I wrote about my thoughts on shale oil here in October.
Over the weekend David Stockman has come out with a great piece on how the shale boom is nothing but a Fed induced malinvestment spree. This is the best quote:
(…) Obviously, what we have here is another massive deformation of capital markets and the related flow of economic activity. The so-called “shale miracle” was not made in Houston with some technology help from Silicon Valley. The technology of horizontal drilling and well fracking with chemicals has been around for decades. What changed were the economics, and those were made in the Eccles Building with some help from Wall Street (…)
This quote says it all. It looks as if the scepticism of my engineer-friends over here was well founded. The “shale-revolution-based-on-new-technology” story seems to have been merely a canard made up by Wall-Street in order to easier raise capital (mainly debt). And there is nothing better than a new technology storyline to sell financial “products” to credulous investors. Surely lots of journalists were “wined and dined” in order to spread the word about America’s innovative capacity here in Europe. Well done!
The anomaly is this: debt finance is mostly unsuitable for a business model like shale oil whose constant drilling with inevitably high failure rates has risk characteristics of a start-up enterprise.
And start-ups should not be financed with debt!
Further, constant drilling is required because of high depletion rates. David Stockman writes that, on average, 90% of a well’s capacity is exhausted after only two years, effectively resulting in a maturity mismatch between assets and liabilities (typically 5 years) – a toxic combination.
As Mises wrote in his 1912 book “Theory of Money and Credit“: it is not only the amount of debt, but also its structure (maturity, covenants) that matters – something which is still not grasped by most mainstream economists (see, for instance, my post about Eugene Fama on Fed QE here).
To be fair: the fact that financing structure during a boom is subject to changes was also observed (although much later) by the now-popular Keynesian economist Hyman Minsky. Of course, Minsky – an empiricist – merely described what he had observed without providing a theory of why market participants behave the way they do (unless you consider”greed” a scientifically valuable explanation) – and of course without ever explaining why/how government officials who are supposed to regulate all this should know better.
Minsky, was on the right track and his work is a useful collection of data. However, without a proper deductive theory he could not connect the dots.
The wrong kind of investments financed with the wrong instruments hints at a malinvestment boom. This not only means that increased defaults are a certainty unless the oil price recovers, but also that a lot of people have gotten the risk assessment on this part of their portfolio holding completely wrong. A large amount of non-natural holders of risk increases the probability of contagion and spill-overs.