The Federal Reserve has acted as a lender of last resort to the shale industry. It could end in economic and climate catastrophe.
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When global energy demand screeched to a halt in the pandemic-ridden spring of 2020, it exposed the dire reality of American shale production. The industry of fracking, as it is commonly called, has brought both the US economy and global climate to increasingly precarious positions.
The oil and gas sector constitutes around 8% of the US GDP, with nearly three quarters of its production from fracked, shale formations. However, since the industry’s rise in 2010, more than $300 billion has been lost. While the fracking boom allowed the US to regain energy independence from other oil producing nations, it has come with incalculable domestic and planetary costs. America’s shale revolution is the latest and perhaps most damaging fossil fuel boom and bust to date. It’s a saga of financial hubris, paradoxical economics, and the antiquated pursuit of global petroleum dominance in a world transitioning to renewable energy technologies.
The Fed rescues American oil
While fracking was initially welcomed by eager investors, Wall Street has abandoned US oil and gas firms in recent years due to longstanding negative cashflow and stagnant production growth. However, in the aftermath of the coronavirus’ shock to energy markets, shale producers have found a surprising ally: the US Federal Reserve. Central banks are designed to function independently from the federal government, autonomous of political discourse and prohibited from prioritizing individual sectors. And yet, the Fed has gone where most investors dare not tread by acting as a “lender of last resort” to a practically insolvent fracking industry.
The unusual turn of events began in March when the central bank announced its $2 trillion Main Street Lending Program as part of its broader COVID-19 relief package. At a time of widespread fossil fuel lobbying, the Independent Petroleum Association of America (IPAA) wrote a letter to the US Federal Reserve imploring them to amend their policy, ensuring that the monetary stimulus could now be used for debt refinancing – something that shale producers urgently needed.
The following week, a group of eleven Senate Republicans from oil producing states echoed these demands. The congressional representatives specifically asked that the Fed move back the date by which a firm’s credit rating would be evaluated and, accordingly, deemed entitled to the program’s benefits.
Also at this time, Secretary of Energy Dan Brouillette and Secretary Treasury Steve Mnuchin worked closely with the Federal Reserve to expand the reach of the Main Street Lending Program to ensure that it would apply to mid-sized firms in addition to smaller ones. Brouillette, who was recently appointed by the president, told Bloomberg TV that he was acting at the direction of the executive branch.
By late April, the Fed issued alterations, many in accordance with the demands of the oil and gas industry and its political advocates. The lending initiative was now eligible to mid-sized firms, the date was moved back and the loan could be used to pay off debt.
As reported by Politico, the US Federal Reserve has denied any allegations of prioritizing oil and gas, let alone any specific sector, in its actions. The Fed has also denied a request from the environmental litigation group Food & Water Watch to release communications with government officials and industry advocates on the topic.
An unprecedented bailout was underway
Leading up to this drastic shift in monetary policy, the fracking industry proved particularly feeble in the wake of the pandemic. In contrast with adjacent economic sectors like communication services or utilities, US energy companies experienced record drops in bond ratings during the shutdown and subsequent collapse of international oil prices. Shale producers were already vulnerable to downgraded credit ratings as they were long dependent on the riskiest form of corporate investment: junk debt.
The rise of shale junk bonds
According to InfluenceMap, a non-partisan UK based think tank, a third of US oil and gas firms are considered “junk” status or non-investment grade. Frackers have accrued insurmountable amounts of junk debt and, amidst plummeting energy demand and prices, many struggled to meet their financial obligations. As a result, some have already declared bankruptcy like in the case of fracking heavyweight Chesapeake Energy Corporation.
Energy sector credit ratings have collapsed following the pandemic
Typically, “junk bonds” (or “high yield bonds,” depending on whom you ask), offer investors higher risk but with the prospect of higher returns than traditional corporate grade debt. Also known as speculative-grade debt, they come with a lower credit rating than investment grade corporate bonds. The energy sector today holds around 12% of the US market for high yield bonds, more than any other industry in the nation.
