The writer is a senior fellow at Harvard Kennedy School
Whenever things went wrong growing up, my dad would tell me, “What doesn’t kill you only makes you stronger.” Dying was supposed to be the worst-case scenario. He never mentioned zombies. But that’s what a bailout for the oil industry would create: zombie companies that can’t earn the cost of staying in business, kept afloat with taxpayer dollars.
The oil patch in the US has been hit by a double whammy. The Saudi-Russian fight for market share helped drop the price of West Texas Intermediate, the American benchmark, to just above $20 a barrel. Then came coronavirus lockdowns, and an unprecedented collapse in demand for oil. While Easter Sunday’s Opec+ deal should reduce the supply glut, it is dwarfed by demand problems: WTI fell to around $18 a barrel on Friday.
With storage facilities near full, there will soon be no place to put the oil. Drillers, producers and oilfield servicers will be forced to halt production and lay off workers. Washington is now in bailout mode. The Trump administration offered storage space in the Strategic Petroleum Reserve. The Energy department is developing a plan to pay producers to leave crude in the ground.
There are valid economic arguments for a bailout. Energy is an important driver of investment. The last time WTI dropped significantly, in 2015-16, capital expenditures contracted and the US fell into an industrial and manufacturing recession. Employment in the oil and gas sector fell by about one-third. Some say it contributed to the discontent that pushed Donald Trump to the presidency in 2016.
But the business model for many exploration and production companies was broken before oil prices fell. Fuelled by cheap credit, US shale producers borrowed heavily to invest in drilling, causing the US energy bond market to triple in size over the past decade. The focus has been on producing quantity to conquer market share and the flood of oil has yielded low returns for equity investors, as frackers reinvested windfalls and raised top executive pay. US fracking pioneer Chesapeake Energy, for example, hasn’t generated a single year of positive free cash flow in the past decade. As debts rose along with oil supplies, a shakeout was inevitable.
A bailout would throw good money after bad, propping up an industry desperately in need of productivity gains and consolidation. Instead, the industry should be left to adapt. According to analysts at Rystad Energy, shale producers should be able to cut costs by 16 per cent this year, productivity gains that would not happen with government funding. High-cost or highly indebted small producers — and their infrastructure — should be taken over by larger, solvent companies. While that would result in bankruptcies and debt write-offs, it would reduce financing costs for those left standing. The industry would come out stronger and more profitable.
A backhanded industry argument for a bailout is that bankruptcies threaten investors and banks with big losses. That’s the nature of capitalism. Investors take risks and are often rewarded with high returns. Sometimes investments go south and they have to absorb losses, but it’s not a systemic risk. A compilation of annual disclosures by Bloomberg News shows Citigroup, Bank of America, Wells Fargo and JPMorgan are the largest US bank energy lenders. Only about 1 to 3 per cent of their portfolios are exposed to the industry. A series of defaults would hurt, but it would not alone bring down the big banks.
Of course the government should offer support for energy workers facing inevitable lay-offs, along with all the other Americans losing their jobs in the crisis. But while many companies closed by coronavirus were healthy businesses beforehand, many in the oil industry were already on a path to failure. This is no time to create zombies.
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