that their inputs (such as
minerals and plastics) can be
supplied without help from
oil, gas or coal.
But we are certainly, at
present, nowhere near such
a breakthrough. Until and
unless this point is reached,
the danger exists that that
the ECoE of renewables may
start to rise, pushed back
upwards by the rising ECoE
of the fossil fuel sources
on which so many of their
inputs rely.
3. The third problem is that,
even if renewables were
able to stabilise ECoE at, say,
8% or so, that would not be
anywhere near low enough.
Global prosperity stopped
growing before ECoE hit 6%.
British prosperity has been
in decline ever since ECoE
reached 3.6%, and an ECoE
of 5.5% has been enough
to push Western prosperity
growth into reverse.
As recently as the 1960s, in
what we might call a “golden
age” of prosperity growth
– when economies were
expanding rapidly, and world
use of cheap petroleum was
rising at rates of up to 8%
annually – ECoE was well
below 2%.
In other words, even if
renewables can stabilise
ECoE at 8% – and that’s a
truly gigantic “if” – it won’t
be low enough to enable
prosperity to stabilise, let
alone start to grow again.
Between Scylla and
Charybdis – energy
subsidy or monetary
orthodoxy?
The idea that we might need
to subsidise energy “for the
greater economic good” is a
radical one, but isn’t without
precedent. As we’ve noted,
the rapid expansion of shale
liquids production in the US
has been a copybook example
of energy supply carried by
subsidy, not from taxpayers
but from the supply of cheap
capital by central bankers,
channelled into shale activity
by investors and commercial
bankers.
But even cheap capital can’t
persuade investors or lenders
to keep on pouring money
indefinitely into a bottomless
pit, which is what the shale
sector has become.
When the point is reached
when shale producers can’t
raise more capital from
investors, either bankers
have to take over by granting
yet more loans, or much of
the sector goes under, falling
off the “drilling treadmill”,
after which the ultra-rapid
depletion rate of existing
wells takes over, and output
plunges. Unless the US wants
this to happen, capital will
have to be provided.
What has to happen instead
is that the Fed buys shale
operators’ bonds, much as it
has previously bought, for
example, toxic mortgage-
backed securities packages.
The support thus provided
would, in effect, make the Fed
a guarantor of future debt
issuance in the sector.
This isn’t, even remotely, an
issue confined to the US, or
indeed to oil alone amongst
energy sources. Production
13
APRIL 2019
from the UK North Sea will
fall rapidly unless we can
find £200 billion to invest
in it, something which
current oil prices won’t fund.
Economies dependent on
oil revenues are in the front
line, as the collision between
rising costs and inadequate
prices drains away their
financial viability.
Venezuela, whatever
the other causes of its
problems, is an early victim
of deteriorating petroleum
margins. If we want to
develop renewables at
rates that are economically
imperative, some form
of subsidy is necessary.
Taxpayers can’t provide this –
but money creation can.
Ultimately, this sets the scene
for an unenviable choice –
do we let energy supplies
dwindle, with all that that
means for the economy, or
do we take risks with the
faith placed in fiat money?
All the evidence points to the
latter choice. After all, we’ve
been here before – in 2008
– and we decided then that
monetary orthodoxy was less
important than rescuing the
banking system.
That choice is going to have
to be addressed first in the
US, for three main reasons.
First, it’s been evident for
some months now that
investors have, at long last,
grasped the loss-making
reality hidden behind the
hype around shale.
Second, the nature of shales
is such that, as soon as the
sector is starved of new
capital, output will plunge
far more dramatically
than would happen in
conventional oil plays.
Third, the US has both the
continued on next page
ISSUE NO. 3
incentive and the ability
to act – the status of the
dollar as the world’s reserve
currency makes it possible
for the US to respond to
what would otherwise be a
drastic increase in the need
to import oil.
Make no mistake, though – as
so often, where the US leads,
others will in due course
follow.
Though we can’t know when
this is going to happen, there
is abundant evidence that
investors are already losing
faith in the shale sector.