Junk bonds were popularized in the 1980s by Michael Milken and the investment firm Drexel Burnham Lambert and have always been controversial. Critics have charged Milken and Drexel with facilitating leveraged buy-outs that led to the dismantling of many American corporations. These acquisitions drastically increased the amount of debt a company incurred, often leading to dramatic cost cutting measures. Some argue that such buy-outs resulted in job losses, plant closings and the hollowing out of key industries – particularly in the manufacturing sector. According to John Morris, a retired managing director at Wells Fargo, junk bonds are “the pawnshop of financial markets.”
Others, however, say high-yield debt was instrumental in opening investment to industries that previously did not have access. By the 1990’s, junk bonds had become a legitimized source of funding for blossoming service sectors like Las Vegas casinos and Silicon Valley tech firms (although precipitating its upheaval in the “dot com crash” of 2002).
Shale producers thrived on junk debt in the aftermath of the 2008 crisis. The wake of financial consolidation presented a fertile environment for frackers to flourish: The recapitalized banks were keen to lend to the industry, catalyzing fracking’s fast-paced, but expensive growth. Accordingly, the Fed’s newly instated 0% interest rates made it easier to raise junk debt.
In the years to follow, the price of oil would float to record highs around $100 a barrel, encouraging investment in what appeared to be a revolution in America’s energy sector.
Junk bonds have skyrocketed since 2008
One of several early fracking firms to receive investment at this time was EOG Resources, considered the US’s largest shale specific oil & gas producer today (Exxon and Chevron produce more when off-shore and conventional drilling is included). EOG, the abbreviation of Enron Oil & Gas, splintered from its parent company in 1999, shortly before Enron’s bankruptcy and conviction of fraud.
Since 2008, the rush of corporate bond investment caused the amount of junk debt in independent oil & gas firms to triple—amassing to nearly $800 billion by the end of 2013, according to The Houston Chronicle. During these same years, junk bond-fueled US oil production increased by more than a half. To many, this was nothing short of a miracle as it marked America’s first consistent growth in oil production since the 1970’s.
As this boom accelerated, the first cracks in the shale narrative appeared. Energy analysts began to point out that fracking is significantly more capital intensive than drilling a conventional well. Shale rock formations are located more than a mile beneath the earth’s surface, while conventional drilling has historically taken place at higher depths. Furthermore, fracturing shale requires sophisticated, deep-reaching directional (or “slant”) drills that are expensive and demand precision as inaccurate fractures can lead to “hundreds of thousands of dollars of lost production value per well,” according to Texas based Motive Drilling Technologies.
Additionally, the supply chains of fracking are vast and costly. Early reports estimate that between 2,300 and 4,000 truck trips are required to frack one well, more than twice that of conventional oil rigs. Oil field servicing firms like Halliburton or Schlumberger provide everything from drilling equipment to the chemical cocktails required for slickwater injection which pushes the oil or gas from the shale sediment.
While these high costs were justified by the notion that fracking would produce a higher yield, the flow from these wells can be unusually short lived. A 2013 Harvard study issued claims that the maximum extractive potential of a fracking rig is only in the “early months of activity” and will produce significantly less crude than a conventional well for the remaining decades of its life. The report goes on to explain that “oil companies intensively drill for new wells that offset the loss of production from older wells.”
It soon became apparent that the logistics of shale extraction were undercutting hopes for a positive cashflow. According to Kathy Hipple, a financial analyst at the Institute for Energy Economics and Financial Analysis, shale companies “did not have a proven business model and, to this date, they do not have a proven business model.”
Similar concerns were echoed by Alexander Medvedev, Deputy Chief Executive of Gazprom, Russia’s largest gas company which had acquired fracking technology in a 2011 deal with Exxon XTO. Medvedev told The Wall Street Journal “our traditional reserves are tenfold more efficient than shale resources” and that Russia would revisit the technology at a later point in the 21st century.
The treadmill effect
The combination of high capital costs and low production yields creates a Kafka-esque cycle of drilling, extracting, under-producing, debt-refinancing, and then fracturing more wells to repeat on a larger scale. To those in the industry, this process is known as “treadmilling” or the “red queen”—a reference to a scene in Alice In Wonderland in which Alice runs vigorously from the Red Queen, only to be stuck in the same place.
