Cheap oil: scenarios and uncertainties for the US energy sector

After beginning a long and steep descent last summer, the price of crude recently dipped below $50 a barrel, the lowest level in almost six years. What’s more, this decline shows no signs of abating, with the most extreme predictions putting it under $30 a barrel within the next few months. Though it’s hard to know exactly how low oil might go, and for how long it might stay there, the consequences of this unexpected fall are considered to be largely positive for consumers around the world, though obviously not for producers.

According to AAA, the US’s largest motoring organization, American drivers alone could save as much as $75 billion at the pump in 2015. Naturally, everybody hopes that this hefty sum will be spent to purchase other goods and services that, instead of lining the pockets of big oil companies, will boost the ongoing recovery. Nevertheless, there is another, less rosy, side of the coin: by negatively impacting producers, the drop in oil prices could have a chilling effect on job creation, especially in those US states that hugely benefited from the shale boom; it might also stir a degree of financial turmoil, as banks have been financing expensive capital projects in the country’s energy sector; and it might undermine the fight against climate change by making the development of renewable sources feel less urgent. 

“We are starting to see a slowdown in investment,” says Leslie Palti-Guzmanm Senior Analyst on geopolitics, energy and global gas for the Eurasia Group. “And to talk more about Mergers & Acquisition [M&A], as companies that are more vulnerable are acquired by stronger players capable of sustaining the new pricing environment.” In early December, ConocoPhillips became the first to announce that it would cut its 2015 capital spending plans by about 20%. This kind of decision, more of which are expected in the coming weeks, has a ripple effect throughout the whole sector, with thousands of jobs already being lost, especially in Texas, North Dakota, Oklahoma and Louisiana. Obviously, the lower the price of crude falls, the higher the number of uneconomical projects becomes and the more layoffs should be expected. Until at some point, the whole shale oil industry in North America, in the US as well as in Canada, becomes untenable – though we are not there yet. “There’s a break-even price to produce shale oil,” says Palti-Guzmann. “If we go below that for a sustained period of time, things could become challenging.”

The sudden distress of the US shale oil sector could also impact the country’s shale gas industry. International natural gas prices are indexed to oil, though not US domestic prices which are determined by the simple rules of supply and demand. As the former decline, they become more competitive and the latter less appealing. This threatens US LNG exports to Europe and Asia, on which many energy and construction companies, as well as many banks and investors, have been betting a lot of money in recent months. Recently, a massive expansion of a LNG facility near Freeport in Texas closed its financing, at around $11 billion dollars, and construction began in November of 2014. “I’m not worried about the projects that are under construction in 2015, those are going to go ahead and it’s already a big milestone for the American LNG industry,” says Palti-Guzman. “But this situation creates more vulnerability for the second wave of US energy projects, those who haven’t found buyers yet.”

This brings us to the US (and Canadian) financial industry, which has been recovering since the collapse of Wall Street in 2008, is better capitalized, more strictly regulated and generally safer than it was before the crisis, but which also carries an exposure to oil and gas. A challenge especially for smaller, less diversified, banks. “Most of the lending in the mid-cap bank space is reserve-based, which means that the collateral supporting the underlying loan is the oil in the ground. When doing reserve-based lending, banks tend to heavily discount the value of the oil and require the borrower to hedge against price fluctuations for a set number of years,” wrote analysts at Morgan Stanley in a report published in December and picked up by the website TheStreet.com. “Lending to energy services is less secure and could lead to higher potential losses.” If defaults, or even delinquencies, by energy companies were to increase substantially, the most invested North American banks could suffer. As a response, they might cut lending to other struggling companies in the same sector, who might then also default. The risk, of course, is to initiate a vicious cycle of increasingly tight credit.

Finally, it is hard to imagine that lower oil prices won’t also amount to a threat to renewable energy, as they weaken the economic argument, though of course not the environmental one, in its favor. In all truth, this outcome wouldn’t have to be immediate, as there are regulations and incentive schemes in place which support  “green energy”, but surely the temptation to burn more is bound to grow. Once again, how low crude goes and how long it stays there matters, as well as the choices that individual companies, and countries, make, as energy will not remain this cheap forever. “It all depends if you have a long term strategy or just a short term strategy based on the volatility of oil and gas prices,” says Palti-Guzman.

Overall, lower oil prices than we’ve seen in the last few years are indeed good news. Much below the $50 a barrel mark for a long period of time, though, and we might have on our hands a case of too much of a good thing.