David Stockman summarizes a report from our friends at Goldman Sachs explaining that over $1 trillion in global oil investments excluding US shale are going to have to be either mothballed or run at a loss given the recent downturn in the price.
The Goldman tally takes the long view of project finance as it plays out over the next decade or more. But the initial impact of low prices may be swift. Next year alone, oil and gas companies will make final investment decisions on 800 projects worth $500 billion, said Lars Eirik Nicolaisen, a partner at Oslo-based Rystad Energy. If the price of oil averages $70 in 2015, he wrote in an email, $150 billion will be pulled from oil and gas exploration around the world.
An oil price of $65 dollars a barrel next year would trigger the biggest drop in project finance in decades, according to a Sanford C. Bernstein analysis last week.
What happened here? Why did investors put so much money into sophisticated, high-cost oil production?
Eugen von Böhm-Bawerk theorized that lower interest rates (indicating a lower cost of capital) encourage investors to put their funds into a ‘lengthening of the capital structure’ (meaning the physical as well as financial structure of production). Hayek, one of his students, noted that when interest rates are forced lower by state policy, it creates a false signal to invest more into earlier stages of production.
You have the Fed going to our respected friends & sponsors in the premier banking houses, giving them free money through various special mechanisms, and then those investors must find uses for that capital that they can credibly make a business case for.
This is what happened with the boom in unconventional oil production: a combination of high commodity prices, combined with nearly infinite available funds for long term capital investment, lead to a mad scramble in speculative development.
Because it’s paradoxically easier for investors to get credit than it is for consumers, you get the classic business cycle effect of excessive investment relative to real market demand. The thumb of the sovereign presses down on the ‘investment’ segment of the economy, while letting the ‘consumption’ segment languish.
The theory motivating this, per Keynes, is that directing funds towards investment through state action results in a ‘multiplier’ effect closer to the consumer. The theory frequently goes awry with the crashes, which are explained away as criminality, an outbreak of ‘animal spirits,’ ‘irrational exuberance,’ or other such statements.
In the contemporary case, the savings of consumers are actively suppressed through low interest rate policy, whereas accounts that might have been compounding at 5% per year at instead compounding at less than 1%. The consumer is being prevented from recovering his purchasing power, while investors are being supplied with ample credit for any scheme that can be credibly proposed, or are otherwise using the money to speculate in the financial markets.