By 2010, oil majors had adopted fracking technology
Despite growing skepticism around the economics of fracking, the Fed’s alumni continued to be one of the industry’s most consistent promoters. At a 2014 conference in Houston, former Fed chairman Ben Bernanke cited shale as “one of the most beneficial, if not the most beneficial developments in the last few years. I mean, it’s just a terrific achievement.”
However, the exponential growth perpetuated by the treadmill effect came with further consequences to the industry’s livelihood. Alongside shifts in geopolitics and OPEC+ policies, the rapid expansion of US shale production created an oversupply that triggered the historic oil price collapse of 2014. While the year began with oil prices floating around $100 a barrel, they had plummeted below $60 by December—a price range far beneath what fracking had initially been built on.
Although oil markets were shaken by such volatility, many US officials saw the shale boom’s promise of oil independence as a foreign policy dream come true. Former Fed Chairman and corporate director at Mobil Corporation (later ExxonMobil) Alan Greenspan, declared victory in a 2015 op-ed in the Financial Times entitled “OPEC has ceded its power to the US over oil price.” Thanks to fracking, Greenspan dubbed the US the winner in the race for global petroleum dominance against the cartel of oil producing nations.
But at this time of collapsing oil prices, Joe Barton, a Republican congressman from Texas, noticed that leading fracking firms like CoconoPhillips and Pioneer Resources were under distress from over-production and lack of refineries for processing. Instead of dialing back such unstable growth, Barton successfully petitioned the Obama White House to end the 40-year ban on oil exports.
With lifting the oil export embargo, the US would surpass Saudi Arabia and Russia in becoming the world’s largest producer and exporter of fossil fuels. Opening US shale to international markets also ensured demand for cash strapped producers and prevented the fracking treadmill of debt from collapsing into a credit crisis.
Many US officials saw the shale boom’s promise of oil independence as a foreign policy dream come true
Facing the economic reality of shale
Despite praise from its former Chairmen, even the Fed itself raised concerns over the industry’s ballooning debt and negative cashflow in a 2016 report. It detailed that break-even prices in different shale producing regions fluctuated between $23-60. The day the report was published, oil prices rested at around $41. By the Fed’s own numbers, much of US shale oil was unprofitable.
The central bank’s report also echoed unsettling data from the US Energy Information Agency (EIA): approximately 80% of revenue produced from onshore drilling was being allocated to debt refinancing. In an ominous conclusion, the Fed warned that “financial markets may also be a mechanism that transmits oil market deterioration to the broader economy.” The statement foreshadowed the central bank’s motives for the bailout in spring of 2020.
Regardless of the growing demand from newly opened international markets, fracking firms were presented with further obstacles. While shale rich regions like the Permian Basin became more densely drilled, decreasing distance between wells was found to depressurize the rush of oil. Known as “child” wells, this lackluster extraction is believed to decrease yield by 15-20% and, as of 2017, effected more than half of all production in the Permian.
As fracking expanded, critical resources used to fracture wells like sand and water became increasingly sought after, adding further to the industry’s already burdensome expenses. The combination of lower marginal returns and higher marginal costs began to impact the balance sheets of shale producers. Even big oil monoliths like Exxon and Chevron were not delivering the profits they had promised. To combat these concerns, Exxon reassured investors that returns would materialize by selling them on a slew of new business strategies. The firm even forged a brand alliance with Microsoft’s Azure cloud computing system that sought to create more accurate, effective fracking.
Exxon struggles to deliver positive cashflow
By 2019, the questionable financials of shale only worsened. The growth and returns that investors were continuously assured never came to be and the expansion of well productivity began to stagnate despite advancements in drilling technology and data analytics. After a decade of financing high-risk fracking projects, Wall Street had sealed its gates to the shale industry.
On the ground, the situation became dire. In May of 2019, West Texas gas had experienced negative prices due to oversupply and lack of adequate infrastructure for transport. By October, fracking trucks stood idle and stripped for precious parts—the treadmill had run itself to the ground.