Media coverage has turned
sharply negative, and the
share prices of operators
such as Continental, Pioneer
and Whiting have all fallen
markedly in recent months.
In saying that energy cost
increases might force us to
‘play fast and loose’ with the
real value of money, I’m not
really forecasting anything
that different than what
was done for borrowers
and lenders back in 2008.
Moreover, it’s an exercise
that’s going to have to be
repeated anyway, as debt
escalation, and the collapse
...as have other shale firms such as Continental
The share price of shale operator
Pioneer has fallen markedly...
of returns on saving, usher
us ever nearer to the sequel
to 2008.
I know that the concept
of creating new money to
subsidise loss-making energy
supply is a startling one – but
that’s exactly why you need
to know about it, and why
I’ve set out here the whole
logic-chain which leads to
this conclusion.
Remember that there are
precedents for creating new
money to “fix” economic and
financial threats. Remember,
14
APRIL 2019
too, that big chunks of energy
supply already rely on
subsidy.
This is going to erode the real
value of cash.
It’s not going to make energy
producers profitable. For
one thing, supporting shale
companies’ production will
prevent a slump in supply
which could otherwise push
oil prices upwards.
But – whether it’s US
shales, the UK North Sea, or
traditional and renewable
energy sectors in Britain and
abroad – it is great news for
supply and service companies
currently threatened by the
worsening financial plight of
their customers.
What we should anticipate
is that investors in these
service companies will heave
a big sigh of relief when they
realise that shale operators,
the really big spenders in the
market for their products and
services, are not, after all,
going to run out of money for
investment.
continued on next page
ISSUE NO. 3
Why the Fed will be forced to prop
up the shale sector
So there we have it.
Tim is certain that, at some
point soon, the Federal
Reserve will buy shale
operators’ bonds on the open
market, making the Fed an
underwriter and guarantor
of future debt issuance. This
will prop up the sector in
the same way it did when
it bought toxic mortgage-
backed securities back in
2008.
Politically, you might think
this would be difficult to pull
off. But let’s consider the
political options from the
Trump administration’s point
of view.
Option A: take no action
With investors finally seeing
the reality of shale finances,
and the news flow turning
decisively negative, three
processes are probably
already under way.
First, shale firms are unlikely
to be able to issue further
equity. Second, if they can
place bonds at all, required
yields would be lethal to
their financial positions
going forward. Third, and
on the principle that banks
only lend to borrowers who
don’t need the money (ie,
they won’t lend to companies
that cannot access capital
markets), bank finance might
dry up as well. Again, rates
could be ruinous.
If finance to the independent
by James Allen
drillers dries up, and
especially if the majors
retrench as well, drilling
virtually stops.
Without new drilling, it’s
probably safe to say that
production would fall from
6 million barrels a day
(b/d) now to, at best, 4m b/d
over the course of just one
year. That would create
an equivalent incremental
import requirement of
around 2m b/d.
In one fell swoop, claimed
US “energy independence”
would have ended on Trump’s
watch. According to recent
reports, the US’ waning
reliance on oil imports has
already emboldened the
Trump administration to take
stronger stances in support of
Israel, including recognising
its sovereignty over the Golan
Heights.
Trump won’t want to lose
any bargaining power or
leverage as it looks to further
US interests around the world,
including in its dealings with
Opec.
What’s more, one immediate
implication of non-
intervention is likely to be
higher oil prices for American
consumers, and that’s exactly
the opposite of what Trump
wants, as I explained earlier
in this issue.
Another implication of
taking no action would be
15
APRIL 2019
heightened dependency on
Middle East supplies. In fact,
it isn’t altogether clear that
replacement capacity even
exists. In early April, Saudi
Aramco, the giant state-
owned oil company in Saudi
Arabia, finally lifted the veil
of secrecy around its mega oil
fields.
What the market discovered
was this: the al Ghawar oil
field, the world’s largest
conventional oil field, can
produce a lot less than
almost anyone believed. The
company’s bond prospectus
revealed that Ghawar is able
to pump a maximum of 3.8
million barrels a day – well
below the more than 5 million
that had become conventional
wisdom in the market.
