JUST over a year ago Harold Hamm, billionaire boss of Continental Resources, one of the biggest shale-oil producers in America, issued a stern warning to his fellow frackers. Drill with restraint or we will “kill the market”, he said. This month the 72-year-old Mr Hamm, son of an Oklahoma cotton sharecropper who went on to become one of the founding fathers of the shale revolution, had a different message. Restraint is working.
The price of West Texas Intermediate (WTI), the light, “sweet” (or low-sulphur) crude that is a benchmark for American producers, rose to $71 a barrel on May 9th, its highest level since November 2014. OPEC, which Mr Hamm once called a “toothless tiger”, is successfully leading efforts to balance the market. Oil prices are partly rallying because President Donald Trump this week pulled America out of the nuclear deal with Iran and said he would reimpose sanctions on a big oil producer. Meanwhile a free fall in Venezuelan production may be further exacerbated by the move of ConocoPhillips, a large American producer, to freeze some Caribbean assets of PDVSA, Venezuela’s state oil company, as part of a long-running legal dispute.
But arguably the most remarkable development is that the rise in the oil price has not yet unleashed a flood of new shale-oil supply, as many market experts had predicted (and Mr Hamm had feared). The reasons for this are threefold: pressure from shareholders more interested in a steady stream of dividends than a gush of oil; production bottlenecks in pipelines and ports in America; and the fast depletion of shale wells after bountiful beginnings.
The question, as producers begin to savour higher profits and investors’ appetite for them increases, is whether the restraint will endure. Bobby Tudor of Tudor Pickering Holt, an oil-and-gas investment bank, says that as oil prices are rising, so are animal spirits. That could perpetuate the age-old pattern of overexpansion in commodities markets. If he is right, the impact of higher supply will be felt throughout global oil markets.
Bringing home the Bakken
Mr Hamm’s Continental is a decent place to start to understand the countervailing forces at play in the shale industry. Like many of its peers, the company has demonstrated the grit and discipline that has brought the shale industry back from the edge of disaster since 2014-16. Now the good times have returned, and with them the temptation to slip the leash.
Continental is a wildcatter’s dream. Started by Mr Hamm when he was 21, a decade ago it was still drilling just 7,000 barrels a day (b/d) in the Bakken, a 9,000 square-mile formation in North Dakota and Montana where it pioneered a combination of hydraulic fracturing (“fracking”) and horizontal drilling; last quarter production reached as much as 161,000 b/d. In 2014 Continental suffered a severe blow when Mr Hamm rashly unwound its oil hedges in the mistaken belief that falling oil prices would swiftly bottom out. Once again it is unhedged, but this time that means it is benefiting more from the current oil-price rally than conservative peers.
Unlike many rival shale producers, it has stuck with the Bakken and with shale deposits in Oklahoma, rather than chasing the more fashionable reserves of the Permian Basin in west Texas and New Mexico. For the past few years this has been a millstone, but now “the Bakken is back—and booming,” executives say. The firm’s production there grew by a whopping 48% in the first quarter of 2018, compared with the same period a year earlier, amid overall growth in its portfolio of 37%. Hess, a rival, is also doing well there. “The notion that you have to be in the Permian to be appreciated no longer holds up,” Mr Tudor says.
Reassuringly for shareholders and creditors, the growth is partly being used to shore up corporate finances. For years the shale-oil industry has been seen as a money pit. According to Bernstein, a research firm, ever since 2012 shale producers on average have spent more than they earned; by the first quarter of 2016 they were burning through more than three times as much cash as they produced. But since last year they have been living within their means, with profit margins rising to about 10% with oil at $55 a barrel—and going even higher now.
Some companies, such as Pioneer Natural Resources, Devon Energy and Anadarko, have used their rising returns to give more cash back to shareholders, through higher dividends, share buy-backs or both. Continental, which plans to generate $1bn of cash this year, is prioritising debt repayments, and is nearing its goal of net debt below $6bn.
Yet amid this Boy Scout good behaviour, the wildcatter spirit remains—all couched in typical industry hyperbole. Continental, for instance, says it plans to invest in a vast new 350-well project in Oklahoma, called Project SpringBoard, which will be drilled and developed so efficiently it will be like “mowing the lawn”. Devon Energy says it has recently drilled wells in the Permian’s Delaware Basin that have the best initial production rates in the basin’s 100-year history. Pioneer, the most successful producer in the Permian, talks of Permian 3.0, a new type of well technology that it says will produce a third more oil than previous wells. Parsley Energy, a small producer, said it started pumping oil from more wells in the Delaware Basin in the first quarter of 2018 than during the whole of 2017. Its average production was up by 57%.
To keep cautious shareholders happy, the industry insists that such drilling will only be focused on high-return projects; that spending discipline will be maintained; and that their goal is return of capital, as well as returns on it. Several exogenous factors are also helping to keep the flow of oil in check for now, notes Roy Martin of Wood Mackenzie, an energy consultancy. These include higher costs of fracking crews, a shortage of truck drivers and the steep price of inputs such as water in dry places like Midland, Texas, which strain even in-the-money shale producers.
