Debt-fuelled oil industry brought down by virus

What you see in an economy changes depending on where you observe it from. For every purchase, there is a sale; for every debtor there is a creditor. In times of great economic upheaval, it’s very easy to focus on the headline issue, without pausing to consider what lurks behind it.

In the early days of the global financial crisis, it appeared the most pressing issue was the poorly regulated and rapaciously greedy American banks, supported by lax insurers and credit rating agencies.

Europeans crowed that the problem was mainly to do with the Wild West of American capitalism, and the future would be more statist, more regulated, more – well, French. ‘‘Self-regulation, to fix all problems, is over. Laissez-faire is over,’’ said then-French president Nicolas Sarkozy.

He was partly right. Necessary regulation returned, but the real problem that blighted the last decade was too much state intervention in Europe, a continent blighted by a dreadful currency, a hamstrung central bank and catastrophic levels of public debt (not to mention far worse banks than the Americans).

The banking crisis became a debt crisis. Instead of bailing out banks, we began bailing out countries.

We know this crisis will be deeper, worse, more painful – but what’s going to change, and why?

A good place to start is debt. The debt story of the GFC certainly wasn’t over when the Covid-19 crisis began. Indebted countries and companies were shepherded through the crisis years by accommodating central banks, which slashed interest rates, keeping the cost of borrowing low to stimulate the economy. Some central banks intervened even more, creating money to buy vast amounts of government debt. They could do this by essentially creating the money out of thin air.

As you’d expect, this vast hunger for debt pushed down the price of borrowing. Governments – although not ours – took on lots of borrowing, and corporates binged.

There’s upside to this. Businesses can binge on cheap debt, making big investments in the things they need to improve.

But long periods of cheap debt are unhealthy.

Economies are really the sum total of lots of decisions made by businesses and people. In aggregate, these give us powerful signals about what people like or don’t like; what investors think is viable and what they think is a risky bet.

Long periods of central bank intervention distort these signals. Pushing down the cost of borrowing all of a sudden makes some risky businesses viable, when they probably aren’t.

This is where the story of the Covid-19 pandemic becomes a story about debt. A flock of mainly American corporates binged on debt, taking advantage of lenders who were looking for more cash than governments and banks were able to give them.

This is particularly true in the oil sector, where cheap debt has driven investment in shale oil, which is so costly to extract that many doubt it would be financially viable were borrowing costs at normal levels, rather than artificial lows.

But now the chickens are coming home to roost. The combination of a collapse in demand for fuel by as much as 20 per cent according to the International Energy Agency, and a diplomatic spat between Saudi Arabia and Russia, has crashed oil prices. Meanwhile, the cost of debt is surging as investors flee to safer waters.

Oil companies are feeling the pinch. The US is slashing the number of rigs operating. Year on year, the US rig count fell 361 to just 664. New investment in oil is collapsing too. Rystad Energy, an Oslobased research and consulting firm, said global exploration and production are expected to fall by US$100 billion this year, down to $446b, a huge decline from the $880b it spent on exploration and production in 2014.

The oil industry’s plight will be applauded by some. But this isn’t the much-needed pivot from fossil fuels we’ve been waiting for. Decline in oil demand represents people becoming poorer as the economy worsens. The fact that the decline has come after an enormous debt binge underscores the danger in having another 10 years of artificially low borrowing masking price signals.

In one ear, governments have been telling energy firms to switch to renewables, in some cases with hefty and expensive tools; in the other, artificially low borrowing and consumers with no alternative have been telling them to keep drilling. The two signals cancelled each other out – the rigs kept pumping.

In the short term, no-one should begrudge governments and central banks crashing borrowing costs to keep firms in business and people employed, but masking the powerful price signals of economies does no-one any good in the long run.

Price signals need to be right – even when what they tell you is scary, like drawing the curtain down on the industry that has showered the developed world with prosperity for a century.

Decline in oil demand represents people becoming poorer as the economy worsens.