Fracking production growth spirals into decline
But the calamitous state of the fracking industry did not hamper the Fed’s vocal support. In November of 2019, Chairman of the Federal Reserve Jerome Powell addressed the US Senate. At the hearing, he was pressed on his opinion of progressive taxation, as it was then being discussed in the Democratic presidential primaries. Powell recused himself from what he rightfully deemed a politicized discussion.
Yet, when Texas Senator Ted Cruz (R-TX) questioned the chairman on what he thought of Bernanke’s praise of the shale boom, Powell did not hesitate to respond that it “had been a great thing for this country” and that efforts to dismantle the fracking industry “would probably not be good for the economy.”
While the Fed does not have the ability to change policy, the words of its Chair and board are carefully observed by both elected officials and financial markets. Perhaps even more important was what the chairman did not say. Left unspoken was any mention of the highly competitive alternative to fossil fuels—renewable energy. Powell did not acknowledge that goals to dismantle the fracking industry go in tandem with bringing the US to 100% clean energy by 2035. A report from UC Berkeley has illustrated that these targets are not only within technological reach, but come with no additional costs for consumers. Other estimates conclude that these goals would produce 25 million new jobs.
Renewables: a way out
Clean energy employs around 3 million Americans today, roughly three times the size of those working in fossil fuels. For the past decade, renewable energy labor markets have grown steadily and, by 2016, the US solar workforce alone surpassed the size of all areas of fossil fuel extraction. Even in Texas, the top shale producing state, the fastest growing job is a wind turbine technician.
US solar PV labor market surpasses those in fossil fuel upstream
Furthermore, the quality of employment that fracking has delivered is unsustainable in both the short and long term. Although built on an initial goldrush, industry claims of economic development in shale rich regions never came to fruition. Unpayable rents, rising foreclosures, stressed education systems, and the proliferation of so-called “man camps”—isolated labor compounds riddled with drugs and sex-trafficking—strained local communities and workers. Many of those laboring on fracking rigs work 12-hour shifts for weeks on end amidst grueling heat and hazardous conditions.
Clean energy employs around 3 million Americans today, roughly three times the size of those working in fossil fuels
Renewables are not only safer for their workers, but also a safer bet for investors. Solar photovoltaic and wind energy have proven more resilient to market volatility than their fossil counterparts. In the months following the pandemic, a report from Climate Nexus’ Bailout Watch indicated that 11% of fossil fuel firms required the US Treasury’s Paycheck Protection Program while only 3% of renewable firms took the stimulus.
While much of the attention has been focused on the fracking boom, quietly, American renewable generation has nearly doubled in the past decade. Since 2015, wind and solar have both been cheaper than gas, causing US energy markets to respond accordingly. The EIA’s 2020 forecasts indicate that two thirds of the year’s newly installed energy generation will be in renewables, with only a third in fossil gas.
While much of the attention has been focused on the fracking boom, quietly, American renewable generation has nearly doubled in the past decade
America’s gamble for energy independence by underwriting shale producers has also come at the expense of the country developing a leading renewable energy industry of its own. Although solar photovoltaics were pioneered in Bell and NASA labs, the US has fallen severely behind in the race for renewable production, let alone possibility of export. The top four solar manufacturers today are all Chinese with the US’ Sun Power coming in tenth place behind Canadian and South Korean firms.
The future is only getting more bleak for US oil and gas producers. Today, they lag in their transition to renewables while nearly a third of their assets are now considered at risk of being stranded. Meanwhile, Nordic fossil fuel firms like Equinor and Ørsted have aggressively swooped into US renewable markets, now dominating offshore wind contracts across the American northeast.
Despite claims of dominance in international petroleum markets, the US never stood a chance in taming state-owned oil giants who can ride out periodic price shocks. When the pandemic slashed global energy demand, Russia began a price war with Saudi Arabia by refusing to cut its oil production. Consequently, the price of oil collapsed to record lows, shattering an already weakened US shale industry.
