MacroView – The Energy Rally Is Likely Premature

energy rally, #MacroView – The Energy Rally Is Likely Premature

The surge in debt, which is supported by the Federal Reserve’s ongoing generosity, has led to a large number of “zombies.”

‘Zombies’ are firms whose debt servicing costs are higher than their profits but are kept alive by relentless borrowing. 

Such is a macroeconomic problem. Zombie firms are less productive, and their existence lowers investment in, and employment at, more productive firms. In short, a side effect of central banks keeping rates low for a long time is it keeps unproductive firms alive. Ultimately, that lowers the long-run growth rate of the economy.” – Axios

energy rally, #MacroView – The Energy Rally Is Likely Premature

Many of these “zombies” exist in the energy space.

These companies that took on the debt, or equity, to drill must keep drilling to generate revenue or die. As supply increases, prices decline, leading to further drilling losses in wells, which were only marginally profitable, to begin with. Companies then have to take on more debt to remain operational, further increasing supply in hopes that prices will eventually rise.

The chart below shows that even minor upticks in oil prices lead to rigs’ rapid deployment to produce more oil, increasing the supply.

energy rally, #MacroView – The Energy Rally Is Likely Premature

While logic would suggest companies actively reduce the supply to increase prices, operators cannot “shut-in” production due to the loss of needed operating revenues. The underlying land leases also constrain them.

The Supply-Demand Imbalance

The current levels of supply create longer-term issues for prices globally. Compounding the problem is weaker global demand due not to just the “economic shutdown” but ongoing issues related to demographics, energy efficiencies, and debt.

The issue remains supply. Despite the crash in oil prices this year, and continued production cuts by OPEC, and nearly 100 energy companies filing bankruptcy, supplies only marginally declined.

energy rally, #MacroView – The Energy Rally Is Likely Premature

Oil production remains near the highest levels in history.

energy rally, #MacroView – The Energy Rally Is Likely Premature

As noted above, oil companies must produce oil to generate revenues with which to operate. For many smaller energy companies, shutting down production is not an option as it would immediately lead to credit defaults and bankruptcies.

In 2008, when prices crashed, the supply of into the marketplace had hit an all-time low while global demand was at an all-time high. Remember, the fears of “peak oil” was rampant, and oil prices soared higher on concerns about a shortage. However, following the “Financial Crisis,” the “fracking miracle” was launched. Supply surged, usurping the demands of a weaker “post-crisis” global economy. 

energy rally, #MacroView – The Energy Rally Is Likely Premature

The supply-demand problem remains even despite the “pandemic” related drop in demand. However, OPEC+ is looking to increase output, which will further exacerbate the supply overhang.

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