Does Financial Innovation Benefit the Society?
We live in a world which idolizes innovation. We tend to idolize companies which have produced some products which can be considered to be innovative. The underlying belief in the capitalistic system is that innovation is beneficial. It is innovation which creates more value, and since the capitalistic system allows the creator of innovation to […]
Zero-Coupon Bonds: Pros and Cons
Zero-coupon bonds are those bonds that are sold at a deep discount to their face value. This means that these bonds do not receive any periodic interest. Instead, the investors have to invest a lump sum amount at the beginning of their investment and get paid a higher lumpsum amount at the end of their […]
Estimating Project Cash Flows: Part 1
Prima facie, capital budgeting may seem like a very simple task. After all, it has just 3 steps. The first is to find the cash flows, the second is to find the appropriate discount rate that represents the time value and riskiness of those cash flows and the third step is to use both these […]
Tax the Rich Policy: A Critical Analysis
There are few issues which strike through the heart of communists in China and capitalists in America similarly. One such issue is the issue of taxes, particularly the taxes that are levied on people of the extremely high income category. The popular opinion is that the rich somehow collude with the politicians to create a […]
Capital Structure Ratios – Meaning and Importance
Capital structure ratios are very important to analyze the financial statements of any company for the following reasons: Same Business Can Yield Different Returns Investors understand that the way a business is funded can have a lot of impact on the returns it provides. Although the total return provided will always be the same, the […]
The fracking industry has had a huge impact on the financial situation of the world in the past decade or so. The process of hydraulic fracturing also known as fracking has allowed countries like the United States to produce oil from shale reserves. The result has been that the United States has become the third largest producer of oil in the world. Texas itself produces more oil than a lot of countries.
The industry has been at the centre of a lot of attention. This is because of the fact that the industry is hungry for a lot of capital. Fracking, like oil refining, is a capital intensive process. Continuous technological developments mean that the fracking industry is always in need of money to buy the latest equipment. For the most part, their hunger for more capital is fulfilled by private equity companies and debt funds.
Recent reports have been suggesting that all is not well in the fracking universe. The industry which was supposed to change the future of energy production, as well as the associated geopolitics, seems to be in the doldrums. In this article, we will have a closer look at some of the financial troubles which the fracking industry is facing.
Many researchers and analysts are drawing parallels between fracking companies as well as Enron. Just like the fracking companies, Enron also claimed that it was going to completely re-engineer the energy industry from the grounds up. Also, just like the fracking industry, the financials of Enron were also opaque.
One needs to understand that fracking is no longer a new or novel concept. This industry has been in existence for more than a decade. As per the projections made by several analysts, the industry should be highly profitable and should be generating loads of cash by now. However, the problem is that the numbers suggest otherwise. Only five of the top twenty fracking companies in the world are cash-flow positive! Profitability is almost non-existent in any of these companies.
The rates of return which are quoted when fracking industry pitches to investors for funds vary widely from the ones which are actually reported in the marketplace. This is the reason why investors have good reasons to believe that all is not as good as it sounds in the fracking industry.
The fracking industry has been one of the largest recipient of debt in the United States. This can be ascertained from the fact that the industry had combined outstanding debt of $50 billion in 2005. This number now stands at close to $250 billion! Also, it needs to be understood that in the period between 2005 and 2019, the interest rates have been abysmally low. This means that a lot of the projects which have been undertaken consider a very low opportunity cost.
The interest rate scenario in the world is about to change. The Fed has already raised interest rates four times in 2018 and is expected to continue doing so in 2019 as well. This means that debt payments will get more and more expensive. The problem is that the fracking industry is barely managing the interest payments when the rates are so low. If the interest rates are raised any further, the fragility of the business model of the fracking industry will be exposed. Any changes in the interest rates are likely to bring about a wave of bankruptcies in the industry.
The next question that arises is how did so much money get into fracking in the first place? Investors are usually conscious about where they invest their money. Since fracking has almost no historical rates of return, why did they invest huge sums of money in the business?
Once again, the answer lies in the interest rate regime. Most of the money that is invested in fracking came from the pension funds. Since the interest rates became extremely low, these funds were not able to find worthwhile investments in the bond market. As such, they turned their money over to private equity and hedge funds. This money then found its way into the fracking industry. About one-third of all the capital in the fracking industry has been built using this capital.
The problem is that the industry has not been generating any significant returns as of now. However, the interest rates are about to rise. Hence, once again, there is a chance that the capital may want to exit the industry causing mayhem and bankruptcies in the process.
Another major problem facing the fracking industry is that it is not in control of the prices. The prices of oil depend on other countries such as Saudi Arabia as well. Saudi Arabia has already dropped the prices of oil over an extended period of time in 2016. There is no reason why Saudi would not do the same again once it senses that the fracking industry is in trouble and can be wiped out completely.
The bottom line is that the fracking industry today stands on extremely shaky ground. It appears as if interest rate hikes and a supply glut by the Saudis could create a perfect storm which the industry will not be able to weather.
Your email address will not be published. Required fields are marked *