Such fragility was conceded in Republican senator Kevin Cramer’s letter to the Fed that pleaded with the central bank to evaluate the credit ratings of domestic energy firms prior to the “market manipulations from the Saudi Arabia and Russia oil dispute.” In this respect, Alan Greenspan’s 2015 declaration that OPEC+ had surrendered control of oil prices looks exceptionally far-fetched: There is no beating the oil cartel at their own game.
By and large, the US has wasted decades by investing in fracking over renewable technologies. Even the oil and gas industry itself recognizes the age of fossil fuels is coming to an end. Both US and Saudi producers have accepted the possibility that oil demand will, or has already, peaked.
Fracking and climate catastrophe
Above all, the US’s disastrous bet on fracking has caused irreparable damage to the climate. Fracked gas was once sold to Americans as a more sustainable alternative to coal by some mainstream environmental groups, the Obama administration and superstar investors like Warren Buffet and Michael Bloomberg.
However, since 2011, Dr. Richard Howarth and a team of Cornell scientists have explicitly warned that shale gas releases exceptional amounts of methane, a greenhouse gas considered 80 times more potent to warming than carbon dioxide. In his forthcoming paper for the Union of the Atomic Scientists, Dr. Howarth writes that fossil gas is a “disastrous fuel, one with a greenhouse gas footprint that exceeds that of coal when viewed over the time period of the next few decades.”
In the life cycle of shale gas production, methane is flared and vented during extraction, leaked during transportation and endlessly spewed from old wells that remain unplugged. According to a Reuters’s special report, the US is currently home to over 3 million abandoned wells, around 2 million of which have not been plugged correctly and are a likely contributor to a recent surge in methane emissions. Due to their depth, plugging shale wells is both labor and capital intensive with estimates ranging between 2,500–100,000 USD per well.
Despite decades of warning from NASA and the Pentagon, the Fed is only now waking up to the inevitable impacts of climate chaos. At a conference in January of 2020, Powell affirmed the central bank’s role in preparing the economy for a changing climate but noted that such threats were not short-term.
The Fed is only now waking up to the inevitable impacts of climate chaos
These tepid assurances came shortly after Kevin Stiroh, the vice president of the New York Federal Reserve, said in a speech that the “US economy has experienced more than $500 billion in direct losses over the last five years due to climate and weather-related events.” In addition, the vice president said that climate change has “significant consequences for the US economy and financial sector.”
Regardless of Stiroh and Powell’s statements, the Fed has yet to follow the EU Central Bank’s lead by incorporating the macroeconomic implications of the climate crisis into its reports, let alone policy making.
In the midst of shale’s bailout, scientists estimate that methane emissions are at an all-time high. Approximately 80% of the US’s recent increase in methane emissions can be linked to fossil fuels and accordingly, the fracking boom (as coal combustion, the other fossil producer of methane, has plummeted by nearly a half since 2010).
The widespread acceptance of methane’s destructive potential comes at a time when scientists say that planetary warming is accelerating faster than previous predictions. A 2020 UN report estimates that rising emissions over the next five years could ensure a 1.5 C rise in warming —an irreversibly damaging threshold for human and ecological life alike.
The Federal Reserve needs a new direction
The Fed’s bailout of the fracking industry not only poses threats to the nation’s environmental and economic future, but it may also be undermining the Fed’s most valuable asset: its monetary integrity and stature as the world’s pre-eminent central bank. In Sebastian Mallaby’s timely piece in Foreign Affairs “The Age of Magic Money,” the economic fellow at the Council on Foreign Relations warns that as the US increases its national debt, successful management of that debt will depend on the credibility of the Federal Reserve. Mallaby goes on to conclude that “If the Fed loses its independence, the age of magic money could end in catastrophe.”
The Federal Reserve now finds itself trapped between contradictory agendas. Despite its much-stated independence from American politics and business, the central bank has put an insolvent industry on life support. In doing so, it appears to prioritize short-term political and financial stability over the disastrous long-term feedback loops for the climate, the economy and its own reputation. By bailing out the fracking industry, it has successfully blurred the line between foreign energy strategy and domestic monetary responsibility. It may be the best example yet of the unintended consequences brought on by the Fed’s unprecedented intervention in the US—and global economy.