It’s noteworthy, too, that
Mexico is no longer a net
oil exporter, meaning the
US won’t be able to rely
on imports from its North
American neighbour, while
production in Venezuela is
inherently unreliable and
able to be disrupted by civil
unrest.
Now let’s take a look at the
possibility of taking action to
prop up the shale sector...
Option B: take action
The US shale industry has
relied heavily on debt to
finance its growth, with
exploration and production
companies raising about $300
continued on next page
ISSUE NO. 3
billion from bond issuance
over the past ten years.
That’s a lot of debt, but not
when set against the sums
spent by the Fed and other
central banks on wholly
worthless paper assets since
the financial crisis. Indeed,
total holdings of worthless
assets acquired by the world’s
central banks are considered
to be about $13 trillion, of
which the Fed accounts for a
significant proportion.
Although shale firms are
heavily indebted, they won’t
need anything like that
to keep them liquid. I’m
guessing this would be in the
region of around $50 billion
a year – not that much at all,
in relative terms. And unlike
mortgage-backed securities,
shale firms’ debt, whilst
overvalued, would not be
totally worthless.
What’s more, Fed support
might well re-open the
private bond sector to shale
Risk warning:
Advice in Power and Profits
does not constitute personal
advice. Any advice should be
considered in relation to your own
circumstances.
Before investing you should
consider carefully the risks
involved, including those
described below. If you have any
doubt as to suitability or taxation
implications, seek independent
financial advice.
General - Your capital is at risk
when you invest, never risk more
than you can afford to lose. Past
performance and forecasts are not
reliable indicators of future results.
There is no guarantee dividends
will be paid. Bid/offer spreads,
commissions, fees and other
charges can reduce returns from
investments.
Overseas shares - Some
recommendations may be
denominated in a currency other
than sterling. The return from
firms, because of the implicit
Fed put – the widespread
belief that the Fed can always
rescue the economy by
decreasing interest rates.
Of course, the Fed already
has a mandate to purchase
corporate bonds. This should
mean that the Fed is in a
position to underpin the shale
sector’s debt position. The best
process is likely to be making
market purchases of shale
firms’ corporate bonds.
It’s a no-brainer
You might think it’s clear that
the balance of probabilities
is overwhelmingly in favour
of acting. In fact, from the
administration’s point of
view, which is likely in this
instance to be shared by the
Fed, this is a no-brainer.
It’s not even as though
taxpayers’ money would
be involved. Instead, the
“subsidy” would work
like quantitative easing
– new money created by
these may increase or decrease as
a result of currency fluctuations.
Any dividends will be taxed at
source in the country of issue.
Funds – Fund performance
relies on the performance of
the underlying investments, and
there is counterparty default risk
which could result in a loss not
represented by the underlying
investment.
Small cap shares - Shares
recommended may be small
company shares. These can be
relatively illiquid meaning they are
hard to trade and can have a large
bid/offer spread. If you need to
sell soon after you bought, you
might get back less that you paid.
This makes them riskier than other
investments. Small companies may
not pay a dividend.
Taxation – Profits from investments,
and any profits from converting
cryptocurrency back into fiat
currency is subject to capital gains
tax. Tax treatment depends on
individual circumstances
16 and may
APRIL 2019
the Fed would be used to
buy up shale firm’s bonds,
supporting their value and
putting a floor under them.
So now that we’ve laid the
case for the Fed acting to
support the US shale sector,
let’s get down to business.
As Tim said, what we should
anticipate is that the stock
prices of oil service companies,
which have been beaten down
in recent months as worries
over the financing of the shale
drillers mount, rise as their
investors realise their main
customers will not be running
out of money.
For me, this is a win-win.
If the Fed subsidies shales,
the order flow of oil services
stocks is assured. But if the
Fed doesn’t do this, or delays,
then the slump in output
should push crude prices
higher, so their order books
pick up and they win out
either way.
be subject to change.
Investment Director: James
Allen. Editors or contributors
may have an interest in shares
recommended.
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