In the Permian, pipeline constraints are making it harder to get oil to the main hubs such as Cushing or the refineries and export terminals on the Gulf coast (see map). This has caused a big discount for crude stranded in Midland, in the heart of the Permian, compared with that in Cushing. For those without firm transport contracts, that reduces the incentive to drill.
Moreover, the productivity of shale wells is becoming harder to improve. Already some of them extend two miles underground. Increasingly new ones are drilled close to prolific wells, which can quickly drain reservoirs. “Some of these companies couldn’t ramp up production if they wanted to. This is helping them tell their story of capital discipline to Wall Street,” Mr Martin says. But he notes that next year new pipelines will be completed to ship more oil out of the Permian, which will ease the bottlenecks. If oil prices rise further, Mr Hamm’s strictures on discipline may again be ignored.
Japan still has great influence on global financial markets
IT IS the summer of 1979 and Harry “Rabbit” Angstrom, the everyman-hero of John Updike’s series of novels, is running a car showroom in Brewer, Pennsylvania. There is a pervasive mood of decline. Local textile mills have closed. Gas prices are soaring. No one wants the traded-in, Detroit-made cars clogging the lot. Yet Rabbit is serene. His is a Toyota franchise. So his cars have the best mileage and lowest servicing costs. When you buy one, he tells his customers, you are turning your dollars into yen.
“Rabbit is Rich” evokes the time when America was first unnerved by the rise of a rival economic power. Japan had taken leadership from America in a succession of industries, including textiles, consumer electronics and steel. It was threatening to topple the car industry, too. Today Japan’s economic position is much reduced. It has lost its place as the world’s second-largest economy (and primary target of American trade hawks) to China. Yet in one regard, its sway still holds.
This week the board of the Bank of Japan (BoJ) voted to leave its monetary policy broadly unchanged. But leading up to its policy meeting, rumours that it might make a substantial change caused a few jitters in global bond markets. The anxiety was justified. A sudden change of tack by the BoJ would be felt far beyond Japan’s shores.
One reason is that Japan’s influence on global asset markets has kept growing as decades of the country’s surplus savings have piled up. Japan’s net foreign assets—what its residents own abroad minus what they owe to foreigners—have risen to around $3trn, or 60% of the country’s annual GDP (see top chart).
But it is also a consequence of very loose monetary policy. The BoJ has deployed an arsenal of special measures to battle Japan’s persistently low inflation. Its benchmark interest rate is negative (-0.1%). It is committed to purchasing ¥80trn ($715bn) of government bonds each year with the aim of keeping Japan’s ten-year bond yield around zero. And it is buying baskets of Japan’s leading stocks to the tune of ¥6trn a year.
Tokyo storm warning
These measures, once unorthodox but now familiar, have pushed Japan’s banks, insurance firms and ordinary savers into buying foreign stocks and bonds that offer better returns than they can get at home. Indeed, Japanese investors have loaded up on short-term foreign debt to enable them to buy even more. Holdings of foreign assets in Japan rose from 111% of GDP in 2010 to 185% in 2017 (see bottom chart). The impact of capital outflows is evident in currency markets. The yen is cheap. On The Economist’s Big Mac index, a gauge based on burger prices, it is the most undervalued of any major currency.
Investors from Japan have also kept a lid on bond yields in the rich world. They own almost a tenth of the sovereign bonds issued by France, for instance, and more than 15% of those issued by Australia and Sweden, according to analysts at J.P. Morgan. Japanese insurance companies own lots of corporate bonds in America, although this year the rising cost of hedging dollars has caused a switch into European corporate bonds. The value of Japan’s holdings of foreign equities has tripled since 2012. They now make up almost a fifth of its overseas assets.
What happens in Japan thus matters a great deal to an array of global asset prices. A meaningful shift in monetary policy would probably have a dramatic effect. It is not natural for Japan to be the cheapest place to buy a Big Mac, a latté or an iPad, says Kit Juckes of Société Générale. The yen would surge. A retreat from special measures by the BoJ would be a signal that the era of quantitative easing was truly ending. Broader market turbulence would be likely. Yet a corollary is that as long as the BoJ maintains its current policies—and it seems minded to do so for a while—it will continue to be a prop to global asset prices.
Rabbit’s sales patter seemed to have a similar foundation. Anyone sceptical of his mileage figures would be referred to the April issue of Consumer Reports. Yet one part of his spiel proved suspect. The dollar, which he thought was decaying in 1979, was actually about to revive. This recovery owed a lot to a big increase in interest rates by the Federal Reserve. It was also, in part, made in Japan. In 1980 Japan liberalised its capital account. Its investors began selling yen to buy dollars. The shopping spree for foreign assets that started then has yet to cease.
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